Streetwise Professor

Most media coverage of hedging is appalling. It tends to focus on the accounting, and not the economics. Unfortunately, managements and analysts too often fall into the same trap.

This WSJ article about hedging by airlines is a case in point:

After decades of spending billions of dollars to hedge against rising fuel costs, more airlines, including some of the world’s largest, are backing off after getting burned by low oil prices.

When oil prices were rising, hedging often paid off for the airlines, helping them reduce their exposure to higher fuel costs. But the speed of the 58% plunge in oil prices since mid-2014 caught the industry by surprise and turned some hedges into big money losers.

Last year, Delta Air Lines Inc., the nation’s No. 2 airline by traffic, racked up hedging losses of $2.3 billion, while United Continental Holdings Inc., the No. 3 carrier, lost $960 million on its bets.

Meanwhile, No. 1-ranked American Airlines Group Inc., which abandoned hedging in 2014, enjoyed cheaper fuel costs than many of its rivals as a result. “Hedging is a rigged game that enriches Wall Street,” said Scott Kirby, the airline’s president, said in an interview.

Now, much of the rest of the industry is rethinking the costly strategy of using complex derivatives to lock in fuel costs, airlines’ second-largest expense after labor.

Roughly speaking, hedgers “lose”–that is, their derivatives positions lose money–about half the time. If the hedge is done properly, that “loss” will be offset by a gain somewhere else on the income statement or balance sheet. The problem is, it’s not identified specifically. In the case of airlines, it shows up as a lower cost of goods sold (fuel expense), but it isn’t identified specifically.

The tendency is to evaluate the wisdom of hedging ex post. But you cannot evaluate hedging that way. You hedge because you don’t know which way prices will go, and because a price move in one direction hurts you more than a price move in the opposite direction of the same magnitude helps you. If you knew which way prices were going to go, you wouldn’t need to hedge.

That is, hedging is valuable for an airline if reducing the variability of profits attributable to fuel cost changes raises average profits. How can this happen? One way is bankruptcy costs. If an airline loses $1 billion due to a fuel price spike, it may go bankrupt, and incur the non-trivial costs associated with bankruptcy: this is a deadweight loss. The airline receives no bonus equivalent in magnitude to bankruptcy costs if it gains $1 billion due a fuel price decline. Therefore, reducing the variability of fuel prices reduces the expected deadweight losses (in this case, expected bankruptcy costs), which is beneficial to shareholders and bondholders.

As another example, an airline that becomes more highly leveraged because of an adverse fuel price movement may underinvest (relative to what an unleveraged firm would) due to “debt overhang”: it underinvests because when it is highly leveraged the benefits of investment accrue to bondholders rather than shareholders. Again, there is unlikely to be a symmetric gain when the company becomes unexpectedly less leveraged due to a favorable fuel price movement. Here, reducing variability reduces the expected losses due to underinvestment.

Hedging can also reduce the costs of providing incentives to management through tying pay to performance. Hedging reduces a source of variability in performance that is outside of managers’ control: since they are risk averse they demand compensation for bearing this risk, so hedging it reduces compensation costs, and makes it cheaper to tie pay and performance.

The problem is, none of these things show up on accounting statements with the clarity of a 9 or 10 figure loss on a derivatives position put on as a hedge. The true gains from hedging are often unseen. The true gains are the disasters avoided that would have occurred in the absence of a hedge. There’s no line for that in the financial statements.

The one saving grace of the WSJ article is that it does mention a relevant consideration in passing, but doesn’t understand its full importance:

Another factor in the hedging pullback: a round of megamergers, capacity cuts and more fuel-efficient aircraft have fattened the industry’s profits, leaving carriers in better financial shape—and less vulnerable to a spike in fuel prices.

Two of the factors that make hedging value-enhance that I mentioned before (bankruptcy costs and underinvestment) are more relevant for highly leveraged firms that are at risk of financial distress. Due to the factors mentioned in foregoing quote, airlines have become less financially distressed, and need to hedge less. But that should have been the focus of the article, rather than the losses on previously undertaken hedges.

And that should be what is driving airlines’ decisions to hedge, although the statement of American Airlines’ president Kirby doesn’t provide much confidence that that is the case, at least insofar as AA is concerned.

Airlines are interesting because they have historically been among the biggest long hedgers in the energy market. This is true because they are one major consumer of fuel that (a) cannot pass on (in the short run, anyways) a large fraction of fuel price increases, and (b) are big enough to make justify incurring the non-trivial fixed costs associated with hedging.

Fuel costs are determined by an airline’s routes and schedule, and fuel consumption is therefore fixed in the short to medium term because an airline cannot expand or contract its schedule willy-nilly, or adjust its aircraft fleet in the short run. Thus, fuel is a fixed cost in the short to medium term. Furthermore, the schedule and the existing fleet determine the supply of seats, and hence (given demand) fares. Since supply and hence fares won’t change in the short to medium term if fuel prices rise or fall, airlines can’t pass on fuel price shocks through higher or lower fares, and hence these price shocks go straight to the bottom line. That increases the benefits for financial hedging: airlines have no self-hedges for fuel prices.

This is to be contrasted to, say, oil refiners. Refiners are able to pass on the bulk of oil price changes via product price changes: pass through provides a self-hedge. Yes, crack spreads contract some when oil prices rise (higher prices->lower consumption->lower utilization->lower margins), but refiners are able to shift most of the crude price changes onto downstream consumers. This reduces the need for financial hedges.

Further, many downstream consumers–gasoline consumers like you and me, for instance–don’t consume in a scale sufficient to justify incurring the fixed costs of managing our exposure to gasoline price changes. Therefore, a large fraction of those who are hurt by rises in the flat price of energy don’t benefit from financial hedging.

Conversely, those hurt by falls in flat prices, firms like oil producers and holders of oil inventories, don’t have self-hedges: they are directly exposed to flat prices. Moreover, they are big enough to find it worthwhile to incur the fixed cost of implementing a hedging program.

This leads to an asymmetry between long and short hedging, which is evident in CFTC commitment of traders data for oil. This asymmetry is why long speculators are essential in these markets. Without long speculators, the (predominant) short hedgers would have no one to take the risk they want to get rid of. This would put downward pressure on futures prices, and increase the risk premium embedded in futures prices.

Which is why airlines have been in the forefront of those hating on speculators. Not because speculators distort prices. But because long speculators compete with long hedgers like airlines to take the other side of short hedgers like oil producers and traders holding oil inventories. This competition reduces the risk premium in futures prices.

This makes it costlier for airlines to hedge, but their higher costs are more than offset by lower hedging costs for producers, stockholders, and other short hedgers. This is why speculators are vital to the commodity markets, and thereby raise prices for producers and reduce costs for consumers.

But apparently this is totally lost on Elizabeth Warren and her ilk. But as the WSJ article shows, ignorance about hedging–and hence about the benefits of speculation–is widespread. Unless and until this ignorance is reduced substantially, policy debates will generate much more heat than light.

If Elizabeth Warren were to have her way, you’d see my mug on the wall of your local Post Office. What have I done to become to earn her nomination as Public Enemy? Having the temerity to oppose position limits, and co-authoring a report summarizing the deliberations of the CFTC’s Energy & Environmental Markets Advisory Committee, which strongly criticized the need for, and details of, the Commission’s proposed position limits rule.

The backstory is this. In 2015 I was an associate member of EEMAC. (As of 10 days ago, I am a full member.) The Committee’s sponsor, Commissioner Christopher Giancarlo, asked me to write the (Dodd-Frank mandated) report summarizing the Committee’s deliberations at two meetings in 2015. I agreed, and along with Jim Allison (who just retired from ConocoPhillips), I wrote a relatively short draft that just summarized the transcripts of the two meetings. The report went through some additional edits, and was then submitted to the nine full members of EEMAC for their approval. It was approved by an 8-1 vote.

The conclusions and recommendations of these meetings were rather straightforward to recapitulate, because there was considerable agreement on the major issues of (a) whether position limits were necessary, (b) the proposed rule’s bona fide hedging exemptions, and (c) whether to implement limits for spot months only initially, or to implement for all months.

If you read the transcript, and read the final report, you will see that the report is a faithful record of what happened during the meetings. As I said in yesterday’s meeting, I viewed my role to be that of “faithful scribe,” and that’s what I was.

But since the message in the report was NOT what Elizabeth Warren (and one of the EEMAC members, Public Citizen’s Tyson Slocum) wanted to hear, Warren, Slocum, and Warren’s journalistic creatures (most notably the New York Times) decided to kill the messenger. Warren wrote a letter to the CFTC, demanding that the report be withdrawn. Slocum wrote a dissent to the majority report. Assorted journos scurried along behind. Each called foul on my authorship. Here’s what Warren said about yours truly:

The second panelist I am concerned about is Dr. Pirrong. According to the New York Times, “Mr. Pirrong has positioned himself as the hard-nosed defender of financial speculators – the combative, occasionally acerbic academic authority to call upon when difficult questions arise in Congress and elsewhere about the multitrillion-dollar global commodities trade…. [who] has reaped financial benefits from speculators and some ofthe largest players in the commodities business,” and played a key part in “a sweeping campaign [by the financial industry] to beat back regulation.”10

With specific regard to the position limits rule, Dr. Pirrong served as a consultant for the International Swaps and Derivatives Association – a lead plaintiff suing to block the very rule he was asked to provide his views on for the EEMAC.11 There is no record indicating that these conflicts were even disclosed by Dr. Pirrong when he served as a witness, let alone addressed by the EEMAC.

Platts is preparing for a Brentless future by introducing a new Dated Brent CIF Rotterdam assessment.  The idea is that as North Sea production continues its decline, other streams of light crude that are imported into Rotterdam can be added to the assessment. Adding (or substituting) say Nigerian crude to the FOB Brent assessment would be much more difficult because of locational differences: FOB Nigeria and FOB North Sea can be quite different, even adjusting for quality, due to freight differentials. A CIF contract eliminates that.

The decline in North Sea production has been occurring for some time, so the need to adjust the pricing mechanism has been apparent. Plants has been thrashing around for a while, mooting the possibility of adding other crude (e.g., Urals Med) to the assessment.  It had already widened the delivery window to make more cargoes eligible (remember 15 Day Brent? 21? It’s now 25 Day.) This problem has become more pressing though, as the decline in prices is hastening the decline in North Sea production.

It is ironic that at the same time that Platts (and therefore, ICE) are grappling with the problem of  declining supply, the main rival to Brent has the exact opposite problem. The WTI contract is currently drowning in oil. Storage at Cushing is bumping up against capacity, and there are reports that some storage operators there are refusing requests to store additional crude.

Although the current situation at Cushing (and in the North American market generally) is as much a demand story as a supply story, the facts are that (a) the NYMEX WTI contract is linked to a much more robust and flexible production base than Brent, and (b) the WTI contract’s periodic difficulties are due to infrastructure issues that are more readily, cheaply, and rapidly addressed than production issues. Thus it has been for the past five years or so, as I discussed when I wrote that those foretelling the demise of WTI were fundamentally mistaken:

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

The CIF alternative makes sense, and is probably superior to the “economic par” contract I suggested in the 2011 post. But once you move to a Rotterdam pricing basis, why remain tied to an assessment mechanism based on transactions in immense full cargoes? The large size of the lots inherently limits the number of transactions, which makes the assessment mechanism more erratic and subject to manipulation. The lumpiness of the market has also led Platts to design a baroque process involving bids and offers, contracts for differences, futures prices, spreads, etc., to increase the number of trades that go into the assessment.

The WTI contract, in contrast, is based on delivery in store of modest-sized (1000 barrel) units of crude. This is much more flexible, and permits a large number of firms to participate in the delivery process. This makes delivery and the threat of delivery a reliable and efficient way of ensuring convergence of futures to cash market values. The mechanism is not immune to all types of manipulation: delivery squeezes are still possible (though relatively unlikely in current market conditions). But small numbers of transactions can’t have a pronounced impact on pricing, and the in store delivery mechanism does not rely on an arcane and mysterious assessment mechanism (which also helps to enrich the party making the assessment).

So rather than shifting to a Rotterdam CIF mechanism, why not shift the futures market to a Rotterdam in store delivery contract? This mechanism is more flexible and resilient in the short run, and is readily adjusted in the long run to respond to changes in the underlying physical production base as NYMEX did by adding foreign crude streams (including Brent) to address the (then) declining domestic production base.

I can see why Platts wouldn’t like this, but it has some decided advantages for ICE, not the least of which is reducing its dependence on Platts. Given the difficulties of changing contract specifications, or generating liquidity for even a better contract introduced in competition with an established liquid one, I doubt this will happen. Which means that ICE, and the market generally, will have to continue to endure periodic changes the “Brent” assessment mechanism as North Sea production continues to decline.

I put “Brent” in quotes because the handwriting is on the wall: any future European-based contract may be called “Brent” even after Brent (and Forties, and Oseberg, and Ekofisk) no longer represent the bulk of the benchmark stream. The contract will come to resemble the old Harry Anderson comedy bit, where he juggled a chainsaw and an axe. He would stop juggling, hold up the axe and say: “This is George Washington’s axe. The handle was replaced years ago, and I just put on a new head, but it’s George Washington’s axe!” So it will be with Brent, and sooner than anyone would have thought even a few short years ago.

Igor Sechin comes in a close second to Rogozin the Ridiculous in providing Russian comic relief. Perhaps there are others in Russia that excel them, and I am only aware of these two because they have a bigger presence in the West, but both can be relied upon for some levity–unintentional, to be sure.

Sechin no longer has the outrageous mullet to amuse, but his public utterances suffice. Today at International Petroleum Week in London are a case in point. The mood at the event was gloomy, with pretty much everyone predicting that we are in a prolonged era of low prices, and everyone had their favorite culprit. But Sechin’s scapegoat was unique: Robots! Well, “robot traders”, anyways:

He blamed ‘financial players’ and automated ‘robot’ traders for driving down the price, saying the collapse to near $30 had little to do with supply and demand.

I presume he means algo traders and HFT. Just how these “robots” trading at subsecond frequencies have mesmerized producers and consumers to behave so as to lead to relentless buildups of inventory–including a looming topping out of capacity at Cushing–is beyond my mere economist’s skills to fathom.

Maybe Igor can commiserate with US cattle producers, who blame HFT for causing excessive volatility in beef prices.

Igor also seems to misunderstand that the “US” is not analogous to Saudi Arabia as a producer (although the phrasing is ambiguous, but I interpret this to include the US in “they”):

“At the end of 2014 some Middle East producers followed the US in their desire to increase production,” Mr Sechin told London’s International Petroleum Week. “They have deliberately created this situation and they are committed to low prices.”

The US oil sector is not a unitary decision maker in the way the Saudis are. The US industry is extremely fragmented and diffuse, with dozens of producers acting independently. They are price takers, not price makers. Very different from KSA or other producers with NOCs. (Relatedly, this is why calling the US the “new swing producer” analogous to the Saudis is dumb.)

It’s also more than a little hypocritical of him to criticize others for increasing output: Russian production has been increasing steadily over this same period.

Sechin also engaged in a little wishful thinking:

He forecast prices would recover later this year as US shale output slows. “We believe that in the coming years US shale will lose its grip on the market,” he said.

Good luck with that, Igor. US shale output has proved to be far more resilient than anyone had expected. Productivity gains and lower input costs have mitigated the impact of low prices. More importantly, the shale sector has the ability to ramp up output rapidly if prices do rise, either due to a rise in demand, or an attempt by other major producers to cut output. Indeed, this is likely the real reason the Saudis resist cutting output: they know it is futile because the supply of non-OPEC output is much more elastic than it used to be. This makes the demand for the output of the major producers, notably the Saudis (and the Russians!) more elastic than it used to be. This implies that it is not in the individual interest of any major producer to cut output unilaterally.

Which brings us to the most informative and refreshingly different part of Sechin’s remarks: his discussion of the prospects of a coordinated output cut involving OPEC and Russia.

This idea has captivated traders, who chase the idea like Randy Chasing the Dragon, shooting (the price!) up every time the rumor is floated, only to watch it fly away from their grasp. Once upon a time, Igor was notorious for encouraging such notions. Not this time around:

The most powerful figure in Russia’s oil industry on Wednesday signalled his steadfast opposition to combining with Opec to reverse the crude price rout through co-ordinated cuts in production.

. . . .
“Who are we supposed to be talking to about cuts?” Mr Sechin said when asked by the Financial Times if he was considering working with Opec, the producers’ cartel, to try to shore up the oil price. “Will Saudi Arabia or Iran cut production?”

Methinks that the real story is that the Saudis have made it clear that they trust neither the Russians nor (especially) other members of OPEC to adhere to any agree upon cuts, even assuming a deal can be cut, which is highly doubtful. So Sechin is acting as if he is the one rejecting the idea, primarily because he knows that it is DOA.

Not that this will stop all those Randys from chasing the next rumor of a coordinated cut.

Which raises the questions: Is Randy a robot? Are robots programmed to buy whenever a rumor of a Russo-Saudi oil deal is announced?

Maybe Igor will enlighten us in his next public appearance. Maybe he can do it to some musical accompaniment. Might I suggest this?:

Putin held a meeting with the CEOs of seven state-owned enterprises to discuss the sale of minority stakes in their companies (a move sometimes mischaracterized as “privatization”). Putin frankly admitted that the impetus for this discussion is Russia’s dire budgetary situation. Putin caused some confusion by saying the “new owners of privatized assets must have Russian jurisdiction,” leading some to conclude that he was ruling out foreign investment. Peskov clarified the next day, saying that Russia welcomed foreign investors, but “If the question is about a foreign investor, that’s one thing. If it’s about a Russian investor, it must not be another offshore scheme.”

I consider it likely that this initiative will be stillborn, at least insofar as sales of stakes to foreigners are concerned. Putin said that the sales must not take place at “knockdown prices.” Well, in the current environment, the prices (especially for Rosneft and VTB) are likely to be very low indeed.

This is especially so since foreign investors will demand a substantial discount to compensate for expropriation risk. Savvy investors with long memories will recall that Putin justified expropriating Shell’s Sakhalin II project by saying that the terms of the Sakhalin PSA were unfair to Russia, and that Shell had exploited Russia’s economic desperation when it signed the deal at a previous time of low energy prices. Putin (or whoever succeeds him) could easily resurrect such rhetoric in the future when oil prices rebound. Further, minority shareholders in Russian enterprises–especially state enterprises–have few protections against schemes that divert assets, or which dilute their holdings.

Given that prices are likely to be very low, if there are sales to foreigners, it will indicate (1) that Russia is desperate indeed, and (2) Putin et al consider it unlikely that sanctions will be relaxed anytime soon.

If there are sales, it is likely to be to Russian oligarchs, and in particular those with extensive holdings outside Russia. Just as Putin dragooned them into paying for Sochi and other prestige projects, he could well pressure them into overpaying for stakes in the state enterprises. This would allow him to kill two birds with one stone. It would help stanch the budgetary bleeding. It would also advance Putin’s longstanding goal of onshoring Russian capital. That would fit with the “owners must have Russian jurisdiction” remark.  And Putin has substantial leverage to get oligarchs to do his bidding–literally.

Even if partial sales take place, it will be merely a stopgap budgetary measure: it will not indicate a fundamental reconsideration of Russian economic policy.  Putin is still obviously a firm believer in the state control/state champion model, despite its manifest inefficiency. Putin prefers the control over resources that state control provides to having an efficient economy. Which is why he finds himself in his current straits.

My grandfather had a wealth of colorful expressions, most of which were the product of his Appalachian upbringing. One, however, was a little different. Whenever it was too late to do something about a particular problem, he’d say: “Well, it’s a little late for herpicide.” In context, I understood what he meant, but the exact meaning escaped me. I asked him one time, and it turns out that Herpicide was a (quack) hair loss cure in the ’30s or ’40s. The company’s add campaign pictured a cue ball-bald man with the caption: “A Little Late for Herpicide.” I guess now it would be “A Little Late for Rogaine.”

This expression came to mind when I read in the FT that “Russia considers hedging part of its oil revenues.” It would have been a good idea when the price was $100, or $90, or even $50. At $30 (or below, as happened on Wednesday and Thursday), well, it’s a little late for hedgicide. Yes, oil could indeed go lower, but hedging today would lock in prices that are low by historical levels.

Hedging would make sense for Russia, just as it does for a highly-leveraged corporate. It clearly incurs financial distress costs when prices are very low. Hedging would reduce the expected costs of financial distress.

Presumably Russia would implement a program like Mexico’s, buying large quantities of out-of-the-money puts. This would allow it to capture the upside but obtain protection on the downside. It would also avoid a problem that it might face if it sold swaps/forwards: finding a counterparty. Selling a put to Russia doesn’t involve counterparty risk. Buying swaps from them would. Although this would be a right-way risk, one could readily see Russia balking on performance if oil prices were to spike, putting a short swap position well out of the money. It would have the cash to pay: the willingness to pay, not so much. Further, although Russia’s ability to pay is closely related to oil prices, it is exposed to other risks that could impair that ability, and these risks would create credit risks for anyone buying swaps from Russia.

Buying puts does create an issue, though: this would require Russia paying a rather hefty premium upfront, at a time when it is cash-strapped. As an illustration of its financial straits, note that it is attempting to avoid having to come up with cash to stabilize troubled megabank VEB. Borrowing to pay the premium is also problematic, given its dicey creditworthiness. Russia’s CDS spread is around 370bp (which, although it has turned up as oil prices took their latest plunge, is still below post-Crimea levels, and even below the levels seen in August). Current sanctions and the prospect of the crystallization of future political risks may also make lenders reluctant to front Russia the premium money.

One interesting thing to consider is how hedging would affect Russia’s output decisions going forward. Hedging, whether by buying puts or selling swaps, would reduce its incentive to cut output in low price environments. As I’ve written before, Russia doesn’t have a strong incentive to cut output anyways because  market share, market demand elasticity, and the cost of shutting down production in Siberia make it a losing prospect (as its refusal to cut output in 2009 and in the past 18 months clearly indicate). However, whatever weak incentives Russia has to cut (in cooperation with the Saudis for instance) would be even weaker if it was hedged. If cooperation on output between OPEC and Russia has proved hard up to now, it would be harder still if Russia was hedged.

A Russian hedging program, if big enough, could affect market pricing, but not the price of oil (at least not directly*): hedging is a transfer of risk, and a big Russian hedge would affect the price of oil risks. Its hedging pressure would tend to increase market risk premia (i.e., reduce forward prices relative to expected spot prices). If done using puts, it would also tend to steepen the put-wing volatility skew and increase volatility risk premium. Adding its hedging pressure to the market would also necessitate the entry of additional speculative capital into the market in order to mitigate these effects. Sechin has criticized speculators in the past: hedging Russian oil price risk would be prohibitively expensive without them.

Although Russia has mooted the possibility, I doubt it will follow through. I would imagine that the combination of the cash cost of options and criticism within the ruling clique of locking in low prices will cause them to pass. If and when oil prices rise substantially, I predict they will forego hedging because they will convince themselves that prices won’t fall again, just as they did post-2009.

In sum, this sounds like an idea that the technocrats have advanced that will die at the hands of the siloviki, like various privatization initiatives.

* The spot price of oil depends on output and demand. Hedging affects spot prices to the extent that it affects output. One way that could happen is that if it reduced Russia’s incentive to cut output. Another way it could happen is that hedging increases Russia’s capacity to finance investments in oil production by reducing capital costs. In this case, investment would be higher and output would be higher.

In each of these scenarios hedging reduces spot oil prices in some states of the world, not because of the direct effects of forward selling, but because the hedging provides incentives to increase output. This is a good thing.

The oil collapse continues apace, after a one day breather on Monday. As I write, WTI and Brent are off almost 8 percent. Equity indices around the world are going in the same direction.

This recent co-movement between crude (and other commodities, especially non-precious metals) has unleashed torrents of twaddle. One of the most egregious pieces thereof was a recent Krugman column:

When oil prices began their big plunge, it was widely assumed that the economic effects would be positive. Some of us were a bit skeptical. But maybe not skeptical enough: taking a global view, there’s a pretty good case that the oil plunge is having a distinctly negative impact. Why?

Well, think about why we used to believe that oil price declines were expansionary. Part of the answer was that they reduced inflation, freeing central banks to loosen monetary policy — not a relevant issue at a time when inflation is below target almost everywhere.

Beyond that, however, the usual view was that falling oil prices tended to redistribute income away from agents with low marginal propensities to spend toward agents with high marginal propensities to spend. Oil-rich Middle Eastern nations and Texas billionaires, so the story went, were sitting on huge piles of wealth, were therefore unlikely to face liquidity constraints, and could and would smooth out fluctuations in their income. Meanwhile, the benefits of lower oil prices would be spread widely, including to many consumers living paycheck to paycheck who would probably spend the windfall.

Now, part of the reason this logic doesn’t work the way it used to is that the rise of fracking means that there is a lot of investment spending closely tied to oil prices — investment spending that has relatively short lead times and will therefore fall quickly.

Where to begin? I guess the place to start is to note that Krugman commits a cardinal economic error (you’re shocked, I’m sure): he argues from a price change. What is frightening is that if you believe his characterization of the received wisdom in macroeconomics, this is the standard way of thinking about these things in macro.

Prices do not move exogenously. Prices can go down because of supply shocks. They can go down because of demand shocks. The price movement is the same direction, but the implications are very different. In particular, the implications for co-movements between oil prices and asset prices are very different. You cannot analyze based on the fact of the price change alone: your analysis must be predicated on what is driving that change.

A price decline because of a favorable supply shock is generally positive for the broader world economy. Yes it is bad for oil producers, but especially for advanced and most emerging economies who are oil/commodity shorts, a supply-driven price decline is beneficial and should be associated with higher stock prices, economic growth, etc. The production possibility frontier shifts out, leading to higher incomes overall although in a world with incomplete risk sharing there are distributive effects. But the adverse consequences for producers are almost always swamped by consumer gains.  In this scenario, growth and asset prices on the one hand, and commodity prices on the other, move in opposite directions.

Things are very different for demand shocks-driven price changes. A price decline because of an adverse demand shock is generally negative for the broader world economy, because it is a weakening world economy that is the major source of the demand decline. This is a matter of correlation, not causation. Causation runs from a weakening economy to lower demand for oil (and other commodities) to lower commodity prices and lower asset prices.  Oil price (and asset price) changes are an effect not a cause.

The current situation is much closer to the latter case than the former. Yes, there have been oil production increases in the last couple of years, but if world economic growth had continued on its pre-mid-2014 pace, demand would have grown sufficiently to absorb this increase. In fact, the decline in oil and other commodity prices starting around June 2014 occurred right about the time that world growth forecasts declined appreciably. Subsequent months have seen a litany of bad growth news from the main sources of commodity demand growth in the boom years, most notably, of course, China. And the news from China keeps getting worse. This is reflected in cratering stock prices there, and other indicia of economic activity. (Notably all of these indicia are pretty much non-official. Official Chinese statistics should be nominated for the next Nobel Prize in Fiction.)

But rather than go back to basics, Krugman assembles a Rube Goldberg contraption to explain what is going on. And of course, austerity and the liquidity trap play a starring role:

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

Since because of his cardinal error Krugman does not identify what caused the price decline that begins his chain of “reasoning,” it’s hard to understand fully what he means. The most charitable interpretation is that there was a favorable supply shock that was so big that it caused such a large price decline in oil that this caused world “aggregate demand” to decline because of the severe adverse consequences on indebted and liquidity constrained producing countries and companies.

Inane. For one thing, these economies and sectors are very small in comparison to the world economy. Commodity producing countries have historically suffered major financial crises with little, if any, effect on growth world-wide, or on asset prices world-wide. The US oil and gas sector has also undergone some severe crises (e.g., 1986-1987) with limited fallout on US and world growth: the impacts tended to be concentrated regionally in the producing states, such as Texas. Not much fun there, but the rest of the country and the world didn’t much notice. In fact, they benefited from the favorable oil supply shock.

For another, even if there is some asymmetry between the “liquidity constraints” of producers and consumers, Krugman has been arguing strenuously that US and European consumers are liquidity constrained, hence his constant attacks on austerity. In Krugman’s argue-from-a-price-change story, that liquidity constraint has eased, and therefore one would expect to see improvement in consumption growth in places like the US, but the reverse is in fact true. The US economy is slowing rather noticeably.

No. The back-to-basics-trace-the-cause-of-the-price-change story is much more plausible. And here’s the irony. The epicenter of the commodity demand and world growth shock is China, which has binged on credit stimulus since 2009 in a way that Krugman should approve. But that cannot go on forever, and indeed, the main source of problems in China is the recognition that it can’t go on forever. China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase. How bad it is depends on how well the Chinese handle it. Given their mania for central control, I do not believe they will handle it well.

Macro panjandrums, like Oliver Blanchard, are puzzled, because official data do not yet reflect any large decline in growth. But that’s because official data are backward looking, and markets look forward relentlessly. They are signaling current and future problems, which official data will eventually validate. (And that’s when the data aren’t made up, as is notoriously the case in China.)

Commodity prices are particularly important, because commodities are consumed in the here and now. When demand declines, consumption declines, and prices decline contemporaneously. For all the talk about financialization, that can’t overcome the decisions of billions of commodity consumers around the world. Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems. You don’t need Rube Krugman contraptions to explain that.

The decline in oil prices is producing a predictable political outcome: attempts to prop up the domestic US industry. Some initiatives would make sense regardless of the financial distress of the US upstream sector: the Clinton and Obama administrations in particular have imposed a variety of inefficient regulations and restrictions on US hydrocarbon production, and it would be desirable to roll these back, as is being proposed:

Among the proposals under discussion: Expediting the process for exporting liquefied natural gas, and upgrading infrastructure to move energy to market more quickly and cheaply.

Another top priority for the two Republicans is loosening environmental and other regulations.

But then there’s just the plain stupid:

Some lawmakers are floating the possibility of taking retaliatory trade measures against Saudi Arabia, which has flooded the market with cheap oil in what some analysts see as a bid to drive America’s growing shale oil industry out of business.

. . . .

North Dakota Rep. Kevin Cramer (R) said lawmakers could begin to mull retaliatory tariffs against Saudi Arabia in the future but emphasized he is not advocating for that yet.

“I’m very hesitant to go down that path at this time but clearly that would be a possible option should the Saudis not play fair. Because as much as I advocate for free and open markets, I also advocate for fair markets,” he said.

Saudi Arabia, taking advantage of its low extraction costs, has refused to curb oil production in a bid to expand market share and undercut competitors. This has raised the prospect of the U.S. government taking action to level the playing field for domestic companies.

“I’m not prone to a lot of government intervention in terms of propping industry up, per se. What would be the most helpful is to roll back regulations that get in the way of further development and profitability,” said Cramer, who cited the Endangered Species Act as one burdensome regulation.

“Obviously they have access to our market and I suppose to some degree there is a role that can be played there. I’m not at the point where I’m ready to advocate tariffs or restricting their access necessarily,” he added.

Any tariff on Saudi imports would be special interest protectionism pure and simple, tarted up in the usual rhetoric (and whining) used to justify protectionist measures. “Fair markets” is a sure tell. Anyone who says “I’m for free markets but they should be fair markets” is a liar, and should drop the pretense. Any such person is all about protecting a favored industry or firm. When someone, regardless of party, says “fair markets”, I strongly advise you to check your wallet, because they are trying to rob you.

And why should Saudi Arabia “refuse to curb oil production”? Indeed, “curbing oil production” is the exercise of market power, for which the US (rightly) criticized OPEC and the Saudis in the past. What’s more, low cost producers are the ones who should sustain output in the face of a demand decline: high cost producers are the ones who should cut back.

Furthermore, although North Dakota is an oil long, the US as whole is an oil short, still producing only about 1/2 of its consumption, despite the spurt in oil production in the past 5-6 years. So low oil prices are still in the interests of the US.

It should also be noted that the “flooding the market with cheap oil” meme is vastly overstated. Saudi output in June, 2014, right before the price collapse began, was about 10mm bpd. It is now about 10.5 mm bpd. That difference represents a whopping .5 percent of world output. Even given an elasticity of 10 (which is probably too high) that could cause at most at 5 percent decline in prices. As I write, Brent just went below $33/bbl, and hence is down almost exactly 70 percent off its pre-collapse levels. So this collapse is not the result of the Saudis flooding the market.

Nor are the Saudis engaged in some predatory pricing strategy. At least I doubt that they are, because such a strategy would be irrational.

The price decline is the result of increased output in a variety of places (including the US), but mainly due to a steep decline in demand growth, especially from China.

Yes, the upstream sector in the US is suffering severe financial distress. So be it. That’s the nature of the business, and the nature of a market system generally. Resources should exit sectors that suffer demand declines. They should not be propped up through trade restrictions, especially trade restrictions that will impose far greater costs on the US economy as a whole than they will benefit one sector in that economy.

It is also perversely ironic that the very same Republicans (I am speaking of the individual legislators, like Murkowski and Cramer, not the party as a whole) who pushed for ending the idiotic export ban are now mooting an equally idiotic restriction in imports. This makes it plain that it’s not about principle, in the least. It’s all special interest politics. That’s not surprising, but it’s not admirable. And it’s not any better when Republicans push it than when Democrats and Obama do.

So yes, eliminate or cut back inefficient restrictions that a relentlessly anti-hydrocarbon administration has imposed, in order to eliminate unnecessary burdens on US oil and gas production that hurt both US producers and consumers in the US and around the world. But don’t impose large costs on American consumers of oil in order to prop up the US upstream sector. The sector should shrink if the demand for its product declines due to increased production elsewhere, or reduced demand. So be it.

Satyajit Das writes some smart things. He also writes some silly things. This article in the FT is definitely in the silly category. Embarrassing is more like it.

Das claims that “increased financialisation” has “exacerbated” the downturn in commodities. What does he mean exactly?

Let’s start with the what Das means by financialization. (I’m ‘Merican and I’ll spell it like a ‘Merican, dammit!) This has become a term of art to mean traditional financial investors (pension funds, hedge funds, retail investors etc.) taking on direct exposure to commodity price risks, usually via derivatives (including ETFs). But Das treats anything touching finance as financialization. His use of the word is so broad as to be meaningless.

Cash flows from future sales were monetised to raise large amounts of debt to finance expansion. The collateral value of commodities secured expansion in borrowing and trading.

Uhm, when has this not been true in commodities? Commodity production tends to be highly capital intensive, which requires, you know, capital, which requires tapping the capital markets to, you know, fund. Since the dawn of capital markets, lenders and equity investors have mobilized savings to supply capital to miners, drillers, etc., to fund the digging of mines and the drilling of wells, based on the expectation of being paid back from cash flows from future sales. That’s exactly what finance is. If that is “financialization,” pretty much everything is “financialized” and the term is so general as to lack all meaning and analytical bite.  Modern markets have always been financialized in this way.

Natural resource firms have long been major users of the capital markets. Indeed, many of the earliest stock and bond markets developed to finance commodity investments, and mining and E&P firms have long been leading names in major stock and bond markets. In that respect, commodities have been financialized a lot more for a lot longer than most sectors of the economy.

In fact, it is the very capital intensity of extractive industries (which made natural resource firms reliant on capital markets from the first) that  explains the boom-bust cycle. Most of the costs of natural resource extraction industries are sunk costs. Literally sunk: very expensive, very long-lived holes in the ground that can’t be undug and used for something else. If demand turns down after these investments are made, it usually makes economic sense to continue operating , because the variable costs of operation tend to be relatively low and can be covered even when prices are low. Since the capacity is long-lived, exit does not occur, meaning that low prices can persist for long periods. But that’s economically efficient when investment is largely irreversible.

Which brings me to Das’s next groaner:

The need to maintain cash flow to service debt requires production levels to be maintained, even if it is below cost. This delays the withdrawal of supply and correction of prices. It also destroys the value of equity, making it difficult for firms to raise new capital to reduce debt.

Producing “below cost” (by which I assume he means continuing to produce when prices are below cost) destroys cash flow, rather than maintains it, if cost is measured properly. It is optimal to operate as long as prices cover avoidable costs (e.g., variable costs, and fixed costs that must be incurred as long as output is positive), even if prices are below some measure of accounting cost which typically embeds sunk costs: you can’t judge economic operation by looking at income statements, which have sunk costs baked in.

This kind of continued operation doesn’t “destroy the value of equity.” To the contrary, it is shutting down when price more than covers avoidable cost that destroys the value of equity. The fact that avoidable costs in natural resource extraction tend to be low relative to total costs means that not exiting even when prices are low is economically efficient.  (Another implication of the cost structure of natural resource production is that it is typically efficient to produce either at capacity or shut down altogether.)

Debt costs reflect the sunk costs of investment. Sometimes–like now–cash flows are insufficient to cover the costs of servicing this debt for many firms. That’s what bankruptcy laws are for. If they work well, the continued operation (or not) of insolvent firms will depend on current and expected future margins between price and avoidable costs, not the Ghost of Sunk Costs Past.

Then there’s this:

For industries like shale gas and oil which were cash flow negative even at high oil prices because of the need to invest in new wells to maintain production, reduction in the supply of capital affects the ability of firms to operate.

Again, Das is apparently utterly confused about the proper cash flow concept to apply. If “maintain production at all costs” was truly the mantra of the E&P industry, the problem would not be financialization, but management retardation. Finance would be implicated only to the extent that financiers are similarly retarded and gladly shovel good money to them to permit continued value destruction. If anything, it is the need to access the capital markets that prevents retarded managements from wreaking havoc: few things are more destructive of value than CEOs with bountiful free cash flows that relieve them of capital market discipline. Cutting off capital from negative NPV projects is a boon, not a burden.

Finally we get to derivatives!:

Hedging ameliorated the effect of declining prices. Derivative gains contributed in excess of 30 per cent of revenues in the US shale industry in 2015

And this is a problem why? This is exactly the way “financialization” is supposed to work. It transfers price risks to those (namely, well-diversified financial investors) who can bear them at a lower cost. Yes, investment probably would have been lower, and prices higher, had this risk transfer mechanism not existed. But this doesn’t mean that the level of investment with an efficient risk transfer mechanism is too high: it means that the level of investment without one is too low.

More bad derivatives stuff:

Margin calls further complicate matters. An airline that has hedged future oil purchases at high prices may face margin calls that make unexpected claims on its cash flow.

Yes, cash flow mismatches on hedges can be a problem. Which is exactly why corporate end users strongly preferred (and prefer) OTC hedges which embedded credit to mitigate these problems.

More financialization evils, according to Das:

Financialisation altered fundamental industrial structures. Traditionally high barriers to entry, such as technology, expertise and access to capital, led to domination by large producers who planned and controlled production.

Now specialised resources service firms provide access to technology and the willingness of capital markets and non-traditional lenders to provide finance allows easier entry resulting in a more fragmented industry.

These are features, not bugs! These are benefits of financialization! Breaking down oligopolistic and monopolistic market structures is good, not bad!

At the same time, trading in financial claims on future commodity cash flows has encouraged institutional investment in the sector as part of diversification into new asset classes. Hedge funds and trading firms now act as quasi banks financing and facilitating risk management by commodity market participants.

So facilitating the flow of capital from savers to investors is a bad thing? Facilitating risk management is bad too? Who knew?

This is just bizarre:

This activity is marked-to-market daily or secured by the value of the commodity. Any change in value can trigger calls for additional collateral complicating cash flow management or force liquidation of holdings. Capital market investors may lack the ability to ride out prolonged corrections. It complicates dealing with financial distress and the necessary restructuring.

Tapping into a deeper pool of capital, which financialization (as defined by Das) allows, spreads the risks and makes it easier to ride out prolonged correction (which, again, are an inherent consequence of the cost structures/operational leverage of natural resource extraction), not harder. And the statement about complicating dealing with financial distress and restructuring is completely conclusory, with no supporting argument or evidence.

Yes, in a world with poorly developed financial markets, large scale investments in industries characterized by irreversibility and large scale (like natural resource extraction) are expensive to fund. “Financialization”–which in Das’s expansive usage, apparently just means lower cost access to bigger pools of investment and risk capital–indeed leads to a bigger natural resources sector. Yes, by its very nature this sector will inevitably go through protracted periods of low prices, which will impose losses on investors. But that’s a risk that they willingly choose to bear, in exchange for an expected return that they consider compensatory.

Das appears to be afflicted with Bastiat Disease, i.e., the inability to distinguish between the seen and the unseen. Das sees the financial carnage that the current natural resources depression has created, but hasn’t considered what would happen if the world was less financialized. What are the unseen consequences of that?

I can tell you: a poorer world.

There are some forms of finance that are wealth-destroying rent seeking. The financing and risk management of the production of minerals and energy are not among them.

The myth that global warming caused a drought which caused the civil war in Syria has been flogged repeatedly by the left, especially in the lead-up to the Paris farce: another example of the “elites” letting no good crisis go to (political) waste. As I discussed in March, there was indeed a drought in Syria, but no credible scientific evidence links the drought to climate change.

Droughts happen. What turned the drought into catastrophe in Syria was the depletion of groundwater by previous government-driven efforts to spur production:

Syria was such a successful producer that it became a net exporter of wheat for the better part of two decades — almost unheard-of in a region where most governments imported cheap wheat from abroad. According to ICARDA Director General Mahmoud Solh, the increased productivity netted the Syrian government more than $350 million a year . The country also kept a strategic reserve of wheat — usually about 3 million metric tons, enough to get it through a lean year or a price spike. In this most stable of dictatorships, nobody dreamed of a war.

But all that productivity came at a price. To produce these remarkable gains, Syria’s agricultural sector “mined” groundwater to irrigate farms. Experts predicted that this would lead to severe water Shortages. When a four-year drought struck in 2006, devastating 60 percent of Syria’s agricultural lands, the country’s groundwater was already depleted.

(This sounds a lot like Soviet agricultural malpractice.)

This brings to mind Adam Smith’s argument that bad government policy turns “dearths” caused by nature into famines:

The seasons most unfavourable to the crop are those of excessive drought or excessive rain. But as corn grows equally upon high and low lands, upon grounds that are disposed to be too wet, and upon those that are disposed to be too dry, either the drought or the rain which is hurtful to one part of the country is favourable to another; and though both in the wet and in the dry season the crop is a good deal less than in one more properly tempered, yet in both what is lost in one part of the country is in some measure compensated by what is gained in the other. In rice countries, where the crop not only requires a very moist soil, but where in a certain period of its growing it must be laid under water, the effects of a drought are much more dismal. Even in such countries, however, the drought is, perhaps, scarce ever so universal as necessarily to occasion a famine, if the government would allow a free trade.

It as not just the  Syrian government that contributed to spiraling food prices which created popular unrest in the Middle East that culminated in 2010-2011 (which the Muslim Brotherhood exploited in Egypt and Syria in particularly): US government policy contributed to the problem. In particular, US biofuels mandates that stimulated the production of ethanol drove up the price of corn by an estimated 30 percent, and as Brian Wright has shown, drove up all other grain prices as well (because corn is a substitute for other grains in both consumption and production). (I strongly recommend reading at least the introduction of the Wright paper: I’d quote in detail, but the online versions embed some devious feature that makes it impossible to copy-and-paste.)

It is sickly ironic that policies intended to reduce global warming pushed by the same crowd that falsely blame the Syrian drought and subsequent civil war on global warming (a) do nothing to reduce global warming, and (b) have done far more to exacerbate poverty and create social unrest  in the Middle East than global warming ever has or ever will.  Ethanol is an unmitigated disaster environmentally, economically, and socially. Yet the people Thomas Sowell trenchantly calls “the anointed” colluded with agricultural lobbies in the United States (encompassing both growers and processors) to inflict this monstrosity on the world.

How dare they–how fucking dare they–presume to lecture anyone on their obligations to “save the planet” and help the poor? Through biofuels policies alone they have inflicted huge misery and privation, and yet they have the audacity to try to exploit one of the consequences of these policies in order to ram more of their brilliant ideas down our throats.

Haven’t they done enough? Can they please now just go away?

Alas, we won’t be so lucky. These are our elites, after all, and we are stuck with them, like a case of malaria. And they are actually proud of stupid policies like biofuel mandates. There is no stupid that can equal the stupid of not just not learning from mistakes, but reveling in them.

Do you still wonder why the Trump phenomenon exists? The global reaction against the elites, of which Trump is just the most prominent example, is yet another baleful consequence of the failure of these so called elites. The reaction may be as bad as the disease, but let the blame fall where it should: squarely on the shoulders of those condescending fools whose allegedly good intentions have paved a superhighway to hell.