Streetwise Professor

October 4, 2018

Elon Musk: Nemesis Has Been Stayed, but Hubris Remains

Filed under: Energy,Regulation — cpirrong @ 7:02 pm

As most of you probably know by now, Elon Musk settled with the SEC.  Though, perhaps it would be more accurate to say that the SEC settled with Elon Musk.  The settlement over last weekend was apparently on the very same terms that he rejected at the end of the week.  Uhm, who leaves a rejected offer on the table, especially when that offer was a gift because the case against Musk was extremely strong.

Apparently it is because Elon is deemed the Indispensable Man.  SEC Chair Jay Clayton said that the settlement was best for Tesla shareholders.  Musk supposedly threatened to quit as CEO unless the board backed him to the hilt.  So apparently both caved to the legend of Elon.

The board’s action is somewhat expected–after all, they are Elon’s co-dependents and enablers.  The SEC’s actions are rather more disappointing.  My best explanation is that the SEC filed suit against Musk only because if they hadn’t they would have been a laughingstock given the outrageousness of Musk’s actions.  Their heart wasn’t in it, however, and they were willing to capitulate rather than bear responsibility for Tesla’s fate.  The fundamentals haven’t changed, and Tesla’s future is still fraught.

And Elon hasn’t changed either.  Even a mild settlement spurred his narcissistic rage, which he expressed in a tweet scorning the SEC as the “Shortseller Enrichment Commission.”  Still obsessed with shorts, still unable to handle any criticism, still unable to count his blessings.

This is the man whom the SEC apparently deems indispensable, and believes is the best guardian of Tesla shareholders’ interests.

Perhaps the judge who must approve the settlement will find the SEC’s arguments unpersuasive.  She has asked for each side to file briefs defending the settlement.  This briefing is pro forma, but in past years–in dealing with big banks and brokers like BofA and Merrill, anyways–judges have rejected SEC settlements.   Perhaps that will happen here.  Tesla stock sank today on the news of the judge’s request, and sank more post-close after Elon’s tweeter tantrum.

Even if the judge blesses the settlement, Tesla still faces its chronic cash flow issues.  The settlement may make it somewhat easier to go to the capital market–although that would potentially–and should–trigger another investigation and perhaps suit given Elon’s adamant denials of the need to do so.  But even with a settlement, recent events have no doubt made it harder–and costlier–for the firm to sell more stocks and bonds.  Elon got off easy once.  Given that he clearly hasn’t changed–and what 47 year olds do, really?–there is a serious risk that (a) he won’t get off so easy next time, and (b) there will be a next time.  That will affect the receptiveness of the capital markets to Tesla’s voracious cash needs.

In sum, by the grace of the SEC, Nemesis has been stayed for now.  But Hubris remains.  Meaning that Nemesis may well return, more vengeful than before.

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September 28, 2018

Hubris Brings Nemesis: Elon Musk Faces Legal Accountability (At Last)

Filed under: Energy,Regulation — cpirrong @ 9:40 am

Soon after the news of the SEC securities fraud lawsuit against Elon Musk, Tim Newman tweeted “Finally says @streetwiseprof.”  Indeed I did.

I am mildly surprised, but presumably Musk’s actions were so outrageous that the SEC couldn’t avoid taking action.

Although it shouldn’t be an issue, because Musk had to have known that his going private tweets were false, the law forecloses any “it was secured in my own mind” defense: recklessness–that he should have known the tweets were materially false–satisfies the scienter requirement.  At least that’s the case for the civil action: I’m not sure about any criminal action by the DOJ.

Several people emailed me soon after the announcement, and my response was (in addition to “It’s about time”): Is this just the first step?  Will the SEC (and perhaps DOJ) expand its investigation, and eventually legal action, to include Musk’s myriad previous dodgy statements?  SolarCity came to mind.  This SeekingAlpha post has a nice summary of some(!) of the others:

There’s been plenty of talk regarding SEC action since the day Elon Musk issued the go private tweet. With the news out Thursday, many would argue that a substantial overhang has been lifted from the stock, but of course, it brings up a lot of other issues that I’ve detailed above. Unfortunately, investors should consider the possibility that more shoes will drop.

There already have been many lawsuits filed from investors who have lost money during this whole fiasco. Additionally, there may be even more action from a number of government bodies. Who knows if the SEC is looking at other items like the Model 3 production ramp or the mysterious solar roof product? Perhaps they might even take a look at this blog post where Elon Musk talked about discussions for going private going back two years. He’s bought tens of millions in Tesla shares since, so would that be trading on material non-public information (insider trading)? Perhaps an investigation is started related to end of quarter sales tactics, where it seems Tesla is holding back deliveries of vehicles despite consumers paying for them. Some say this would be an effort to add much needed cash to the balance sheet or book unearned revenues for quarter’s end.

Not to mention missed production deadlines, the supercharger rollout, and on and on and on.  And what could a deep dive into Tesla’s accounting reveal?

Elon’s co-dependents, AKA the Tesla Board of Directors, came out in his support.

Good luck with that!  Though truth be told, they are so deeply connected to Elon that it would be pointless to try to cut loose from him now: their best bet is to go to the mattresses with him.  Not a good bet, but their best one.

A friend has repeatedly asked me why haven’t there been class action lawsuits.  My reply: not until there is a big break in the stock price.  That is occurring now.  So I wouldn’t stand in front of federal courthouses in the SDNY or NDCal for fear of being trampled by class action attorneys rushing to file.

The knock-on effects of this are many.  As I’ve written repeatedly, despite Elon’s denials (another possible legal vulnerability!) Tesla needs cash.   I don’t see a public equity or debt raise being remotely possible now, which would cripple the company’s ability to grow–and fulfill Elon’s grandiose promises.  Moreover, Elon has borrowed extensively against Tesla stock.  Margin call, anyone?  And if that happens, what will he do and how will that impact the stock?

It was only a matter of time before Elon’s words–and his tweets–came back to haunt him.  The only surprise is that it took such a long time.  But his aura as a visionary protected him.

There is an element of Greek tragedy here.  Hubris brings nemesis.  To say that Elon exhibited hubris is the understatement of the century.  If nemesis is even remotely proportional to hubris, he is in for hellish torments.

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September 26, 2018

We’re From the International Maritime Organization, and We’re Here to Help You: The Perverse Economics of New Maritime Fuel Standards

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 6:26 pm

This Bloomberg piece from last month claims that the International Maritime Organization’s looming 2020 caps on sulfur emissions from ships “could lift crude prices by $4 a barrel when the measures come into effect in 2020.”

Not so fast.  It depends on what you mean by “crude.”  According to the International Oil Handbook, there are 195 different streams of crude oil.  Crucially, the sulfur content of these crudes varies from basically zero to 5.9 percent.  There is no such thing the price of “crude,” in other words.

The IMO regulation will have different impacts on different crudes.  It will no doubt cause the spread between sweet and sour crudes to widen.  This happened in 2008, when European regulation mandating low sulfur diesel kicked in: this regulation contributed to the spike in benchmark Brent and WTI prices, and wide spreads in crude prices.  During this time, (if memory serves) 10 VLCCs full of Iranian crude were swinging at anchor while WTI and Brent prices were screaming higher and sweet crude inventories were plunging precisely due to the fact that the regulation increased the demand for sweet crude and depressed demand for heavier, more sour varieties.

The IMO regulation will definitely reduce the demand for crude oil overall.   The demand for crude is derived from the demand for fuels, notably transportation fuels.  The regulation increases the cost of some transportation fuels, which decreases the (derived) demand for crude.  This change will not be distributed evenly, with demand for light, sweet crudes actually increasing, but demand for sour crudes falling, with the fall being bigger, the more sour the crude.

The regulation will hit ship operators hard, and they will pass on the higher cost to shippers.  In the short run, carriers will eat some of the cost–perhaps the bulk of it.  But the long run supply elasticity of shipping is large (arguably close to perfectly elastic), meaning after fleet size adjusts shippers will bear the brunt.

The burden will fall heaviest on commodities, for which shipping cost is large relative to value.  Therefore, farmers and miners will receive lower prices, and consumers will pay higher prices for commodity-intensive goods.  Further, this regulatory tax will be highly regressive, falling on relatively low income individuals, who pay a higher share of their income on such goods.

This seems to be a case of almost all pain, little gain.  The ostensible purpose of the regulation is to reduce pollution from sulfur emissions.  Yes, ships will produce less such emissions, but due to the joint product nature of refined petroleum, overall sulfur emissions will fall far less.

Many ships currently use “bottom of the barrel” fuel oil that tend to be higher in sulfur.  Many will achieve compliance by shifting to middle distillates.  But the bottom of the barrel won’t go away.  Over the medium to longer term, refineries will make investments that allow them to squeeze more middle distillates out of a barrel of crude, or to remove some sulfur, but inevitably refineries will produce some low-quality, high sulfur products: the sulfur has to go somewhere.  This is inherent in the joint nature of fuel production.

And yes, there will be some adjustments on the crude supply side, with the differential between sweet and sour crude favoring production of the former over the latter.   But sour crudes will be produced, and new discoveries of sour crude will be developed.

Meaning that although consumption of high sulfur fuels by ships will go down, since (a) in equilibrium consumption equals production, and (b) due to the joint nature of production the output of high sulfur fuels will go down less than its consumption by ships does, someone will consume most of the fuel oil that ships no longer used.  And since someone is consuming it, they will emit the sulfur.

The most likely (near term) use of fuel oil is for power generation.  The Saudis are planning to ramp up the use of 3.5 percent sulfur fuel oil to generate power for AC and desalinization.  Other relatively poor countries (e.g., Bangladesh, Pakistan) are also likely to have an appetite for cheap high sulfur fuel oil to generate electricity.

The ultimate result will be a regulation that basically shifts who produces the sulfur emissions, with a far smaller impact on the total amount of emissions.

This represents a tragic–and classic–example of a regulation imposed on a segment of a larger market.  The pernicious effects of such a narrow regulation are particularly acute in oil, due to the joint nature of production.

Given the efficiency and distributive effects of the IMO, it is almost certainly not a second best policy.  Indeed, it is more likely to be a second worst policy.  Or maybe a first worst policy: doing nothing at all is arguably better.


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September 25, 2018

Default Is Not In Our Stars, But In Our (Power) Markets: Defaulting on Power Spread Trades Is Apparently a Thing

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Regulation — cpirrong @ 6:34 pm

Some other power traders–this time in the US–blowed up real good.   Actually preceding the Aas Nasdaq default by some months, but just getting attention in the mainstream press today, a Houston-based power trading company–GreenHat–defaulted on long-term financial transmission rights contracts in PJM.  FTRs are financial contracts that have cash-flows derived from the spread between prices at different locations in PJM.  Locational spreads in power markets arise due to transmission congestion, so FTRs can be used to hedge the risk of congestion–or to speculate on it.  FTRs are auctioned regularly.  In 2015 GreenHat bought at auction FTRs for 2018.  These positions were profitable in 2015 and 2016, but improvements in PJM transmission caused them to go underwater substantially in 2018.  In June, GreenHat defaulted, and now PJM is dealing with the mess.

The cost of doing so is still unknown.  Under PJM rules, the organization is required to liquidate defaulted positions.  However, the bids PJM received for the defaulted portfolio were 4x-6x the prevailing secondary market price, due to the size of the positions, and the illiquidity of long-term FTRs–with “long term” being pretty much anything beyond a month.  Hence, PJM has requested FERC for a waiver to the requirement for immediate liquidation, and the PJM membership has voted to suspend liquidating the defaulted positions until November 30.

PJM members are on the hook for the defaulted positions.  The positions were underwater to the tune of $110 million as of June–and presumably this was based on market prices, meaning that the cost of liquidating these positions would be multiples of that.  In other words, this blow up could put Aas to shame.

PJM operates the market on a credit system, and market participants can be required to post additional collateral.  However, long-term FTR credit is determined only on an annual basis: “In conjunction with the annual update of historical activity that is used in FTR credit requirement calculations, PJM will recalculate the credit requirement for long-term FTRs annually, and will adjust the Participant’s credit requirement accordingly. This may result in collateral calls if requirements increase.”  Credit on shorter-dated positions are calculated more frequently: what triggered the GreenHat default was a failure to make its payment on its June FTR obligation.

This event is resulting in calls for a re-examination of  PJM’s FTR credit scheme.  As well it should!  However, as the Aas episode demonstrates, it is a fraught exercise to determine the exposure in electricity spread transactions.  This is especially true for long-dated positions like the ones GreenHat bought.

The PJM episode reinforces the Aas episode’s lessons the challenges of handling defaults–especially of big positions in illiquid instruments.  Any auction is very likely to turn into a fire sale that exacerbates the losses that caused the default in the first place.  Moral of the story: mutualizing default risk (either through a CCP, or a membership organization like PJM) can impose big losses on the participants in risk pool.

The dilemma is that the instruments in question can provide valuable benefits, and that speculators can be necessary to achieve these benefits.  FTRs are important because they allow hedging of congestion risk, which can be substantial for both generation and load: locational spreads can be very volatile due to a variety of factors, including the lack of storability of power, non-convexities in generation (which can make it very costly to reduce generation behind a constraint), and generation capacity constraints and inelastic demand (which make it very costly to increase generation or reduce consumption on the other side of the constraint).  So FTRs play a valuable hedging role, and in most markets financial players are needed to absorb the risk.  But that creates the potential for default, and the very factors that make FTRs valuable hedging tools can make defaults very costly.

FTR liquidity is also challenged by the fact that unlike hedging say oil price risk or corn price risk, where a standard contract like Brent or CBT corn can provide a pretty good hedge for everyone, every pair of locations is a unique product that is not hedged effectively by an FTR based on another pair of locations.  The market is therefore inherently fragmented, which is inimical to liquidity.  This lack of liquidity is especially devastating during defaults.

So PJM (and other RTOs) faces a dilemma.  As the Nasdaq event shows, even daily marking to market and variation margining can’t prevent defaults.  Furthermore, moving to a no-credit system (like a CCP) isn’t foolproof, and is likely to be so expensive that it could seriously impair the FTR market.

We’ve seen two default examples in electricity this past summer.  They won’t be the last, due the inherent nature of electricity.


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September 20, 2018

The Smoke is Starting to Clear from the Aas/Nasdaq Blowup

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 11:08 am

Amir Khwaja of Clarus has a very informative post about the Nasdaq electricity blow-up.

The most important point: Nasdaq uses SPAN to calculate IM.  SPAN was a major innovation back in the day, but it is VERY long in the tooth now (2018 is its 30th birthday!).  Moreover, the most problematic part of SPAN is the ad hoc way it handles dependence risk:

  • Intra-commodity spreading parameters – rates and rules for evaluating risk among portfolios of closely related products, for example products with particular patterns of calendar spreads
  • Inter-commodity spreading parameters – rates and rules for evaluating risk offsets between related product


CME SPAN Methodology Combined Commodity Evaluations

The CME SPAN methodology divides the instruments in each portfolio into groupings called combined commodities. Each combined commodity represents all instruments on the same ultimate underlying – for example, all futures and all options ultimately related to the S&P 500 index.

For each combined commodity in the portfolio, the CME SPAN methodology evaluates the risk factors described above, and then takes the sum of the scan risk, the intra-commodity spread charge, and the delivery risk, before subtracting the inter-commodity spread credit. The CME SPAN methodology next compares the resulting value with the short option minimum; whichever value is larger is called the CME SPAN methodology risk requirement. The resulting values across the portfolio are then converted to a common currency and summed to yield the total risk for the portfolio.

I would not be surprised if the handling of Nordic-German spread risk was woefully inadequate to capture the true risk exposure.  Electricity spreads are strange beasts, and “rules for evaluating risk offsets” are unlikely to capture this strangeness correctly especially given the fact that electricity markets have idiosyncrasies that one-size-fits all rules are unlikely to capture.  I also conjecture that Aas knew this, and loaded the boat with this spread trade because he knew that the risk was grossly underpriced.

There are reports that the Nasdaq margin breach at the time of default (based on mark-to-market prices) was not nearly as large as the €140 million hit to the default fund.  In these accounts, the bulk of the hit was due to the fact that the price at which Aas’ portfolio was auctioned off included a substantial haircut to prevailing market prices.

Back in the day, I argued that one of the real advantages to central clearing was a more orderly handling of defaulted portfolios than the devil-take-the-hindmost process in OTC bilateral markets (cf., the outcome of the LTCM disaster almost exactly 20 years ago–with the Fed midwifed deal being completed on 23 September, 1998). (Ironically spread trades were the cause of LTCM’s demise too.)

But the devil is in the details of the auction, and in market conditions at the time of the default–which are almost certainly unsettled, hence the default.  The CME was criticized for its auction of the defaulted Lehman positions: the bankruptcy trustee argued that the price CME obtained was too low, thereby harming the creditors.   The sell-off of the Amaranth NG positions in September, 2006 (what is it about September?!?) to JP Morgan and Citadel (if memory serves) was also at a huge discount.

Nasdaq has been criticized for allowing only 4 firms to bid: narrow participation was also the criticism leveled at CME and NYMEX clearing in the Lehman and Amaranth episodes, respectively.  Nasdaq argues that telling the world could have sparked panic.

But this episode, like Lehman and Amaranth before it, demonstrate the challenges to auctioning big positions.  Only a small number of market participants are likely to have the capital, or the risk appetite, to take on a big defaulted position in its entirety.  Thus, limited participation is almost inevitable, and even if Nasdaq had invited more bidders, there is room to doubt whether the fifth or sixth or seventh bidder would have been able to compete seriously with the four who actually participated.  Those who have the capital and risk appetite to bid seriously for big positions will almost certainly demand a big discount to  compensate for the risk of holding the position until they can work it off.  Moreover, limited participation limits competition, which should exacerbate the underpricing problem.

Thus, even with a structured auction process, disposing of a big defaulted portfolio is almost inevitably something of a fire sale.  This is a risk borne by the participants in the default fund.  Although the exposure via the default fund is sometimes argued to be an incentive for the default fund participants to bid aggressively, this is unlikely because there are externalities: the aggressive bidder bears all the risks and costs, and provides benefits to the rest of the other members.  Free riding is a big problem.

In theory, equitizing the risk might improve outcomes.  By selling shares in the defaulted portfolio, no single or two bidders would have to absorb the entire position and risk could be spread more efficiently: this could reduce the risk discount in the price.  But who would manage the portfolio?  What are the mechanics of contributing to IM and VM?  Would it be like a bad bank, existing as a zombie until the positions rolled off?

Another follow-up from my previous post relates to the issue of self-clearing.  On Twitter and elsewhere, some have suggested that clearing through a 3d party would have been an additional check.  Surely an FCM would be less likely to fall in love with a position than the trader who puts it on, but the effectiveness of the FCM as a check depends on its evaluation of risk, and it may be no smarter than the CCP that sets margins.   Furthermore, there are examples of FCMs having the same trade in their house account as one of their big customers–perhaps because they think the client is really smart and they want to free ride off his genius.  As a historical example, Griffin Trading had a big trade in the same instrument and direction as its biggest client.  The trade went pear-shaped, the client defaulted, and Griffin did too.

I also need to look to see whether Nasdaq Commodities uses the US futures clearing model, which does not segregate positions.  If it does, and if Aas had cleared through an FCM, it is possible that the FCM’s clients could have lost money as a result of his default.  This model has fellow-customer risk: by clearing for himself, Aas did not create such a risk.

I also note that the desire to expand clearing post-Crisis has made it difficult and more costly for firms to find FCMs.  This problem has been exacerbated by the Supplementary Leverage Ratio.  Perhaps the cost of clearing through an FCM appeared excessive to Aas, relative to the alternative of self-clearing.  Thus, if regulators blanch at the thought of self-clearing (not saying that they should), they should get serious about addressing the FCM cost issue, and regulations that inflate these costs but generate little offsetting benefit.

Again, this episode should spark (no pun intended!) a more thorough reconsideration of clearing generally.  The inherent limitations of margin models, especially for more complex products or markets.  The adverse selection problems that crude risk models can create.  The challenges of auctioning defaulted portfolios, and the likelihood that the auctions will become fire sales.  The FCM capacity issue.

The supersizing of clearing in the post-Crisis world has also supersized all of these concerns.  The Aas blowup demonstrates all of them.  Will CCPs and regulators take heed? Or will some future September bring us the mother of all blowups?

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August 25, 2018

Elon Musk Channels Emily Litella: Nevermind (About That Going Private Thingy)

Filed under: Economics,Energy,Regulation — cpirrong @ 6:49 pm

Elon Musk took to YouTube to make a big announcement about his plans to take Tesla private:


Just kidding.  Like a thief in the night, Elon disclosed that he was not proceeding with his brilliant plan in a blog post that was posted at 11ET last night–Friday night.

Quite the weasel move.  I say when you screw up, man up.  But not our Elon.  He took the coward’s way out with a Friday night–late night–news dump.  Hell, he didn’t even Tweet it.

Of course the statement is filled with argle-bargle rationalizing the decision, and the previous big announcement about funding secured, $420/share, and all that.

He is sticking with the story that there was plenty of funding available.  Really?  Plenty of funding to take out shareholders at $420/share, and allow most of the existing shareholders to remain owners of the private firm in a magical structure never seen before, and almost surely a violation of the securities laws, and allow access to continued funds to fuel Tesla’s cash burn?

Musk of course had an alternative explanation for his U-turn: going private on the terms he had envisioned (or hallucinated) would be “even more time-consuming and distracting than initially anticipated.”

Yes, attempting the impossible usually is pretty time-consuming.

What next? Well, Tesla’s structural financial problems remain.  The company is facing the daunting challenge of navigating between the Scylla of Musk’s promise of no new capital raise and the Charybdis of the incessant cash burn.  Not to mention the problem of a delusional megalomaniac CEO.

Charley Grant of the WSJ has been skeptical of Musk–well, by journalist standards anyways–but he misdiagnoses his and the company’s current predicament.  Grant says that Musk made two mistakes in 2016–buying Solar City, and plunging ahead with the Model 3.  But Musk really had no choice on either: letting SCTY fail or ditching the everyman’s EV would have undermined Musk’s aura in 2016–and that aura is what has kept the capital flowing since.  If he had not done these things, Musk would have faced two years ago the problems he does now.

The other night I watched a BBC documentary about the Wars of the Roses, in which narrator (and historian) Dan Jones argued that Richard III wasn’t evil–the choices he made (killing Lord Rivers, kidnapping and then likely killing the princes in the Tower) weren’t really choices.  If he hadn’t done those things he would have faced immediate doom.  By doing them he bought some time–and delayed his doom.  Richard did what was necessary to survive to fight again another day.

Methinks Musk’s situation is similar.

I was amused that Morgan Stanley had announced Thursday that it was advising Musk on the going private plan, and then Musk pulls the plug about 40 hours later.  Does it really take that long to say “are you out of your fucking mind?”  Or did it take them that long to recover from the giggles? Or maybe Elon just sat on the bad news from MS until he could release it with the least attention possible.

The only real questions remaining are: (a) what caused Elon’s synapses to conceive of this brilliant plan?, and (b) will there be legal consequences?

Insofar as (a) is concerned: LSD? Lack of sleep? Impending mental breakdown? Or was there something more desperately Machiavellian about it?  Regardless, I can’t think of an explanation that bodes well for Tesla.

With regards to (b).  It is so blindingly obvious now (and should have been from word one) that his announcement Tweets were materially false.  They had large impacts on the price of Tesla stock.  They followed years of other dubious announcements, both on Twitter and in SEC filings and investor disclosures. If the SEC lets this slide it will make a mockery of the securities laws, and suggest that there are different standards for some people.

Some have suggested that the SEC is reluctant to take actions that will kill Tesla, or crater its stock price.  Well, why should Tesla be any different than other companies?  SEC actions have cratered other firms. (Dynegy is an example that comes to mind.)   The stock price falls were features, not bugs.  The SEC actions cratered these other firms because they revealed widespread wrongdoing and material falsity in corporate disclosures that had caused stock prices to be greatly inflated.  Why would the SEC want to perpetuate inflation in Tesla’s stock price?  If the stock price can’t handle the truth, well, that would be the problem that the SEC is supposed to be addressing, wouldn’t it?

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August 13, 2018

Elon’s Magical Mystery Tour Gets More Magical By the Day: $80 Billion Is Only the Beginning

Filed under: Economics,Energy,Regulation — cpirrong @ 8:14 pm

The Elon Magical GoPrivate Mystery Tour gets more magical by the day.  Today Elon tried to do some ‘splainin’, but his explanation was effectively a guilty plea.  He said that he left a late-July meeting with the head of the Saudi investment fund convinced that it would fund the transaction.

Legal memo to Elon: “secured in my mind” is not the same as secured, secured, all legal and such.  Even if–especially if–you are a legend in your own mind.

Musk’s explanation is more of a guilty plea than a defense.  The intersection between “funding secured” and “conversations are ongoing” is a set of measure zero.

Then there’s the magical structure.  As I noted in an earlier post, he wants it all ways.  He wants to be a private firm, but still have a herd of small shareholders.  In other words, he wants a structure that does not exist, most likely because it violates the securities laws.

There’s also another issue that has received no real attention, though it should.  All of the figgerin’ I’ve seen so far just totes up the amount of money required to buy out Tesla shareholders at $420/share.

But that’s just the start!  Tesla has been a cash bleeder for years, and has gone to the secondary offering well again and again to raise the money necessary to fund its operations and capex.  There is no prospect of that ending soon–indeed, one of the reasons I suspect Elon is throwing this Hail Mary is the fundamental inconsistency between his recent assertions that no additional capital raises would be necessary and the need for further funds.

So any sugar daddies will not merely have to stump up as much as $80 billion to buy the outstanding equity–they will have to commit to fund it while it continues to be cash flow negative to the sum of ~$500 million-$1 billion per quarter.

Going private deals are usually done for cash-flow positive companies.  They are levered up and use the cash flows to service the debt.  The PE dealmakers extract cash at the beginning, and definitely don’t plan to inject more cash for the indefinite future. That traditional framework obviously can’t work for Tesla.  So not only is the legal structure that Musk has mooted a figment of his imagination, the economic model is also fantastical.

But other than that, the deal sounds totally great, Elon.

One final note that makes me chuckle.  Elon made his big announcement on Twitter.  He has also blocked a lot of people on Twitter–including me in 2013 or 2014.  Well, selective disclosure of public information–giving it to some people earlier than others–violates Reg FD (“Regulation Fair Disclosure”).  So by (a) blocking me (and many others) on , and (b) running his big brain waves through Twitter, Elon might have committed other securities violations.





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August 7, 2018

Always Remember–Elon Rhymes With Con

Filed under: Economics,Energy — cpirrong @ 6:26 pm

Today on Twitter Elon Musk floated the possibility of taking Tesla private.  Perhaps coincidentally, it was revealed that the Saudis have accumulated a stake in Tesla worth a couple of billion.  Adding two and two, many have leaped to the conclusion that the Saudis will be in essence the private equity firm behind the deal, perhaps as part of some futuristic hedge against the end of oil.

As with all things Elon, look for the con.  Case in point.  He hyped the Tesla takeover of Solar City as the creation of a visionary vertically integrated clean energy company.  I saw it as a way of preventing an embarrassing bankruptcy of Solar City, and of bailing out Musk relatives using Tesla shareholder money.  The wind-down of Solar City’s business pretty much has proven me correct.  And  all talk of the visionary vertical integration strategy has ceased.  Indeed, the lack of discussion of the solar business reminds me of the old expression “don’t speak ill of the dead.”

So what’s the angle here?  I conjecture as follows.  Tesla is still losing money hand over fist.  It is burning less cash–but only because it has slashed expenses and capex–which puts a crimp in its growth plans.  And “burning less” is a relative statement–it is still a world class incendiary.

In the past Elon has fed the cash machine with stock and bond sales.  But he has publicly stated repeatedly that no future capital raises will be necessary.  It is clear, however, that such promises are not credible.  He has also promised that profits are just around the corner.  But that promise is also hardly credible, especially after serial failures to deliver on past promises.

This puts Elon in a bind.  He needs money, but a capital raise would (a) hammer is already tottering reputation, and (b) more seriously, create a huge risk of shareholder lawsuits and an SEC securities fraud case.

Further, it is clear that Elon finds many aspects of running a public company distasteful.  He particularly hates analysts (stock analysts, not psychiatrists, though maybe he hates them too!) who question his judgment, his statements, and sometimes his sanity.

He also hates short sellers.

So how to escape these problems? Easy–go private! Especially if the world’s deepest pockets are behind it.  No need for a public capital raise.  No more pesky outsiders questioning his competence, strategy, or behavior.  No more short selling a-holes.

The trifecta.

Of course, maybe Elon is just attempting to goose the stock price and inflict some pain on the shorts.  But if this is the case, he is digging his securities fraud hole deeper.

As for the Saudi angle.  A big bet on Tesla would be a rather foolhardy way to hedge against the end of oil.  It is a hedge rife with idiosyncratic risks–Tesla’s mercurial CEO being just one of them.  A more diversified strategy–investing in battery technology, and cobalt mines, and the like–would make more sense.

It will be entertaining to watch this spectacle unfold.  The one thing I can be sure of is that the story that Elon tells will not be the true story.  So look for the angle, and watch for the con.  My conjecture is plausible, but it is not the only possible scenario.  But whatever scenario plays out, it is likely to be as crooked as a dog’s leg.

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July 24, 2018

Who Knew Igor Was a Deadhead?: Sechin Plays Shakedown Street

Filed under: Economics,Energy,Politics,Russia — cpirrong @ 6:14 pm

The Sechin business model is clearly not to generate profit through canny investment, careful stewardship of capital, and containing cost.  Rather, it could be called The Rent Seeking Variations.

One of Sechin’s favorite variations is to pump up a flagging bottom line by shaking down his erstwhile partners.  The classic in this genre is the takeover of Bashneft at a knockdown price extracted by putting its owner Sistema under extreme legal pressure, which Sechin followed by suing Sistema for alleged misappropriations, which were only vaguely pleaded, and which if anything suggested that Rosneft was delinquent in its due diligence.

Sechin is now replaying this gambit, this time with its partners is Sakhalin I–which include ExxonMobile.  Again, the allegation is lacking in specifics.  Rosneft accuses the partners of “unjust enrichment” in 2015 and 2016.  In a world-class, epic act of projection, Rosneft accuses Exxon Neftgaz and the others of “interest gained by using other people’s money.”

The case was filed on Sechin’s home court–the arbitrage court on Sakhalin.  I seriously doubt that Exxon would have put itself into a situation where it was at the mercy of a Russian kangaroo court, so no doubt the first battle will be jurisdictional.

Sechin succeeded against Bashneft and Sistema in large part because Russia put its main shareholder Vladimir Yevtushenkov in jail at one point, and clearly was in a position to do it again.  ExxonMobil and the others in the partnership are less vulnerable, and Exxon in particular is used to these sorts of bruising battles.  So Igor has his work cut out for him.

For a while–during the Tillerson years–Exxon and Rosneft were chummy.  Sanctions put a kaibosh on the relationship, and this is clearly a signal that they are sooooo over.  Which just leaves Rosneft even more isolated than before, and unlikely to attract technology, expertise, and money from a major foreign power anytime soon absent some exchange of hostages that will curb Sechin’s predatory instincts.

The fallout for Russia more broadly is also clearly negative.  This is just another indication of its opportunistic and predatory approach to foreign investment, which just will raise further barriers to such investment in the future.

Operating on Shakedown Street can be lucrative in the short run, but pretty soon you run out of suckers to shake down.

Perhaps counterintuitively to some, this is an indication of why freaking out over Russia is so overdone.  Its internal dysfunction has hampered, hampers, and will hamper in the future its economic performance, and hence its potential to build capability to challenge the US in a serious way.   Yes, it can be a pain, but the very aspects of its system that make it so objectionable also serve to undermine its ability to pose a serious threat to any major power.

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July 16, 2018

Oil Spreads Go Non-Linear (Due to Infrastructure Constraints), To the Chagrin of Many Traders: The Pirrong Commodity Catechism in Action

Filed under: Commodities,Economics,Energy,Exchanges — cpirrong @ 3:59 pm

When I wrote about the demise of GEM Trading a few weeks ago, I hypothesized that sharp movements in various spreads had been its undoing.  A story in Reuters says that GEM was not the only firm rocked by these changes.  Big boys–including BP, Vitol, Trafigura, and Gunvor–have also suffered, and the losses have caused traders their jobs at Gunvor and BP:

The world’s biggest oil traders are counting hefty losses after a surprise doubling in the price discount of U.S. light crude to benchmark Brent WTCLc1-LCOc1 in just a month, as surging U.S production upends the market.

Trading desks of oil major BP and merchants Vitol , Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.

The sources did not give precise figures for the losses, but they said they were enough for Gunvor and BP to fire at least one trader each.

The story goes on to say that binding infrastructure constraints are to blame, which is certainly the case.  But implicit in the article is a theme that I have emphasized for literally years (I recall incorporating this into my class lectures in about 2004).  Specifically, bottlenecks imply that marginal transformation costs (e.g., marginal costs of transporting oil between Cushing and the GOM) tend to rise very steeply when capacity constraints are reached.  That is, when you are operating at say 90 percent of capacity, variations in utilization have little impact on marginal transformation costs, but going from 95 to 96 can cause costs to explode, and basically go vertical as capacity is reached.

This has an implication for spreads.  Another part of the Pirrong Commodities Catechism is that spreads equal marginal transformation costs, and are essentially the shadow prices on constraints.  The behavior of marginal transformation costs therefore has implications for spreads: in particular, spreads can be very stable despite variations in the utilization of transformation assets, but as utilization nears capacity, the spreads become much more volatile.  Moreover, and relatedly, small changes in fundamentals can lead to big moves in spreads when constraints start to bind.  The relationship between fundamentals and spreads is non-linear as capacity constraints become binding, and well, here spreads have gone non-linear, to the chagrin of many traders.

Put differently, spread trades aren’t always “widowmakers” (as the article calls them)–sometimes they are quite safe and boring.  But when bottlenecks begin to bind, they can become deadly.

There is one odd statement in the article:

“As the exporter of U.S. crude, traders are naturally long WTI and hedge their bets by shorting Brent. When the spreads widen so wildly, you lose money,” said a top executive with one of the four trading firms.

Well, why would you hedge WTI risk with Brent?  You could hedge your WTI inventory by selling . . . WTI futures.  The choice to “hedge” WTI by selling Brent is effectively a choice to speculate on the spread.  That brings to mind the old Holbrook Working adage that hedging is speculation on the basis.  The difference here is that most, say, country grain elevators about which Working was mainly writing had no choice in hedging instrument (at least not in liquid ones), and perforce had to live with basis risk if they wanted to eliminate flat price risk.  Here, BP and Gunvor and the rest had the choice between two liquid instruments, and if the “top executive’s” statement is correct, deliberately chose the one that exposed them to greater spread (basis) risk.

So this isn’t an example of “sometimes stuff happens when you hedge.”  The firms chose to expose themselves to a particular risk.  They took a punt on the spread, which was effectively a punt that infrastructure constraints would ease.  They lost.

In my 2014 white paper on commodity trading firms (sponsored by Trafigura, ironically) I noted that to the extent that they speculate, commodity trading firms tend to speculate on the spreads, rather than flat prices, because that’s where they have something of an information advantage.  But as this episode shows, that advantage does not immunize them against risk.

This also makes me wonder about the risk models that the firms use, which in turn affect the sizes of positions traders can put on, and where they put them on.  I, er, speculate that these risk models don’t take into account the non-linearity of spread risk.  If that’s true, traders would have been able to put on bigger positions than they would have been had the risk models accurately reflected those risks, and further, that they were incentivized to do these trades because the risk was underpriced.

All in all, an interesting casebook study of commodity trading–what can go wrong, and why.

Correction: Andrew Gowers, head of corporate affairs at Trafigura says in the comments that (a) Trafigura did not suffer a loss, and (b) the company had told this to Reuters prior to the publication of the article.  I have contacted the editor of the story for an explanation.

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