Streetwise Professor

April 18, 2023

Wither Shale? Don’t Count on It. It Has Been a Technological Progress Story, Not a Diminishing Returns Story

Filed under: Commodities,Economics,Energy — cpirrong @ 2:00 pm

Recently there have been quite a few articles declaring the death, or at least the senescence, of the shale boom. This from today’s Bloomberg, about the Permian specifically, is one of the more optimistic takes.

The gravamen of the argument of those digging shale’s grave is that the most promising prospects have been drilled already. This is no doubt true–and I’ll present some evidence of that shortly–but it’s hardly the entire story. When one looks more comprehensively at the shale boom, it becomes clear that it was driven by technological progress that has overwhelmed the traditional sources of declining productivity in natural resource extraction.

I recently completed a paper on the shale boom. It examines the sources of productivity growth in both oil and gas unconventional wells. In particular, it quantifies the impact of learning-by-doing on productivity growth on a well-by-well basis in all of the major production basins.

The empirical framework captures three potential sources of productivity growth. Firm specific learning, basin-wide learning, and exogenous technological change. As is conventional, I measure the former effect by the cumulative number of unconventional wells drilled in a basin by a given firm prior to drilling a particular well. The second effect is measured by the cumulative number of unconventional wells drilled by all firms in a basin prior to the drilling of a particular well. The last effect is captured by a time trend (again conventional in the learning-by-doing literature dating back decades).

I examine a variety of productivity measures. In what I consider the most novel and potentially interesting part I also look for evidence of cost-reducing innovation and learning effects.

Productivity measures include things like initial production, maximum production, production over the first 12 months, and decline rates. I find strong evidence of firm-specific learning effects in the first three variables, but not so much in decline rates. (Interestingly, learning does not appear to improve drilling speed, contrary to empirical findings in conventional wells.) I do not find strong evidence of industry-wide learning effects.

The last finding sheds light on the exploitation of most promising prospects first. The cumulative basin-wide experience variable is also impacted by this effect. More wells drilled means more industry experience, but it also means more of the good prospects have been drilled. Those two things offset, leading to coefficients that are small positives or actually negative.

The crucial thing to note is that productivity increased from 2011-2020 (in oil) despite the impact of going to progressively less promising sites. This demonstrates the importance of learning and exogenous technological change.

The cost results are the most fascinating to me. I regress the number of wells drilled in a given month in a given basin against the learning variables, input cost variables, a time trend, and price (instrumented for gas to take into account endogeneity–the oil price is reasonably exogenous). I find strong industry-wide cost reducing effects of learning. Specifically, holding price and input costs constant, the number of wells drilled in a given month increases strongly with cumulative industry experience in a basin. That is, cumulative experience shifts out the supply curve. This is evidence of declining cost, and in particular declining fixed cost.

Here again you would expect that the exploitation of the low hanging fruit first should lead to higher costs as cumulative experience grows. But if that effect is there, it is overwhelmed by learning-driven cost reductions.

Based on this research, I am more bullish about the prospects for unconventional production growth in the United States than the conventional wisdom is. The conventional wisdom focuses on a single margin: the stock of potential drilling locations. That totally overlooks the real shale story: massive technological improvement, largely driven by learning effects. Those learning effects work on a variety of margins, including getting more out of a given well, and reducing the cost of drilling a well.

In essence the conventional wisdom is like neoclassical growth theory, in which diminishing returns are the depressing fact of life. But as modern growth theory emphasizes, technological progress has overcome diminishing returns. That’s why we are so rich–far richer than neoclassical growth theory can explain.

My interest in learning-by-doing dates back decades, to my amazing experience of taking bob Lucas’ undergraduate economic growth course at Chicago: Bob decided to teach the course as a way to master the growth literature, and so those fortunate few of us in the class were witnesses to the genesis of his research on growth, which is more important than his (still important) macro/money research for which he won the Nobel.

I wrote a few papers in grad school on LBD, for example showing how learning effects drove productivity growth in US gun manufacturing (at Springfield and Harpers Ferry Armories) in the 19th century. Researching learning in shale gave me an opportunity to dust off and update that previous research interest.

I would also note that shale pessimism is focused on oil. Gas has continued to go great guns–despite the fact that the same diminishing returns effect should be operating there as well. US gas production has continued to grow, especially in Marcellus and Permian. The latter is largely associated gas, but the former is not. This is a productivity story, and it’s not like diminishing returns don’t operate in Marcellus.

Indeed, gas supply growth has been so robust that prices are hovering around $2/MMBTU–back to the level prior to the spike in 2021-2.

Of course one cannot count on the rate of technological improvement continuing at the rate observed in 2010-2020 (for oil) and 2006-2020 (for gas). But one should certainly not discount it, and one should definitely not ignore it altogether and focus only on a source of diminishing returns.

Print Friendly, PDF & Email

April 17, 2023

Fixing Texas’ Electricity Market: The Theory of the Second Best In Action

Filed under: Climate Change,Economics,Energy,Politics,Regulation — cpirrong @ 6:05 pm

The Texas legislature meets every other year, meaning that 2023 is the first session in which legislation to address the issues that became apparent with the near death experience of the Texas power grid during Winter Storm Uri in February 2021 can be considered. The Texas Senate has passed two bills. Senate Bill 6 mandates the building of 10,000 MW of thermal generation (with on-site fuel storage), to be paid for via an “insurance” mechanism that guarantees a 10 percent rate of return to be funded by uplift charges to transportation and distribution utilities. Senate Bill 7 effectively creates an ancillary services market that allows dispatchable generation to sell reserves (e.g., spinning reserves) on a day ahead basis.

Opponents of the legislation state that it represents backsliding from the ideal of competitive energy markets:

Opponents immediately created the false narrative that the Texas bills are proof that Texas politicians “no longer have faith that competitive markets can adequately and economically satisfy the electricity need of Texas citizens,” said Beth Garza, a consultant for the think tank “R Street Institute.”

Well, the bills do represent major departures from Texas’ “energy only” market design. But this raises the question of what undermined the energy only market in the first place. And the answer to that is clear: subsidies for renewables. Past subsidies have wreaked havoc for years. Future subsidies, especially those in the Green New Deal in Drag, AKA the Inflation Reduction Act, threaten to wreak even more havoc in the future.

As I’ve written, this problem was evident years ago, in the mid-2000s. Even then, the penetration of renewables was undermining the economics of thermal generation, leading to exit of such capacity, thereby pressuring reserve margins and compromising–seriously–reliability. The process has continued inexorably in the past 15 years or so, leading to the precarious situation that culminated with Uri–and which has led to chronic concerns about blackouts during every cold snap and heat wave since.

The upshot of the process is an electricity system with a decidedly suboptimal generation mix. Too much intermittent, non-dispatchable renewables, too little dispatchable thermal. The Senate bills are attempts to address that distortion.

This is a great example of the “theory of the second best,” in which one policy that would be suboptimal in the absence of any distortions is welfare-improving in the presence of other distortions. The massive past, present, and prospective subsidies for renewables have distorted the operation of an energy only market. The past subsidies cannot be undone, and the future subsidies are also largely out of the control of Texas and ERCOT. So subsidies for thermal generation that would otherwise be objectionable can improve economic efficiency because they counterbalance the effects of these other subsidies.

It is clear that persisting with the EO market would be a recipe for future disaster. Subsidy to offset subsidy is a second best approach, but the first best is unattainable due to the renewable subsidy induced distortion.

Are there other policies that might be preferable? The only real alternative I can see is a capacity market (another departure from energy only), with capacity obligations clearly directed at dispatchable resources. I am skeptical about the credibility of capacity commitments, and the ability to tailor them to address reliability concerns in particular. Furthermore, political economy considerations threaten capacity markets: renewables operators will lobby to qualify for capacity payments.

SB6 is focused on encouraging investment in dispatchable, reliable capacity. It is likely the MW will be forthcoming. The main challenge is whether the MWh will be there when needed, that is to ensure that the new generation is maintained so as to be able to supply surge demand with a high probability. To provide the incentive to make it so the EO market has to allow generators to earn high prices when supplies are tight. Political economy may again be the main obstacle to this. The new generation will earn high returns–perhaps well above 10 percent–during the periods they are most needed. This will create political pressure to claw back these profits: “windfall profits tax,” anyone? The prospect for clawback undermines the incentive of the new generation to be optimized to supply power in times of short supply.

In sum, renewable subsidies distorted the EO market. Some second best measure (the first best being no renewable subsidies) is necessary. These must effectively subsidize investment in reliable, dispatchable, thermal generation. Between the two main alternatives on offer–guaranteeing a return on investment on such generation, or a capacity market–the former seems superior. But regardless of which is chosen, it is essential to keep in mind what requires the choice: the distortion that compromised the reliability of the Texas grid in the first place, namely, renewables subsidies.

Print Friendly, PDF & Email

January 12, 2023

Just Because It’s Not All Bad Doesn’t Mean It’s All Good, Man

Filed under: Clearing,Derivatives,Economics,Energy,Exchanges — cpirrong @ 12:02 pm

A coda to my previous post. The EU natural gas price regulation avoids many of the faults of price controls, largely as a result of its narrow focus on a single market: TTF natural gas futures. That said, the fact that it potentially applies to one market means that there are still potentially negative consequences.

These negative consequences are not so much to the allocation of natural gas per se, but to the allocation of natural gas price risk. Futures markets are first and foremost markets for risk, and the price regulation has the potential to interfere with their operation.

In particular, the prospect of being locked into a futures position when the price cap binds will make market participants less likely to establish positions in the first place: traders dread being stuck in a Roach Motel, or Hotel California (you can check out but you can never leave). Thus, less risk will be hedged/transferred, and the market will become less liquid. Relatedly, price caps can lead to perverse dynamics when the price approaches the cap as market participants look to exit positions to avoid being locked in. This can lead to enhanced volatility which can perversely cause the triggering of the cap.

Caps also interfere with clearing. There is a potential for large price movements when the cap no longer binds. Thus, in the EU gas situation, ICE Clear Europe has said that it will have to charge substantially higher initial margins (an estimated $33-47 billion more), and indeed, may choose to exit the EU.

These negative effects are greater, the closer prices are to the cap. Europe’s good luck with weather this winter has provided a relatively large gap between the market price and the cap, so the negative impacts are relatively unlikely to be realized. But that’s a matter of luck rather than a matter of economic principle.

Risk transfer is a vital economic function that generates substantial economic value. The cost of interfering with this mechanism is material, and should not be ignored when evaluating the EU policy. That policy avoids many of the standard problems with price caps, but its narrow focus to the futures market means that it has the potential to create economic costs not typically considered in evaluations of price controls. Meaning that not even Saul Goodman would come to its defense.

Print Friendly, PDF & Email

January 9, 2023

The Least Bad Price Control Ever?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 4:13 pm

At the very end of last year the European Union finally agreed on a rule capping natural gas prices. And what a strange duck it is–unlike any price cap I’ve seen before, which is probably for the best for reasons I discuss below.

Rather than a simple ceiling on the price of natural gas–which is what many EU nations were clamoring for–the rule limits trading in front month, three month, and one year TTF futures if (a) the front-month TTF derivative settlement price exceeds EUR 275 for two week(s) and (b) the TTF European Gas Spot Index as published by the European Energy Exchange (EEX) is EUR 58 higher than the reference price during the last 10 trading days before the end of the period referred to in (a).  The “reference price” is: “the daily average price of the price of the LNG assessments “Daily Spot Mediterranean Marker (MED)”, the “Daily Spot Northwest Europe Marker (NWE)”, published by S&P Global Inc., New York and of the price of the daily price assessment carried out by ACER pursuant to Article 18 to 22 of Council Regulation .”

So in other words: (a) the TTF price has to be really high for two weeks straight, and (b) the TTF price has to be really high relative to the European LNG price over that period.

In the event the cap is triggered, “Orders for front-month TTF derivatives with prices above EUR 275 may not be accepted as from the day after the publication of a market correction notice.” So basically this is a limit up mechanism applied to front month futures alone that basically caps the front month price alone. Moreover, it will not go into effect until mid-February, meaning that the last two weeks of February would have to be really cold in order to trigger it. (The chart below shows how far below prices currently are below the flat price cap trigger.)

These conditions are so unlikely to be met that one might get the idea that the cap is intended never to be triggered, and if it is, its impact is meant to be limited to front month futures. And you’d probably be right. Some nations definitely wanted a traditional cap on the price of gas inside the EU, but the Germans and Dutch especially realized this would be a potential disaster as it would cause of of the usual baleful effects of price controls, notably shortages.

The rule as passed does not constrain the physical/cash market for natural gas anywhere in the EU. This is the market that allocates actual molecules of gas, and it will continue to operate even if the front month futures market is frozen. The freezing of futures may well interfere with price discovery in the physical/cash market, but regardless, prices there can rise to whatever level necessary to match supply and demand. As a result, the cap will not achieve the objectives of those pressing for a traditional price ceiling, and won’t result in the consequences feared by the Germans and Dutch.

So the cap is unlikely ever to be triggered, and if it does, won’t interfere with the operation of the physical market or have much of an impact on the prices that clear that market. So what’s the point?

One point is political: the Euros can say they have imposed a cap, thereby appeasing the suckers who don’t understand how meaningless it is.

Another point is distributive–which is also political. The document setting out and justifying the rule spends a tremendous amount of effort discussing a very interesting fact: namely, that when prices spiked last year, basis levels got way out of line with historical precedents. Notably, TTF traded at a big premium relative to LNG prices, and to prices at other hubs in the EU. Sensibly, the document attributes these extreme basis levels to infrastructure constraints within the EU, namely constraints on gasification capacity, and pipeline constraints for moving gas within the EU. (Although I note that squeezing the TTF could have exacerbated these basis moves.)

Again, the rule won’t have any impact on the basis levels in the physical market. So again–what’s the point? Well almost in passing the document notes that many natural gas contracts throughout the EU are priced at the TTF front month futures price plus/minus a differential. What the rule does is prevent prices on these contracts from being driven by the TTF front month price when those infrastructure constraints cause TTF to trade at a big premium to LNG or to prices at other hubs. So for example, a buyer in Italy won’t pay the market clearing TTF price when that would have traded at a big premium and high flat price level: instead, the buyer in Italy will pay the capped TTF front month price.

In other words, the mechanism mitigates the impact of a very common pricing mechanism adopted in normal times against the impacts of very abnormal times. A buyer outside of NW Europe takes on basis risk by purchasing at TTF plus a differential, but usually that basis risk is sufficiently small as to be outweighed by the benefits of trading in a more liquid market (with TTF being the most liquid gas market in Europe, just as Henry Hub is in the US). However, the stresses of the past year plus have greatly increased that basis risk. The price cap limits the basis risk on legacy contracts tied to TTF, without unduly interfering with the physical market. The marginal molecules will still be priced in the (unconstrained) physical market.

So there you have it. Beneath all the political posturing and smoke and mirrors, all the rule does is limit the potential “windfall” gains of those who sold gas forward basis front month TTF, and limit the “windfall” losses of those who bought basis front month TTF. If demand spikes and the infrastructure constraints bind (or if someone exploits these constraints to squeeze TTF futures) causing the basis to blow out, the rule will constraint the impact on those who benchmarked contracts to the front month TTF.

In some respects this isn’t surprising. All regulation, in the end, is distributive.

Putting it all together, this is probably the least bad price control I’ve seen. It is unlikely to go into effect, and even if it does its impact is purely distributive rather than allocative.

Print Friendly, PDF & Email

November 16, 2022

Biden’s Latest Energy Brainwave: Engrossing Diesel!

Filed under: Commodities,Derivatives,Economics,Energy,Politics — cpirrong @ 7:38 pm

The latest Biden energy brain wave is a possible requirement that fuel suppliers hold a minimum level of diesel inventory:

US President Joe Biden is considering forcing the nation’s fuel suppliers to keep a minimum level of inventory in tanks this winter as a means of preventing heating oil shortages and keeping prices affordable. It may actually do the opposite. 

Well actually actually, there’s no “may” about it. It will, if the administration indeed forces away.

As I’ve written previously, there are times when economic conditions make it optimal to hold low (and perhaps no) inventories. When the supply/demand balance is expected to improve in the future, holding inventories moves a commodity from when it is relatively scarce, to when it is relatively abundant. It is better to do the opposite. But since you cannot transport future production to meet present consumption, the best thing to do is to draw down inventories–perhaps to zero.

There is no reason to believe that the market has “failed” to respond efficiently to fundamental conditions. There is absolutely no reason to believe that Joe Biden or anyone who works for him has solved the Knowledge Problem and knows how to allocate scarce diesel over time better than the markets do. Do you really think Joe et al know that the supply/demand balance in diesel is actually going to get worse, when the market judgment is the opposite? If you do, seek help.

So yes, if carried out, this action would increase spot prices because the only way to increase inventories is to reduce current consumption, and the only way to increase current consumption is through higher spot prices. Further, this action would tend to depress deferred prices because it will increase future consumption.

So if he does this, it would be totally correct to put one of those “I did that” stickers on a diesel pump.

It’s ironic to note that mandatory government stockholding programs, sometimes seen in agricultural markets, are intended to increase prices (to help farmers, for instance). It’s also ironic that Biden is floating this after months of drawing down on government inventories of crude in the SPR–in order to reduce prices.

What Biden is proposing could be seen as a government run corner: the antitrust case of U.S. v. Patten (1913) identifies one of the salient features of a corner as “withholding [a commodity] from sale for a limited time” with the purpose of “artificially enhancing the price.” Biden is proposing “withholding” diesel from the market.

Or, using more archaic language, it is government run “engrossing” or “forestalling,” something that speculators are often (wrongly) accused of, as Adam Smith wrote about in The Wealth of Nations.

The only good news to report here is apparently market participants think this idea is so stupid that not even this administration will implement it. Diesel flat prices and calendar spreads haven’t moved much after Biden’s announcement.

But it would be much better if the administration actually had some good ideas rather than a stream of bad ones, some of which are so obviously bad that they will never come to fruition.

Print Friendly, PDF & Email

October 28, 2022

Blowing Smoke About Diesel

Filed under: Commodities,Economics,Energy,Politics,Regulation,Russia — cpirrong @ 6:31 pm

There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:

Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.

First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.

Stocks v. flows, Tucker, stocks v. flows.

Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.

Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.

Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.

The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.

For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).

To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.

Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.

And that’s basically what has happened in the diesel market.

Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):

Gulf Diesel-WTI Crack

Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.

In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.

To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.

As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.

I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.

Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.

Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.

But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:

Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.

Yeah. That’ll fix things.

What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.

And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.

Print Friendly, PDF & Email

October 1, 2022

Another Anti-Anglo Saxon Jeremiad From a Demented (and Desperate) Dwarf

Filed under: Energy,History,Military,Politics,Russia,Ukraine — cpirrong @ 11:15 am

In an earlier post I said that Putin’s mobilization address was his most unhinged speech ever. That record did not last long: his Friday speech announcing the annexation of four Ukrainian regions was beyond unhinged.

The speech was Castroesque in length. The bulk of it was a jeremiad against the west, and “Anglo-Saxons” in particular. (Apparently he is unaware of American diversity!) He justified his invasion of Ukraine, and the annexations, as a war of survival against a west that is hell bent on subjugating Russia. The speech was a litany of the west’s sins, colonialism and slavery most prominent among them. He conveniently elided over Russia’s imperialism, symbolized today by the disproportionate representation of ethnic groups from Russian republics in those fighting–and dying–in Ukraine, and touted the USSR’s “anti-colonial” record in Africa and elsewhere.

The speech was chock-full of projection, most importantly regarding waging war on civilian populations. There were also the now familiar accusations of Ukrainian Naziism, the betrayal of 1991, and the non-existence of Ukrainian nationhood.

In brief, Putin portrayed the war in Ukraine as an existential conflict waged to defend Russia against Anglo-Saxons attempting to colonize Russia, and to defend the world against such western rapacity. (The reference to the Opium Wars was obviously an attempt to appeal to China, whose ardor for this Ukrainian adventure is obviously waning fast.)

The atmospherics were also bizarre. The images of a dwarfish Putin clasping hands with the hulking mouth breathers leading the sham annexed regions, chanting “Ross-i-ya!” with a demented grin on his face are quite striking–and disturbing. Especially when contrasted to the reality on the ground, where Russian forces continue to reel and rout–the bugout from Izyum being the latest example. “Reservists” are being shoved to the front without even a simulacrum of training, where they will no doubt be slaughtered without changing the battlefield dynamic one iota. Putin is giving no retreat orders and is bossing about formations that have been destroyed or dissolved. Gee, whom does that remind one of?

Tens of thousands of Russian men are fleeing to avoid the press gangs, a visible demonstration of widespread panic. (Kazakhstan–the Russian Canada!) Personal contacts indicate that the panic is widespread even among those who have not fled, but who fear the knock on the door.

The realities of the battlefield and the home front reveal that this is truly an existential conflict–for Putin. He objectively can’t win, but he can’t lose and survive. This creates a tremendous bias towards escalation, with nuclear weapons being his only real escalation option.

There is a considerable debate over whether when push comes to shove Putin will push the button. This is an unanswerable question. Suffice it to say that his Downfall-esque rants in public (one can only imagine what he’s like in private) mean that there is a material probability that he will.

Which poses a grave dilemma to the Anglo-Saxons. (In this respect, Putin is on to something: the continentals are hopelessly ineffectual and along for the ride.) Months ago I wrote that Putin was in zugzwang, i.e., a situation where any move made the situation worse, but one is compelled to move. Well, currently the US is arguably in zugzwang as well. The consequences of letting Putin off the hook or pushing him to the wall are both deeply unsatisfactory.

What is in the US’s opportunity set? The situation on the battlefield does suggest that giving Ukraine a blank weapons check could result in pushing Russia out of most of, and perhaps all, of the occupied portions of the country–including Crimea. But choosing that option is a bet on Putin’s sanity and willingness to go nuclear, and how far up the escalation ladder Putin is willing to go. Conversely, pulling the Ukrainian’s leash will likely result in a continued grinding war with its global and human and economic toll. Brokering a compromise is almost certainly out of the question, given the intransigence of the parties and the completely irreconcilable nature of their demands (though Putin did graciously say that he was willing to accept Ukraine’s capitulation).

The administration is clearly leaning towards–but not completely towards–engineering Russian defeat on the battlefield. Most of the American populace is disengaged. The populist right in the US is engaged but stupidly pro-Russian, because (a) Putin criticized the west’s trans obsession, and (b) the enemy of their enemy (the administration) is their friend. With respect to (a) this is beyond bizarre because these passing references were embedded in a speech that damned the entirety of American history in a way that would make Howard Zinn beam: is the PR buying into that now? (It is also stupid because it validates left narratives about them being Russian puppets.)

The populist right also immediately concluded that the US is responsible for the destruction of the Nord Stream I and II pipelines under the Baltic. The fact is we have no facts, other than that the pipelines suffered catastrophic ruptures, possibly the result of deliberate sabotage. Everything else you read is speculation about motive, which only prove whom the speculators hate most. Those who know ain’t talking, and those talking don’t know.

Although I immediately concluded sabotage, there is reason to doubt this too. This is plausible to me, based on my knowledge of natural gas pipelines and Russian incompetence. (Anybody remember the shitshow of the Russian oil pipelines in spring 2019?)

But again–nobody knows nothing beyond the fact that the pipelines are fucked, so speculation is pointless. And depressingly, given the natures of everyone involved, I can’t say there’s anyone I would trust to reveal the facts.

The populist right is annoying, but largely powerless. Even if the Republicans prevail in the upcoming election, the PR will represent a clamorous but ultimately irrelevant force. Meaning that the US will continue to stumble along, mainly in the direction of pushing an increasingly desperate Putin.

Yes, I can see the upside of that. But I also see considerable downside risk, and indeed the risks are asymmetric. Even as things stand now, beyond nuclear weapons Russia’s military capability has proven even more illusory than a Potemkin village of legend. His conventional threat to Nato is demonstrably non-existent. So the upside to the US and Nato of drubbing Putin further is very limited. But the downside of drubbing him could be serious indeed.

So mutual zugzwang is a not unrealistic description of the current situation.

Print Friendly, PDF & Email

September 11, 2022

If You Don’t Like the Message the Price Sends, Ignoring It Only Makes Things Worse

Filed under: Commodities,Economics,Energy,LNG,Regulation — cpirrong @ 2:50 pm

European politicians are desperate, and desperate politicians thrash around and grab stupid ideas–any idea–that they think will alleviate the source of their desperation.

The cost of energy is extremely high now in Europe, and that is stoking political desperation. The politicians don’t like the price signals that the market is sending, and so they are exploring myriad ways of interfering with the price system. These policies (e.g., price controls) cannot solve the underlying problem: Europe is structurally short energy. Moreover, they will create their own problems, which will result in panicked reactions that will create new problems. Wash, rinse, repeat. The whole thing is doomed to collapse. In tears.

There is no better illustration of the European failure to come to grips with their real problems than some of the recent proposals surrounding LNG. One is to cap the price of imported LNG.

Brilliant! That way you’ll have even less gas, and the marginal value of power will go up! Yay!

Er, the LNG market is a world market. Yes, Europe collectively is large enough to have some monopsony power and thus can reduce price: but one exercises monopsony power by cutting purchases. That is, less gas will flow to Europe. Europeans will consume less electricity, and they will substitute higher cost ways of generating it. The shadow price (the opportunity cost, i.e., the real cost) of electricity and gas will increase, not fall.

Another proposal is in some ways even whackier: to replace the Dutch Title Transfer Facility (TTF) price with the Japan-Korea Marker (JKM) as the benchmark price for gas in Europe. Because the JKM price is lower. Or something:

As a last resort in case of supply disruption in Europe the EU could also explore temporarily pegging the TTF to the JKM Asian benchmark as a dynamic cap. Yet that would require the use of other hubs or mechanisms to allocate gas inside Europe, the commission said in the document on benchmarks for the wholesale gas market. “In this situation, JKM would become the world price for international gas for some time,” the commission said. “The wholesale market would be therefore determined by LNG supply/demand, and not by the EU’s internal bottlenecks. LNG would still be attracted by the fact transport costs are lower to the EU.”

In other words, the EC doesn’t like the basis between the price of pipeline gas in Europe (as measured by the TTF price in the Netherlands) and JKM. So, voilà! Make JKM the benchmark and tie the TTF price to the JKM price.

This begs the question of why the basis is what it is. The basis–the spread–reflects bottlenecks as well as shipping costs. If TTF is at a premium to JKM (which it is) even though shipping costs to Europe are lower, that means that there is some bottleneck to transform LNG on the European coast into gas in a pipeline on the continent. The most likely bottlenecks is gasification capacity. The Europeans are scrambling to get floating LNG gasification facilities operating, but the basis/spread is saying that a lot more capacity is needed.

The EC concedes that TTF is at a premium, and that the premium has increased: ““The price premium between the TTF and Europe’s LNG delivered ex-ship indices has widened significantly bringing up questions about its representativeness as an index for linking the contracts in the whole EU-27.”

It only brings up questions to fools. Non-fools get it.

If by “pegging” the Europeans impose some spread between TTF and JKM (adjusted for shipping cost differentials) that does not reflect these EU bottlenecks and their associated costs, the supply of LNG to Europe will be reduced. The only way to incentivize the flow of gas from overseas into European pipes is to have a price that covers the cost of that transformation. If there are bottlenecks, that transformation is expensive.

Thus, it is utterly delusional to think that a price that does not reflect “the EU’s internal bottlenecks” is a good thing: you want a price that does reflect them. The bottlenecks don’t go away because you don’t let the market price reflect them. If you don’t let the market price reflect them, the gas will go away. (Asia will send its regards, by the way.)

You may not like the message the price sends, but you cannot wish it away. And if you try, the message will be sent in an even more painful way. The Europeans (and the UK) seem hell bent on proving this very basic point the hard way, rather than learning from the hard experience of others dating back millennia.

Print Friendly, PDF & Email

September 1, 2022

European Sparks & Darks Tell a Fascinating Story

While writing the post on European electricity prices, I was wondering about the drivers. How much due to fuel prices? How much due to capacity constraints? Risk premia?

Spreads, specifically spark and dark spreads, are the best way to assess these issues. Spark spreads are the difference between the price of electricity and the cost of natural gas necessary to generate it. And no, dark spreads are not the odds that Europe will shiver in the dark this winter–though I’m sure that you can find a bookie that will quote that for you!: a dark spread is the difference between the price of power and the cost of coal required to generate it. In essence, spark and dark spreads tell you the gross margin of generators, and the value of generation capacity. High spreads indicate that capacity is highly utilized: low spreads that capacity constraints are not a maor issue.

Sparks and darks depend on the efficiency of generators, which can vary. Efficiency is measured by a “heat rate” which is the number of mmBTU necessary to generate a MWh of electricity. Efficiency can be converted into a percentage by dividing the BTU content of electricity (3,412,000).

Electricity is a highly “spatial” commodity, with variations across geographic locations due to the geographic distribution of generation and load, and the transmission system (and the potential for constraints thereon). Moreover, since electricity cannot be stored economically (although hydro does provide an element of storability) forward prices for delivery of power at different dates can differ dramatically.

Looking at sparks and darks in Europe reveals some very interesting patterns. For example, comparing the UK with Germany reveals that German day ahead “clean” sparks (which also adjust for carbon costs) are negative for relatively low efficiency (~45 percent) units, and modestly positive (~€35) for higher efficiency (~50 percent) generators. In contrast, UK day ahead sparks are much higher–around €200.

Another example of “identify the bottleneck.” The driver of high spot power prices in Germany is not limitations on generating capacity–it is the high fuel prices. (Presumably the lower efficiency units are offline in Germany now, as their gross margin is negative.) Conversely, generation capacity limits are evidently much more binding in the UK.

But if you look at forward prices, the story is different. Quarter ahead clean sparks in Germany are around €200, while in the UK they are over €300. Two quarter ahead (the depth of winter) are almost €600 in Germany and a mere €300 or so in the UK. (All figures for 50 percent efficiency units).

These suggests that capacity will be an issue in both countries, but especially Germany. Way to go, Germany! Relying on solar in a country with long nights ain’t looking so good, is it?

The wide sparks also undermine attempts to blame it all on Putin. Yes, high gas prices/gas scarcity courtesy of Vova is contributing to high power prices, but that’s not the entire story. Though to be fair, more gas generating capacity wouldn’t help that much if they become energy limited resources due to a lack of Russian gas.

The high forward prices may also reflect a high risk premium. My academic work from the 2000s showed that there is an “upward bias” in electricity forward prices. That is, forward prices are above–and often substantially above–expected future spot prices. My interpretation was that this reflects “spikeaphobia”: power prices can spike up, but they are supported by a floor. This means that being caught short is much riskier than being long. This creates an imbalance between long hedging (to protect against price spikes) and short hedging (to protect against price declines that are likely to be far smaller than upward spikes). This creates “hedging pressure” on the long side: if speculative capital to absorb this imbalance is constrained, this hedging pressure drives up forward prices relative to expected spot prices.

The imbalance is likely exacerbated by the fact that there are large fuel price spike risks too. Moreover, the price and liquidity risks that speculators absorbing the imbalances must shoulder is likely raising the cost of speculative capital in electricity trading, meaning that there is both a demand pull and cost push driving the risk premium. Thus, I conjecture that some portion–perhaps a hefty portion–of the large spark spreads for German and the UK is risk premium. (Back in the days I started to estimate the risk premium in the US markets in the late-90s, the risk premium was as much as 50 percent of the forward price. That decline substantially over the next decade to about 10 percent for summer peak as the electricity markets became more “financialized.” Financialization, by the way, is usually a pejorative, which drives me nuts. Financialization typically reduces the cost of hedging.).

In the aftermath of the mooting of EU proposals to intervene massively in electricity markets, especially through price controls, forward power prices have plummeted: the above figures are from before the collapse. Price controls would impact both the expected spot price and the risk premium–because they take the spikes out of the price. However, as I noted in my prior post, this is not good news: if prices cannot clear the market, rationing will.

Dark sparks also tell a fascinating story. They are HUGE. The German dark spark for 2 quarters ahead (Jan-Mar) is over €1000, and the UK dark spread is over €600. In other words, it’s good to own a coal plant! By the way, these are clean darks, so they take into account the cost of carbon. Meaning that the market is sending a signal that the value of coal generation–even taking into account carbon–is very high. This no doubt explains why despite massive green and renewable rhetoric in China, the Chinese are building coal capacity hand over fist. It also points out the insanity of European policies to eliminate coal generation. Even if you believe in the dangers of carbon, the way to deal with that is to price it, rather than to dictate generation technology.

To give some perspective, the above figures imply that a 500MW coal plant in Germany was anticipated to produce €870 million in value in 23Q3 (24 hours/day x .80 operating rate x 91 days/quarter x 500 MW x €1000/MW). That’s more than the cost of a plant. Even if you cut that in half to take into account today’s power price collapse, it’s a huge number.

Think about that for a minute.

In sum, spreads tell fascinating stories about what is happening in the European electricity market, and in particular the roles of input prices and capacity constraints and risk premia in driving the historically high prices. But perhaps the most fascinating story they tell is the high price that Europe is paying to kill coal.

Print Friendly, PDF & Email

August 29, 2022

New European Energy Policy Follies: The Inevitable Consequence of Past European Policy Follies

European power prices are going hyperbolic, with day ahead prices in swathes of the continent varying between €660 and €750/MWh.

For those who want to play at home–spot the congestion!

Even more remarkably, Cal 2023 power prices are around €1000/MWh in German and France:

That’s for baseload, folks. 24/7/365. Peak Cal 2023 French power is currently at €1425. Ooh la la!

This has of course set of a flurry of policy proposals.

None of these proposals will mitigate the fundamental problem–energy supply is extremely scarce. Most of these proposals will actually exacerbate the underlying scarcity.

Instead, these proposals are all about how to distribute the cost of scarcity. They are fundamentally redistributive in nature.

The proposals include price controls (natch), windfall profits taxes, and nationalization.

Price controls always exacerbate the scarcity and create actual shortages by encouraging consumption and discouraging production. They will necessitate rationing schemes. In electricity, rationing often involves brownouts and blackouts. Planned blackouts, such as no power availability at all for some hours of the day.

WIndfall profits taxes attempt to capture the surplus of inframarginal (i.e., low cost) suppliers, and redistribute that surplus (somehow) to consumers. Redistributing through subsidized prices exacerbates scarcity because it increases demand.

Windfall profits taxes may otherwise have few distorting effects in the short run, given that supply from the inframarginal firms is likely to be highly inelastic (they basically operate at capacity). (Ironically, the scheme to hit Russia by capping the prices it receives on oil is predicated on a belief that supply is highly inelastic.). However, windfall profits taxes have very deleterious long run incentives. They deprive those who invest in production capacity of the value of those investments precisely when they are greatest (which really distorts investment incentives). Even the risk that windfall taxes will be imposed in the future depresses investment today. Meaning that although such taxes may not do too much damage in the present, they increase the likelihood of future scarcity.

The reach of windfall profits taxes is also limited. Many of the rents resulting from the current world energy situation accrue to input suppliers (e.g., owners of LNG liquefaction capacity, coal miners that export to Europe) who are beyond the reach of grasping European hands via windfall profits taxes. (And are the Norwegians going to transfer wealth to Europe by imposing windfall taxes on their gas production and writing a check to Brussels? As if: the Norwegians are already talking about limiting energy exports to Europe.)

Nationalization can be a crude form of windfall profits tax: nationalizing low cost producers basically seizes their surplus. Nationalization can also be a form of subsidization: seize unprofitable firms, or firms that can only survive by charging very high prices, and sell the output below cost. Losses from below cost sales are socialized via taxpayer support of loss-making nationalized enterprises (which creates deadweight costs through taxation present and future).

Nationalization of course generates future operational and investment inefficiencies due to low power incentives, corruption, etc. Moreover, to the extent that nationalized entities subsidize prices, they will encourage overconsumption, and thereby create true shortages and necessitate rationing.

All of these policies aim to mitigate the pain that power consumers incur by shifting the costs to others–and in the forms of subsidies funded by general taxation, the overlap between those who receive the subsidies and those who pay them is pretty large. But even this transforms a very visible cost into a much less visible one, and thus has its own political benefit.

The Germans–at least the Green Party ministers in the government–are advocating a fundamental change in the market mechanism, specifically, eliminating marginal cost pricing:

“The fact that the highest price is always setting the prices for all other energy forms could be changed,” Economy Minister Robert Habeck, who is also the vice chancellor in the ruling coalition in Berlin, said in an interview with Bloomberg.

“We are working hard to find a new market model,” he said, adding that the government must be mindful not to intervene too much. “We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused.”

Marginal cost pricing is a fundamental economic tenet: price equal to marginal cost gives the right incentives to produce and consume. Below marginal cost pricing (the cost of the most expensive resource sets the price) encourages overconsumption. Further, unless marginal units are compensated there will be underproduction. Both of these create inefficiencies, exacerbate scarcity, and can lead to actual shortages and the necessity of rationing.

On a whiteboard you could draw up a pricing mechanism that perfectly price discriminates by paying each resource its marginal cost. This effectively appropriates all of the producer surplus which can be redistributed to favored political constituencies. But this doesn’t cover fixed costs and a return on capital, which discourages future investment.

Further, classroom whiteboard exercises are usually impossible even to approximate in reality. Knowing what marginal cost is for each resource in a complicated system is a major problem, especially when you take transmission into consideration. The likely outcome would be some sort of kludge with roughly average cost pricing combined with some Rube Goldberg scheme to compensate producers. This whole system would involve massive redistribution and all of the politicking and corruption attendant to it.

The real problem the Europeans have is that they want to kill the market messenger. The market is signaling scarcity. The scarcity is real, and acute, but they no likey! And by the nature of energy production–capital intensive, with moderate to long lead times to enhance capacity–the scarcity will continue for some time, with little the Europeans can do about it.

In other words, they can’t fix their real problem (scarcity), which is the harvest of their previous policy follies. So they are left to find redistributive schemes to allocate the costs in a politically satisfactory way. These redistributive schemes–price ceilings, windfall profits taxes, nationalization, fundamental restructuring of the market mechanism–all tend to exacerbate scarcity in both the short and longer runs.

The fact is, when you’re screwed, you’re screwed. And Europe is well and truly screwed. What is going on in policy circles in Europe right now is figuring out who is going to get screwed hardest, and who is going to get screwed not so much. And there will be substantial costs, both in the short but especially the longer term, as whatever Frankenstein “market” emerges from these frantic policy stopgaps will wreak havoc in the future, and will be very hard to put down.

Print Friendly, PDF & Email

« Previous PageNext Page »

Powered by WordPress