Streetwise Professor

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.

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.

If you didn’t think the Rosneft-Glencore-QIA-Intessa-CEFC deal could get more bizarre–WRONG! Today Reuters reports that during the period of time that Chinese Firm of International Mystery CEFC agreed to buy a 14.6 percent share in Rosneft from whom it was parked initially–Glencore and QIA, funded by Intessa Saopaolo and ???–it was paying loan-shark rates to secure short term financing:

But from at least the second half of last year CEFC was approaching shadow bankers – non-traditional lenders – for costly short-term loans, said six sources with direct knowledge, in a sign of the strained liquidity the company was facing.

In early January, CEFC borrowed 1 billion yuan ($158.00 million) from the Shanghai-based Bida Holding Group, also known as U.Trust Holding Group, for a 15-day loan with a daily interest rate of 0.1 percent, equivalent to an annual interest rate of 36 percent, said one person with direct knowledge of the matter.

And, of course, it was recently revealed that the head of the CFIM–Ye Jianming–is under investigation for “economic crimes.” And an arm of the government of Shanghai has taken control of CEFC Energy–the part of the convoluted group that actually agreed to buy the Rosneft shares. Given the news relating to CEFC’s desperate need for funds in the shadow banking market, this now is quite clearly a shadow bailout.

More puzzles: at the time the deal was announced CEFC made a “huge” initial payment. To whom? Where is the money now? Glencore states that it anticipates the deal will close in the first half of 2018–meaning that they haven’t been paid.  Intessa says “no problema! The deal will-a get-a done!” Meaning it hasn’t been done and they are still on the hook.  The Qataris of course say nothing.

So where’s the money? Show me the money!

Some great due diligence by all involved, no? Sell out to a virtually unknown company with the creditworthiness of a busted racetrack punter. No doubt everyone was too anxious to get out to look too closely at the buyer, and perhaps they took it for granted, or on faith, or something, that CEFC was really a stalking horse for the Chinese government, and so no worries!

The Rosneft “privatization” has been opaque since day one.  And no surprise, as it involves a convergence of the most opaque entities on the planet: Russia, China–specifically a virtually unknown Chinese conglomerate with apparent ties to the Chinese security apparatus–Middle East investors, and a Swiss commodities firm.  Have them walk into a bar, and you have the beginnings of a great joke. Put all these together, and you get a black hole from which no light can possibly emerge.

And I say again: the one entity that should be shedding light because it is a listed public company in the UK–Glencore–provides little more information than the other conspirators involved in this drama.  The FCA should be all over Glencore like flies on cow pies. But it isn’t–although the recent Beaufort Securities scandal suggests its lassitude should be no surprise.

So what happens next? I have no idea. But whatever happens, there’s no guarantee that the world at large will know what actually happens, given this lot of opaque–and unaccountable–participants.

Overall, I have found the Trump administration’s economic policies to be favorable.  The tax bill was pretty good, even though it was worse than the administration’s original proposal.  The chipping away at the encrustation of regulation has been highly beneficial.

But there was always a sword of Damocles hanging by a thread over our heads: protectionism. Heretofore, that sword has remained dangling, but last week the hair broke (perhaps by Trump’s hair-trigger temper) when he announced plans to impose substantial tariffs on imported steel and aluminum.

This is egregiously bad policy, even on its own terms. Like all tariffs, these will impose far greater costs on consumers than they will generate benefits for producers.  Since steel and aluminum are intermediate goods, the first consumers are manufacturers that use the metals.  The cost will be borne in the form of lower output from these firms, lower employment and wages in the consuming industries, and higher prices for the final goods.

These tariffs are a failure on their own terms, and demonstrate Trump’s economic ignorance. Trump wants to bolster American manufacturing: these tariffs will harm US manufacturing overall, even though they benefit relatively small subsectors thereof.   This is because US manufacturing is a big consumer of these materials.  As an example, Trump touts the American energy revolution and promotes American energy exports.  Well, the energy business is a huge consumer of steel in particular, in everything from pipelines to rigs to drill pipe to storage tanks to oil refineries to LNG liquefaction plants.  By helping one shrunken sector of the US economy, Trump is imposing substantial harm on a growing one–and one that he touts, no less.

A common retort to criticisms like mine is that the trade playing field is unfair, and that countries like China in particular advantage domestic producers at the expense of foreigners.  Well, they do that in many sectors, but even though that is inefficient, it redounds to the benefit of other sectors in the US economy: for example, subsidizing aluminum benefits US auto manufacturers, who increasingly utilize aluminum (in part to achieve compliance with self-inflicted regulatory harms, namely CAFE standards).

What is little understood is that a tax on imports is a tax on trade: it reduces both imports and exports.  Similarly, subsidizing exports increases trade–including exports by the country importing the subsidized good.

This is true over the long run: in the short run capital flows adjust as well as trade flows.  For example, Chinese subsidies can lead to an increased US trade deficit (Chinese trade surplus), which means that the Chinese accumulate US dollar claims–pieces of paper (or, more accurately, electronic book entries).  Then one of two things happens.  Either the dollar claims prove worthless, or the Chinese spend the dollars on US goods.  So we either get goods in exchange for worthless pieces of paper (or electronic records), or we export goods later.

If retaliatory measures like Trump’s tariffs could result in some bargain or accommodation that levels the playing field, then perhaps the benefit would exceed the cost (although ironically much of the overall benefit will redound to those who tip the playing field, because they bear the brunt of the cost of doing so). The track record on this is hardly encouraging, however. I predict that the likelihood is that Trump’s actions will not materially reduce imbalances in the trade playing field, and that as a result they will be highly detrimental to the US economy–including the sectors which Trump claims to champion.

When Trump was a candidate, I was highly critical of his views on trade, e.g.:

Perhaps to give him more intellectual credit than he deserves, Trump is a died-in-the-wool mercantilist who believes trade is a zero sum game, and who favors protectionism and beggar-thy-neighbor currency policies. He talks like it is the late-80s, and Japan is still an economic juggernaut that will overwhelm the US, completely overlooking the fact that Japan’s crypto-mercantilist policies gifted it a 25 year long lost decade, and that neo-mercantilist China is on the brink of the same fate. If it is lucky.

and:

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

I was hoping that he would not act on these impulses, or that he would be constrained from doing so. No such luck. Impulsive ignorance has won out.

The FT ran a long profile of Igor Sechin today.

Nothing in the piece should be news to those who have followed my coverage of his escapades over the years. (I still miss the mullet!)

There are some interesting numbers in the piece that do speak volumes.  Such as Rosneft’s market cap–$65 billion. (ExxonMobil–$324b. Shell–$266b.) The number of employees–almost 300,000. (ExxonMobil–73,500.  Shell–92,000.)  The fact that Rosneft paid $55b for TNK BP–and still has a market cap of only $65b.

Rosneft is a Frankenstein’s monster that has been stitched together over the years from stolen body parts.  Igor is therefore a fitting name for its CEO.

I recall being quite amused at those who panicked over Rosneft investing large amounts of money in Venezuela’s cratering national oil company PDVSA, thinking that it gave the Russians a vital foothold in America’s back yard. They’ve outsmarted us again! said this lot.

My thought was the exact opposite: they were utter fools for plunging billions into a country and a company run by socialist lunatics (excuse me, “Bolivarian” lunatics), and figured that it would not go well:

Rosneft lent large money to a deadbeat. It’s not going to get paid back so it is seizing assets, and will end up losing money. Playing repo man is hardly the road to riches. It just mitigates the losses from making a bad loan, and it is the bad loan that is the real story here.

But it gets better!  Repo Man Igor outsmarted himself by getting Rosneft’s collateral in the US in the form of a lien on Citgo’s US refineries.  But given sanctions, the probability that he will be able to repossess them can be rounded up to zero.

Now oil trading firm Mercuria senses weakness, and is involved in an effort to take the collateral off Igor‘s hands:

Commodity trader Mercuria has asked the US Treasury for permission to buy out a $1.5bn loan between Russia’s Rosneft and Venezuela’s state oil company, which had raised the prospect of Moscow taking control of refineries on US soil.

. . . .

“Rosneft would have faced an uphill struggle to get approval to exercise a stake in Citgo so this avoids a potential diplomatic strain between the US and Russia if this deal goes ahead,” said Mr Mallinson.

“If this signals that Russia is looking to reduce its loans to Venezuela rather than offering more support that leaves Caracas with nowhere obvious to turn.”

Rosneft has said it is unwilling to extend further loans to PDVSA, many of which have been secured against crude supplies, as the country’s economic crisis starts to hit oil output from the country. The Russian company is seen as keen to reduce its exposure to Venezuela as oil output falls, with the country seen as precariously close to defaulting on its debts.

Well played, Igor. Bravo! The move was so brilliant, that now he’s desperate–sorry, “keen” doesn’t quite cover it–to get out.

Rosneft’s bargaining leverage is pretty much nonexistent.  PDVSA is circling the drain, with a collapse in oil output and revenues.  It can’t pay back the Russians. The collateral is off limits to them.  So Rosneft faces a choice between a big fat zero, and whatever Mercuria et al deign offer it. Perhaps Rosneft can scare up other bidders, but the company holds a very weak hand, and will be lucky to walk away with kopecs on the ruble.

Keep this in mind whenever anyone tries to convince you of Putin’s or Sechin’s strategic brilliance. In this case, they have brilliantly succeeded in flushing several billion into the Venezuelan cesspool, with no real recourse or exit strategy.

They can take some comfort, though, having lent Venezuela a mere $5 billion. The even more brilliant Chinese lent 11 times as much. So there’s that, Igor!

Back in the day, Bart Chilton was my #2 whipping boy at the CFTC (after Gary Gensler AKA GiGi). Bart took umbrage (via email) at some of my posts, notably this one. Snort.

Bart was the comedian in that dynamic duo. He coined (alert: pun foreshadowing!) such memorable phrases as “cheetah” to criticize high frequency traders (cheetah-fast cheater–get it? Har!) and “massive passives” to snark at index funds and ETFs. Apparently Goldilocks could never find a trading entity whose speed was just right: they were either too fast or too slow. He blamed cheetahs for causing the Flash Crash, among other sins, and knocked the massive passives for speculating excessively and distorting prices.

But then Bart left the CFTC, and proceeded to sell out. He took a job flacking for HFT firms. And now he is lending his name (I won’t say reputation) to an endeavor to create a new massive passive. This gives new meaning to the phrase sell out.

Bart’s massive passive initiative hitches a ride on the crypto craze, which makes it all the more dubious. It is called “OilCoin.” This endeavor will issue said coins, and invest the proceeds in “reserve barrels” of oil. Indeed, the more you examine it, the more dubious it looks.

In some ways this is very much like an ETF. Although OilCoin’s backers say it will be “regulatory compliant,” but even though it resembles an ETF in many ways, it will not have to meet (nor will it meet, based on my reading of its materials) listing requirements for ETFs. Furthermore, one of the main selling points emphasized by the backers is its alleged tax advantages over standard ETFs. So despite the other argle bargle in the OilCon–excuse me, OilCoin–White Paper, it’s primarily a regulatory and tax arb.

Not that there’s necessarily anything wrong with that, just that it’s a bit rich that the former stalwart advocate of harsher regulation of passive commodity investment vehicles is part of the “team” launching this effort.

I should also note some differences that make it worse than a standard ETF, and worse than other pooled investment vehicles like closed end funds. Most notably, ETFs have an issue and redemption mechanism that ensures that the ETF market price tracks the value of the assets it holds. If an ETF’s price exceeds the value of the assets the ETF holds, an “Authorized Participant” can buy a basket of assets that mirrors what the ETF holds, deliver them to the ETF, and receive ETF shares in return. If an ETF’s price is below the market value of the assets, the AP can buy the ETF shares on the market, tender them to the ETF, and receive an equivalent share of the assets that the ETF holds. This mechanism ties the ETF market price to the market prices of its assets.

The OilCoin will not have any such tight tie to the assets its operators invest in. Insofar as investment policy is concerned:

In addition to investing in oil futures, the assets supporting OilCoin will also be invested in physical oil and interests in oil producing properties in various jurisdictions in order to hold a diversified pool of assets and avoid the risk of holding a single, concentrated position in exchange traded futures contracts. As a result, OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

I note the potential illiquidity in “physical oil” and in particular “interests in oil producing properties.” It will almost certainly be very difficult to value this portfolio. And although the White Paper suggests a one barrel of oil to one OilCoin ratio, it is not at all clear how “interests in oil producing properties” will figure into that calculation. A barrel of oil in the ground is a totally different thing, with a totally different value, than a barrel of oil in storage above ground, or an oil futures contract that is a claim on oil in store. This actually has more of a private equity feel than an ETF feel to it. Moreover, even above ground barrels can differ dramatically in price based on quality and location.

Given the illiquidity and heterogeneity of the “oil” that backs OilCoin, it is not surprising that the mechanism to keep the price of the OilCoin in line with “the” price of “oil” is rather, er, elastic, especially in comparison to a standard ETF: the motto of OilCoin should be “Trust Us!” (Pretty funny for crypto, no?) (Hopefully it won’t end up like this, but methinks it might.)

Here’s what the White Paper says about the mechanism (which is a generous way of characterizing it):

OilCoin’s investment returns will approximate but not precisely track the price movement of a spot barrel of crude oil.

. . . .

In order to ensure measurable intrinsic value and price stability, each OilCoin will maintain an approximate one-to-one ratio with a single reserve barrel of oil. [Note that a “reserve barrel of oil” is not a barrel of any particular type of oil at any particular location.] This equilibrium will be achieved through management of the oil reserves and the number of OilCoin in circulation.

As demand for OilCoin causes the price of a single OilCoin to rise above the spot price of a barrel of oil on global markets [what barrel? WTI? Brent? Mayan? Whatever they feel like on a particular day?], additional OilCoin may be issued in private or open market transactions and the proceeds will be invested in additional oil reserves. Similarly, if the price of an OilCoin falls below the price of a barrel of oil, oil reserves may be liquidated with the proceeds used to purchase OilCoin privately or in the open market. This method of issuing or repurchasing OilCoin and the corresponding investment in or liquidation of oil reserves will provide stability to the market price of OilCoin relative to the spot price of a barrel of crude oil and will provide verifiable assurances that the value of oil reserves will approximate the aggregate value of all issued OilCoin.

OilCoin’s price stability program will be managed by the OilCoin management team with a view to supporting the liquidity and functional operation of the OilCoin marketplace and to maintaining an approximate but not precise correlation between the price of a single OilCoin and the spot price of a single barrel of oil [What type of barrel? Where? For delivery when?]. While maintaining price stability of digital currencies through algorithmic purchase and sale may be appropriate in certain circumstances, and while it is possible as a technical matter to link such an algorithm to a programmed purchase and sale of oil assets, such an approach would be likely to result in (i) the decoupling of the number of OilCoin in circulation from an approximately equivalent number of reserve barrels of oil, and (ii) a highly volatile stock of oil reserve assets adding unnecessary and avoidable transaction costs which would reduce the value of OilCoin’s supporting oil reserve assets. Accordingly, it is expected that purchases and sales of OilCoin and oil reserves to support price stability will be made on a periodic basis [Monthly? Annually? When the spirit moves them?] as the price of OilCoin and the price of a single barrel of oil [Again. What type of barrel? Where? For delivery when?] diverge by more than a specified margin [Specified where? Surely not in this White Paper.]

[Emphasis added.]

Note the huge discretion granted the managers. (“May be issued.” “May be liquidated.” Whenever they fell like it, apparently, as long as there is a vague connection between their actions and “the spot price of crude oil “–and remember there is no such thing as “the” spot price) A much less precise mechanism than in the standard ETF. Also note the shell game aspect here. This refers to “the” price of “a barrel of oil,” but then talks about “diversified holdings” of oil. The document goes back and forth between referring about “reserve barrels” and “barrels of oil on the global market.”

Note further that there is no third party mechanism akin to an Authorized Party that can arb the underlying assets against the OilCoin to make sure that it tracks the price of any particular barrel of oil, or even a portfolio of oil holdings. This means that OilCoin is really more like a closed end fund, but one  that is not subject to the same kind of regulation as closed end funds, and which can apparently invest in things other than securities (e.g., interests in oil producing properties), some of which may be quite illiquid and hard to value and trade. One other crucial difference from a closed end fund is that OilCoin states it may issue new coins, whereas closed end funds typically cannot have secondary offerings of common shares.

Closed end funds can trade at substantial premiums and discounts to the underlying NAV, and I would wager that OilCoin will as well. Relating to the secondary issue point, unlike a closed end fund, OilCoin can issue new coins if they are at a premium–or if the managers feel like it. Again, the amount of discretion possessed by OilCoin’s managers is substantially greater than for a closed end fund or ETF (or an open ended fund for that matter). (There is also no indication that the managers will be precluded from investing the funds in their own “oil producing interests.” That potential for self-dealing is very concerning.)

There is also no indication in the White Paper as to just what an OilCoin gives a claim on, or who has the control rights over the assets, and how these control rights can be obtained. My reading of the White Paper does not find any disclosure, implicit or explicit, that OilCoin owners have any claim on the assets, or that someone could buy 50 percent plus one of the OilCoins, boot the existing management, and get control of the operation of the investments, or any mechanism that would allow acquisition of a controlling interest, and liquidation of the thing’s assets. (I say “thing” because what legal form it takes is not stated in the White Paper.)  These are other differences from a closed end fund or ETF–and mean that OilCoin is not subject to the typical mechanisms that protect investors from the depredations of promoters and managers.

A lot of crypto is all about separating fools from their money. OilCoin certainly has that potential. What is even more insidious about it is that the backers state that it is a different kind of crypto currency because it is backed by something: in the words of the White Paper, OilCoin is “supported” by the “substantial intrinsic value of assets” it holds. The only problem is that there is no indication whatsoever that the holder of the cryptocurrency can actually get their hands on what backs it. The “support” is more chimerical than real.

So my basic take away from this is that OilCoin is a venture that allows the managers to use the issue of cryptocurrency to fund totally unconstrained speculations in oil subject to virtually none of the investor protections extended to the purchasers of securities in corporations, investors of closed end funds, or buyers of ETFs. All sickeningly ironic given the very public participation of a guy who inveighed against speculation in oil and the need for strict regulation of those investing other people’s money.

My suggestion is that if you are really hot for an ICO backed by a blonde, buy whatever Paris Hilton is touting these days, and avoid BartCoin like the plague.

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

Who knew that Igor Sechin was such a shy and retiring type? He has been summoned thrice to testify at the Ulyukaev bribery trial, and thrice he has failed to appear. One time he apparently dodged the summons by hiding in his office, and having his staff refuse to accept it. The other times he has said his busy travel schedule precludes him from attending. He has been summoned yet again to appear on 27 November, but the judge in the case said that Sechin indicates that his schedule wilt allow him to testify before the end of the year.

What will his next excuse be? “Sorry. I’m washing my hair that day”? Alas, “I’m scheduled to have my mullet trimmed” is no longer credible.

So why is Igor so reticent? After all, it is because of him, and a sting in which he participated, that Ulyukaev is in the dock. I discussed the issue with a Russian who follows the situation closely–perhaps too closely for comfort, in fact–and we pretty much agree on three possible explanations.

First, embarrassment. Transcripts, then audio, and now video of the sting have been released. Sechin does not come off well in these, and his offer of sausages in a hamper has become something of a running joke in Moscow. Relatedly, Sechin’s behavior violates the norms of inter-elite interaction (sort of like violating the mafia code), and this is there for all to see.

Second, there have been inconsistencies in the prosecution story. Sechin may dread cross-examination that will expose the episode as entrapment or fraud.

Third, Sechin may be testing the limits of his power and autonomy, or deliberately flouting the rules to show that he is an untouchable.

Will we ever learn the truth? This being Russia, there is considerable room for doubt. But one thing we can be sure is not the truth is that Sechin is a respectable figure. He is either an arrogant thug who operates outside the law–or wants to do so. Or he is a buffoon who played out a charade–badly–in order to punish someone who tried to thwart him.

Come to think of it, I’m going with “both”.

And it is not that Sechin’s performance as head of Rosneft compensates for his buffoonish thuggery (or is it thuggish buffoonery?). Indeed, the last earnings report was a disaster, and there are still many questions about the whole Rosneft-Glencore-QIA-Intesa-VTB-CEFC-Ivan Doesky* deal, and just how money from that deal made it (or didn’t) to the Russian budget to fulfill Putin’s privatization promise.

Rosneft’s stock price has been lackluster, at best. Yet the company has been on an acquisition binge overseas. (And how is that Venezueula thing working out? Pouring money down a corrupt rathole–sheer genius! What strategic vision!)

Things have gotten so bad–and so impossible to ignore–that even Sberbank released a scathing criticism of the company:

In the 64-page research report, dated October 2017, Sberbank’s division Sberbank CIB called on Rosneft to change its strategy “markedly” after the energy company incurred huge debts following an acquisition spree at home and abroad.

“Rosneft has been touting its top-down efficiency effort, complete with Stalinesque tales about employees being confronted with charges of malfeasance at management meetings and marched straight into police custody,” the initial report said.

. . . .

The report’s authors, in a section titled “Rosneft: We Need to Talk About Igor”, also said Rosneft’s powerful Chief Executive Igor Sechin “almost single-handedly sets the company’s strategy”.

They calculated that since purchasing oil and gas producer TNK-BP for around $55 billion in 2013, Rosneft had spent a net $22 billion on acquisitions, “with no clear focus”.

“Assuming he remains in charge, the company will continue to pursue volume growth. In doing so, its heft will push it further out of Russia and perhaps further out of oil. This will only disappoint its shareholders,” the report said.

LOL.

Actually, Sberbank wasn’t laughing, because Igor and Rosneft took extreme exception to the snarky criticism. Sberbank subsequently withdrew the report and reissued it, minus the offending language.

One can imagine what transpired in order to achieve that result.

Thus the management of the world’s largest publicly traded oil company (by volume, NOT by value, to be sure). Run by–indeed dominated by–a strategic imbecile who attempts to compensate for his managerial incompetence by strong-arming his domestic rivals into giving up their resources, and engaging in clownish masquerades to frame up those who have attempted to thwart him.

There are larger lessons here too. Keep Igor in mind whenever anyone shrieks about Putin’s fearsome juggernaut. If the management of a national champion in the largest and most important industry in Russia is any indication, the colossus has feet of clay–and a head of brick.

* And no, Donald Trump is not one of the Ivan Doeskys, dossier notwithstanding. I am referring to the unknown party or parties who (a) chipped in the difference between what Glencore, QIA, and Intesa cop to have paid, and the amount that Rosneft claim to have received, and (b) indemnified Glencore against loss.

I am experiencing considerable–what’s that word? oh yes!, schadenfreude–at the German election results. Although Angela Merkel’s party received the largest share of the vote, the results were a shocking setback for her. The CDU/CSU won the largest share of the vote, but this share was the lowest since WWII and represented a double-digit drop from the 2013 vote. Further, the CSU’s leader is mooting a split from the CDU. Merkel is almost certain to have to craft a coalition including three other parties–including the Greens–and this will be time consuming and constrain her power even once the coalition is in place. But the biggest setback at all was due to the stunning surge of Alternative for Deutschland (AfD), the nationalist (and typically referred to as “far right”) party, which not only surpassed the 5 percent hurdle for parliamentary representation, but garnered 13 percent of the vote.

On Friday, Merkel was lionized. Now she is a greatly diminished figure. So much for the New Leader of the Western World, the Tamer of Trump, the Vanquisher of Populism.

And it’s not like this should be surprising. This is at least the third major replay of the movie–first Brexit, then Trump, now Merkel/AfD. Like the Remainers and the Democrats, Merkel condescended to the broad strain of popular (and populist) unease at her policies, most notably her immigration policy. Indeed, she and the rest of “elite” German (and indeed, Western) opinion could barely contain their disdain, and indeed revulsion, at any of the hoi polloi who dared question the wisdom of admitting a million plus immigrants from Muslim countries, or who expressed so much as concern at the criminality (especially sex crimes) and terrorism risk associated with the immigration wave: such people were the German version of The Deplorables. To the contrary: Merkel et al used this criticism as an opportunity to engage in a spasm of virtue signalling, not to say moralistic onanism. Those who agreed with them were morally elevated: those who disagreed, or even questioned, were knuckle dragging crypto–or not so crypto–fascists.

And as in the UK and the US, the knuckle draggers had the vote–and used it to take their revenge.

It is hard to discern from biased media coverage just what AfD really is. Perhaps David Goldman (AKA Spengler) is right that it is “an America-hating ethnic nationalist monster crawling with Nazi nostalgia.” I seriously doubt, however, that most of those who voted for it fit that description. But in some ways the party’s alleged ugliness, and the scorn and derision heaped on it by Merkel and the establishment, were a feature and not a bug to those looking to express opposition to the establishment’s policies. In a parliamentary system, voting for a fringe party is a way of sending a message, and what better way to send a message to Angela et al than by voting for a party that makes them recoil in horror because of its often extreme views? The only way to snap them out of their virtue signaling and self-pleasuring reveries is a 2×4 upside the head: voting for an AfD that elite opinion considered beyond the pale did just that. For that purpose, the more reprehensible the party, the better.

Such a smack may be necessary, but it may not prove sufficient. For what the post-Brexit and post-Trump reactions of the elite demonstrate is that they are incapable of reconsideration or self-examination or self-doubt. They are so convinced of their own superiority (especially moral superiority) that they tend to double down on the derision and condescension. Thus, electoral shocks tend to be merely the first battle in a protracted and increasingly hysterical war between the soi disant elite and those they believe it is their right to rule. We see that in the US today, with no respites even on the Sabbath, as the current frenzy over the NFL demonstrates.

My schadenfreude is only increased by the fact that Germany lapped France  as the most annoying country in Europe some time ago. German annoyingness was the product of two currents, one of which is longstanding, the other more recent. The longstanding current is that of various German national neuroses, most notably the need to cope with the awesome responsibility for the greatest catastrophes of the 20th century, the two World Wars, and in particular the crimes committed in the second of these. To prove that they are different now, the Germans have long held themselves out as morally superior judges of everyone else. Notable examples include virulent German criticism of Israel (especially useful because if Israelis are no better than Nazis, the moral valence of the Holocaust is diminished) and of the US in Vietnam, and latterly Iraq. German criticism of lazy southern Europeans is a somewhat less egregious, but nonetheless notable, example of this tendency. Virtue signaling is a natural pastime.

The second current is Germany’s economic ascendance, especially in the context of the EU. Germany emerged from the Financial Crisis as the dominant economy in Europe, by far. Its main rival within the EU, France, fared not nearly so well, and this combined with British exit has left Germany preeminent in the EU. And they have not been shy to exercise this dominance–nor should they have been expected to, given the aforementioned belief in their moral superiority. Germany–with Merkel in the lead–has been the biggest force pushing for MOAR Europe, because in their current circumstances, More Europe means More German Power.

Of particular relevance in light of the election results, one of the most appalling manifestations of this has been Germany’s insistence on imposing its open borders policy on other countries, especially in eastern Europe (notably Poland). For its part, the Polish government knows how to hit Germany where it hurts (in its swollen sense of superiority) by threatening to demand trillions in reparations for WWII. (The issue of WWII illustrates Churchill’s aphorism about the Germans being either “at your throat or at your feet” very well. It is interesting to note how the Germans have been at times groveling to the Russians in recognizing their depredations in Russia during WWII, but have not behaved similarly to Poland, even though German crimes there were probably greater, and Polish responsibility for the war far less than Russia’s.)

German energy policy is another example. The Germans have been intent on forcing Nordstream I and now II on Europe because it benefits Germany, even though it leaves eastern Europe in the Russian energy thrall. Related to this is the schizophrenic German policy on Russia. On the one hand it has insisted on maintaining sanctions on Russia for Ukraine, but on the other hand it freaked out when the US tightened sanctions on Russia because this undermined German attempts to secure gas supplies from the Russians.  The Germans insist on sending a signal–as long as they don’t have to pay a price.

So even if–or especially if–AfD is as bad as Spengler says, its shockingly strong performance yesterday will have major political effects outside of the borders of Germany. It has proven that Merkel has feet of clay. It will lead to a protracted negotiation over a coalition that in the end will leave Merkel diminished and constrained. It will probably spark a vicious political battle in Germany over immigration and Europe that will derail Germany’s attempt at world domination by other means.

And as much as the western establishments will wail, these are good things. In fact, the wailing is probably the best indication of that which one could imagine.