Streetwise Professor

Traveling and family obligations, so limited time to comment on events. But an opportunity (sitting at the gate in Greenville) to take a few quick hits.

The US announced some additional sanctions today. To indicate how lame these sanctions are, the Russian market (MICEX) was up 2.35 percent when the names on the list (or more accurately, the names that weren’t on the list) were announced.

One notable name: Sechin. Roseneft was down 1.7 percent, and BP, tied to the hip with Rosneft, was down about two percent.

Other than that. Zip. In an inversion of the usual expression, this was a situation to sell the rumor and buy the fact.

The Euro list comes out tomorrow. It is rumored to be even more lame than the US list.

Over the weekend in Malaysia, Obama made it clear that he would coordinate sanctions with the Euros, and that the US would not impose unilaterally sanctions that were much tougher than what the Europeans will agree with. Meaning that given that the EU requires unanimous approval for its actions, Obama is deferring to the Austrians and the Slovenians and the Germans, who are utterly compromised by Russian influence and cash.

Most likely, Obama really wants to do nothing. This allows him to do that while claiming he’s all for solidarity and diplomacy and action. This is the negation of leadership. Leading from behind doesn’t even come close to describing this.

And to think that Obama ran on eliminating cynicism from US foreign policy.

We’ve seen this script before, in Syria. Kerry comes out and makes an angry denunciation, followed by threats. Followed by  . . . nothing.

All the circumstances in Syria were much more favorable to justify action. A true humanitarian crisis. Viable military options, not least because there would not be a direct confrontation with Russia. Crimes against humanity.

Kerry compared Assad to Hitler. Obama threatened to attack. But then the US grabbed the first fig leaf Putin proffered, and bugged out.

If the US will not act aggressively in Syria, it won’t act aggressively-even with respect to sanctions-in Ukraine.

The US sanctions announced today were intended to strike at Putin’s inner circle, but not at Putin himself. Presumably the threat is that he could be targeted next. The NYT ran an article over the weekend about trying to track down Putin’s money.

Fat chance.

First, even if Putin’s name is listed at the owner of some company or companies, they would be separated from the real money by a labyrinth of shell companies, trusts, etc.

Second, paper and electronic records or ownership are essential in countries subject to the rule of law because third party enforcement is relied upon to protect property rights and ownership.

That is NOT the way Putin needs to rely on such mechanisms to enforce his access to and control over his property. Russians are notorious for making huge deals verbally, and relying on, umm, informal means to enforce contracts. Putin’s deals are sealed with a handshake-if that. Maybe there is a piece of paper in his safe. But he has the power of a very scary security apparatus at his beck and call. That is what he relies on to secure his property. No need for the formalities of ownership when the real enforcers are under one’s command.

And this is precisely why he so desperately needs to hold onto power. That power secures his wealth. This also means that trying to trace his wealth and property is a fool’s errand.

There is a Midas-like aspect to Putin’s fortune. There are constraints on his ability to consume it. But he definitely cannot consume it if he loses power. Which is why, like all autocrats, he will only leave office horizontally, at room temperature.

With that happy image in mind, some musical entertainment in honor of Igor Sechin, today’s only meaningful sanctions target. The man with the hockey hair.

I have been working since last year on a whitepaper (sponsored by Trafigura) on The Economics of Commodity Trading Firms. After about a month of limited theatrical release, the paper is now publicly available at the link.

Even if I do say so myself, the paper provides a pretty thorough overview of commodity trading firms, ranging from their economic function as “agents of transformation” (of commodities in space, time, and form), to risks and risk management, to corporate structure (private vs. public), to capital structure, to asset ownership, to the systemic risks (or lack thereof) of commodity trading.

One of the main takeaways for me was the diversity of commodity trading firms. Making generalizations is difficult. Another takeaway (related, in a way) is that some of the conventional wisdom about these firms (e.g., there is a general trend to asset ownership and vertical integration) is not correct.

But rather than discuss the report extensively here, I leave it to you all to read it. Comments welcome.

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.

Although the Euros wring their hands at the costs they would bear if serious economic sanctions were imposed on Russia, as I’ve said, there is a huge asymmetry in vulnerability: Russia is substantially more vulnerable to a cutoff in trade, especially the energy trade.  Take gas.  Germany imports about 12b Euros of gas annually.  Its GDP is about 2.5t Euros.  So natural gas expenditures are about .5 percent of GDP, and even a substantial price increase would represent a relatively small burden on German expenditures.  In contrast, Russian energy exports (63 percent of which are to Europe) account for 50 percent of the country’s budget.  So trade restrictions would be an inconvenience for Europe, and pose an existential challenge for Russia.

Such are the wages of being a petrostate.  Using the energy weapon is national economic suicide.

FT Alphaville has a nice overview of this and other asymmetries.

One quibble, related to this:

In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

If it comes to a trade and finance showdown, it won’t have the money to be buying anything.  So a cutoff of purchases of dollars, euros, etc., is not something that Russia could threaten: it would be an inevitable consequence of a trade and finance war.  And Russia is not such a big buyer that it would make all that much of a difference anyways.

The FTA piece also dispatches the fantasy Russians and their fellow travelers are peddling: that China will assist Russia by waging economic combat against the West.  China is a huge dollar and UST long, so it would be an incredible act of economic masochism to dump dollars or Treasuries.  And Russian fantasies aside, China is not that into them.

The asymmetry of power, especially economic power, couldn’t be more obvious.  But that is counterbalanced by an asymmetry in will, and heretofore that has proved the decisive difference.  Putin has wagered that Europe is unwilling to suffer any discomfort to counterattack against Putin’s anschluss.  So far, he has been right.

I heard a hilarious story the other day about an incident that occurred when European Commission investigators raided a trading shop in connection with the Brent investigation.  While going through trader emails and documents, one of the crack investigative team came across numerous documents about trading on ICE.  The investigator was puzzled, so he asked the a lawyer for the trading company: “You trade ice?”  Lawyer: “Yes, we trade on ICE.”  Investigator: “You mean you really trade ice?  Frozen water?”  Lawyer: This is my please-tell-me-you’re-sh*tting-me face.

No prizes for figuring out which was Abbot, and which was Costello.

We are in the best of hands.  The best of hands.

That would be me.  At least according to the Google translate version of this profile of me in Neue Zürcher Zeitung. It’s a nice piece, and a fair one (in contrast to some other articles I won’t mention).  Except I am really a mild mannered guy.  Really!

A couple of stray thoughts regarding the Gunvor story.

First, virtually all of the oil trade (and the global commodities trade generally) is done in dollars.  Gunvor needs dollar financing to carry out its trading.  Anything done in dollars puts the provider of the dollar finance in the crosshairs of a panoply of US regulators.

Case in point is RBS, which paid $100 million in settlements to the Fed and the New York Department of Financial Services for violating sanctions on Iran, Burma, Sudan, and Cuba.  One law firm concluded:

A lesson that foreign financial institutions and other multinational companies should draw from these cases is that they continue to face significant risk if they engage in any business related to parties or countries (particularly Iran, Cuba and Sudan) that are restricted under US economic sanctions provisions, even if their activities may have appeared to be lawful at the time.  Such activities create risk when they have even a minimal nexus with the United States, including clearing financial transactions in US dollars, furnishing financial services through institutions in the United States, processing payments through foreign branches of US financial institutions, or knowingly relying on services provided by US persons anywhere in the world to facilitate, participate in, approve, or support restricted transactions.

Foreign persons providing a variety of financial services, including banking, money remittance, insurance, reinsurance, investment, foreign exchange, mortgages and secured transaction/letter of credit services, should recognize the inherent US enforcement risk in concealing or intentionally omitting identifying information from payment messages involving a sanctioned country, entity or person, when the transaction has some nexus to the United States or US persons (including US dollar exchange).  Deceptive activity also formed the basis for part of the recent settlement against Weatherford International Ltd. (see our advisory on Weatherford). [Emphasis added.]

To reiterate.  A “minimal nexus” with the US puts a foreign financial institution at risk when it deals with a sanctioned entity.

Here is an Economist piece on how the US uses merely touching a dollar as a basis for aggressive prosecution.  Here is the Telegraph screeching about how the US has extracted billions of dollars in settlements from British banks for engaging in transactions in dollars.

The basic issue is that any transactions done in US dollars, even between foreign entities, have a US bank involved at some point to process the dollar transactions.  You do a deal in dollars with a US-sanctioned entity, you are at huge risk of prosecution.

The implication is that even if Gunvor deals only with non-US banks, as long as it deals in dollars, if the firm becomes a sanctioned entity anyone who is on the other side of the dollar transaction is at risk.  FUD is most acute with any transaction that touches the dollar.  And you can’t engage in the international oil trade (or commodities trade generally) without dealing in dollars.

Second, a somewhat related issue. Let’s say that Törnqvist really did buy out Timchenko’s shares.  Let’s say he didn’t pay with a note.  Where can Timchenko stash the cash? Paying in Euros or CHF could perhaps avoid the problems discussed above, but even so, what western financial institution wants to take Timchenko’s money?  Even Sberbank might have some reservations.

Just landed at O’Hare on my way back from Brussels and Geneva.  Right before taking off I saw that Gunvor’s bond price tanked at the open.  It closed yesterday yielding 10.9 percent, and spiked at the open to 13 percent.  I understand it is still tanked.

In other words, the market either totally disbelieves the story that Timchenko sold out, or thinks that the sale is irrelevant in determining the company’s vulnerability to sanctions or investigation.

My suspicion is the latter, because of the Treasury’s deviously, devilishly clever strategy.  Recall that UST said that Putin is a part owner of Gunvor.  No hedging about that claim, no “may be a part owner”:  a flat statement that Putin is an investor.  It said that Putin might have access to Gunvor funds.

So regardless of whether Timchenko sold, or commits ritual public suicide tomorrow, Treasury has put the Mark of Cain on the company.  Every counterparty, every lender has to have serious, serious concerns that the company may be sanctioned due to the Putin connection.

The tanking bond price makes it clear that the credit markets have serious doubts about the company’s survival prospects.  No doubt this reflects bankers’ serious reluctance to continue to finance a company that the US government has publicly tied to Putin.

Yes, most of Gunvor’s lenders are European banks, but ask Swiss banks about the joy of taking on the US government when it has an important policy objective in mind.  And think of all the leverage the US has over European banks given the myriad ongoing investigations of Libor, FX, ISDA Fix, and on and on.   Even if the Euros don’t sanction Timchenko (or Gunvor) (and they abstained from doing so today, waiting to announce that until I’d left Brussels, the cowards), the US has plenty of leverage over European banks.

The company has the weekend to try to turn things around.  But that Treasury statement casts a huge shadow.   In the current environment, bankers are afraid of their own shadows, let alone the shadow of a US government with blood in its eyes.

Press coverage of this story has been credulous, especially in the FT.  The stories have uncritically repeated Gunvor’s statements that Timchenko sold at fair value, and that there is no option for Timchenko to repurchase.  But they would say that, wouldn’t they?  And the stories don’t point out that the bond market is basically calling BS on Gunvor.

Speaking of fair value, I know Torbjörn Törnqvist is not an idiot.  He can go through the game tree, and realize that there is large probability that his shares, and the ones he purchased from Timchenko, will be worthless.  Meaning that he won’t have paid Timchenko book value, or anything even close.

Which raises the interesting question: if Timchenko is really just a front man for Putin, as the US government asserts, any big discount comes right out of Putin’s pocket.

Which is pretty much the point, isn’t it?  That’s exactly why UST’s statement is a big flashing neon light arrow pointing right at Putin.

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.

Please.

Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

German utilities claim to be developing work-arounds that would provide Ukraine with gas in the event Russia cuts off supplies due to non-payment, or as part of an economic war against Ukraine.

Now Germany’s major energy utility companies are developing strategies to help Ukraine fill the shortfall if Moscow decides to cut gas supplies. Companies including RWE and E.on are working on plans to supply Ukraine with weeks’ worth of gas.

Currently, Ukraine taps around half of it gas needs from Russia. But last Friday, Russian Gas monopolist Gazprom threatened to suspend deliveries to Ukraine if the country doesn’t pay its outstanding February bill of €1.7 billion ($2.35 billion).

In an emergency, the flow through Europe’s pipelines could simply be reversed, with gas getting pumped from German reservoirs through the Czech Republic and Slovakia directly to Ukraine. Following this year’s especially mild winter, Germany’s reservoirs are much fuller than usual. Even long-term deliveries would be conceivable at the moment.

Ukraine already signed a framework agreement in 2012 with RWE to make the gas deliveries possible. Under the contract, the company has committed itself to delivering up to 10 billion cubic meters of gas per year to Ukraine, which the country was going to use this summer to fill its reservoirs for the coming winter. But RWE executives say they could provide deliveries much sooner.

RWE currently draws its gas from Norway or the Netherlands, both major suppliers in Western Europe. It would also be possible to redirect Russian gas from the Nord Stream Baltic Sea pipeline — which connects Russia and Germany — through pipelines in the Czech Republic and Slovakia to Ukraine.

Color me skeptical.

The article notes that there are clauses in the contracts with Gazprom that preclude redirection of supplies, but the German utilities claim these are readily circumvented: given that gas in German storage reservoirs comes from multiple sources, how  could Gazprom prove its gas has been redirected?

But this is based on the naive view that Gazprom’s sole (or even preferred) recourse against German supply of Ukraine would be to file a legal action.  It could decide instead to retaliate for German shipments of gas to Ukraine by shutting off gas flowing on the Nordstream and Yamal pipelines. Given no gas would be flowing to Germany via Ukraine, if Gazprom did so the German companies would soon be drawing down their stocks rather heavily and be vulnerable to Gazprom’s  tender mercies going forward.

Would they really be willing to take that risk on behalf of Ukraine?

And there is also the matter of the huge political pressure Russia would exert on Germany if RWE and E.on were to attempt such a thing. After all, former Chancellor Gerhard Schroeder chairs the Nordstream board and still exercises considerable influence in Germany, and Germany has proven quite vulnerable to Russian pressure in the past.  Numerous German businesses would be importuning Merkel not to antagonize Russia.

I strongly suspect that this “plan” and the article about it have been created and planted to give Merkel and Steinmeier political cover: “See! We are doing something to help Ukraine.”  But if called upon to perform on their promises, I would expect the Germans to fold like a cheap suit in the face of Russian threats to cut off gas.  And Putin is playing for keeps here.  Don’t think for a moment he won’t do it even though he would incur a greater economic cost than the Germans (and other European consumers of German gas).

And remember, gas is not the only lever.  Coal is the major alternative to gas, but Germany (and also the UK, to an even greater degree) get a large fraction of their coal supplies through Russia.   This is a real game of chicken, and I am not putting my money on the Germans.

That’s because based on experience, and my perception that Germany is trying to get short run political benefits by dispelling serious doubts about its commitment to Ukraine, I do not consider the proposed plan to be very credible.  Just as the French (and British) made promises to the Poles in 1939, and then left them hanging when Poland called on them to deliver, I think there is a strong possibility that these German promises will be of the piecrust variety: easily made, easily broken.

In other words, Ukraine should not base its plans on the assumption that Germany has its back on gas, or anything else for that matter.