Streetwise Professor

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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July 6, 2018

Chinese Oil Futures: Performing As Predicted

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:27 pm

The recent introduction of Shanghai oil futures has resulted in a lot of churn in the front month, and very little activity in even the 1st and 2nd nearby:

China’s new oil futures are a hit with investors but they’re facing commitment issues.

While daily volume in the yuan-denominated contract has increased five-fold since its debut in late-March amid steady growth in open interest, almost all trading is focused in front-month, September futures.

. . . .

It suggests that, for now, traders are using the futures principally to speculate on short-term price fluctuations, as opposed to hedge long-term consumption or production, according to Jia Zheng, a portfolio manager at Shanghai Minghong Investment Co.

Which is pretty much what I predicted on the day of the launch:

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

. . . .

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.


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June 28, 2018

A Tarnished GEM: A Casualty of Regulation, Spread Explosions, or Both?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 6:28 pm

Geneva Energy Markets LLC, a large independent oil market maker, has been shuttered.  Bloomberg and the FT have stories on GEM’s demise.  The Bloomberg piece primarily communicates the firm’s official explanation: the imposition of the Basel III leverage ratio on GEM’s clearer raised the FCM’s capital requirement, and it responded by forcing GEM to reduce its positions sharply.  The FT story contains the same explanation, but adds this: “Geneva Energy Markets, which traded between 50m and 100m barrels a day of oil, has sold its trading book after taking ‘significant losses’ in oil futures and options, a person close to the company said.”

These stories are of course not mutually exclusive, and the timing of the announcement that the firm is shutting down months after it had already been ordered to reduce positions suggests a way of reconciling them. Specifically, the firm had suffered loss that made it impossible to support even its shrunken positions.

The timing is consistent with this.  GEM is primarily a spread trader, and oil spreads have gone crazy lately.  In particular, spread position short nearby WTI has been killed in recent days due to the closure of Canadian oil sands production and the relentless exports of US oil.  The fall in supply and continued strong demand have led to a rapid fall in oil stocks, especially at Cushing.  This has been accompanied (as theory says it should be!) by a spike in the WTI backwardation, and a rise in the WTI-Brent differential (and other quality spreads with a WTI leg).  If GEM was short the calendar spread, or had a position in quality spreads that went pear-shaped with the explosion in WTI, it could have taken a big hit.  Or at least a big enough hit to make it unviable to continue to operate at a profitable scale.

Here’s a cautionary tale.  Stop me if you’ve heard it before:

“The notional value of our book was in excess of $50 billion,” Vonderheide said. “However, the actual risk of the book was always relatively low, with at value-at-risk at around $2 million at any given time.”

If I had a dollar for every time that I’ve heard/read “No worries! Our VaR is really low!” only to have the firm fold (or survive a big loss) I would be livin’ large.  VaR works.  Until it doesn’t.  At best, it tells you the minimum loss you can suffer with a certain probability: it doesn’t tell you how much worse than that it can get.  This is why VaR is being replaced or supplemented with other measures that give a better measure of downside risk (e.g., expected shortfall).

I would agree, however, with GEM managing partner Mark Vonderheide (whom I know slightly):

“The new regulation is seriously damaging the liquidity in the energy market,” Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

It makes it costlier to make markets, which erodes market liquidity, thereby making it costlier for firms to hedge, and more difficult to enter and exit positions.  Liquidity reductions resulting from this type of regulation tend to be most acute during periods of high volatility–which can exacerbate the volatility, perversely.  Moreover, like much of Frankendodd and its foreign fellow monsters, it tends to hit small to medium sized firms worse than bigger ones, and thereby contributes to greater concentration in the markets–exactly the opposite of the stated purpose.

As Reagan said: “The most terrifying words in the English language are: I’m from the government and I’m here to help.” Just ask GEM about that.

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May 24, 2018

Gazprom and Its Connected Contractors: The Credit Mobilier Scheme, With Russian Variations

Filed under: Commodities,Economics,Energy,History,Russia — The Professor @ 6:05 pm

A couple of SWP friends were kind enough to send me a copy of the swan song of one Alex Fak, an erstwhile senior analyst at Sberbank.  Alex lost his job because he committed a mortal sin: telling the truth, in this instance about the monstrosity that I have savaged for years–Gazprom.

Alex said that the oft-heard question “why does Gazprom do such stupid things?” is off base because it presumes that the company is run in the interest of shareholders: if it were, its unmatched record of value destruction would indeed be stupid.  However, Mr. Fax opined that the company’s actions over the decades are definitely not stupid if you evaluate them from the perspective of its contractors, who make massive amounts of money building obscenely negative NPV projects.

Why does this persist, in the Putin era, which allegedly cracked down on oligarchic thievery? Well, one reason is that the biggest contractors happen to be owned by–wait for it–the two biggest friends of Vova: Gennady Timchenko (a hockey buddy) and Arkady Rotenberg (a judo buddy).*  Putin did not eliminate oligarchs, so much as replace them with his cronies.  Calling out such connected men by name is no doubt why Mr. Fax is an ex-Sberbank analyst.  And saying this kind of thing puts him at risk of being an ex-person.

The Gazprom MO described by Mr. Fak  represents a continuation of, and a mega-sizing of, the bizness model of the 1990s, when the “red directors” of state-owned firms tunneled out huge amounts of funds by having their firms buy supplies and services at seriously inflated prices from firms owned by their relatives.

Indeed, in the pre-Cambrian days of this blog–2006(!)–I hypothesized that Gazprom and its contractors were in effect a Russian version of Credit Mobilier, the construction firm that the Union Pacific hired to build the railroad.

The WaPo article also mentions that Gazprom’s pipeline construction costs are two to three times industry norms. To me this suggests a Credit Mobilier-Union Pacific type situation, where inflated prices for materials and equipment flow into the pockets of companies owned by Gazprom managers. Just thinkin’.

Thomas C. Durant was the president of the Union Pacific–and the major shareholder in Credit Mobilier.  The UP paid Credit Mobilier around $94 million, and Credit Mobilier incurred only about $50 million in costs to build the UP.   The Gazprom arrangement is somewhat different given that neither Timchenko nor Rotenberg are executives at the Russian gas giant, but the basic idea is very similar. (I also noted early on that Transneft, the oil pipeline monopoly, operates on the same model.)  Gazprom and its contractors operate on the Credit Mobilier model, with Russian variations.

Once upon a time Gazprom CEO Alexei Miller boasted that he would make Gazprom the world’s first trillion dollar company.  Today it’s market cap is south of $55 billion.  Hey! anybody can be off by two orders of magnitude, right?

This is not surprising, because maximizing value to shareholders is not, nor has it ever been, the objective of Gazprom.  The objective is, and always has been, to divert resources to the politically connected via wasteful capital expenditures (that happen to be the revenues of the likes of Timchenko and Rotenberg).  Alex Fak understood this, and paid the price for shouting that the emperor had no clothes.

Both Gazprom and Rosneft are world leaders in destroying value, rather than creating it.  But this is a feature, not a bug, given the natural state political economy of Russia, which prioritizes rent creation and redistribution to the elite. And this is precisely why Russia’s pretensions to great power status rest on economic quicksand.  That should be blindingly obvious, and I am sure that Putin understands this at some level.  But revealed preference suggests that he values enriching his friends more than implementing the economic changes that would make his nation economically and militarily competitive.

*The sums tunneled from Gazprom to Timchenko make me laugh when I think about the oft-repeated allegation that oil trader Gunvor (half-owned by Timchenko) was a source of massive personal wealth for Putin (via Timchenko).  There was much more money to be made much closer to home, and completely outside the scrutiny of bankers and regulators.

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May 17, 2018

Rosneft: The Farce Continues

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 7:22 pm

Remember when the Russian government said it was going to privatize a piece of Rosneft? Hahahaha. That is so 2016–please try to keep up!  In its announcement of “Rosneft 2022” the company proposes to buy back about $2 billion in shares, which is just about 20 percent of the piece sold off in 2016–no, wait–2017–no, wait–2018.  Adding even more hilarity is that the buyback plan was apparently at the insistence of Qatar, the last buyer standing which agreed to buy most of the shares initially privatized, much to the relief of the banks (Intesa and unnamed Russian ones) who were wearing a big piece of the risk.

I’m guessing that this was one of the terms Qatar laid down to absorb the entire hand-me-down stake for the original 2016 price, even though in Euro terms Rosneft’s shares are substantially lower today (despite a rallying oil price!)

Quite the vote of confidence there, eh?  Well, not that that’s surprising.  The conspicuous failure of any Chinese buyer to step into the shoes of disgraced CEFC tells you just how much confidence Rosneft inspires these days.

I am hard pressed to recall such a farcical series of events involving a major company.  If this one of  Russia’s state champions, just think of the shape the palookas are in!

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Today’s Adventures in Trumpland

Filed under: Economics,Energy,Politics,Russia — The Professor @ 6:38 pm

The WSJ reports that the Trump administration has told Germany that the US would restart talks on a trade deal with Europe if Germany pulls the plug on support for the Gazprom-led Nord Stream project.  I find the linkage rather odd, but we’re talking the Trump administration here, and moreover, it may well be a brushback pitch after all of the German-led Eurowhining about the US: “Think it’s bad now? Let’s see what it’s like when I put my mind to it.”

One EU official responded as follows:

“Trump’s strategy seems to be to force us to buy their more expensive gas, but as long as LNG is not competitive, Europe will not agree to some sort of racket and pay extortionate prices,” an EU official said.

I could perhaps take this seriously, were it not for the fact that Germany forces its own citizens to pay “extortionate prices” for power produced by outrageously uncompetitive means as a result of its idiotic energiewende policy.

How extortionate? How uncompetitive? The article claims that US LNG would cost about 20 percent more than Russian gas.  Well, Germans pay approximately 50 percent more for power than the average across the EU, and EU-wide average prices are about double the US average.

In other words, Europe has its own energy extortion racket in place, and doesn’t want to let in any Americans.

The other interesting aspect to this story is that it is yet another example (I’ve lost count of the number) of the alleged Putin pawn Trump taking a major shot at the Russians.  The Russians are not pleased:

The Kremlin shot back immediately as spokesman Dmitry Peskov called the U.S. efforts “a crude effort to hinder an international energy project that has an important role in energy security.”

“The Americans are simply trying crudely to promote their own gas producers,” he said.

All I can say is that if Trump was bought, he sure as hell didn’t stay bought.  Not that any of those who have invested their entire being in the Trump-Russia collusion narrative will bother to notice.

Speaking of the obsessed and delusional, yesterday represented an all time low in the dishonesty of the inveterate Trump haters.  In a meeting with law enforcement officers, Trump called members of the brutal Salvadoran gang MS-13 “animals,” but the media and many politicians widely asserted that he was referring to immigrants as a whole.  If you read the transcript, it is clear that only someone who is deeply and deliberately dishonest could make such an assertion.

The fallback position of these reprobates is that well, MS-13 members are people too, so it is wrong to call them animals.

All right, if that’s what you think–prove it.  Invite a few to move in with you, and you can discuss the nuances of “kill, rape, and control” (“mata, viola, controla“) which just so happens to be the MS-13 motto. (Some say that “rob” is part of the motto too.)  If you’re real nice, they just might honor your request not to bring those icky guns into your house, and will just bring their machetes instead.  After a few verses of Kumbaya, I’m sure that your common humanity will shine through, along with some light illuminating the hole in your neck where your head used to be.

Of course, that will never happen.  Those who are preening and posing would never dare even enter the neighborhoods where MS-13 and similar gangs operate, let alone invite them into their houses.

Further: by defending these beasts, our better thans are condemning decent and innocent people whom they claim to care about to their depredations.

This is the worst kind of moral posing by the worst kind of poseurs.  These are twisted partisan hacks pretending to be moral titans. To let their rank partisanship utterly blind them to the reality of evil, and to ignore those who will have to suffer from that evil, is appalling beyond words.

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May 15, 2018

Contrary to What You Might Have Read, the Oil Market (Flat Prices and Calendar Spreads) Is Not Sending Mixed Signals

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:27 pm

In recent weeks, the flat price of crude oil (both WTI and Brent) has moved up smartly, but time spreads have declined pretty sharply.  A common mistake by oil market analysts is to consider this combination of movements anomalous, and an indication of a disconnect between the paper and the physical markets.  This article from Reuters is an example:

Oil futures prices have soared past three-year highs, OPEC’s deal has cut millions of barrels of inventory worldwide and investors are betting in record numbers that prices could rocket past $80 and even hit $90 a barrel this year.

But physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

The divergence is notable because traditionally, physical markets are viewed as a better gauge of short-term fundamentals. Crude traders who peddle cargoes to refineries worldwide say speculators are on shaky ground as they drive futures markets above $70 a barrel, their highest levels for three-and-a-half years, on concerns about tighter supply from Venezuela and the potential impact of U.S. sanctions on supply from Iran.

Investors have piled millions of dollars in record wagers in the options market, betting on a further rally on the back of rising geopolitical tensions, particularly in Iran, Saudi Arabia and Venezuela, and the global decline in supply.

“Guys who are trading futures have a view that draws are coming and big draws are coming,” a U.S.-based crude trader at a global commodity merchant said, adding that demand could ramp up as global refinery maintenance ends.

. . . .


Those on the front lines of the physical market are not convinced. Traders say the surge in U.S. exports to more than 2 million bpd has saturated some markets, leaving benchmark prices ripe for a correction.

“There is a huge disconnect between futures and fundamentals,” a trader with a Chinese independent refiner said. “I won’t be surprised if prices correct by $20 a barrel.”

In fact, the alleged “disconnect” is readily explained based on recent developments in the market, notably the prospect for interruption/reduction in Iranian supplies due to the reimposition of sanctions by the US.  The situation in Venezuela is exacerbating this situation.  Two things are particularly important in this regard.

First, the Iranian situation is a threat to future supplies, not current supplies: the potential collapse in Venezuela is also a threat to future supplies (although current supplies are dropping too).  A reduction in expected future supplies increases future scarcity relative to current scarcity.  The economically efficient response to that is to share the pain, that is, to shift some supply from the present to the future by storage.  To reward storage, the futures price rises relative to the spot price–that is, the time spread declines.  However, since the driving shock (the anticipated reduction in future supplies) will result in greater scarcity, the flat price must rise.

A second effect works in the same direction. This is a phenomenon that I worked out in a 2008 paper that later was expanded into a chapter my book on commodity price dynamics.  Both the US actions regarding Iran, and the current tumult in Venezuela increase uncertainty about future supplies.  The efficient way to respond to this increase in fundamental uncertainty is to increase inventories, relative to what they would have been absent the increase.  This requires a decline in current consumption, which requires an increase in flat prices.  But incentivizing greater storage requires a fall in calendar spreads.

An additional complicating factor here is the feedback between inventories or calendar spreads (which are often used as a rough proxy for inventories, given the opacity and relative infrequency of stocks numbers) and OPEC decisions.  To the extent OPEC uses inventories or calendar spreads as a measure of the tightness of the supply-demand balance, and interprets the fall in calendar spreads and the related increase in inventories (or decline in the rate of inventory reductions), it could respond to what is happening now by restricting supplies . . . which would exacerbate the future scarcity. Relatedly, a known unknown is how current spread movements reflect market expectations about how OPEC will respond to spread movements.  The feedback/reflexivity here (that results from a price maker/entity with market power using spreads/inventory as a proxy for supply-demand balance, and market participants forming expectations about how the price maker will behave) greatly complicates things.  Misalignments between OPEC behavior and market expectations (and OPEC expectations about market expectations, and on an on with infinite regress) can lead to big jumps in prices.

Putting to one side this last complication, contrary to what many analysts and market participants claim, the recent movements in flat prices and spreads are not sending mixed signals.  They are a rational response to the evolution in market conditions observed in recent weeks: a decline in expected future supply, and an increase in fundamental risk.  The theory of storable commodities predicts that such conditions will lead to higher flat prices and lower calendar spreads.

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May 4, 2018

Stick a Fork In It: It’s Done

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 10:02 am

Glencore has just announced that the deal to sell Rosneft shares to CEFC has been terminated.  Furthermore, the QIA-Glencore consortium is being wound up, with virtually all of the shares going to QIA:

The members of the Consortium have agreed to dissolve the Consortium originally put in place in December 2016 for the purposes of acquiring a 19.5% stake in Rosneft and will take direct ownership of the underlying Rosneft shares.  In connection with that, the Consortium has today entered into an agreement to transfer a 14.16% stake in Rosneft to a wholly owned subsidiary of QIA (the “Transaction”) the consideration for which will to be used for the settlement of the Consortium’s liabilities. This agreement will become effective on 7 May 2018.

On completion of the Transaction, the Consortium will be wound up and the margin guarantees provided by Glencore will be terminated.  At that point, Glencore will retain an equity stake in Rosneft shares commensurate with its original equity investment announced in January 2017, which amounts to 0.57%, and QIA will hold an equity stake of 18.93%.

Meaning that in reality, as I noted at the outset of the deal, Glencore was basically a straw buyer–a beard–to provide the appearance of western corporate participation in the deal.

The price is also interesting:

The consideration for the Transaction attributable to Glencore’s interest in the Consortium (being 50% of the consideration for the Transaction) is approximately EUR 3.7 billion.

Well, the original December 2016 price was EUR 10.2 billion, meaning that this price is at a 25 percent discount from the original deal.

Who ate this difference?  Glencore?  I doubt it, but if it did, it would raise huge questions about its disclosures (or lack thereof) at the time of the original deal.  Regardless, this is yet another example of Glencore playing with fire.  What comes after trifecta?

I further note that whereas it was rumored that a Chinese state company would step into the shoes of CEFC, this hasn’t happened.  Yet, anyways.

Some state champion, that Rosneft, eh?

Update.  Some arithmetic.  The sums disclosed by today’s announcement basically indicate that Qatar assumed all but Glencore’s sliver at an amount equal to the original amount of the deal agreed to in December, 2016–including the mystery €2.2 billion which pretty much everybody but me and Ivan Tkachaev at RBC missed.  Qatar originally put up €2.5b, Glencore €.3b, and Intesa €5.2b, which adds up to €8b, or €2.2b short of the announced €10.2b.  The difference apparently came from as yet unnamed Russian banks, this in spite of Putin’s claim that Russian banks would not provide financing for a Rosneft “privatization.”

Today Qatar agreed to pony up €7.4b.  Add to that its original €2.5b and Glencore’s €.3b, and voila!, you have . . . €10.2b.  Miraculous, no?  Everybody remains whole!

Here’s the problem though.  Rosneft has been trading pretty much flat in RUB.  On 9 December, 2016, its share price was 370.8 RUB.  Today, it is 386.75 RUB, about 4 percent higher.  However, the RUB has depreciated about 12 percent against the EUR, going from 65.9707 to 75.155RUB/EUR.  So, in EUR terms, Rosneft is worth about 8.5 percent less than in December, 2016, but Qatar is paying the same price today as was agreed to then.

Why would Qatar do this?  Yes (as Ivan T points out to me) ~€1b is pocket change for the QIA, which has a $320b portfolio.  But still, you don’t get rich by gifting ~10 percent of deals.  So is there a side deal?

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March 27, 2018

CEFC: Everything Must Go! Does that Include Rosneft?

Filed under: China,Energy,Politics,Russia — The Professor @ 4:11 pm

The bizarre saga of CEFC just keeps getting more bizarre.  Today Bloomberg reports that the company is selling off all its real estate.  All of it: Everything must go!

CEFC China Energy Co., the sprawling conglomerate that’s come under increasing government scrutiny, plans to sell its entire global property portfolio with a book value of more than 20 billion yuan ($3.2 billion), according to people with knowledge of the matter.

Almost 100 properties are up for sale, including its headquarters in an upscale Shanghai neighborhood, four floors of the Hong Kong Convention & Exhibition Centre and a condominium at the Trump World Tower in Manhattan, as well as hotels, residential apartments and industrial facilities, said the people, asking not to be identified because the deliberations haven’t been publicly disclosed. The properties, mostly located in big Chinese cities, include a smattering of developments overseas, the people said.

Where this leaves the deal to buy the 14.1 percent stake in Rosneft from Glencore and the QIA is anybody’s guess.  But it probably doesn’t leave it in a good place.

Rosneft’s guess is probably as good as yours or mine.  They made inquiries, and learned nothing:

Rosneft representatives have since traveled to China but failed to get any update from CEFC on the stake acquisition deal, according to the sources.

“The other party (CEFC) has just vanished,” one source said.

“Just vanished” is not a phrase you normally hear uttered when referring to the purchaser of $9.1 billion in equity!  And definitely not one you want to hear!

(The Reuters piece is horribly and confusingly written, by the way.)

CEFC had apparently already paid out some money on the deal, but it has not closed.  Glencore optimistically asserted that the deal would close in the first half of 2018–which is already half over.  Given all of this uncertainty about CEFC, this looks incredibly unrealistic, but Glencore has not provided any more guidance. Go figure!

The price  CEFC agreed to was never disclosed in full, but was allegedly enough to allow Glencore (and the Russian banks backing it) and Intessa Saopaolo to emerge whole.   Glencore did let on that the price was at a 16 percent premium to the 30 day volume weighted average of the Rosneft price, presumably meaning the 30 day period (business days? Calendar days?) prior on 8 September, 2017.  In August-early September, 2017, Rosneft traded in the $5-$5.25 range, which puts the price in the $5.80-$6.00 ballpark.  That comports with a $9 billion total price for 14.16 percent of Rosneft’s 10,598,177,817 shares, which works out to about $6/share.  The price yesterday was $5.41, so it is clear that CEFC’s position is well under water.   This readily explains why the two Chinese government entities that have taken stakes in CEFC are allegedly reluctant to takeover the company altogether and proceed with the deal: it has already incurred a 10 percent loss.

To make things even more dicey, in January VTB announced it was “ready to” loan CEFC the money to finance the deal.  Presumably some of this money flowed, and is the source of the funds that have already been paid out.

So CEFC is selling off all its property.  Will it try to unload the Rosneft stake too? Or will the deal just collapse, leaving the original parties holding the bag? The deal was touted as a great example of Sino-Russian cooperation.  Will this compel the parties to save face by proceeding, or substituting some other Chinese firm?  Presumably this will require a price adjustment.  Who will eat that?

From day one almost 17 months ago the most bountiful product of the Rosneft privatization was questions.  And they just keep on coming.


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March 23, 2018

Will Chinese Oil Futures Transform the Oil Market? Highly Unlikely, and Like All Things China, They Will Be Hostage to Government Policy Whims

Filed under: China,Derivatives,Economics,Energy,Exchanges,Regulation,Russia — The Professor @ 11:08 am

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

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