Streetwise Professor

April 29, 2024

Learning by Doing in Solar, Even if Proven, Would Not Imply Solar Was Subsidized Too Little, Too Late

Filed under: Climate Change,Economics,Energy,Politics,Regulation — cpirrong @ 10:01 am

The estimable Francis Menton has noted repeatedly that the “energy transition” has set loose upon the world a host of innumerates who assure us that they know best when in fact they know less than nothing. And perhaps to coin a phrase, I would add that they are ineconimate, i.e., know nothing about economics. Arrogance and ignorance is a lethal combination. Such people will make us poor, and likely shivering in the dark.

Alas, the mind eating virus has even infected many who were once sensible, or at least periodically sensate or sentient. Such as the FT’s Tim Harford. (I am guessing that the brain eating ameobae at the FT have finally gotten to him.)

Harford wrote that instead of saying “I could’ve had a V8” 40 years ago, we should have said “I could’ve subsidized solar and then all our energy and climate problems would have been already solved.”

In a nutshell, Harford invokes learning by doing, which he refers to as Wright’s Law in honor of an aeronautical engineer in the 1930s who first identified this phenomenon. It has since been documented in numerous other areas, starting probably with Liberty Ships in WWII.

Yes, LBD is a thing. It has been part of the theory of economic growth since at least the 1970s, starting most notably with Paul David’s work on the antebellum cotton spinning industry in the US, and earlier than that even with work by Kenneth Arrow. Robert Lucas taught about it in the economic growth undergraduate (!) course I took as a small child at Chicago in 1981, FFS. (What a privilege and experience it was to be in that course.) I was so taken by the subject that my paper for George Stigler’s economic policy course in 1982 (when he won the Nobel Prize) examined empirically learning by doing at the Springfield and Harpers Ferry Arsenals prior to 1860. It’s hardly a new idea, or an unexplored one.

Alas, there are numerous problems with Harford’s application of LBD/Wright’s Law to solar.

One issue is: who is to say that the highly touted reductions in the cost of solar aren’t due to LBD?

That is, since cumulative output in solar panels has indeed increased dramatically over the years, learning would presumably have taken place and that plausibly accounts for some of the cost reductions. Harford himself says “PV is now so cheap that the question is moot.” So, perhaps LBD did its work.

Empirical evidence would be nice. And at most what Harford is saying is that we could have learned earlier. But if the learning has taken place (as evidenced by it being “so cheap”), albeit belatedly, solar should be taking over the world now, without subsidies, right?

Further, if Harford really means that too little learning has taken place, or it has occurred too late, then that would require (a) externalities/spillovers in learning, (b) the large subsidies to solar (which Harford pooh-poohs) were in fact too small and/or too late to generate the right amount of learning at the right time, and (c) market participants were unaware of the spillovers and did not take obvious steps to internalize them. He provides support for none of these.

With respect to externalities, it is not obvious that LBD effects are largely external to firms. Firms may be able to keep the benefits of their experience largely to themselves. To the extent they are internalized, there is no rationale for subsidies, and competitive firms will treat current production in part as an investment in future lower costs and expand output accordingly without need for government support or protection.

(NB. Non-compete agreements may be one way firms attempt to keep the benefits of experience internalized. I will soon write a post on the idiocy of the FTC’s ban of such agreements.)

I have analyzed LBD in the US shale sector in detail. I have found extensive learning effects, but the evidence for learning spillovers is weak. A firm’s own experience contributes more to its productivity than collective industry experience. This is evidence that learning is internalized.

Further, firms respond rationally to spillovers–by trying to internalize them. Mergers, consolidation, and concentration are means of internalizing learning. I note that consolidation is coming to shale only after more than a decade after the industry dramatically increased output and drilling experience.

In shale, it is plausible that much of the learning is done by service firms who internalize the benefits. Thus, even to the extent that industry experience explains productivity improvement, to the extent that service firms who, well, service the industry are the ones who generate this learning, these industry experience effects may be internalized as well.

That is, just because there is learning by doing, doesn’t necessarily mean that there are learning spillovers of the type that justify subsidies (or tariffs) to increase output (and hence learning). And if there are, there are strong economic incentives to internalize them. And if there aren’t, there’s no justification for subsidization. (David’s work on the cotton industry addressed the question of whether tariffs to stimulate domestic cotton cloth output were justified because of learning spillovers.)

All of these factors undercut the argument that the PV industry learned too little, too late. Where is the evidence that PV is unlike shale, and characterized by large learning spillovers which industry participants did not attempt to internalize through merger or other means? (I would also like to highlight the irony that Harford’s argument would imply that shale, for which there is actual evidence of LBD, should have been subsidized decades ago.)

Harford also has a myopic focus on PV cost, and fails to consider the total cost of renewables, including solar. Like other renewables, solar has intermittency and diffusiveness problems. Moreover, it has large and predictable output fluctuations (e.g., the “duck curve” problem in which solar output plunges when the sun starts to set). Due to these inherent features, useful solar will require beyond revolutionary innovations in battery technology (something Menton has analyzed in detail) that are not anywhere on the horizon.

(I note that battery technology has been the subject of massive research. It has also experienced tremendous growth in cumulative output, which has presumably contributed to learning. Yet it is nowhere even close to being an economical way to address output variability for renewables.)

Word to the wise: we are not going to be able to learn our way out of the sun rising, and more importantly setting. Or out of rain, clouds, and hailstorms. Or out of voracious needs for land to site renewables. Or out of the difficulties of disposing defunct panels.

Solar is part of a complex energy system. The cost of solar panels is actually among the least important aspects of the cost of relying on solar as a source of energy.

And talk about hindsight. Harford laments our failure to gaze into the distant future and foresee with precision the obsession with CO2 and climate change, and supersize solar panel output in time to provide cheap solar power when those obsessions became manifest. Yeah, and I should have invested in Apple when Harford says we should have subsidized solar. Or Bitcoin in 2013.

In sum, Harford’s woulda, coulda, shoulda lament in the FT is yet another example–as if more were needed–of the intellectual vacuity of those hyping the “energy transition.” Harford invokes a respectable economic concept–learning by doing–but does so in a superficial way that betrays a complete lack of understanding of it. And in a way that also betrays a lack of understanding of the real challenges of transforming an extremely complex energy system. Cheap solar panels may be a necessary condition for a cheap transition, but it’s hardly a sufficient one, or indeed, even likely an important one.

Alas, learning by doing doesn’t appear to apply in the writing of newspaper columns.

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April 20, 2024

Why Do Governments Repeatedly Engage in Energy and Environmental Boondoggles?

Filed under: Climate Change,CoronaCrisis,Economics,Energy,Politics,Regulation — cpirrong @ 1:34 pm

In the Wealth of Nations, Adam Smith famously wrote:

By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland? (WN IV.ii.15)

This came to mind when reading this Bloomberg article about an “efuels” venture:

At its plant, electrolyzers break down water into hydrogen and oxygen, using electricity generated from nearby wind and solar farms. The hydrogen is then transported to a reactor, where it meets CO2 captured from local refineries, setting off a series of complex chemical reactions aided by patented catalysts. The result is a synthetic fuel with the same chemical properties as its fossil fuel-based cousins.

Yes, this process can create “equally good” fuel as traditional hydrocarbons. But at what cost? Well, they could tell you, but then they’d have to kill you:

How Infinium fits into that future remains to be seen. Schuetzle is tight-lipped about the company’s exact plans. While acknowledging that Infinium’s e-fuel is “more expensive” than conventional fuel, he didn’t disclose the cost difference. 

Probably not the 30x of Adam Smith’s Scottish wine, but evidently a large enough multiple to frighten the horses if disclosed.

Because of this cost differential, this industry will come into existence only as the result of heavy-handed government policy, in the form of subsidies, kneecapping competitors (namely traditional fuels), or more likely both. And echoing Smith, the question becomes “is it a reasonable law or policy to rig they system to favor this technology, merely to encourage the making of efuels?”

Smith did not answer his question because it answered itself. And the same is true of mine.

To repurpose an old joke, the government wants to address climate change in the worst way, and it is. Picking technologies that are feasible but exorbitantly costly in order to achieve a putatively desirable objective is a tried and false modus operandi of government. And this has been especially true of environmental and energy policies in the United States going back to the dawn of the EPA in the early 1970s, and the energy crisis of the mid-to-late 1970s.

I recall the “synfuels” boondoggles of the late-70s, e.g., making oil from shale. No, not the shale revolution you might be thinking of that actually resulted in the economical production of vast amounts of crude oil and natural gas, but taking shale rock in Wyoming with embedded hydrocarbons, subjecting it to energy intensive transformations (redolent of those described above for the efuels project) to produce oil at vastly higher cost than even the then-elevated price of conventionally produced oil. The government spent billions back when a billion actually meant something on this effort (and other synfuel efforts). And every dollar was wasted.

And reading the Bloomberg article demonstrates that the government, in its wisdom, is doing Adam Smith one better: it wants to mandate technologies that don’t really exist (unlike Smith’s “glasses, hotbeds, and hotwalls”):

Some regulators seem to agree with that thinking. The EU will phase out government subsidies for e-fuel made with fossil fuel-sourced CO2 by 2041. 

In its place, governments will mandate that efuels be made from CO2 obtained from air capture, a technology that the Bloomberg article describes as “nascent” but is more accurately described as “pie in the sky” (literally, in this case).

This generation of efuels will come into existence only as the result of government diktat, just as the first generation–ethanol and biodiesel–did. And the efuel technological greenhouse forcing is just one small part of an array of mandating of technology choices, all in the name of fighting global warming. The electrification of everything is if anything a more extreme example: the EPA’s mileage mandates (intended to make ICE vehicles uncompetitive with EVs), its emission standards for fossil fuel generation, and the lavish subsidization of inefficient (because diffuse and intermittent) renewables are if anything more egregious than growing the efuels industry like orchids.

But bureaucrats are geniuses, and will only do what’s best, right? Right? To disabuse yourself of such notions, refer back to the synfuels case discussed above. Or consider two more recent examples.

One was the European policy to force the replacement of gasoline engines with diesel ones in passenger vehicles, with the unintended–but totes foreseeable–result of increased particulate emissions (and widespread fraud by automakers to conceal that). Europe had to jettison that policy, so it has substituted another: eliminating ICE vehicles altogether. I’m sure that will work out swell.

Another that I find particularly rich is the sulfur standards for marine fuels introduced in 2020. In another unintended (but again foreseeable) consequence, the resulting reduction in particulate emissions is allegedly contributing to global warming. The irony behind this (compounded by the fact that efuels funder Bill Gates is also a fan of this technology) is demonstrated by serious proposals–recently experimented with–to inject particulates into the atmosphere to, yes, mitigate global warming.

So why do governments repeatedly adopt excessively costly policies to address putative problems? One part of the answer is hubris combined with the knowledge problem: they think they know a lot more than they do. But that’s not the entire answer.

At root, I think the more fundamental driver is public choice-related. Specifically, specific technologies have specific constituencies who would benefit from their subsidization (or other forms of policy support). They exert influence on legislators and bureaucrats to implement policies that favor them. (It is not a coincidence, comrades, that Bill Gates and the like have connections with many of these schemes.)

In contrast the effects of policies such as a carbon tax or cap and trade are much more diffuse and far less predictable because the ultimate outcome would be determined by market processes in a complex system. Adjustments would occur on myriad margins, not just by large firms but billions of individuals. The winners and losers in such a process are unknown, unknowable, and highly diffuse–these are not the concentrated interests that exert disproportionate influence on public policy.

(NB: I am not endorsing a carbon tax or cap and trade. I merely assert that they would be better ways of reducing carbon emissions than subsidizing or mandating technologies to do so. An exercise in the Theory of the Second Worst, if you will.)

In sum, political systems produce bad “solutions” to problems because of the very nature of politics, a nature that Mancur Olson and others pointed out years ago. A nature in which “public choice” means that the public gets screwed.

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April 9, 2024

To Call Biden Administration Energy Policy “Schizo” Is an Insult. To Schizos.

Filed under: Commodities,Economics,Energy,Politics,Russia — cpirrong @ 3:13 pm

Not surprisingly given its avatar, the Biden administration is a picture of drooling incoherence. This is especially true when it comes to energy policy and the Russo-Ukrainian War and especially the intersection of these.

Case in point. The administration constantly asserts that it is a vital US interest for Ukraine to prevail and Russia to lose. Secretary of State Blinken went so far as to promise that Ukraine would join Nato, despite the fact that this is akin to waving a red flag in front of a bull (in the form of Putin). Ukraine must win! We must provide massive military aid! UKRAINE MUST WIN! FREEDOM AND OUR DEMOCRACY ARE AT STAKE!

But not if it raises the price of gasoline in an election year, apparently. In recent months one of Ukraine’s most successful gambits has been drone attacks on Russian oil refineries. These attacks focused on distillation units, the disabling of which sharply cuts refinery output. As a result, Russian refined product output is supposedly down around 10-15 percent, exports of gasoline have been banned for six months, and the country is desperately seeking imports of gasoline from Kazakhstan. This is a serious economic blow to Russia, and also crimps military efforts which are obviously dependent on fuel supplies.

Further, the impact is likely to be long lasting because repairs depend on foreign parts and foreign expertise that Russia cannot readily obtain due to sanctions.

These attacks are also mirror images to Russia’s relentless bombardments of Ukrainian energy facilities, especially electric power generation.

Especially given the trivial resources devoted to the campaign (which is carried out using drones), this is arguably one of the most effective measures that Ukraine has implemented in the two plus years of war.

So given the allegedly existential stakes in a Ukrainian victory, the administration is gung ho in its support for these attacks, right? Right?

Wrong! The administration, first in the form of the execrable Ichabod Crane doppelgänger Jake Sullivan, then in the form of the utterly embarrassing Secretary of Defense Lloyd “AWOL” Austin, is intensely pressuring Ukraine to cease its campaign against Russian refineries.

Why? Because it might raise gasoline prices. It’s an election year dontcha know:

The incoherence is only compounded when you consider the administration’s antipathy for fossil fuels in its obsession over climate change. The administration thinks that fossil fuels are really, really bad, m’kay, and wants to reduce sharply their use. What better way to do that but to make them more expensive?

Now that I mention it, none, actually. Demand curves slope down. So for the climate change obsessed, burning Russian refineries and the consequent increase in fuel prices is a good thing. A great thing, according to the theory of the second best! And something that harms our alleged arch enemy to boot! What could be better?

Well, what could be better to someone who thinks logically is the real question. The freak out over the refinery attacks is clearly symptomatic of people who refuse to think logically. People who apparently elide the word “foolish” from Ralph Waldo Emerson’s epigram that “a foolish consistency is the hobgoblin of little minds.”

The administration’s draining of the Strategic Oil Reserve is another example of its foolish inconsistency.

There are many other examples. One that also checks the Russia and energy boxes is the insane pause on US LNG development approvals. This will also “impact global energy markets,” and not in a good way. And in particular not in a way that helps those whom we hope will help Ukraine.

When European natural gas prices reached stratospheric levels in the immediate aftermath of Russia’s invasion of Ukraine, Biden proclaimed that the US had Europe’s back, and would replace Russian gas with good ol’ ‘Merican LNG.


The administration’s obsession with keeping down the most visible price of energy (that paid at the gas pump) also clashes starkly with an array of other policies that will dramatically increase the cost of energy. The push towards electrification of everything, with the electricity generated by renewables, is just one example. Renewables are not cheap. They are expensive. Hella expensive–just look at how much higher electricity costs are in jurisdictions here (e.g., California) and abroad (e.g., Denmark and Germany) where renewables penetration is highest. Driving up demand (e.g., by penalizing the use of ICE vehicles) of a high cost resource is a recipe for higher energy costs. Much higher.

The force feeding via vast subsidies of high cost efuels and hydrogen will also inflate energy costs, though here (not coincidentally) the cost will be concealed in your tax bill and higher interest rates (required ot get people to buy US debt).

In sum, to call Biden administration energy policies “schizo” is an insult. To schizos. It is full spectrum contradiction and incoherence that simultaneously strives to lower energy costs and raise them, and to protect Russia while demonizing it.

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April 1, 2024

Resource Nationalism and Nationalization is the Root of Corruption

Filed under: Commodities,Economics,Energy — cpirrong @ 5:35 pm

Recently major commodity trading firms have plead guilty to, and/or had employees convicted of, violations of the US Foreign Corrupt Practices Act. The companies collectively have paid billions in fines, and the convicted traders face decades in the Club Fed.

Corruption is bad, uhm-kay, but the rather lurid focus on the traders is unbalanced and gives a misleading impression of the real root of this evil. It takes two to tango: in these situations, the briber and the bribe taker. Here the bribe takers are the real drivers, and they derive their power from the simple fact that they are agents of nationalized companies. That is, the “root causes” here are the nationalization of resources, and the creation of national companies that control access to resources. Yet the bribe payers get most of the attention.

The firms that have been charged and plead are not a random selection of trading companies. Instead, they are the biggest oil trading companies–Vitol, Trafigura, Gunvor, and Glencore. Not grain traders or softs traders or even the metals, natural gas, or power trading operations of these companies. Why? Because whereas national oil companies are common, traders dealing outside oil markets are typically not dealing with national companies.

As the DOJ put it in its announcement of a $1.5 billion 2022 plea agreement with Glencore:

Between approximately 2007 and 2018, Glencore and its subsidiaries caused approximately $79.6 million in payments to be made to intermediary companies in order to secure improper advantages to obtain and retain business with state-owned and state-controlled entities in the West African countries of Nigeria, Cameroon, Ivory Coast, and Equatorial Guinea. (Emphasis added.)

The fundamental problem here is that South American and African countries with oil tend to be extremely corrupt. Indeed, they are likely corrupt in large part because they have oil. It is also likely that national oil companies are the norm in such places precisely because they provide a structure that allows elites to appropriate oil resource rents (via bribery and various tunneling schemes).

Levying substantial penalties on trader will reduce these companies’ derived demand for corruption, and this will reduce bribery income of kleptocrats. But if the big guys leave, or sharply reduce their activities in these countries, their place will be taken by dodgier outfits who will pay bribes. The recent experience with Russian and Venezuelan sanctions shows that eliminating illicit transactions in oil is devilish hard.

The incentive is immense. According to the DOJ, Glencore paid about $80 million over 11 years to get access to oil flows that generated hundreds of millions in profit–roughly a 5-to-1 ratio. Basically what will happen is that the dodgier outfits will pay lower bribes to get these benefits, with the lower bribes being a compensating differential for the legal risk.

Nationalization was originally adopted because international oil companies (IOCs) were allegedly exploiting nations with oil resources. Even if that was indeed true, nationalization merely changed the identity of the exploiters from the IOCs to local elites who obtained power by force, or yes corruption, or both. Further, nationalized companies are notoriously inefficient and putting them in charge has reduced the value of oil resources, further reducing the benefits that the citizens of these nations (as opposed to the elites) derive from these resources. (To get an extreme example of the grotesque inefficiency of nationalized companies, look at PDVSA especially starting with Chavez over 20 years ago. But wherever you look, the inefficiencies are manifest.)

In sum, bribery by major oil trading firms is just another symptom of an underlying disease–resource nationalism. The focus on the payers of bribes, rather than on those who demand and receive them, obscures that fundamental truth.

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January 27, 2024

The “Pause” on LNG Permitting: Another Manifestation of “Elite” Hatred of Humanity, and a Monument to Stupidity

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 7:25 pm

The Braindead Administration–sorry, sorry, the Brandon–I mean Biden!–Administration (understandable confusion there)–has announced a pause on permitting on new liquified natural gas (LNG) terminals. And how long a pause? How ’bout to a quarter ’til never:

The review will take months and then will be open to public comment which will take further time, Energy Secretary Jennifer Granholm told reporters in a teleconference.

This policy, if one can dignify it with such an appellation, is a sop to the ecoloonies upon whom the administration depends for support:

The growth [in LNG exports] has set off protests from environmentalists, part of Biden’s base. Activists say new LNG projects can harm local communities with pollution, lock in global reliance on fossil fuels for decades, and lead to emissions from burning gas and from leaks of the powerful greenhouse gas methane.

In brief, the administration (regime, really) wants to kneecap the remarkable energy revolution of the past 20 years, which has seen technological innovations that have turned the US from a nation worried about where its next MMBTU would come from to a natural gas production powerhouse, and which have allowed others to share in its bounty with the world.

But you see, to the ecoloonies that’s the bad news. Really bad. Climate change, dontcha know.

But even evaluated on those (dubious) terms, the policy is demented. Because the ecoloonies don’t understand basic economics. They are myopic, linear thinkers who are incapable of analyzing the ultimate impact of their policy.

In their thinking, less LNG exports from the US equals less fossil fuel consumption equals lowers carbon emissions equals saving the polar bears. Even overlooking the (again dubious) last step in the logical chain (hey, I’m a a generous guy) the analysis is flawed. Where it definitely breaks down is the third, and arguably the second, steps.

Yes, reducing US natural gas output (by choking one source of demand) will reduce world natural gas production. But the resulting higher world price will induce higher output by competing producers (e.g., Qatar, Australia, PNG, Africa, etc.), resulting in a net decline in world gas production smaller than the decline in US production–and it is world production that matters when considering “well mixed” GHGs. Further, some production that would have otherwise been exported will be consumed domestically instead, meaning that a given decline in exports does not result in an equal decline in production.

But more importantly, the rise in the price of gas relative to other fuels–notably coal–will induce substitution towards those fuels. Since those fuels are more carbon intensive than natural gas, it is possible, and indeed likely, that the net effect of the policy would be to increase the output of GHGs.

So at the very least, the amount of reduction in GHGs resulting from this policy will be far smaller than the reduction in US LNG exports that it will cause, and plausibly will result in an increase of GHGs.

Well played! All pain, no gain!

But the economic idiocy of ecoloonies is an old story by now. Perhaps you’ve read of the recent finding that the ban on “single use” plastic bags in New Jersey led to a tripling of consumer plastics consumption because of the substitution effects that the ban induced. Again, myopic, linear, one-step ahead thinking led to a policy that produced perverse results.

The foregoing analysis focuses on only one dimension–GHG output. But one also has to consider the cost incurred to achieve any GHG gains (if there are any, that is). But trade-offs (costs vs. benefits) is not something that ecoloonies do. They are monomaniacs, and monomaniacs don’t evaluate trade-offs.

This policy will also shtup European allies, whom in the aftermath of the Russian invasion of Ukraine Biden promised would receive bountiful supplies of US gas.

To paraphrase Animal House: “You fucked up, Europe! You trusted Biden!”

The administration pinky swears that

the pause would not hurt allies, saying the plan will come with exemptions for national security should they need more LNG.

Yeah, because it’s just like turning the faucet on and off, right?

If you believe what they say, you are truly an idiot and probably believe they’ll respect you in the morning.

But none of this should be a surprise. After all, this is an administration that is infested with members of the “elite,” and which counts on the “elite” for its support. According to a recent Rasmussen poll:

An astonishing 77% of the Elites – including nearly 90% of the Elites who graduated from the top universities – favor rationing energy, gas, and meat to combat climate change. Among all Americans, 63% oppose rationing.

Face it. They hate your guts and want you to suffer. This “pause” on LNG exports is just another manifestation of their hatred.

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December 5, 2023

Luddism in the Oil Futures Markets

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 1:06 pm

The old, old game of Pin the Tail on the Speculator has been updated. According to Bloomberg, the speculators who now “disrupt” the oil markets are not human: they are bots. Specifically, bots operated by Commodity Trading Advisors (CTAs).

This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.

Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:

Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.


Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.

The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.

With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).

Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.

Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.

Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”

So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.

As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:

There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.

Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:

That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.

It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.

Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:

Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.

But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:

The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.

It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.

The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.

How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.

As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.

Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.

So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.

That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.

And another paragraph in the Bloomberg article suggests at what is actually happening here:

The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.

What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”

Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.

Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.

It does not mean that they are making the markets move.

So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.

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September 3, 2023

Shell Has a Come to Jesus Moment: Will the Politicians? Alas, Probably Not.

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 3:22 pm

In 2010, along with my UH colleagues Victor Flatt and Praveen Kumar, I taught what I believe was the first academic carbon trading course in the world. My lectures in the course related to the economic challenges of creating traded commodities, specifically the challenges of merely defining what the commodity is and monitoring adherence to the standards so established.

Now, this may seem trivial, but even something like “wheat” poses challenges due to heterogeneity related to quality (even within a given variety, such as soft red winter wheat) and monitoring whether the wheat traded under a contract adhered to the relevant terms agreed to by the parties. Indeed, as I noted in an early article of mine, the genesis and early development of commodity exchanges like the Chicago Board of Trade and the Liverpool Cotton Exchange was not driven by the desire to trade futures: these were cooperative, private efforts to define property rights and to create a mechanism to standardize commodities and to adjudicate contractual disputes primarily over quality. Only after these challenges were met was it possible to trade futures. Standards (and their enforcement) are obviously a necessary condition for trading standardized instruments like futures.

The major intended takeaway from my lectures in 2010-11 was that the problems of standard definition and especially standard enforcement were even more daunting in carbon than in traditional commodities like wheat or cotton, and that this was especially true with respect to carbon offsets–things like contracts to plant trees to capture carbon.

How do you define what is being bought and sold? How do you monitor whether the offset contracted for performs as agreed? How do you address contract performance failures? The Chicago Board of Trade struggled for years to overcome these issues in wheat and corn and oats in the post-Civil War era, even though the trade was relatively geographically concentrated, the contracts were of relatively short duration (typically for a single consignment), and the commodity was relatively simple.

All of these challenges are far greater for carbon, let alone for offsets. Sources of carbon emissions are numerous and diffuse and costly to monitor. With respect to offsets, they are highly heterogeneous; have very long lives; require continuous investment and upkeep; and have highly unpredictable performance (e.g., the forest that you plant may burn down, or be ravaged by insects). These contracts are far more complex than a deal to buy 10,000 bushels of SRW winter wheat for delivery in Chicago next month. Moreover, many offsets are located in countries with weak–and sometimes close to non-existent–legal systems.

Furthermore, the incentives of the parties to these agreements can be perverse, especially for “voluntary” offsets. A buyer who pumps its ESG score by purchasing offsets that turn out not to perform seldom suffers serious adverse consequences (although there is some backlash against “greenwashing”), and the seller has a strong incentive to collect the cash and not make the necessary expenditures to ensure that the offset performs as promised.

I taught the class in the immediate aftermath of the Global Financial Crisis, and I suggested that there were a lot of similarities between offsets and the kinds of deals that wreaked havoc in the banking system in 2008-2009, where bankers paid their bonuses upfront based on imagined profits predicted by highly speculative models to be realized over several years churned out garbage securities.

In 2010 I was therefore extremely skeptical about the viability of markets for offsets. And the defects that I talked about have been increasingly recognized in the last year or so.

I believe that the actions of Shell during the last week represent an authoritative recognition that these predictable–and predicted–problems have come to pass. Like other (especially European) energy firms. Shell made ambitious carbon reduction pledges that it intended to meet largely through the use of offsets. But reality has reared its ugly head, and Shell is all but abandoning this strategy. Other companies (e.g., Microsoft) say that they are still committed, but if they are even remotely interested in spending their shareholders’ money wisely, they will eventually have the same come to Jesus moment as Shell.

A Shell-funded mangrove restoration project in Senegal (Bloomberg).

This represents another grievous blow to the ambitions of the Net Zero fanatics. Offsets are a major component of Net Zero plans. Renewables are another part–and reality is catching up with that too (as the travails of Danish renewables developer Orsted and German turbine manufacturer Siemens demonstrate).

But will the fanatics be deterred? Alas, it appears not. Indeed, they appear to be doubling down, as illustrated by lunatics like Michael Gove:

Net Zero and the policies intended to bring it about–including extensive reliance on renewables and offsets–are a guaranteed recipe for an impoverished future. This was predictable–and predicted–more than a decade ago. But when will the madness end? I am guessing not before these policies cause economic catastrophe.

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July 14, 2023

The Hydrogen Economy, or The Hindenberg Economy? Or, Gosplan Goes Gassy

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 12:32 pm

The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).

It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.

There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:

Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.

We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.

Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.

But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.

Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.

According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital,  which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”

Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!

John Kerry flogged the risk issue on MSNBC (h/t Powerline):

“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”

Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).

I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!

Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)

At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?

In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”

The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.

One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:

Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.

The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.

I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.

I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.

Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.

One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).

The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.

Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.

And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.

Some examples.

I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.

Does the CEA (or John Kerry!) believe the shale sector in the US is too small?

Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.

LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)

The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.

I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)

In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.

I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.

Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.

The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.

I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).

Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.

One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.

In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.

The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.

What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.

A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.

All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.

In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.

I crack myself up sometimes.

In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.

All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.

In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.

What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.

Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.

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June 6, 2023

Stop Me If You’ve Heard This Before: Those Damned Speculators Are Screwing Up the Oil Market!

Filed under: China,Commodities,Derivatives,Economics,Energy,Russia — cpirrong @ 1:05 pm

Saudi Arabia is fussed at the low level of oil prices. So true to form with those unsatisfied with price, they are rounding up the usual suspects. Or in this case, suspect–speculators!

I’m sure you never saw that coming, right?

As the world’s biggest oil producers gather here Sunday to decide on a production plan, the spotlight is on the cartel kingpin’s fixation on Wall Street short sellers. Abdulaziz has lashed out repeatedly this year against traders whose bets can cause prices to fall. Last week he warned them to “watch out,” which some analysts saw as an indication that the Organization of the Petroleum Exporting Countries and its allies may reduce output at their June 4 meeting. A production cut of up to 1 million barrels a day is on the table, delegates said Saturday. 

Claude Rains is beaming, somewhere.

I’m so old that I remember when oil prices were beginning their upward spiral in 2007-8 (peaking in early-July), in an attempt to deflect attention from OPEC and Saudi Arabia, one of Abdulaziz’s predecessors blamed the price rise on speculators too.

Is there anything they can’t do?

Not that I’m conceding that speculators systematically or routinely cause the price of anything to be “too high” or “too low,” but if you do think that they influence price, they should be Abdulaziz’s best buddies. After all, they are net long now and almost always are. (Cf. CFTC Commitment of Traders Reports.)

If the Saudis (and other OPEC+ members) have a beef with anybody, it is with their supposed ally, Russia. Russia had supposedly agreed to cut output in order to maintain prices, but strangely enough, there is no evidence of reductions in Russian supplies reaching the world market, even despite price caps on Russian oil and the fact that they are selling it at a steep discount to non-Russian oil. Perhaps Russia has really cut output, but (a) that doesn’t really boost the world oil price if Russian exports haven’t been cut, and (b) it would mean that Russian domestic consumption is down, which would contradict Moscow’s narrative that the economy is hunky-dory, and relatively unscathed by sanctions.

But I think that the more likely story is that Russia is playing Lucy and the football with OPEC.

Which would be a return to form: see my posts from years ago. And I mean years ago. Apparently Won’t Get Fooled Again isn’t on Abdulaziz’s play list.

The other culprit behind lower oil prices is China: its tepid recovery is weighing on all commodity prices–not just oil. A fact that Abdulaziz should be able to understand.

But it’s much easier to shoot the messenger, and that’s what speculators are now–and almost always are. Venting at them probably makes Abdulaziz feel better, but even if he were to get his way that wouldn’t change the fundamental situation a whit.

Bashing speculators is what people who don’t like the price do. And since there’s always someone who doesn’t like the price (consumers when it’s high, producers when it’s low) bashing speculators has been and will continue to be the longest running show in finance and markets.

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May 9, 2023

Oh No Not This BS Again: The EU Looks to Regulate Commodity Trading Firms Like Banks

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 1:09 pm

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

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