Streetwise Professor

The FT, Goldman, Jonathan Stern at the Oxford Institute of Energy Research, Vitol, and others are now predicting that the emergence of the US as an LNG exporter, and the looming surplus driven by that plus supplies from Australia, PNG, and elsewhere, are inexorably pushing this commodity away from traditional oil-based long term contracts towards spot trading.

Huh. I remember reading something along those lines last September. Oh, yeah. Here it is. (Also available in Spanish!) I guess it’s more accurate to say I remember writing something exactly along those lines in September.

The opening of the Cheniere* and later the Freeport and Cameron LNG trains in the Gulf will be particularly important. The US is likely to be at the margin in Asia, Latin America and perhaps Europe. Prices are set at the margin, meaning that the LNG pricing mechanism can be integrated into the already robust US/Henry Hub pricing mechanism. Giving the tipping effects discussed in my paper, the transition in the pricing mechanism and the development of a robust spot market is likely to take place relatively rapidly.

I know there is skepticism in the industry about this, but I am pretty confident in my prediction. Experiences in other markets, notably iron ore and to some degree coal, indicate how rapid these transitions can be.

Funny story (to me anyways). I gave the keynote speech at LNG World Asia in Singapore in September, and I laid out my views on this subject. I gave the talk in front of the giant shark tank at the Singapore Aquarium, and I could help but think of Team America, Kim Jung Il, and Hans Blix. I’m sure there were a few people in the audience who would have liked to feed me to the sharks for calling oil-linked pricing “a barbarous relic” and encouraging them to embrace the brave new world of LNG trading.

But whether they like it or not, it’s coming. The inflection point is nigh.

*Full disclosure. Number One Daughter works for Cheniere.

It has been a hellish few months for Gazprom. It’s profits were down 86 percent on lower prices and volumes and the weak ruble. Although the ruble has rebounded, the bad price news will persist for several months at least, given the lagged relationship between the price oil and the price of gas in the company’s oil-linked contracts. The company has been a die-hard defender of the link: another example of be careful what you ask for.

Moreover, the EU finally moved against the firm, filing antitrust charges. Although many of the European Commission’s antitrust actions, especially against US tech firms, are a travesty, the Gazprom brief is actually well-grounded. At the core of the case is Gazprom’s pervasive price discrimination, which is made possible by its vertical integration into transportation and contractual terms preventing resale of gas. Absent these measures, a buyer in a low-price country could resell to a higher price country, thereby undercutting Gazprom’s price discrimination strategy.

It is interesting to note that the main rationale for Gazprom’s vertical integration is one which was identified long ago, based on basic price theory, rather than more elaborate transactions cost economics or property rights economics theories of integration. Back in the 1930s  economists identified price discrimination as a rationale for Alcoa’s vertical integration. There was some formal work on this in the 70s.

Gazprom is attempting to argue that as an arm of the Russian state, it is not subject to European competition rules. Good luck with that. There is therefore a decent chance that by negotiation or adverse decision that Gazprom will essentially become a common carrier/have to unbundle gas sales and transportation, and forego destination clauses that limit resale. This will reduce its ability to engage in price discrimination, either for economic or political reasons.

The company is also having problems closer to home, where it is engaged in a battle with an old enemy (Sechin/Rosneft) and some new ones (Timchenko/Novatek), and it is not faring well.

Gazprom and Putin have always held out China as the answer to all its problems. There were new gas “deals” between Russia and China signed during Xi’s visit to the 70th Victory Day celebration. (Somehow I missed the role China, let alone the Chinese Communists, played in defeating the Nazis.) But the word “deal” always has to be in quotes, because they never seem to be finalized. Remember the “deal” closed with such fanfare last May? I expressed skepticism about its firmness, with good reason. There is a dispute over the interest rate on the $25 billion loan that was part of the plan. Minor detail, surely.

Further, Gazprom doesn’t like the eastern route agreed to last year. It involves massive new greenfield investments in gas fields as well as transportation. It has therefore been pushing for a western route (the Altai route) that would take gas from where Gazprom already has it (in western Siberia) to where China doesn’t want it (its western provinces, rather than the more vibrant and populous east). The “deal” agreed to in Moscow relates to this western route, but as is almost always the case, price is still to be determined.

If you don’t have a price, you don’t have a deal. And the Chinese realize they have the whip hand. Further, they are less than enamored with Russia as a negotiating partner. Who could have ever predicted this? I’m shocked! Shocked!:

Chinese and Russian executives and advisers said that in addition to the challenge of negotiating prices acceptable to both sides, energy deals between the countries have also been hampered by mutual distrust and Chinese concerns about antagonising the US.

“The Russians are unreliable. They are always flipping things around for their own interest,” said one Chinese oil executive.

Who knew?

Putin is evidently losing patience with the company, and its boss Alexei Miller, is far less powerful than Sechin and Timchenko. When it was a strategic asset in Europe, and offered real possibilities in Asia, it could defend itself. Now that leverage is diminishing, its future is much cloudier.

The impending new supplies of LNG coming online in the US and Australia dim its future prospects further.

In sum, Gazprom is beset by many agonies. Couldn’t happen to a better company.

Der Spiegel reported that Greek officials claim that the country is on the verge of signing a deal with Russia that would give the Greeks €5 billion upfront, to be repaid from transit fees on a yet-to-be-built Turkish Stream pipeline: the Russians deny any deal. The quoted (but anonymous) Greek official said that this would “turn the tide” for Greece.

Really?

Some thoughts off the top.

First, Greece owes €320 billion, including payments of €30 billion in 2015 alone. It is “scraping the bottom of the barrel” by borrowing from various state entities (e.g., the public transport system) to meet April payroll. It has a budget deficit of €23 billion. Deposits at Greek banks fell by about €20 billion last week. This creates a liability for the Bank of Greece to Target2 (i.e., to the members of the ECB). A measly €5 billion will buy it a few weeks time, at best.

Second, it’s not as if creditors (e.g., the EU and the IMF and Target2 members) are going to give Greece discretion over how to spend this money. And they have many levers to pull. So it would set the stage for more arguments between the creditors and the debtor.

Third, the Russians are likely to write terms that secure the debt and give it priority over other creditors (at least with respect to any future transit fees). (Just remember how tightly the Russians crafted the Yanuk Bonds.) The Euros will flip out over any such terms. This would set up an epic The Good, The Bad, and the Ugly three-way standoff.

Fourth, this initiative would be directly contrary to European energy policy, which is finally attempting to reduce dependence on Russia and limit vulnerability to Russian gasmail and the use of energy as a wedge to create divisions within the EU.

Fifth, what are the odds that the pipeline will get built? The Europeans are against it. It requires the Greeks and the Turks to play well together, and we know how that usually works out. It requires additional investment in infrastructure in Turkey, which is problematic. Further, the Russian track record on these sorts of projects leaves much to be desired.

So what happens if the pipeline isn’t built, or is delayed significantly. No doubt the Russians will anticipate this contingency in the debt agreement, and write things in such a way that they have security or priority, which will just spark another battle with Greece’s European creditors.

In sum, such a deal would hardly be a solution to Greece’s problems. Indeed, it only escalates conflicts between Greece and the EU.

Which may be Putin’s purpose, exactly. Exacerbating Greek-EU conflict over a matter involving Russia directly at a time when Greece could scupper the extension of sanctions against Russia suits Putin perfectly. The fact that the pipeline is as much pipe dream as realistic project doesn’t matter a whit. This is all about stirring trouble. And that’s Putin’s speciality.

The Industrial Energy Consumers of America has submitted a comment letter on the CFTC’s position limit rule making. The letter contains this libel:

If one looks at the agenda from the February 26, 2015 meeting (see below), other than CFTC presenters, every presenter has views that are not consistent with CFTC action to set speculative position limits. Professor Pirrong has a long history of client paid studies in this area and will need to identify who paid for the underlying data and study for his results to be credible on this subject.

My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.

It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.

The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.

I am following around Iranian negotiator Javad Zarif, arriving this morning in Geneva, and then going to Brussels next week. Don’t worry, I won’t go biking. Certainly not in the absurd getup that Zarif’s interlocutor-or should I say Sancho Panza-John Kerry did here on the shores of Lac Leman. The man is obviously immune to mockery.

I am resigned that Sancho-I mean John-and Javad (remember, they are on a first name basis!) will reach some sort of deal that will clear Iran’s path to becoming a nuclear power in the near-to-medium term, with all of the malign consequences that entails. Which leads me to contemplate some of those consequences.

One of which relates to the price of oil (and natural gas), the malignity of which depends on whether you are long or short oil (and gas). Of course, one of the countries that is very long oil (and gas) is Russia, and from its perspective the consequences of a deal will be very malign. Which makes one wonder if Putin (or whoever is really in charge these days!) will attempt to do something to derail it. (Or are they too distracted by the folly in Ukraine? Or by dog fights under the carpet?)

The crucial issue is how rapidly, and by how much, Iranian output will ramp up if a deal is reached. There is both a political dimension to this, and an operational one.

The political issue is how rapidly a deal will result in the dismantling of the myriad sanctions that impede Iran’s ability to sell oil:

“Don’t expect to open the tap on oil,” one Gulf-based Western diplomat told Reuters. It is much easier to lift financial sanctions because so many components of Iran’s oil trade have been targeted, the diplomat said.

. . . .

But for Iran to sell significantly more crude and repatriate hard currency earnings, many U.S. and European restrictions on its shipping, insurance, ports, banking, and oil trade would have to be lifted or waived.

Yet because they represent the bulk of world powers’ leverage over Iran, initial relief would probably be modest, said Zachary Goldman, a former policy advisor at the U.S. Treasury Department’s Office of Terrorism and Financial Intelligence, where he helped develop Iransanctions policy.

Goldman predicted the first step would be to allow Tehran to use more of its foreign currency reserves abroad, now limited to specific bilateral trade.

“It’s discrete, and it doesn’t involve dismantling the architecture of sanctions that has been built up painstakingly over the last five years,” said Goldman, who now heads the Center on Law and Security at New York University.

Even with a nuclear deal, oil sanctions would probably effectively stay in place until early 2016, said Bob McNally, a former White House adviser under George W. Bush and now president of the Rapidan Group energy consultancy.

The operational issue is how rapidly Iran can reactivate its idled fields, and how much damage they have suffered while they have been off-line. The Iranians claim that 1mm barrels per day can come online within months. The IEA concurs:

Turning lots of production back on suddenly can be complicated—and time consuming—even if wells and reservoirs are maintained studiously. It could be even harder in complex Iranian fields that have been pumping for decades.

Still, some analysts have concluded that a good deal of that lost output could return more quickly than often anticipated. The International Energy Agency, for example, has said that it expects a relatively rapid burst of exports if sanctions are lifted.

“They’ve deployed considerable ingenuity in getting around sanctions and keeping fields in tiptop shape. We think Iran could pretty much come back to the market on a dime,” Antoine Halff, head of the IEA’s oil industry and markets division, recently told an audience at the Center for Strategic Studies in Washington.

Perhaps up to 2mm bpd of additional output could come back later. Then there is the issue of how a relaxation or elimination of sanctions would affect output in the long run as (a) western investment flows into the Iranian oil sector, and (b) other producers, and notably OPEC, respond to Iran’s return to the market.

In the short run, the 1mm bpd number  (corresponding to about 1.1 percent of world output) looks reasonable, and given a demand elasticity of approximately 10, that would result in a 10 percent decline in oil prices. Additional flows in the medium term would produce additional declines.

Even if Iran’s return to the market is expected to take some time, due to the aforementioned complications of undoing sanctions, much of the price effect would be immediate. The mechanism is that an anticipated rise in future output reduces the demand to store oil today: the anticipated increase in future output reduces future scarcity relative to current scarcity, reducing the benefit of carrying inventories. There will be de-stocking, which will put downward pressure on spot prices. Moreover, since an increase in expected future output reduces future scarcity relative to current scarcity, future prices will fall more than the spot price, meaning that contango will decline.

Some of the price decline effect may have already occurred due to anticipation of the clinching of a deal: the May Brent price has declined about $10/bbl in the last month. However, the movement in the May-December spread is not consistent with the recent price decline being driven by the market’s estimation that the odds  that Iranian output will increase in the future have risen. The May-December spread has fallen from -$4.47 (contango) to -$6.36. This is consistent with a near-term supply-demand imbalance rather than an anticipated change in the future balance in favor of greater supply. So too is the increase in inventories seen in recent weeks.

Predicting the magnitude of the price response to the announcement of a deal-or the breakdown of negotiations-is difficult because that requires knowing how much has already been priced in. My lack of a yacht that would make a Russian oligarch jealous indicates quite clearly that I lack such penetrating insight. However, the directional effect is pretty clear-down (for a deal, up for a breakdown).

Which is very bad news for the Russian government and economy, which are groaning under the effects of the oil price decline that has already occurred. Indeed, Iran’s return to the market would weigh on prices for years, reducing the odds that Russia could count on a 2009-like rebound to retrieve its fortunes.

Add to this the fact that a lifting of sanctions would open Iran’s vast gas reserves (second only to Russia’s) to be supplied to Europe and Asia, dramatically reducing the profitability of Russian gas sales in the future, and Iran’s return to the energy markets is a near term and long term threat to Russia.

Which makes Putin’s apparent indifference to a deal passing strange. The Russians freak out over developments (e.g., the prospect for an antitrust investigation of Gazprom, or pipsqueak pipeline projects like Nabucco) that pose a much smaller threat than the reemergence of Iran as a major energy producer. But they have not done anything overt to scupper a deal, nor have they unleashed their usual screeching rhetoric.

What gives? Acceptance of the inevitable? A belief that in the long run the deal will actually increase the likelihood of chaos in the Middle East that will redound to Russia’s benefit? Strategic myopia (i.e., an obsession with reassembling Sovokistan, starting with Donbas) that makes the leadership blind to broader strategic considerations? Distraction by internal disputes? Or does Putin (or whoever is calling the shots!) have something up his (their) sleeve(s)?

My aforementioned pining for a super yacht that would make Abramovich turn green again betrays my inability to penetrate such mysteries. But it is quite a puzzle, for at least insofar as the immediate economic consequences are concerned, Russia would be the Biggest Loser from a deal that clears Iran’s return to the oil market.

H/T to @libertylynx for the idea for this post.

This nice piece from the WaPo points out the link between oil prices and Russian aggressiveness:

From this perspective, Russia is not so much an insecure superpower as it is a typical petrostate with a short-term horizon that gets aggressive and ambitious once it accumulates substantive oil revenues. Back in the early 2000s when the price of oil was $25 a barrel, Putin was a friend of the United States and didn’t mind NATO enlargement in 2004. According to Hendrix’s research, this is exactly how petrostates behave when the oil prices are low: In fact, at oil prices below $33 a barrel, oil exporters become much more peaceful than even non-petrostates. Back in 2002 when the Urals price was around $20, in his Address to the Federal Assembly Putin enumerated multiple steps to European integration and active collaboration aimed at creating a single economic space with the European Union among Russia’s top priorities. In 2014 – with the price of oil price around $110 – Putin invaded Ukraine to punish it for the attempts to create that same single economic space with the E.U.

I made these basic points eight years ago, in a post titled “Cocaine Blues.”

The graph depicts Gaddy’s estimates of the energy rents accruing to the Soviet–and Russian–economy. Each of the two spikes in the graph corresponds to a period of Soviet/Russian adventurism. The first shot of oil/cocaine during the 1970s oil shock fueled Soviet aggressiveness around the world. The second oil/cocaine shot–the post-2003 runup in oil prices–is powering Putin’s recent revanchism.

There were some follow up posts on the same theme.

This post from Window on Eurasia quotes a Russian social scientist who disputes the importance of oil prices in explaining Russian behavior in the Putin era. Instead, Vladislav Inozemtsev identifies the lack of formal institutions as the characteristic feature of Putinism.

But these things are not mutually exclusive. Indeed, another SWP theme from about this same time period (2007-2008) is that Russia is a natural state in which Putin uses control over resource rents to maintain a political equilibrium. Resource rents permit personalized rule and impede the development of formal, impersonal institutions.

In other words, in Russia, resource rents, and especially oil/energy rents matter, both for its political structure and evolution, and its behavior as an international actor.

China is notorious for flouting intellectual property rights. From stolen technology (including notably military gear) to designer knock-offs, China pirates everything and everyone. It is therefore a rather jaw-dropping act of chutzpah for to Chinese Zhengzhou Commodities Exchange to send a nasty cease-and-desist letter to the Singapore subsidiary of ICE demanding that ICE not copy ZCE’s cotton and sugar contracts:

Intercontinental Exchange has been forced to delay the launch of its new Singapore platform after a Chinese exchange threatened legal action to stop the US group launching two commodity futures that are copies of contracts offered in China.

The move by the Zhengzhou Commodity Exchange is likely to send shockwaves through the global futures industry because it signals that China will not tolerate foreign exchanges copying its futures contracts, and comes despite the practice of offering “lookalike” contracts being accepted around the world for years.

The ICE contracts are not copies, exactly. Similar to its “NYMEX lookalike” contracts, which cash settle against the expiring NYMEX future, the ICE Singapore commodity contracts are to be cash settled based on the settlement price of the expiring ZCE future. The ZCE future is delivery-settled. Meaning that the delivery mechanism ensures convergence between physical and futures prices, and the lookalike contract can ensure convergence by cash-settling against the delivery-settled contract.

The issues here are common to all intellectual property controversies. Strong intellectual property rights impede competition. Against that, free riding off the creativity or investment of others can impede innovation.

There isn’t a one-size-fits-all answer to this trade-off. In the case of exchange traded contracts, I tend to lean towards weak intellectual property rights.  The network effects of liquidity tend to weaken competition, and to give incumbents a strong advantage over entrants. There is already a substantial stream of rents to being first that gives strong (and maybe overly-strong) incentives to innovate, making strong intellectual property rights superfluous, and indeed damaging because they place another burden on already weak competition.

The US courts arrived at a similar conclusion, ruling that NYMEX did not have property rights over its settlement prices that it could use to preclude ICE from using them to cash settle its contracts. This is one factor that has encouraged a relatively robust competition in energy derivatives, which is the exception rather than the rule.

In sum, I hope ICE is able to prevail in its battle with ZCE. In part on economic grounds, and in part on the grounds that it burns me to see IP pirates protect their turf by asserting IP, especially over something for which IP is unwarranted.

Igor Sechin, he of the ape drape, has taken to the pages of the Financial Times to diagnose the causes of the recent collapse in oil prices. I am sure you will be  shocked to learn that it is those damned speculators:

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

. . . .

Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all. There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

No, condemnations of speculation are not the last refuge of scoundrels attempting to assign blame for sharp movements in commodity prices: they are the first and only refuge. Prices going up? Speculators! Prices going down? Speculators! Poor, poor little companies like doughty Rosneft and even international cartels like OPEC are mere straws at the tossed before the speculative gales.

Sechin’s broadside is refreshingly untainted by anything resembling actual evidence. The closest he comes is to invoke long run considerations, relating to the costs of drilling new wells. But supply and demand are both very inelastic in the short run, meaning that even modest demand or supply shocks can have large price impacts that cause prices to deviate substantially from long run equilibrium values driven by long run average costs.

It is also hard to discern a credible mechanism whereby diffuse and numerous financial speculators could cause prices to be artificially low for a considerable period of time. (It is straightforward to construct models of how a local market can be manipulated downwards, but these are implausible for a global market. Moreover as I showed years ago, markets that are vulnerable to upward manipulation by longs are relatively invulnerable to downward manipulation by shorts.)

And the empirical implications of any such artificiality are sharply inconsistent with what we observe now. Artificially low prices would induce excessive consumption, which would in turn result in a drawdown in inventories. This is the exact opposite of what we see now. Inventories are growing rapidly in the US in particular (where we have the best data). There are projections that Cushing storage capacity will be filled by May. Internationally, traders are leasing supertankers to store oil. These are classic effects of demand declines or supply increases or both that are expected to be transient.

Insofar as requiring some percentage of oil contracts (by which I presume he means futures and swaps) be satisfied by delivery, the mere threat of delivery ties futures prices to physical market fundamentals at contract expiration. What’s more, the fact that paper traders are largely out of the market when contracts go spot means that they cannot directly affect the supply or demand for the physical commodity.

Sechin’s FT piece is based on a presentation he gave at International Petroleum Week. Rosneft thoughtfully, though rather stupidly given the content, posted Sechin’s remarks and slides on its website. It makes for some rather amusing reading. Apparently shale oil companies are like dotcoms, and shale oil was a bubble. According to Igor, US shale producers are overvalued. His evidence? A comparison of EOG and Hess to Lukoil. The market cap of the EOG is substantially higher than Lukoil’s, despite its lower reserves and production, and lack of refining operations. Therefore: Bubble! Overvaluation!

Gee, I wonder if the fact that Lukoil is a Russian company, and that Russian company valuations are substantially below those of international competitors, regardless of the industry, has anything to do with it? In fact, it has everything to do with it. Sechin’s comparison of a US company with a Russian one points out vividly the baleful consequences of Russia’s lawless business climate. It’s not that EOG and other shale producers are bubbles: it’s that Lukoil (and other Russian companies) are black holes.  (It was the very fact that Russia’s lack of property rights, the rule of law, and other institutional supports of a market economy that got me interested in looking at the country in detail in the first place almost a decade ago.)

I was also amused by Sechin’s ringing call for greater transparency in the energy industry. This coming from the CEO of one of the most opaque companies in the most opaque countries in the world.

Reading anything by Sechin purporting to be an objective analysis of markets or market conditions is always good for a chuckle. His FT oped and IPW remarks are no exception. As a market analyst, he makes a better KGB operative. Enjoy!

The Bank for International Settlements  is creating some waves with a teaser about a forthcoming report that claims to show that financialization is largely responsible for the recent fall in oil prices. Even by the standards of argument usually seen criticizing financializaton, this one is particularly lame.

BIS notes that the upstream business is heavily leveraged: “The greater debt burden of the oil sector may have influenced the recent dynamics of the oil market by exposing producers to solvency and liquidity risks.” The BIS summarizes the well-known fact that yields on oil company bonds have skyrocketed, and claims that this has contributed to the price decline. But it is plainly obvious that cause and effect overwhelmingly goes the other way: it is the sharp decline in prices that damaged the financial conditions of E&P firms. The closest that BIS can come to showing the direction of causation going from debt to price is this: “Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market.”

At most, this means that future output may be higher in the future than it would have been had these firms been less leveraged, thereby weighing on future prices and through inter temporal linkages (e.g., storage) on current prices. It is difficult indeed to attribute the earlier price declines that caused the financial distress to this effect. Moreover, the BIS suggests that oil output from existing wells can be turned off like a water faucet. Given that the costs of capping a well are not trivial, this is not true: except under rather extreme circumstances, producers will continue to operate wells (which flow at an exogenously determined rate) even when prices fall substantially. Thus, this channel is not a plausible contributor to an appreciable fraction of the 50 percent decline in prices since July.

Then BIS turns its attention to hedging:

Since 2010, oil producers have increasingly relied on swap dealers as counterparties for their hedging transactions. In turn, swap dealers have laid off their exposures on the futures market as suggested by the trend increase in the CFTC short futures positions of swap dealers over the 2009-13 period.

However, at times of heightened volatility and balance sheet strain for leveraged entities, swap dealers may become less willing to sell protection to oil producers. The co-movement in the dealers’ positions and bouts of volatility suggests that dealers may have behaved procyclically – cutting back positions whenever financial conditions become more turbulent. In Graph 2, three such episodes can be seen: the onset of the Great Recession in 2008, the euro area crisis combined with the war in Libya in 2011, and the recent price slump. In response to greater reluctance by dealers to take the other side of sales, producers wishing to hedge their falling revenues may have turned to the derivatives markets directly, without going through an intermediary. This shift in the liquidity of hedging markets could have played a role in recent price dynamics.

BIS’s conjecture regarding producers hedging directly can be tested directly. The CFTC Commitment of Traders data, which BIS relies on, also includes a “Producers, Merchants, Processors and Users” category. If BIS is correct and producers have gone to the futures market directly rather than hedged through dealers, PMPU short interest should have ticked up. So why they are guessing rather than looking at the data is beyond me.

What’s more, using declines in swap dealer futures positions to infer pro-cyclicality seems rather odd. Swap dealer futures hedges of swap positions means that they are not taking on a lot of risk to the balance sheet. That is the risk that is being passed on to the futures market, not the risk that is being kept on the balance sheet.

The decline in swap dealer short futures positions more likely reflects a reduced hedging demand by producers. For instance, at present we are seeing a sharp drop in drilling activity in the US, which means that there is less future production to hedge and hence less hedging activity. The fact that the decline in swap dealer short futures is much more pronounced now than in 2008-2009 is consistent with that, as is the big rise in these positions during the shale boom starting in 2009. This is exactly what you’d expect if hedging demand is driven primarily by E&P companies in the US. Regardless, the BIS release does not disclose any rigorous analysis of what drives swap dealer positions or hedging positions overall, so the “reluctance of dealers” argument is at best an untested hypothesis, and more likely a wild-assed guess. Using drilling activity, or capex, or E&P company borrowing as control variables would help quantify what is really driving hedging activity.

And the conclusion is totally inane: “This [unproven] shift in the liquidity of hedging markets could have played a role in recent price dynamics.” Well, maybe. But maybe the fact that the moon will be in the seventh house on Valentine’s Day could have played a role too. Seriously: what is the mechanism by which this (unproven) shift in liquidity in hedging markets affected price dynamics?

Further, if E&P company balance sheet woes are making it harder for them to find hedge counterparties, this would impair their ability to fund new drilling, and tend to support prices. This would offset the alleged we’ve-got-to-keep-pumping-to-pay-the-bills effect.

BIS also offers this pearl of wisdom:

Rather, the steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset. As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions.

What, commodities have not previously been subject to large price moves and high volatility? Who knew? I’ll bet if I dug for a while I could find BIS studies casting doubt on the prudence of bank participation commodity markets because the things are so damned volatile. And what accounts for the extremely low volatility in the first half of 2014, something BIS itself documented? Is financialization that fickle?

Moreover, why shouldn’t oil prices be driven by changes in expectations about future market conditions? It’s a storable commodity (both above and below ground), and storage links the present with the future. Furthermore, investments today affect future production. Current decisions and hence current prices should reflect expected future conditions precisely because of the inter-temporal nature of production and consumption decisions.

In fact, oil is not a financial asset, properly understood. The fact that the oil market goes into backwardation is sufficient to demonstrate that point. But it is hardly a sign of inefficiency, or of a lamentable corruption of the oil markets by the presence of financial players, that expectations of future conditions affect current prices. In fact, it would be inefficient if expectations did not affect current prices.

I understand that what the BIS just put out is only a synopsis of a more complete analysis that will be released next month. Maybe the complete paper will be an improvement on what they’ve released so far. (It would have to be.) But that just raises another problem.

Research by press release is a lamentable practice, but one that is increasingly common. Release the entire paper along with the synopsis, or just shut up until you do. BIS is getting a big splash with its selective disclosure of its purported results, while making it impossible to evaluate the quality of the research. The impression has been created, and by the time March rolls around and the paper is released it will be much harder to challenge that established impression by pointing out flaws in the analysis: that’s much more easily done at the time of the initial announcement when minds are open. This is the wrong way to conduct research, especially on policy-relevant issues.

Update: I had a moment to review the CFTC COT data. It does not support the BIS’s claim of a shift from dealer-intermediated hedging to direct hedging. From its peak on 1 July, 2014 to the end of 2014, Open interest in the NYMEX WTI contract fell from 1.78 million contracts to 1.46 million, or 18 percent. PMPU short positions fell from 352K to 270K contracts, or about 24 percent. Swap dealer shorts fell from 502K to 326K, or about 36 percent. Thus, it appears that the fall in short commercial positions were broad-based. Given that PMPU positions include merchants hedging inventories (which have been rising as prices have been falling) not too much can be made of the smaller proportional decline in PMPU positions vs. swap dealer positions. Similarly, dealer shorts include are hedges of swaps done with hedge funds, index funds, and others, and hence are not a clean measure of the amount of hedging done by producers via swaps.

I am also skeptical whether producers who can no longer find a bank to sell them a swap can readily switch to direct hedging. One of the advantages of entering into a swap is that it often has less stringent margining than futures. How can cash-flow stressed producers fund the margins and potential margin calls?