Streetwise Professor

November 29, 2018

News for Barry: You Didn’t Build That

Filed under: Economics,Energy,Politics — cpirrong @ 9:59 am

Hard as it is to believe, it appears that Obama has become even more supercilious since his departure from the Oval Office.  All of his sneering grandiosity was on display during a visit to Houston.  (I hope you are sitting down for this: I didn’t attend!)

Being in Texas, Obama felt that he should be thanked for the dramatic growth in US oil production: “You wouldn’t always know it, but it went up every year I as president. That whole, suddenly America’s like the biggest oil producer and the biggest gas—that was me, people.”

I’m wracking my brain here, trying to recall something he said some years ago.  Oh yeah, I remember now: “If you’ve got a business, you didn’t build that.”

Barry: you definitely didn’t build that.  Yet you claim credit anyways.  You remind me of the rooster that believes the sun rises because he crows.

Long-time commenter Howard Roark noted to me on Twitter that the “you didn’t build it” remark was arguably the worst of his many execrable utterances.  That’s probably true, and he makes it all the worse by claiming credit for building something which he had less than bupkis to do with.

Obama also claimed credit for the economy’s recent performance.   He noted, in essence, that the first derivative in GDP was positive during his term, so that he is responsible for the first derivative being positive now.  Apparently the man who is so smart that he can apply the theory of relativity to constitutional law doesn’t understand second derivatives.  Economic growth has accelerated markedly under the Trump administration, and has achieved 3.5 percent growth, something that Obama dismissed as an impossibility when he was criticized for the anemic 1-2 percent growth rate in the aftermath of the Financial Crisis (when one would have expected growth at a rate above long term trend, not below). (I love the title of the linked paper, by the way.  Hilarious!)

But Obama was done.  After claiming credit for building everything, he shared his deep thoughts on identity politics:

“Which is why, by the way, when I hear people say they don’t like identity politics, I think it’s important to remember that identity politics doesn’t just apply when it’s black people or gay people or women,” Obama said. “The folks who really originated identity politics were the folks who said Three-Fifths Clause and all that stuff. That was identity politics … Jim Crow was identity politics. That’s where it started.”

He’s largely correct that Jim Crow and “all that stuff” was identity politics.  But rather than using this to show that identity politics is fundamentally wrong, he uses it to somehow validate its current incarnation.  It happened before, so you can’t criticize it now.  Two wrongs make a right.   You did it to us, so we get to do it to you.

Please go away.  So we can miss you.  Except that I won’t.  But go away anyways.



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November 24, 2018

This Is What Happens When You Slip Picking Up Nickels In Front of a Steamroller

Filed under: Commodities,Derivatives,Energy,Exchanges — cpirrong @ 7:14 pm

There are times when going viral is good.  There are times it ain’t.  This is one of those ain’t times.  Being the hedgie equivalent of Jimmy Swaggert, delivering a tearful apology, is not a good look.

James Cordier ran a hedge fund that blowed up real good.   The fund’s strategy was to sell options, collect the premium, and keep fingers crossed that the markets would not move bigly.  Well, sold NG and crude options in front of major price moves, and poof! Customer money went up the spout.

Cordier refers to these price moves as “rogue waves.”  Well, as I said in my widowmaker post from last week, the natural gas market was primed for a violent move: low inventories going into the heating season made the market vulnerable to a cold snap, which duly materialized, and sent the market hurtling upwards.   The low pressure system was clearly visible on the map, and the risk of big waves was clear: a rogue wave out of the blue this wasn’t.

As for crude, the geopolitical, demand, and output (particularly Permian) risks have also been crystalizing all autumn.  Again, this was not a rogue wave.

I’m guessing that Cordier was short natural gas calls, and short crude oil puts, or straddles/strangles on these commodities.  Oopsie.

Selling options as an investment strategy is like picking up nickels in front of a steamroller.  You can make some money if you don’t slip.  If you slip, you get crushed.  Cordier slipped.

Selling options as a strategy can be appealing.  It’s not unusual to pick up quite a few nickels, and think: “Hey.  This is easy money!” Then you get complacent.  Then you get crushed.

Selling options is effectively selling insurance against large price moves.  You are rewarded with a risk premium, but that isn’t free money.  It is the reward for suffering large losses periodically.

It’s not just neophytes that get taken in.  In the months before Black Monday, floor traders on CBOE and CME thought shorting out-of-the-money, short-dated options on the S&Ps was like an annuity.  Collect the premium, watch them expire out-of-the-money, and do it again.   Then the Crash of ’87 happened, and all of the modest gains that had accumulated disappeared in a day.

Ask Mr. Cordier–and his “family”–about that.


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November 21, 2018

Yes, But He’s *OUR* Bastard: Trump’s Transactional Realpolitik in Action

Filed under: Energy,Politics — cpirrong @ 1:38 pm

So Franklin Roosevelt* allegedly responded to Sumner Welles’ statement that Nicaraguan dictator Anastacio Samoza was a bastard.  Despite Samoza’s odiousness, Roosevelt put up with him because it advanced American interests.

Trump might as well have said the same about Mohammed bin Salman and Saudi Arabia yesterday.  Despite the hue-and-cry over the Khashoggi murder, Trump made it clear that he has decided that US interests are best served by sticking with our bastards in Riyadh, rather than engaging in moralistic virtue signaling.

As I wrote before, there are no good guys in the Middle East generally, and KSA in particular.  Since there are no George Washingtons waiting in the wings to replace MbS, I can say with metaphysical certainty that any replacement would be as bad, or worse, insofar as brutality is concerned.  More to the point, it is almost as certain that any replacement would be less supportive of US interests that MbS.  This is particularly true now, given the leverage that the murder has given Trump.

So our choice is: (a) a thug who has largely acted commensurately with American interests, and who has mitigated KSA’s longstanding hostility to Israel, or (b) a thug who may be far more hostile to American interests.

This is not a hard choice to people who exist in reality.  Which largely excludes most of the political and media class.

Further, will those who beat their chests in indignation please specify what would happen the day after the US destabilizes the Saudi regime?  After all, the US record in intervening in Middle East regimes is so great, right?  It always works out swell, no?

And as horrible as the Khashoggi murder was, let’s see things for what they are.  Contrary to his latter-day pose as a crusader for reform, he was in effect a middling character in Game of Thrones who was on the losing side in an internal regime struggle.  You can guarantee had his side prevailed, someone on the other side would have met a grisly death too.  The main remarkable thing about Khashoggi’s death is we know about it.  Pretty sure that there are a lot we don’t know about, and wouldn’t know about, regardless of which of the zillion princes wound up on top.

A friend remarked that maybe there are some princes in KSA who would not act as brutally as MbS were they in charge.   To which I replied: probably so, but immaterial.  Any such softer figure would not prevail in the internecine struggle for power.

Trump’s remarks and the underlying policy choice reflected his transactional approach.  MbS is someone he can deal with.  He has negotiating leverage.  He has used it.  Hence the boasts about lower oil prices, which has spurred people who never gave a crap about the US oil industry before to clutch their pearls about the impact of this on US oil companies, because, well, they have to find a way to criticize Trump.

The most remarkable thing about Trump is that in contrast to Roosevelt, who justified siding with Samoza in private, Trump said he was standing by our Saudi bastard in public.  This demonstrates another way in which he differs from conventional politicians.  Yes, he lies and bullshits repeatedly, but he also tells blunt truths that most politicians would conceal, or wrap in vaporous clouds of hypocrisy.  That’s kind of refreshing, actually.

*This remark is also attributed to Truman.

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November 18, 2018

File Under “Duh”

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

The IEA points out the obvious:

Driving electric cars and scrapping your natural gas-fired boiler won’t make a dent in global carbon emissions, and may even increase pollution levels.

Higher electrification may lead to oil demand peaking by 2030, but any reduction in emissions from the likes of electric vehicles will be offset by the increased use of power plants to charge them, according to the International Energy Agency’s annual World Energy Outlook, which plots different scenarios of future energy use.

Substitution electrical motors for internal combustion engines involves a substitution of one fossil fuel for another?  Who knew?  WHY WASN’T I TOLD????

Further, especially when it comes to countries outside the EU, Canada, and the US, this will result in a substitution towards coal, electrification will involve a substitution of higher-CO2 intensive fuel (coal) for lower CO2-intensive fuel.

But, but, but . . . renewables! Right?

Of course, Bloomberg feels obliged to quote a green fantasist:

“Electrification is a necessary part of deep decarbonization because it is relatively easy to decarbonize the power sector,” said Lauri Myllyvirta, a senior analyst at Greenpeace’s air pollution unit. “But electrification only helps if the power sector moves rapidly towards zero emissions.”

Zero emissions power sector.  “Relatively easy to decarbonize.”  Apparently, Greenpeace does not require drug tests.  Or perhaps, they do, but if you test negative you’re fired.

What is the cost of zero emissions power sector? (Anything is “easy” if cost is no object.)  Even far smaller renewable penetration (Denmark, Germany, California) results in substantially higher electricity costs.  Costs which fall extremely regressively, especially if implemented no a global basis, but upper middle class types who populate Greenpeace and Green Parties etc. couldn’t be bothered thinking about that.

Furthermore, there is no proof that renewables scale, and indeed,  basic considerations and basic economics strongly suggest they will not and cannot.  Renewables are diffuse and intermittent, and as a result maintaining reliability is costly, and this cost increases at an increasing rate the larger the share of renewables in the generation mix.

But, but, but . . . . batteries!

Batteries have been the subject of intense research for decades, and costs are falling, but again there are serious doubts that they can scale sufficiently to make zero emissions power even remotely attainable.  Indeed, batteries perhaps can handle diurnal variations in renewable power production, but handling the massive seasonal fluctuations in power demand is another matter altogether.

Further, from a lifecycle perspective, it is by no means clear that electric vehicles reduce CO2 emissions.  What’s more, the monomaniacal focus on CO2 ignores the other environmental and economic consequences of renewables generation, including profligate use of land, blended birds, the pollution created by extraction of minerals used in batteries and motors, and the pollution caused by the disposal thereof.

These issues always bring to mind James Scott’s Seeing Like a State, which shows that “high modernist” projects envisioned by alleged elites invariably result in catastrophe because they inevitably impose simplistic, low-dimension measures on complex, high-dimension systems.  Unintended consequences usually strike with a vengeance, and even the intended consequences fail to materialize.

The massive re-engineering of society required to de-carbonize is in many ways the zenith of high modernism, and is destined to produce a nadir of consequences, even compared to some of the other disasters that Scott examines.

The IEA’s caution should be heeded.  But it will not be.  Those Who Know Better will plunge ahead, until it becomes clear that they in fact know very little about what they imagine to design.  Alas, they will not bear the costs of their conceit.  The Lesser Thans will, and the lesser you are, the greater the costs will be.


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November 17, 2018

Read Financial Journalism For the Facts, Not the Analysis

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 7:19 pm

One of the annoying things about journalism is its predilection to jam every story into an au courant narrative.  Case in point, this Bloomberg story attributing a fall in bulk shipping rates (as measured by the Baltic Freight Index) to the trade war.  Leading the story is the fact that iron ore and coal charter rates have fallen about 40 percent since August. The connection between these segments in particular to the trade war is hard to fathom, and the article really doesn’t try to make the case, beyond quoting a shipping industry flack.

An earlier version of the story included a few paragraphs (deleted in the version now online) about grain shipping, stating that grain charter rates had also fallen, since the decline in shipments from the US to China had depressed the rates for smaller ships.  It was not clear from the unclear writing whether the smaller ships referred to just means that smaller vessels are used to carry grain than ore or coal, or whether it means that among grain carriers, the smaller ones have been hit hardest.  If the former, it’s by no means clear that the trade war should reduce shipping rates for most grain carriers.  Indeed, by disrupting logistics through reducing shipments out of the US, Chinese restrictions on US oilseed imports has forced longer, less efficient voyages, which effectively reduces shipping supply and is bullish for rates.  If the latter, yes, it is possible that the demand for smaller ships that normally operate from the USWC to China has fallen, but this can hardly explain a fall in the Baltic Index, which is based on Capesize, Panamax, and Supramax voyages, not (as of March, 2018) of Handymax let alone Handy-sized vessels.  (Perhaps this is why the paragraphs disappeared.)

Bulk shipping rates are used as an indicator of world economic activity: Lutz Kilian pioneered the use of freight rates as a proxy for world economic conditions.  Thus, it’s more likely that the decline in the BFI is a harbinger of slowing global growth–and growth in China in particular.  There are other indications that this is happening.

Yes, the trade war may be impacting the Chinese economy, but it is more likely that it is just the icing on the cake, with the main ingredients of any Chinese decline (which is indicated by weakening asset prices and lower official GDP numbers, though those always must be taken with mines of salt) being structural and financial imbalances.

If you are going to look to freight markets for evidence of the impact of the trade war, it would be better to look at container rates, which have actually been increasing robustly while bulk rates have declined.

While I’m on the subject of pet peeves relating to journalism, another Bloomberg story comes to mind.  This one is about oil hedging:

The plunge in oil prices may finally make oil producers’ hedging contracts into a financial winner for 2018.

After more than a year of surging prices made the contracts a drag on profits, the slide in West Texas Intermediate crude to around $55 a barrel this month means some of the hedges are edging toward profitability, said Anastacia Dialynas, a Bloomberg NEF analyst.

Uhm, that’s not the point.  Just as this article misses the point:

There’s a downside to oil prices being up that could cost the industry more than $7 billion.

When crude markets slumped, explorers used hedging contracts to lock in payments for future barrels to ride out prices that fell as low as $27 a barrel in 2016. Now, as global tensions and OPEC supply cuts drive prices toward $70 in New York, those financial insurance policies have become a drag on profits, limiting some companies from cashing in on the rally.

Even the title of this week’s article is idiotic: “Hedging Bets.”  What would those be, exactly?  “Hedging bet” (as distinguished from “hedging your bets”) is pretty much an oxymoron.  If hedge is any kind of bet, it is a bet on the basis–but that’s not what these articles are talking about.  They focus on flat prices.

The point of these contracts is to reduce exposure to flat prices, and to reduce the sensitivity of revenue to price fluctuations.  The hedger gives up the upside during high price environments to pay for a cushion on the downside in low price environments.  Thus, if anything, these articles shows hedges are performing as expected.  They are in the money in low price environments, and out in high price ones, thereby offsetting the vicissitudes of revenues from oil production.

The problem with journalism regarding hedging (and these articles are just the latest installments in a large line of clueless pieces) is that it doesn’t view things holistically.  It views the derivatives in isolation, which is exactly the wrong thing to do.

Journalists are not the only ones to commit this error.  Some financial analysts hammer companies that show big accounting losses on hedge positions.  “The company would have made $XXX more if it hadn’t hedged.  Dumb management!” Er, this requires the ability to predict prices, and if you can do this, you wouldn’t be hedging–and if it’s so easy, you shouldn’t be a financial analyst, but a fabulously wealthy trader living large on a yacht that would make a Russian oligarch jealous.

Derivatives losses deserve scrutiny when they are not (approximately) offset by gains elsewhere.  This can occur if the positions are actually speculative, or when there is a big move in the basis.  In the latter case, the relevant question is whether the hedge was poorly designed, and involved more basis risk than necessary, or whether the story should be filed under “stuff happens.”

Which brings me to a recommendation regarding consumption of most financial journalism.  Look at it as a source of factual information that you can analyze using solid economics, NOT as a source of insightful analysis.  Because too many financial journalists wouldn’t know solid economics if it was dropped on them from a great height.

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November 14, 2018

Return of the Widowmaker–The Theory of Storage in Action

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 7:37 pm

I’m old enough to remember when natural gas futures–and the March-April spread in particular–were known as the widowmakers.  The volatility in the flat price and especially the spread could crush you in an instant if you were caught on the wrong side of one of the big movements.

Then shale happened, and the increase in supply, and in particular the increase in the elasticity of supply, dampened flat price volatility.  The buildup in production and relatively temperate weather encouraged the buildup in inventories, which helped tame the HJ spread.  But the storage build in 2018 was well below historical averages–a 15 year low.  Add in a dash of cold weather, and the widowmaker is back, baby.

To put some numbers to it, today the March flat price was up 76 cents/mmbtu, and the HJ spread spiked 71.1 cents.  The spread settled yesterday at  $.883 and settled today at $1.594.  So for you bull spreaders–life is good.  Bear spreaders–not so much.

The March-April spread is volatile for structural reasons, notably the seasonality of demand combined with relatively inflexible output in the short run.  As I tell my students, the role of storage is to move stuff from when it’s abundant to when it’s scarce–but you can only move one direction, from the present to the future.  You can’t move from the future to the present.  Given the seasonal demand for gas it is scarce in the winter, abundant in the spring, meaning that carrying inventory from winter to spring would be moving supply from when it’s scarce to when it’s abundant.  You don’t want to do that, so the best you can do is limit what you carry over, so you don’t carry it from when it’s scarce to when it’s abundant.

Backwardation is the price signal that gives the incentive to do that: a March price above the April price tells you that you are locking in a loss by carrying inventory from March to April.   Given the seasonality in demand, the HJ spread should therefore be backwardated in most years, and indeed that’s the case.

But this has implications for the volatility in the spread, and its susceptibility to big jumps like experienced today.  Inventory is what connects prices today with prices in the future.  With it being optimal to carry little or no inventory (a “stockout”)  from winter to spring, the last winter month contract price (March) has little to connect it with the first spring contract price (April).  Thus, a transient demand shock–and weather shocks are transient (which is why the world hasn’t burned up or frozen)–during the heating season affects that season’s prices but due to the lack of an inventory connection little of that shock is communicated to spring prices.

And that’s exactly what we saw today.  Virtually all the spread action was driven by the March price move–a 76 cent move–while the April price barely budged, moving up less than a nickel.

That’s the theory of storage in action.  Spreads price constraints.  For example, Canadian crude prices are in the dumper now relative to Cushing because of the constraint on getting crude out of the frozen North.  The March-April natty spread prices the Einstein Constraint, i.e., the impossibility of time travel.  We can’t bring gas from spring 2019 to winter 2019.  Given the seasonality of demand, the best we can do is to NOT bring gas from winter 2019 to spring 2019.  Winter prices must adjust to ration the supply available before the spring (existing inventory and production through March).  The supply is relatively fixed (inventory is definitely fixed, and production is pretty much fixed over that time frame) so an increase in demand due to unexpected cold winter weather can’t be accommodated by an increase in supply, but by an increase in price.  The Einstein Constraint plus relatively inflexible production plus seasonal demand combine to make the inter-seasonal spread an SOB.

There will be a test.  Math will be involved.

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October 4, 2018

Elon Musk: Nemesis Has Been Stayed, but Hubris Remains

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

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

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

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

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

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

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

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

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

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September 28, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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September 26, 2018

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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September 25, 2018

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

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

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

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

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

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

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

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

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

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

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

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


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