Streetwise Professor

There is an apocryphal story about Moshe Dayan, in which when asked what was the secret of his success, he answered “fighting Arabs.” True or not, there is a certain veracity to the judgment. It’s not for no reason that there are articles with titles like “Why Arabs Lose Wars” and books with titles like “Armies of Sand: The Past, Present, and Future of Arab Military Effectiveness.” Yes, there have been exceptions, like the Jordanian Legion, but for the most part when Arab armies fight non-Arabs, the former get by far the worst of it.

The Saudi armed forces are arguably the worst of the lot, despite the billions in advanced arms that have been lavished on them over the years. It is a force designed primarily for regime protection, or more accurately, designed so that it does not pose a threat to the regime. Fighting the KSA’s external enemies is a secondary–or tertiary–consideration. In their minds, that’s what they pay the US for.

The appalling performance of the Saudi army in wars in Yemen, whether it be decades ago or today, provides ample testimony to this rather harsh judgment.

With this sorry history in mind, I consider it highly likely that Saudi military ineptitude contributed to, and was arguably the primary cause of, the devastating attack on the Abqaiq oil processing plant. This has resulted in the disabling, for an indeterminate period, of 50 percent of Saudi oil production.

Especially in light of past Houthi (and Shiite Iraqi militia) attacks on Saudi facilities, this was an obvious target. For it to be hit so effectively, with not even the Saudis claiming to have downed any of the attacking aircraft (drones? rockets? missiles?) is a military failure of the first order.

So what now? The US has come out and directly blamed Iran. Whether Iran used one of its myriad cutouts, or pushed the button itself, is immaterial. It is almost certain that it is responsible.

So how to respond?

Even by Trump’s standards, his initial tweet in response was cringeworthy:

It’s one thing to await information from the KSA, and to coordinate with them. It’s quite another to delegate–as Trump appears to do–the decision on the American response to the militarily inept oil ticks that rule Saudi Arabia who are not our friends.

Trump has shown forebearance with Iran before. But shooting down a drone (albeit an expensive one) and attacking what is arguably the singlemost important oil installation in the world are on totally different levels. And Trump no doubt is thinking “if this is what forebearance gets me, screw it.”

Ironically, moreover, this occurred after Trump unceremoniously defenestrated the most conspicuous Iran hawk in his administration, and made noises about negotiating with Iran, and backing the French credit line initiative.

Want to bet that John Bolton is laughing his ass off now?

And what say you, Emmanuel Macron and Angela Merkel?

Iran’s escalation at a time of American efforts to defuse tensions is akin to burning its boats. It makes clear that negotiation is off the table. It is either capitulation by the US (and Europe, as if it counts) or conflict. And how the US responds to this extremely provocative act is not something that should be left to the House of Saud.

Donald Trump recently unleashed yet another tsunami of ridicule by suggesting that the US should buy Greenland, a Danish possession. There he goes again! The idiot! The fool! What a ridiculous idea!

Trump responded by pointing out that Greenland is a strategic place. And he’s right.

And you know who thinks it’s incredibly strategic?: Vladimir Putin, and the Russian defense establishment. Under Putin, Russia has poured extensive resources into an attempt to dominate the Arctic. It has been building bases in the region at a fevered pace, and is imposing restrictions on ships using the northern sea route. It is attempting to grab as much of the Arctic seabed as possible, because of the potential energy resources it contains. Putin himself has said the Arctic “the most important region that will provide for the future of Russia.” Putin wants to turn the Arctic into a Russian lake.

Further, the strategic importance of this region is greater, the more you believe in climate change, or the stronger you believe it will be. Considerable warming would turn the Arctic into one of the dominant shipping routes in the world.

So by expressing an interest in Greenland, Trump is making a move that poses a direct, and serious, threat to Russian interests. Replacing a geopolitical pipsqueak (Denmark) that has a seat at the table in all negotiations in the Arctic, and which cannot utilize Greenland for any military purpose, with Putin’s bugbear–the US–would be a real blow to him. In Soviet lingo, it would dramatically shift the correlation of forces in the Arctic. That’s a big deal. For Putin especially.

Greenland is also a potential source of rare earths, currently a Chinese near-monopoly (and one of their most powerful “trade war” weapons), so US control would be antithetical to Chinese interests as well.

The irony is just too, too much. I guarantee that those who are ridiculing Trump most intensely also believe absolutely that he is Putin’s puppet, and are also fervent believers in the existential threat of anthropomorphic climate change. Yet they are so blinded by their prejudices and obsessions that they cannot see that the latest object of their ridicule proves how unhinged they are.

I am sure Putin does not think Trump’s gambit is the least bit amusing. But I am equally sure that he takes great solace in the fact that–yet again–he can rely upon a cavalcade of useful idiots who will act in his interest by attacking Trump all the while believing that they are actually fighting against Putin.

The US military has been raising concerns about Russian initiatives in the Arctic for some time. Trump apparently has been listening, and has come up with an out-of-the-box, color-outside-the-lines idea that of course appears ludicrous to the dreary, narrow, conventional minds that inhabit the media, political, and government establishments.

If this indicates that Trump is crazy, all I can say is that we need more crazy. And now.

I’m sure you’ve read articles claiming that the cost of renewables electricity generation is approaching that (or even lower than) the cost of traditional thermal generation. I am deeply skeptical of these claims even when evaluated on their own terms (which focus on generation costs alone), but find them particularly misleading because they ignore other costs attributable to the facts that renewables are intermittent and diffuse, and that the siting of renewables generation is sharply constrained because they are energy limited resources; the distribution of energy is dictated by nature; and typically is not closely related to the distribution of load.

In other words, renewables are costly because you can’t stick them where the sun don’t shine (or the wind don’t blow).

Case in point: Australia. As even Bloomberg (a tiresome renewables fanzine) reports:

Australia’s financing of cleaner power is slowing because the country’s aging grid isn’t being upgraded quick enough to accept new, intermittent generation and transport it efficiently to demand centers.

Although Bloomberg attempts to blame an old, creaky transmission system, this is misleading in the extreme. It would be far cheaper to upgrade Australia’s transmission system to accommodate thermal generation than it will be to build transmission to increase the fraction of generation coming from renewables.

This is true for at least a couple of reasons.

First, the energy-limited nature of renewables means that you have to site them where the energy is available–sunny or windy places. This imposes a constraint on the location of generation resources that is not relevant for thermal generation. With traditional fossil-fueled generation, you have more flexibility in trading off transmission costs with generation costs (including the cost of brining fuel to plants) than is the case with wind. This flexibility means that all else (notably the spatial distribution of load) equal, transmission costs are lower with thermal generation than renewable power.

Second, the intermittent and inherently more volatile nature of renewables generation increases the variance in the spatial distribution of generation. This variability in the spatial distribution of generation necessarily requires more transmission capacity per unit of load. This, in turn implies a lower average rate of utilization of transmission resources.

The basic idea here can be illustrated relatively simply. Consider a system with two generation resources. One is highly volatile (e.g., a renewable resource). The other is controllable. There is one load location. The transmission capacity from the volatile location to load must be high enough to carry the power when output is high (because the energy input is high due to the vicissitudes of sun or wind). The transmission capacity from the location with controllable generation must also be high enough to transmit enough power to fill the gap left when the renewable output is low.

Note that when renewable output is high, controllable output will be low and the transmission lines from the latter will operate at low capacity. When renewable output is low, the lines serving it will be operating at low capacity.

It’s possible to expand the example to include multiple variable, energy limited, but imperfectly correlated renewables resources, but the outcome is the same. You need more transmission capacity to deal with the spatial volatility in generation, and given load, higher capacity translates into lower average capacity utilization.

Thus, the problem that Australia is confronting isn’t a function of an old grid: it arises from the fact that increased reliance on renewables requires investment in new transmission capacity even in a system where transmission is optimized relative to (thermal) generation and load.

The need to maintain relatively underutilized transmission capacity to deal with the inherent volatility of renewables generation is mirrored by the need to maintain underutilized thermal generation capacity:

While new clean energy projects struggle to gain access to a congested grid, aging coal and gas-fired generators are being kept running for longer to maintain system stability. AGL Energy Ltd. said Friday it would delay the planned closure of its Liddell and Torrens A plants, both around 50 years old, to help the national energy market cope with peak summer demand, which has seen blackouts in parts of southeastern Australia in recent years.

Who knew?

Yet the renewables industry/lobby continues to flog the dogma that they will inevitably be more efficient:

Despite the challenges facing the industry, it’s not all doom and gloom. A number of coal-fired plants will be retired over the next decade and they will only be replaced by the cheapest cost of energy, which is renewables, Clean Energy Finance Corp. Chief Executive Ian Learmonth said in an interview.
“I’m hoping once some of these issues around the grid and regulations are settled that we’ll see another significant uptick in the renewable energy pipeline,” he said.

What costs is Mr. Learmonth including in his assertion that renewables are the “cheapest” source of energy? His statement that settling “issues around the grid” will lead to increased renewables investment suggests that he is ignoring crucial costs, because settling these issues doesn’t come for free.

It’s not as if the transmission issue is unique to Australia. It is present in every locale that has force-fed renewables. Germany is a prominent example. Wind energy is abundant in the North Sea, but believe it or not, there aren’t a lot of electricity consumers there (despite my ardent wish that Merkel and her ilk get into the sea). Major sources of load are in central and southern Germany, so bringing North Sea wind power to load requires massive transmission investments, which inevitably are not just costly, but politically difficult (Der NIMBY, anyone?). These difficulties inflate the cost.

Renewables boosterism operates in an atmosphere of serious unreality because it consistently glosses over–or ignores altogether–the costs arising from intermittency, diffusiveness, the energy-limited nature of wind and solar, and the caprices of nature that cause a mismatch between where the energy exists and where it is needed. When these facts are considered, sticking renewables where the sun don’t shine makes perfect sense.

Totalitarian and authoritarian regimes are noted for their vicious internecine battles between the lords of various economic fiefdoms: Nazi Germany presents a classic example (and perhaps a good thing too, because these battles crippled German war industry). Not-quite-totalitarian Russia is seeing such a battle today, over the fallout from the Druzhba pipeline fiasco. Pipeline operator Transneft and oil producer and refiner Rosneft are at it hammer and tong over the issue:

Russian state-owned pipeline monopoly Transneft launched a broadside at Rosneft on Monday, publicly criticising the oil producer for dragging its feet over oil quality controls and making unsubstantiated damages claims.
Transneft said that Rosneft had been unwilling to help resolve a contaminated oil crisis in the Russian Druzhba export pipeline which began in late April and that the oil producer was seeking compensation from it without any grounds.
Rosneft did not immediately responded to a request for comment.

For his part, Putin is steering clear:

The dispute between Rosneft and Transneft (TRNF_p.MM) is not a matter for Russian President Vladimir Putin to intervene in because it is a corporate matter, Kremlin spokesman Dmitry Peskov said on Wednesday.

As if Putin never got involved in corporate matters before. Hell, this is supposed to be his job. As I have pointed out for well over a decade, Putin’s primary function in the Russian “natural state” has been to be the balancer, the adjudicator of conflicts within the Russian economic elite, and the distributor of rents among them.

So why is he standing aloof? His power has eroded to the point that he can’t dictate or even negotiate a settlement? Or does he actually quite like economic titans bashing out each other’s brains, thereby distracting them from scheming against him?

I’m guessing the latter. After some more weeks or even months of Tokarev and Sechin bashing one another, he’ll swoop in and graciously broker a solution.

An aside on Transneft’s criticism of Rosneft dragging its feet on “oil quality controls.” To me that is an implicit accusation that the massive contamination wasn’t caused by a handful of mopes currently enjoying the hospitality of a Russian prison, but was the result of something Rosneft did (or didn’t do). Given the volumes involved, that’s quite plausible.

And if true, it would make Sechin’s demand for compensation, and his praise for the operators of Rosneft’s German refinery, truly awesome examples of chutzpah. But we all know that chutzpah is one thing Sechin is expert at. Or should I say the one thing?

In my recent post on position limits, I suggested that at most spot month limits are justified as a means of constraining market power manipulation. It is important to note, however, that setting spot month limits at levels that approximate stocks in deliverable position may not be sufficient to prevent the exercise of market power during the delivery period, with the resultant deleterious effects on prices.

The basic motivation for position limits equal to stocks is predicated on a model of manipulation that makes particular assumptions about market participants’ beliefs. I pointed out the importance of this assumption in my 1993 Journal of Business article on market power manipulation. In one model of that paper, I assume that market participants believe that a large long who takes delivery will resell what is delivered, and will not consume it. In the other model, market participants believe that the large long will consume (or otherwise withhold from the market) some fraction of what shorts deliver to him.

Under the first set of beliefs, it is indeed a necessary condition for profitable manipulation that a long’s position exceed inventories in deliverable position. It is this kind of manipulation that spot month limits pegged to inventories can prevent.

However, under the second set of beliefs, a large long with a position smaller than inventories in deliverable position can exercise market power and inflate prices. Spot month limits based on inventories cannot prevent this type of manipulation.

I recently completed a paper that incorporates this insight into a standard signalling model. In the model, there are two kinds of longs: (a) “strong stoppers,” who have a real demand for the deliverable commodity, place a higher value on it than others, and who will consume at least some of what is delivered to them, and (b) manipulators, who have no real demand for the deliverable and who will resell what is delivered. Shorts do not know which type is standing for delivery.

In the model, a long submits an offer to sell his futures position at a specified price prior to expiration. The strong stopper submits an offer above the price that would prevail in the absence of a strong stopper (reflecting his high valuation of the commodity). I show that under different out-of-equilibrium beliefs there is a pooling equilibrium in with the manipulator mimics a strong stopper, and submits a high offer price at which he is willing to liquidate.

In the pooling equilibrium, the shorts deliver a quantity that exceeds the quantity that they would deliver if they knew the long was a strong stopper: this reflects the fact that they realize that the manipulator will resell what is delivered, and the shorts can repurchase it at a depressed price. However, in this equilibrium the manipulator sells some of his futures position at a supercompetitive price, and earns a supercompetitive profit even though he has to “bury the corpse” of a manipulation.

Crucially, the manipulation can succeed even if the long’s position is smaller than inventories, as long as the flow supply curve is upward sloping at such quantities. The flow supply curve can be upward sloping merely due to the theory of storage: an anticipated depletion of stocks increases the value of the remaining inventory. Therefore, if shorts anticipate a positive probability that a long will consume what is delivered, the theory of storage implies that the supply of deliveries is an increasing function of the futures price at expiration.

Thus, a futures position in excess of inventories in deliverable position may be a sufficient condition to exercise market power, but it is not a necessary one. If shorts are uncertain about a long’s motive for taking delivery, and some longs are strong stoppers who will consume what is delivered and thereby deplete inventories, manipulators can mimic strong stoppers and extract a supercompetitive price even with a position smaller than inventories.

One implication of this analysis is that reliance on spot month position limits is not sufficient to prevent market power manipulations. Additional measures, what I have called “ex post deterrence” since my 1996 Washington and Lee Law Review article, are also necessary. In my earlier work I argued that they are necessary because it was unlikely that position limits could adjust to reflect inevitable changes in inventories. This new paper shows that even if they could so adjust limits, they would be inadequate. Market power manipulation facilitated by fraud (i.e., falsely pretending to have a real demand for the commodity) can occur even if position limits prevent a long from obtaining a position during the delivery period that exceeds stocks in deliverable position.

This analysis also implies that equating “deliverable supply” with “inventory in deliverable position” is wrong. The supply available at the competitive price may be smaller than inventories–and indeed, far smaller than inventories–when shorts do not know the “type” of long standing for delivery.

The traditional model of deliverable supply is predicated on a view of manipulation shaped by the big corners of history, in which there was little doubt about the motivations of a large long. But as the court in the Cargill case noted, “[t]he methods and techniques of manipulation are limited only by the ingenuity of man.” Exploiting shorts’ ignorance about his motive for taking delivery, a long can ingeniously exercise market power even with a position smaller than deliverable supply.

This is a possibility that is only dimly recognized in the existing regulatory structure in the US. Most importantly, it implies that a reliance on preventative measures like position limits alone is inadequate to reduce efficiently the frequency and severity of market power manipulation. Ex post measures are required as well.

Vladimir Putin held his annual marathon phone-in session last week. Although Vova was taking the calls, he was the one who was clearly phoning it in. By all accounts his performance was bored and listless, and largely unresponsive to the economic and environmental (as in garbage disposal) concerns expressed by many callers.

Putin’s answers to questions regarding declining living standards bordered on the pathetic, and definitely revealed he has no answers and can offer no serious succor. The best he could do is to tell Russians that things aren’t as bad today as they were in the 90s.

If the key to success is setting low expectations, Putin certainly succeeded! Perhaps the only current world leader who is doing worse than Russia’s in the 90s is Maduro.

As for explanations, the best Putin could offer was sanctions, and low oil prices. The sanctions excuse is somewhat amusing, given that Putin had previously claimed that sanctions not only wouldn’t hurt/weren’t hurting Russia, they would actually rejuvenate the Russian economy by encouraging the development of import-substituting industries. Insofar as oil prices are concerned, Putin’s answer only underlines the failure of Russia under his watch to develop outside the resource extraction sectors.

None of this should be surprising, and I have predicted such a trajectory. Maximum Leaders get old. They get tired. They get bored. They run out of new ideas and don’t have the energy or inclination to generate them. They begin to prefer a quiet life and to abhor change and innovation. Even they get captured by vested interests who strongly favor maintaining the status quo. Moreover, authoritarian leaders like Putin inevitably become progressively more isolated and out-of-touch because they are surrounded by sycophants, and deprived of feedback from elections, a free press, and open debate.

We are witnessing the senescence of Putin, and Putinism. The most grave concern–for Russians mainly, but for the rest of the world too–is that another inherent feature of authoritarian systems like the one in Russia is that the current leader has no interest in creating a system of succession: indeed, he has an interest in NOT creating one. As he continues to age, or if he dies suddenly, the battle to succeed him will intensify, and inevitably destabilize Russia (with spillover effects around the world).

This brings to mind two closing thoughts.

First, if you think Putin is bad, you should shudder at the type who will prevail in the struggle to succeed him. (Such person will almost certainly emerge from the shadows of the security services or their allies, and you will likely not have heard of him.)

Second, for years Putin’s political hole card has been “I have given you stability.” But ironically, his creation of an increasingly ossified system creates the conditions for a resurgence of instability–perhaps as bad as the 90s–upon his demise, or even his enfeeblement.

So it is more accurate to say that Putin has perhaps delayed instability, and guaranteed that the instability will be all the more intense when it inevitably reappears.

I have known CFTC Commissioner Dan Berkovitz for almost 20 years, when he was a senior staffer on the Senate Permanent Subcommittee on Investigations, and he reached out to me for guidance on market manipulation issues. I think it’s fair to say that we disagree on most important issues. He supports many regulations I strongly oppose, but despite that our relationship has been cordial and mutually respectful.

Dan’s recent speech at the FIA Commodities Symposium in Houston focuses on issues that we happen to disagree on, and needless to say, I am unpersuaded. Indeed, I think his remarks demonstrate quite clearly the fundamental intellectual failings with the regulatory measures he favors.

He focuses on two issues: competition in OTC derivatives, and speculative position limits. With respect to OTC derivatives, he says

There are now 105 swap dealers and 23 swap execution facilities registered with the Commission. Almost 89% of interest rate swaps and 96% of broad index credit default swaps are cleared through a central clearinghouse. Nearly 98% of all swap transactions involve at least one registered swap dealer. The CFTC’s swap trading rules have led to more competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms

But then he contradicts himself on competition:

Despite this progress, we have seen an increase in concentration in the trading and clearing of swaps among the bank swap dealers.  [Emphasis added.] Although we have more competition in the swaps market since the passage of Dodd-Frank, in the form of tighter bid-ask spreads and lower transaction costs, we have fewer competitors.  [Which makes me question whether the tighter spreads are the result of more competition, or other factors.] High levels of concentration present systemic risks and provide fewer choices for end-users.  [But wasn’t the point of DFA to reduce systemic risk by reducing concentration? GiGi sure said so.] One of the purposes of the Commodity Exchange Act (“Act” or “CEA”) is to promote fair competition.  The Commission therefore has an obligation to address this issue.

How concentrated are our derivative markets?  For swaps trading, five registered bank swap dealers are party to 70% of all swaps and 80% of the total notional amount traded. And for clearing services, the five largest FCMs—all affiliated with large banks—clear about 80% of cleared swaps.[  The eight largest firms clear 96% of cleared swaps.  I am concerned about what could happen if one of those providers fails.  I am also concerned about the impact on the price of derivatives for end users.

Even prior to Frankendodd, I predicted that the regulations would lead to greater concentration, precisely because regulatory burdens create fixed costs, which favor scale. The concentration among FCMs is particularly worrisome from a systemic risk perspective, and has been exacerbated by the way clearing regulations have been implemented. Not all of these are the CFTC’s fault: it has attempted to push back on the Fed’s implementation of the liquidity ratio, which creates unnecessary capital charges associated with segregated margins. Dan alludes to that issue thus: “We must find ways to increase bank capital standards without discouraging the availability of clearing and other risk-management tools available to end users.” But the basic conclusion remains: measures intended to reduce concentration in order to reduce systemic risk have not achieved that objective, and have in fact likely increased concentration.

The biggest weakness in Dan’s speech is his valiant, but tellingly and painfully strained, justification for position limits.

The CFTC has a long history with speculative position limits, and their benefits to the market are well established.  Section 3 of the Act identifies risk management and price discovery as fundamental purposes of U.S. derivatives markets. Meaningful position limits coupled with appropriate hedge exemptions are crucial to advancing those purposes.  Position limits help prevent corners, squeezes, and other forms of manipulation.  They prevent distortions in the prices of many major commodities in interstate commerce—ranging, for example, from wheat to gold to coffee to oil.  The Hunt brothers’ attempts to corner the silver market, the Ferruzzi squeeze of the soybean market, and the Amaranth hedge fund’s excessively large positions in the natural gas futures and swaps markets are clear examples of why position limits are needed to prevent the price distortions and real-world impacts that can result from excessive speculation.  Episodes such as these validate Congress’ and the CFTC’s long-held view that position limits are “necessary as a prophylactic measure” to deter sudden or unreasonable price fluctuations and preserve the integrity of price discovery and risk mitigation on U.S. derivatives markets.

Insofar as prevention of market power manipulations (squeezes and corners) are concerned, this can be achieved through spot month limits and does not require restrictions on the positions held prior to the delivery month, and across all months, as the Commission’s previous proposals would impose. Meaning that the proposed regulations are over-inclusive and an unduly restrictive means of achieving their stated objective.

Further, insofar as the examples are concerned, they provide no support for the types of expansive limits that have been proposed. None.

As I’ve said repeatedly about the Hunt episode (the CFTC’s favorite go-to example): when do we get to the Trojan War? That episode is ancient history, and is more the exception that proves the rule than a warning of a clear and present danger. I have said this repeatedly only because the CFTC brings up the example repeatedly. If they stop, I will!

Ferruzzi is interesting, because Ferruzzi cornered a market with position limits, from which the company had an exemption. Indeed, it was the CFTC’s and CBOT’s revocation of Ferruzzi’s hedge exemption during the spot month that broke the company’s corner (and launched my academic career in commodities!–thanks to all!) I can think of other examples in which long hedgers with exemptions executed market power manipulations, and indeed, long hedgers with exemptions are the most dangerous manipulators. Meaning that position limits on speculators are beside the point when it comes to addressing market power manipulation.

With regards to Amaranth, Dan states

The Amaranth episode provides another clear example of how large speculative positions can distort market prices.  At one point, Amaranth held 100,000 natural gas contracts, or approximately 5% of all natural gas used in the U.S. in a year. “Amaranth accumulated such large positions and traded such large volumes of natural gas futures that it distorted market prices, widened the spreads, and increased price volatility.”

The quotations are to a Senate Permanent Subcommittee report (which Dan was an author) . I can say definitively that the analysis underlying those conclusions is completely unpersuasive, and would fail to pass muster in any manipulation litigation. The analysis lacks statistical rigor, and demonstrates neither “artificial” prices or that Amaranth caused these artificial prices (intentionally or otherwise).

Indeed, the CFTC did not pursue Amaranth for distorting natural gas prices through its immense OTC derivatives positions (the 100,000 contracts Dan refers to) outside the delivery month. Instead, it (and FERC) went after the fund and its head trader Brian Hunter for three “bang the close” manipulations in 2006. (Full disclosure: I was an expert for plaintiffs on those manipulations in a private lawsuit.) Position limit regulations would not have prevented those manipulations.

Indeed, other manipulation cases the CFTC has pursued, including bang the settle type cases against Optiver and Parnon and Moore Capital (which I was also an expert in in related private litigation) also would not have been impacted by position limits. That is, limits would not have prevented them. In another recent CFTC case (just settled, and again, I am an expert in related private litigation), the party accused by the CFTC (Kraft) was a long hedger with a hedge exemption.

In brief, neither Dan nor anyone else has presented an example of a post-Trojan War alleged manipulation that position limits would have prevented.

So what’s the point? Can position limits reduce the risk of distortion arising from something non-manipulative?

Dan has an answer, and the answer is “no!” (though he says “record before us demonstrates that the answer is ‘yes.'”)

What speculative position limits are intended to do is to prevent a single market participant from moving markets away from fundamentals of supply and demand through the accumulation of large speculative positions.  [Emphasis added.] In this regard, it’s important to note that speculative position limits focus on the positions held by a single trader or trading entity, not on the overall level of speculation in a market.  The Commission’s task in setting speculative position limits is not to determine how the collective level of speculation in a market might affect prices.  [Emphasis added.] Nor is it to try to determine the “correct” level of speculation that should be permitted in a market.  Instead, the Commission must focus on the single speculator and the impact of large speculative positions on the market.

But this demolishes the argument for limits that was made with increasing intensity around 2006, and peaking (along with oil prices) in mid-2008. Those advocating position limits then could point to no single large trader that was distorting prices. Instead, they blamed (to use Dan’s phrase) “the collective level of speculation” to justify limits–which is exactly what Dan (rightly) says the limits won’t and can’t constrain. Meaning that the CFTC’s proposed limits represent a bait-and-switch: by a limit supporting CFTC commissioner’s own admission, the proposed limits won’t address the supposed ill that led Congress to legislate them in the first place.

To summarize: Position limits outside the spot month are unnecessary to prevent market power manipulations (and other deterrent measures can enhance spot month limits); position limits won’t prevent other kinds of manipulation (e.g., bang the settlement); there are no examples in decades of distortions that position limits of the type proposed might have mitigated; the examples that have been proposed are wrong; the most likely market power manipulators (long hedgers) would be exempted from limits; limits would not have prevented the specific manipulations the CFTC has alleged in recent years; and the limits the CFTC has proposed would not touch the kinds of allegedly multi-trader “collective” excess speculation that caused Congress to mandate position limits in the first place.

Other than that, the case for position limits is rock solid!

Dan Berkovitz manfully attempts justify limits but achieves just the opposite. The arguments and evidence he brings to bear demonstrate how bankrupt the case for limits truly is.

Given that limits will involve substantial compliance costs, and bring no benefits, the song remains the same: position limits are all pain, no gain.

Virtual Power Purchasing Agreements (VPPAs) have been around for a while, and play a particularly important role in securing financing for renewable energy projects, as this article from Reuters regarding VPPAs in Europe indicates. They are essentially long term swaps whereby one party (e.g., a wind or solar operation) receives a fixed price for power, and pays a floating price, usually based (in the US) on the spot price in an RTO/ISO market (e.g., PJM, or MISO).

These contracts present interesting pricing issues because of the unique nature of electricity as a commodity, and the unique nature of renewable generation in particular. Electricity is not an asset per se, and electricity price risk is not hedgeable, even theoretically, through a dynamic trading strategy in the way that the price risk in a stock option is. This means that electricity markets are “incomplete,” and that Black-Scholes-Merton-like formulas that derive prices that do not depend on risk premia do not exist for power derivatives.

The risk premia embedded in power prices can be large, though they have been falling over the years. I wrote extensively about this subject for about 10 years (late-90s to late-00s), including this article. That paper provides a way of extracting risk premia from the prices of traded claims (e.g., monthly power forward contracts). One virtue of that approach is that the primary state variable in the model is not price, but load (which is translated into price via the supply curve). Thus, the relevant price of risk is the price of load risk, which can be used in the valuation of load-dependent claims. Such claims could be full requirements deals, for example.

One challenge to the approach is that the realistic horizon of the market price of risk function estimate is that of the visible forward curve, which is typically far less than the maturity of long term electricity deals. The prices in such contracts effectively reflect a market price of risk negotiated between the two parties, in the absence of corresponding forward curve data.

Renewables VPPAs face an even bigger challenge: the variability of the output of a renewables asset. There is not only price risk (or market load risk) associated with a given region: there is the output risk of the facility, which may be material given the vicissitudes of wind and sun. Thus, the dimensionality of the pricing problem is higher, which is a problem given that the methods I employed in my 2008 paper (co-authored by Martin Jermakyan) are subject to “the curse of dimensionality.”

Furthermore, given the joint dependency on market price (or load) and project output, these are correlation-dependent claims. That is, what is the dependence between market price and wind output? This could be a particularly big issue given that high wind output is often associated with negative prices. Guaranteeing a fixed price therefore involves something of a wrong way risk.

The long tenor of VPPAs makes these issues even more devilish, given that pricing involves forecasting the relevant dynamics and parameters (including those associated with dependence among the state variables) over long horizons–horizons over which entry can occur and technology can change, making historical data of little relevance in estimation. Indeed, there is an element of endogeneity: the prices in VPPAs can affect the economics of entry, which can affect future price behavior, which is (theoretically, anyways) an input into the “right” VPPA fixed price.

All in all, a very interesting and challenging pricing problem, that like the simpler problems Martin and I tackled some years ago, require the use of advanced pricing techniques, numerical methods, and econometrics even to conceptualize, let alone solve. Sounds like an interesting problem–or problems–for aspiring scholars in energy pricing.

I promised I would write a post on the Australian power market when a suitable article came along, and that time has come.

Check out the logic. Australia closes its coal plants (highly efficient, reliable, and with a cheap source of fuel given Australia is a dominant coal producer), and replaces them with wind. Wind, being highly erratic, requires (given the closure of the coal plants) gas-fueled plants to offset the variability of wind output, and as a result gas is on the margin most hours in Australia. And Australian power prices are sky-high because . . . LNG exports reduce gas supplies in Australia, keeping the price of gas high.

Riiiggghhhttt.

You cannot make up this stuff.

No. It’s not the first two links in the process that are blamed–the ones that those who are whinging deliberately chose. Instead, it’s the last link, which was an inevitable result of the first two choices.

This is blame shifting on crack.

I should also note that those gas resources that supply exports would not have been developed absent the export market. They would not have been developed to supply the domestic market alone. So LNG exports are a scapegoat for a problem created by conscious decisions by the green left (i.e., the watermelons) to jam renewables down people’s throats.

It is particularly ironic that this article came out shortly before the Australian election, the results of which have caused a complete mental breakdown on the left. The Liberal Party (which is to the right, relatively speaking, Down Under) staged a surprising upset of the Labor Party, resulting in an unhinging comparable to that in the UK after Brexit or the US after Trump. I can’t tell you the number of tweets I read where people–adults, allegedly–confessed to crying uncontrollably.

I frolic in their salty tears.

The irony comes from the fact that the Labor Party is hard core in its support for yet more attempts to decarbonize Australia’s economy. Perhaps they should consider the possibility that a major reason for their rejection at the polls is the anger of many Australians at the consequences of previous climate-driven policies (including sky high electricity prices), and their wanting no more of such nonsense.

The shock on the left at the outcome shows that three years after Brexit and two-and-a-half years after Trump the leftist elites have learned nothing, and forgotten nothing. It is no doubt another example of their perpetual bullshit loop in action. Leftist-friendly views dominate the media. Anyone expressing contrary views is attacked, which leads to self-censorship and preference falsification. So leftist opinions and sentiment dominate public discourse, convincing leftists that everybody agrees with them, except for a lunatic fringe. But in the privacy of the polling booth, people can express their true views, and perhaps do so with a relish, as this is an opportunity to stick it to those who shout them down. The result is shock and dismay on the left.

But they are as ever incapable of learning, instead just writing off their conquerors as cranks and extremists. As annoying as they are, I hope they don’t change. Because as long as they don’t change, they will continue to lose.

Ironically, the left’s climate change obsession is one of the things that doomed them:

Australian conservative Prime Minister Scott Morrison’s surprise come-from-behind win in national elections was fueled by a campaign that focused on fears that economic and climate policies pledged by center-left opponents would end the world’s longest growth streak.

. . . .

Climate change re-emerged as an election issue following a summer of wildfires, drought, floods and extreme temperatures. Voter support for policies aimed at addressing climate change was at the highest level since 2007. But, as in the U.S., divisions grew more stark as the issue gathered steam.
Labor pledged to reduce emissions by 45% from 2005 levels by 2030, after Australia under the conservatives became the first developed nation to abolish a price on carbon in 2014. The party also promised a push on renewable energy and electric vehicles, offering detailed and transparent policies that opened its agenda to months of concerted attack from Mr. Morrison.

Given the track record (e.g., the high electricity prices that motivated this post), this was a target rich environment for Mr. Morrison and the Liberals. And it is evident that they put much steel on the target.

Also ironic is that the Labor Party was defeated in part by the impact of its climate policies on what was once upon a time the bedrock of labor movements and parties around the world: coal miners, and those dependent on coal production. This demonstrates yet again that left parties have basically abandoned their historical constituencies, and are now dominated by effete metropolitans who are not only completely unfamiliar with muscular labor, but actually despise the muscular laborer.

Excuse me while I engage in a little long distance schadenfreude, and scroll through Twitter to witness yet another meltdown by the Bourbon left.

Russia roiled European oil markets by shipping millions of tons (perhaps upward of 5 million, or about 35 million barrels) of crude oil contaminated with organic chlorine over the Druzhba (“Friendship”) pipeline. The contaminants have the nasty habit of turning into hydrochloric acid in refineries–not good!

About 2 weeks after the first news of the contamination, the Russians claimed they had cracked the case. They arrested four executives of an obscure oil company in Samara, and sought two more, claiming that the company had pumped the oil to conceal a million ruble fraud. One million rubles, as in about $15 grand.

Now, I can see how some Fargo-esque Russian crooks could wreak such havoc to cover up a petty crime, but I’m also very skeptical of the official story.

To start with, amazing, ain’t it, that crack Russian investigators who let many major crimes go unsolved for, like forever can solve this one in mere days? The fact that some of the alleged perps have Chechen names also suggests that this was a “round up the usual suspects” bust that would make Claude Rains/Captain Renault proud.

Also, the quantities don’t make sense. The contamination is serious, and even 10 million rubles of oil would represent only a couple of thousand barrels: could that create the kind of contamination that has forced the shutdown of a pipeline that can carry 1.2-1.4 million barrels per day?

No, pinning this on some obscure suspects seems just too pat, and calculated to let major players (such as the pipeline monopoly Transneft, and major producers, such as Rosneft) off the hook.

Even if crooks in Samara succeeded in introducing into Druzhba contaminated oil in quantities sufficient to make millions of tons unusable, this just raises other questions. Like, who was monitoring what was going into the pipeline? How were the crooks able to get this much bad oil into Druzhba? How is Transneft’s failure to detect this not negligent–or perhaps itself criminal (e.g., involving bribing Transneft employees to overlook the introduction of the tainted oil into the pipeline).

However you look at it, this validates many stereotypes about Russia. Rife criminality, or corruption, or incompetence–or all of the above!

Update. Some back-of-the-envelope calculations. The contaminated oil had 150-330 ppm of the organic chlorides. The acceptable level is 10 ppm. Assume that prior to the contamination, the oil had the maximum allowable amount, 10 ppm. If the contaminated oil had 100 times the allowable amount (1000 ppm) over 14 percent of the oil in the pipe had to be contaminated to that level just to get it to 150 ppm. To get it to 330 ppm, almost a third would have to be contaminated. At 1mm bpd of throughput, that’s 140k-330k bpd. That’s a lot of oil, and certainly more than the piddly companies blamed for this contamination can produce. Even if you increase the contamination by an order of magnitude, you are still talking 1 to 3 percent of the oil in the pipeline.

But if you crank up the contamination rate to cut down the volumes, that just raises the question: WTF was Transneft doing to allow oil with 100 to 1000 times the allowable limit getting into the pipeline.

Pick your poison, Transneft.