Streetwise Professor

There’s a lot of talk about exploiting the US energy boom to undermine Putin and Russia.  This boom may have profound effects in the long run, but there is nothing that can be done now that can materially harm Putin in to punish him for his anschluss in Crimea, or subsequent aggressive moves he may make.

Yes, the US restrictions on exports of natural gas and crude oil are economically idiotic, even absent geopolitical considerations.  But even if those bans were eliminated tomorrow (a huge if, given he who sits in the White House-or golfs in Key Largo, as the case may be) Europe’s energy situation would not change one whit.

It would be possible to start moving large quantities of crude if the export ban were lifted, but this would be largely offset by a decline in US exports of refined products.  A major effect of the ban is to distort where crude is refined, not the total supply of crude and refined products (especially in the short run).  The major effect of the ban at present is to benefit US refiners who refine crude that is selling at below world prices because of the ban and export the products.  One study estimates that eliminating the ban would drop world oil prices by cents not dollars.

With respect to natural gas the situation is even less favorable.  Even if DOE granted all pending LNG export licenses, it will be years before product will start flowing.  Cheniere received the first license, in May, 2011, and its facility will not come on line until late-2015 at the earliest.  The company had a head start because it was converting an existing facility built to import LNG: other facilities will take longer to build because they are starting from scratch.

The long run impact of eliminating the export ban depends on the elasticity of supply of gas in the US.  If it is very elastic at current price levels, then yes, once the ban is lifted world prices will fall substantially, and Russia will be hit hard by that.  If supply is less elastic, the impact will be far smaller.  The elasticity of supply will depend crucially on technological factors, including the suitability of new formations to fracking and horizontal drilling, the depletion rates of wells, and the rate of technological innovation.  All of these factors are quite uncertain, and if the experience of the past decade says anything, it says be leery about making predictions about natural gas supply.

In brief: US energy export policy is stupid, but fixing the stupidity will have no appreciable impact on Russia for years.

Similarly, fixing stupid European policies on energy (e.g., fracking bans, massive renewables subsidies like Energiewende) should be done for reasons independent of geopolitics, and even if done tomorrow will have no material impact on European energy prices or Russian energy revenues for years to come.

The main way to impose substantial costs on Russia today via energy would be to impose trade sanctions.  Given the fact that the oil market is essentially global in scope, and that coordinating a global boycott of Russian oil would be virtually impossible, natural gas is a more feasible target.  Europe could boycott Russian gas  unilaterally, and there is no effective way for Russia to sell that gas to Asia or anywhere else.

There is a substantial asymmetry here.  Russia depends heavily on gas exports.  Approximately 25 percent of the Russian government’s revenue comes from Gazprom. The knock on effect on the Russian economy would likely be huge, as severe fiscal constraints would likely put substantial strains on the Russian banking system.

Yes, Europe would be hurt by higher prices and lower consumption of gas.  But gas comprises a far lower percentage of European expenditures than it does of Russian income, meaning that the hit on Europe would be far smaller.  Moreover, some of the impact could be mitigated by substantially increasing coal imports, increased Norwegian production, and some diversion of LNG from Asia to Europe, especially to the UK (which has excess LNG import capacity and could use LNG to displace North Sea gas which it could then pipe to Europe).   Moreover, winter is ending, and the cost of a supply interruption in the spring and summer would be far less than the cost in the winter.

But I doubt that is going to happen, because of another asymmetry.  The asymmetry in political will.  Old Europe has no stomach for a confrontation with Putin over Crimea, Ukraine, or much of anything else. (And yes, Donald Rumsfeld was an a$$hole-a claim I can vouch for based on family experience-but the Old Europe vs. New Europe formulation does capture an essential truth, especially where Russia is involved.) This lack of intestinal fortitude means that Old Europe-and especially Germany-is unwilling to pay any price to punish Putin.  Talk is free, and that’s all they are willing to pay.

And don’t think for a moment that Putin hasn’t based his plans on exactly that calculation.

In an attempt to scare off any attempt at sanctions, Russia has threatened retaliation: Lavrov has told Kerry any such moves will “boomerang.”  Other Russian officials have said that Russia can insulate itself from the west, thereby making it immune to any sanctions.

The retaliation that has been threatened includes expropriation of the assets of western companies.  A quite predictable Russian reaction, and typically self-destructive.  Any such expropriation would just cement Russia’s reputation as a lawless country where foreign investors rush in where angels fear to tread.  Russian equity valuations would crater, and direct investment would too.  Capital flight would accelerate.  The costs inflicted on Russia would dwarf those inflicted on the US and Europe, and would last for years.

Other that that, a great plan!  Another major asymmetry: any Russian retaliation would harm Russia far more than Europe or the US.  Some boomerang.

It reminds me of the old joke about the genie who grants the muzhik one wish, with one condition: anything the muzhik wishes for he gets, but his neighbor gets double. The muzhik thinks for a minute, then says: “I wish that you pluck out one of my eyes.”

All that said, I do not think that economic sanctions in the form of boycotting Russian energy or other exports, or cutting off imports (e.g., of drilling equipment) are the most effective, or the least costly, way of imposing costs on Putin and the elite on whom he depends. As I have said since Georgia, 2008, the best way to attack Putin and the elite is to go after their money in the west. (This policy is getting widespread publicity now.  I will lay claim to being a very early advocate.)

Such a measure is targeted on those who make the decisions, rather than Russia and Russians generally: as such, it could not be used by Putin to claim that the west was waging a war on Russia.  Indeed, it could undermine his political support not just among the elite who would be paying the price for his adventures, but among the broader population who are already disgusted by corruption and who would be unlikely to have any sympathy for that corruption being exposed, and the ill-gotten gains being seized.  The cost on western economies would very small indeed.  It would represent a victory for the rule of law.

But this would impose some costs on some very connected people in the west.  Moreover, precisely because it would strike so deeply at Putin it would cause him to lose his sh*t, and fear of that causes the Euros to shrink away from it in terror.

But this is something the US can pursue unilaterally.  Yes, given that most dirty Russian money is in Europe or the Caribbean, these measures would be much more effective if the Europeans participated. But the US still can wield considerable power (note how it forced Switzerland to heel on tax issues-not something that I agree with, btw, just pointing out that the US has leverage) and indeed, the mere threat of exposing what it uncovers could make the Europeans think twice.

But again, there is a lack of will.  Hope drives policy: “If we concede Crimea to Putin, he will stop.”

In sum, there is a powerful policy tool at our disposal.  A far better tool than is available in most such circumstances.  Other tools (sanctions) are more costly.  Yet other supposed tools-increasing US energy exports-are chimerical.

If we’re serious, we’ll use it.  But I have my doubts that we’re serious. If Europe (and to a lesser degree the US) has demonstrated anything in recent years, it is that they are past masters at kicking the can.  Crimea, Ukraine, and Putin are likely to be just another can.

ExxonMobil’s CEO Rex Tillerson (whose first name gives you an idea of his self-image) has decided to suspend offshore gas exploration projects in Ukraine, while continuing extensive cooperation with Russia (including a project very close to Crimea).

Talk about shivving someone when they are down.  Although any project like that the one that Exxon shelved would only produce years from now, if ever, a necessary condition for Ukraine to escape the Russian yoke is that it reduce its dependence on Russian energy, particularly Russian natural gas.  The Exxon decision makes that prospect ever more unlikely.  Ukraine’s bargaining power vis a vis Putin has just taken a big hit.  The Exxon betrayal also has huge symbolic importance: it indicates that energy companies are likely to deal with the devil-Putin-and willingly throw Ukraine on his tender mercies.  This will further convince Ukraine, and the Euros, that the country’s only option is to kneel before Don Vladimir.

Tillerson claims that he has no qualms about continuing to work with Russia, because he perceives no political risk:

“As for the current situation, obviously it’s early days,” he said. “There’s been no impact on any activities or plans at this point, nor would we expect there to be any, barring governments taking steps beyond our control.

“In terms of our view of country risk, geopolitical risk, other than things like sanctions, we don’t see any new challenges out of the current situation,” he said.

If you don’t see any new challenges relating to political risks in Russia arising from this situation, Rex, you need to get an eye test.  The substantial sell-off in Russian stocks was all about political risk.  And a victory in Ukraine would embolden Putin and make him more likely to expropriate western energy companies, including Exxon.

But maybe Tillerson’s vision is just fine. As I wrote about a couple of years ago, Exxon has tried to manage that expropriation risk by tying its ventures in Russia to cooperating with Rosneft in the Gulf of Mexico in what is effectively an exchange of hostages: if Russia takes from Exxon in Russia, Exxon can retaliate against Rosneft here. Maybe that’s what convinced Tillerson he can deal with the devil.  He gets the devil’s goodwill by abandoning Ukraine, and feels confident that the hostage he holds in the GOM will protect XOM against future Russian predations.

Arguably this is a smart bargain from the perspective of Exxon shareholders. But there are huge externalities here. Ukraine is obviously a big loser.  But so are other investors in Russia who are not so fortunate as to have valuable hostages as does Exxon.  But US national interests, and the interests of myriad US allies, notably Poland and the Baltic states, are also severely damaged by Tillerson’s cynical calculation.

This is precisely the circumstance in which it is justifiable, and indeed necessary and desirable, for the government to address a serious collective action problem through the imposition of sanctions on Russia and companies that provide it material and moral support (as Exxon is doing), and through the use of carrots and sticks to cajole companies like Exxon to provide aid and comfort to Ukraine.

But, cynic that I am, I doubt that this will happen.   The reason that Germany and the UK are so adamant against sanctions or any other economic measures against Russia in response to Ukraine is that it hits their businesses’ bottom line, and those businesses are are pressuring their governments very hard to take a soft line on Putin.  No doubt Exxon is doing the same.

Lenin was right about at least one thing, perhaps.  That capitalists would sell you the rope you use to hang them.  Or in this instance, Exxon will gladly sell Russia the rope Putin uses to hang Ukraine.

Russia has invaded Crimea-and hence has invaded Ukraine.  No Obamaesque circumlocutions about “uncontested arrivals” can gainsay that very basic fact.  The Russians have occupied a major Ukrainian air base in the peninsula, and have given an ultimatum to all Ukrainian military units to surrender their posts.

Yes.  All unopposed. So I guess that makes it OK.

But what to do about it?

First: a no brainer.  Eject Russia from the G8, and reschedule a meeting of the G7 somewhere far away from Sochi (as is scheduled for June).  But seeing as that it is the Obama administration and various EU factotums that will make the decision, no brainer is probably asking a wee bit too much.

Second: pressure FIFA to strip Russia of the 2018 World Cup.  Even though the thought of Putin blowing another $50 billion on a vanity project has some appeal.

@libertylynx suggests persuading the Saudis to turn on the taps to reduce oil prices, and hit Putin where it hurts.  (Though since Obama has seriously alienated the Saudis with his Syria policy and his dalliance with Iran, there is serious room to doubt whether the Saudis would be at all accommodating.)  Indeed, in 1986, the dramatic increase in oil production by the Saudis struck the USSR a mortal blow, and Putin’s Russia is almost as dependent on oil revenues as the Soviets.  (See Gaidar’s memoirs for a blow-by-blow account of how the collapse in oil prices gutted the USSR.  I’ve often wondered whether the Saudi action was directed against the USSR, rather than OPEC cheaters as was stated publicly, and done at the behest of the Reagan administration.)

There are some differences, though.  In ’86 KSA had about 7 million barrels of spare capacity, at a time when world consumption was on the order of 60 million barrels.  By producing to the max, the Saudis drove the price from around $23/bbl in December, 1985 to under $10/bbl in mid-1986, about a 60 percent drop.  Now Saudi spare capacity is  around 2 million bpd, when world output is around 90 million bpd.  A 2+ percent increase in Saudi output would result in at most a 20 percent price decline.  (Note that other producers would cut back, so that world output would go up by less than 2 percent even if the Saudis produced to their capacity.) Certainly enough to hit Putin hard, but not enough to create the existential crisis that the Soviets faced in the 80s.  But every little bit helps.

Insofar as gas is concerned, the Europeans could cushion the blow of sharply reducing consumption of Russian gas by increasing use of coal, which is in abundant supply in the US because the shale gas boom has displaced large quantities of coal in electricity generation.  But I doubt Europe has the stomach for that, and it could not get along without Russian gas altogether.

This leaves one last thing: crying havoc, and letting loose the accountants of war, a policy I advocated in August, 2008.  There is nothing that would make Putin and his coterie of thieves and thugs freak out more than putting their billions in loot stashed in the West at risk.

The fall of the Yanukovych regime provides a perfect cover for such an operation.  An aggressive search for the boodle of Yanukovych and his spawn would no doubt serendipitously uncover other illicit loot from the FSU: after all, a Hermitage Capital investigation traced connections between Yanukovych-linked companies and the fraud that the martyred Sergei Magnitsky uncovered.

This suggests a potentially fruitful asymmetric attack on Putin.  Loudly and publicly announce a thorough investigation of Yanukovych monies in the West.  Through back channels, tell Putin that unless he backs off-way off, like back to Rostov-on-Don off-that any dirty Russian money (and is there any other kind in Western banks-hell, even Putin pretty much agrees with this) that just so happens to be discovered during the investigation of Yanukovych will go to covering the US national debt.  Then go ahead and investigate anyways, and keep track of the moneys uncovered, for potential use at a later date.

Alas, even though this is a bloodless alternative (though it would drain the blood from Putin’s already pale, Botox-injected face), I seriously doubt Obama has the stomach for it.  In part because he knows Putin would lose his sh*t, and he doesn’t want to deal with that.

But here’s the thing.  There’s really not much reason to be intimated by Putin’s bluster–outside the FSU, anyways.  Russia has economic feet of clay.  Militarily it is a pretend power, fit to intimidate other decrepit post-Soviet militaries in smaller states on its borders, but sadly outmatched against a real power.  So call his bluff. Guarantee full employment for forensic accountants.

Then buy ear protection to guard against the shrieks emanating from points east and north, grab some popcorn, and sit back and enjoy the show.

The world petroleum market is undergoing substantial organizational changes, with private oil companies become progressively less vertically integrated and increasingly focused on the upstream.  The latest indicator of this trend is that Chevron is investigating the possibility of divesting its midstream operation.  This follows hard on the heels of the sale of Shell’s midstream and downstream operations in Australia to Vitol (bonus SWP quotes in the linked Reuters article).

This represents an interesting case study in transactions cost/Coasian economics.  In particular, the development of vibrant spot and forward markets for crude oil and petroleum products, and the growth and development of specialized trading firms (like Vitol, Trafigura, and Glencore) have reduced the costs of transacting on the market via the price system relative to the costs of conducting transactions within integrated firms.  Given the existence of thick, liquid, and active spot markets, and the development of logistical expertise by trading firms, assets at a particular stage of the value chain are less subject to holdup by owners of assets at adjacent links of the chain.  For instance, the existence of highly competitive spot markets for crude means that a refinery is  not locked into a small number of upstream suppliers, and thus need not be integrated with a source of crude supply to avoid contractual hazards.  The existence of active product markets has a similar effect.

It is interesting to note that much of the recent disintegration is occurring in smaller markets, and emerging markets, where contracting hazards have historically been particularly acute.  But this is precisely where the trading firms (notably Trafigura and Vitol) have stepped in and acquired assets from oil majors.

This evolution allows the majors to free up capital that they can employ in higher returning-and massively expensive-upstream exploration, development, and production activities.

I said that this was an illustration of transactions cost/Coasian economics in action.  As in most things economic, Adam Smith should really get the credit.  He noted that the division of labor (i.e., specialization) is limited by the extent of the market: Stigler used this insight to explain vertical integration.  The past thirty years have seen the development of a very extensive and vibrant market for oil and refined products (with Marc Rich deserving much of the credit for starting the process).  This spot market facilitates specialization, with the petroleum markets being increasingly characterized by firms that specialize in upstream, midstream, or downstream activities.

Interestingly, this development creates political and regulatory battles, as specialized firms at different segments of the value chain use political and regulatory means to capture a bigger share of the value of a barrel (pace the new battle over US crude oil exports).

Markets in action are a beautiful thing to behold.  Politics not so much.

Russell Gold has an  interesting piece about Bakken crude, specifically, its highly volatile nature.  This volatility makes it particularly dangerous to transport, especially by rail: due to its volatility, it is prone to explode in the event of a derailment or collision.

Further illustration, as if any were needed, that oil is not all alike.  Crude is a mixture of various hydrocarbons (and impurities), and different crudes are different mixtures.  Some are very light-almost like gasoline.  Some are very heavy-almost like asphalt. Different crudes present different challenges to refine-and different dangers to produce, transport, store, and refine.

My prediction is that this will result in some technical innovation that will make crude more amenable to transportation.  Maybe some sort of processing at the rail terminals.

This also brings to mind (mine, anyways) a historical episode.  In mid-1944, the Imperial Japanese Navy was tethered to bases in Indonesia, due to the ravaging of its tanker fleet by American submarines: fuel was available in Indonesia.

And a very special kind of fuel.  Crude produced on Tarakan Island was sufficiently light that it could be burned in ship boilers without refining.  One problem was that the crude was also sour (i.e., had a high sulphur content) and this corroded boiler tubes.

But the bigger problem was that it was very volatile, due to the large quantity of naphtha in the Tarakan crude.  This proved to be deadly to the IJN carriers Taiho and Shokaku (a veteran of Pearl Harbor) during the decisive Battle of the Philippine Sea (waged during the US invasion of Saipan).  When these ships were torpedoed by American submarines, the highly volatile fuel (and the vapors from aviation fuel leaking from ruptured tanks) eventually ignited, turning the ships into huge infernos.  The fuel eventually exploded, obliterating the huge carriers with massive losses of life. (Poor damage control on Taiho contributed to its destruction.)

Oil is not to be trifled with.  Which makes it all the more amazing how much is transported, stored, and consumed without incident.  Yes, Bakken presents challenges, but I am sure that economic imperatives (liability, the desire to avoid seeing valuable oil go up in flames, and yes, regulation) will result in adequate precautions and technical innovations that will substantially reduce the risks.  Desperation made the Japanese carriers fatal run risks with the oil they burned: we are not so desperate.

I haven’t written much at all about Elon Musk and Tesla since the middle of last year.  I have no reason to change my opinion that the prices of Tesla and Solar City stock were manipulated in April-May, but by the same token don’t believe that their subsequent increases are primarily the result of manipulation.  Those stock prices are partying like a 1999-era dot com company.  I think the party will end soon, but I don’t know when and I could be wrong.

But my main issue with Musk was not about the stock price.  It was about the fact that all of his companies were heavily dependent on government subsidies and support.  This support socialized the potential losses, and allowed Musk (and other major investors, notably Goldman) to capture the upside.  My point was if his products and business models were so great, he could succeed on his own, by attracting private capital.

One company that I mentioned in passing was SpaceX, his  space launch venture.  Inevitably, this company is dependent on government contracts, given that a very large fraction of space launches carry government payloads.  This is something different from Solar City and Tesla, where the government is providing subsidies but not receiving any product or service in return.  But still, it means that Musk depends crucially on cultivating government support.  Government contracting-especially big ticket contracting-is hardly a pristine activity.  A firm does not succeed or fail at it primarily on the basis of the superiority of its product, but instead on the basis of its ability to influence politicians and bureaucrats.  And a lack of scruple is often a feature not a bug in that regard.

SpaceX was  looking for a commercial launch site, and  seeking state subsidies in order to build it.  The company has been playing states off against one another, looking for tax benefits. My current home state, Texas, has been one of his targets.

Cynically, Musk focused on one of the poorest parts of the state-Brownsville-and dangled the prospect of a mere 600 jobs, in exchange for  $20 million dollars or so in tax benefits.  Some of which will come from the taxpayers of that very poor community.  And sadly, the state legislature has succumbed.

I’ve been to downtown Brownsville.  I testified at a trial there in 2008.  (The reason that what was the biggest bankruptcy case in US history was being heard in Brownsville is a story in itself.)  The law office for the local counsel in the case was at the edge of downtown, and during breaks I wandered around.  It was an educational experience.  I had just flown in from Milan (another story), and to be honest, I felt more foreign in downtown Brownsville than I did in Italy: and I certainly got far more puzzling and suspicious looks in Brownsville than around Lake Como.  Let’s just say it ain’t the Bay area.  And that Elon Musk wouldn’t be caught dead there.  Well, maybe if he did go there . . .

The poorest people in Brownsville will not benefit the slightest from the SpaceX venture.  But he and his lobbyist successfully importuned the state and county to take taxpayer money and give it to SpaceX by invoking their poverty.  It was utterly cynical for a billionaire to extract tens of millions from Texas taxpayers in the name of the poor Mexican Americans of Brownsville.

I know this is the way the game is played.  And that’s the problem: the game is cynical and wrong.  It is mere rent seeking.  Musk is particularly appalling because he is a rent seeker posing as a technological visionary.  His businesses all depend on extracting rents from the government, which he pockets.

But he has a cult of personality that portrays him as some towering visionary genius.

Maybe he is.  If he is, he should be able to make it all on his own, like some 19th century titan (Rockefellar, Carnegie), without collecting hundreds of millions from taxpayers.

I say let him try.  And I am dismayed that the Texas legislature didn’t.

Bloomberg Business Week has a long profile of Igor Sechin that illustrates perfectly why Putinism is an economic dead end.  Huge, inefficient state companies run by Putin cronies who have no clue about economics or how to create value.  But you’ll say: “Sechin has a PhD in economics!”  Well, a PhD in economics from a Soviet university is best described as an advanced degree in idiocy.

The piece describes Sechin as having an encyclopedic knowledge of Communist Party congresses dating from before the Revolution. So yeah, that definitely comes in handy in maximizing the value of the largest oil reserves of any publicly traded oil company.

Sechin refused to be interviewed for the article (probably a wise idea), but Putin’s Carney, Dmitri Peskov shared this description of Sechin’s penetrating economic philosophy:

“Sechin is a believer in the role of the state in his economic philosophy while at the same time not excluding a free-market approach. And he is firm in pursuing his viewpoint.”

Clear as mud. Problem is, I am sure that  it is an accurate characterization of Sechin’s muddled thinking.

Peskov is actually quite revealing, though almost certainly unintentionally so, in revealing the “thinking” that is propelling Russia into an economic cul de sac:

“For example, in shipbuilding it’s absolutely pointless to carry out privatization,” he says. “You can privatize enterprises, but they won’t be competitive; they will be doomed to failure. So consolidating the assets under the state’s wing is the only way to preserve key sectors of the economy.”

The reason for relying on markets, and privatization, is to determine the industries and firms that are economically viable.  The ones that generate more value than it costs to produce it.  Propping up those that would otherwise fail using state resources-which, never forget, are extracted by force from the citizenry-destroys wealth.   If Russian shipbuilding can’t compete against the Chinese or Koreans, it’s because Russian costs are higher.  Since costs are driven by the value of resources in alternative uses, the losses suffered by Russian shipbuilders in open competition means that the resources the Russian companies use would generate more value if deployed elsewhere.

That is, the success or failure of firms in the market is the mechanism that communicates where resources should be deployed, and where they shouldn’t be.  But that’s not the way statists-and Putinists-think.   Rather than having the market reveal which firms and industries should survive, the Putinists stand things on their head: they decide what industries they think are important, and provide the state resources necessary to ensure their survival. Their determination of the importance of industries is driven largely by history and political economy: the managers (and some workers) of legacy industries importune the state for support, and through personal and political connections largely succeed.  Thus the dead hand of the past rules the present and the future.  Rather than embracing the creative destruction of unviable firms and sectors, Putin embraces the destructive maintenance of legacy companies and industries.

It is a fundamentally uncreative system, because it is bounded by the cramped imaginations and interests of those who benefit from the status quo.  The interests of those who run the state are inherently biased to the status quo.  The more dominant the state becomes, the greater the tendency to stasis, and the greater the resistance to dynamism and change.

This affects even industries that are viable: the Russian oil and gas industries are clearly viable, due to the the capriciousness of nature which has endowed the country with bounteous reserves.  But the statist, Putinist system squanders that bounty.  The statistics don’t lie:

Compared with non-state-owned energy giants such as Exxon, Rosneft is inefficient. Even though Rosneft’s lifting costs — the cost of getting oil out of the ground — are less than a third of Exxon’s, the Russian company’s workforce is less productive.

Net profit per employee at Rosneft was $70,815 in 2012, versus $620,026 for Exxon. Rosneft’s price earnings ratio was 5.4, compared with Exxon’s 13.2 as of Jan. 13. Rosneft shares fell 6.87 percent in 2013, while Exxon shares rose 16.93 percent during the year.

But many find the company’s reserves to be an irresistible allure:

“The main reason to hold Rosneft is the reserves,” Greenwich Capital’s Snykov says.

But the point is that the value of these reserves is radically diminished by putting them under the control of a mullet-headed ex-KGB mouth breather.

The mental world of Sechin and Putin and the like was shaped in the USSR.  They don’t want to recreate it down to every last detail, but they do want to restore its broad outlines.  This is a recipe for stagnation.

And it will only get worse.  There is no mechanism for changing the leadership: indeed, Putin’s priority project in the past several years has been to neuter-or worse-any possible challenge to the incumbents.  So the current gang-and it is a gang, in all essential features-will remain in control for the foreseeable future.  And as they age, they will become even more resistant to change, and more sentimental about the world of their youth.

I still shake my head at those who understood the problems with the existing system, and assumed that Putin would too, and would be forced to institute changes and reforms to prevent the system from lapsing into senescence. How can one be so oblivious to the implications of the interests of the rulers of a system combined with the conservative impulses of aging men? Together, these forces work relentlessly to resist change and reform, and to attempt to maintain the status quo–or even roll back the clock.

Indeed, just this week, one of the few tepid reforms instituted by Medvedev has been rolled back.  The eunuch prime minister announced that state officials will be allowed to serve on the boards of state corporations, reversing a policy instituted a few years ago.  Remember when Medvedev’s original announcement was viewed as a dire defeat for Sechin, in particular?  Hardly.  Medvedev is being kept around to serve as the sacrificial lamb to pay for Putin’s mistakes, and Sechin is the second most powerful man in Russia.

So read the BW profile to understand Russia’s past, present, and future in a single story.  For Igor Sechin is the poster boy for Sovokistan, and Sovokistan is what Putin has created.

After years of wending through to what is to an American an incomprehensible legislative process that involves a three body problem (the trialogue of the Commission, the EU Parliament, and member states), Europe has agreed on its version of the trade execution portion of Frankendodd: Mifid II.  (The clearing and OTC collateralization equivalents are covered under a different law, EMIR.)  A good summary is here.

It contains many of the objectionable features of Frankendodd, namely, a mandate that swaps be executed on SEF-like entities (Organized Trading Facilities, or OTFs, in Euro parlance), and commodity position limits.  The former were pretty much a done deal after the Pittsburgh G20 meeting, the latter a reflection of the global suspicions of “speculation” in commodities, but intensified by European NGO convictions that speculation in food is evil.  (The shade of Adam Smith is shaking his head, noting that his observation about the equivalence between the popular terrors and suspicions against speculation and  the popular terrors and suspicions involving witchcraft is as apt today as it was in 1776.  Except that witchcraft is probably much more socially acceptable these days.)

But the EU has added its own idiosyncratic idiocies to its law.  Two things stand out.

First, the EU has mandated open access to derivatives exchange CCPs, in an attempt to demolish the vertical silo model.  Yes, the mandate is delayed-by as much as 5 years-but “I will wait 5 years to be stupid” hardly seems to be much of  a defense.  As I’ve written for years-a year or two before SWP began, in point of fact-the vertical silo makes economic sense (from a transactions cost economics perspective), and the pro-competition justification for it (namely, to encourage competition in execution) is inconsistent with what economists have known since the 1960s (the “one monopoly rent” theorem).

Second, and even more inanely, Mifid II caps the dark pool share in the trading of any individual equity at 8 percent.  Overlooking the operational difficulties of enforcing a collective constraint on volume across multiple venues, this reflects a suspicion of dark pools (a pejorative name in itself) that is again not grounded in good economics.  In a second best world, where competition between exchanges is imperfect, off-exchange venues (block markets in the old days, internalization, dark pools) can be welfare enhancing.  The fact that many market participants find them the lowest-cost venue to transact in should at least give pause to regulators, and ask them to inquire why this is true, and do the appropriate cost-benefit analysis of the trade-offs involved.  But no, fools rush in.

It strikes me that the  Euros have created a new Pixar character.  Buzz Darkpool: “To stupidity and beyond!” Derivatives trading mandates and position limits are stupid, but they’ve decided to go beyond that.

Meaning that the US can perhaps adopt what I’ve often said is the Russophile motto: “Not the worst!”

Scott Irwin has provided his responses to David Kocieniewski.  Read the whole thing.

It’s My Turn

The responses to the recent NYT article by David Kocieniewksi certainly make interesting reading.   I don’t want to belabor points already made so well by others in response to the numerous problems with the article (especially Craig).  Instead, I want to offer some additional points that I think merit further consideration or elaboration:

1. To start, it is important to clarify that the heart of the controversy is the trading activities of a new type of participant in commodity futures markets—financial index investors—during the 2007-2008 commodity price spikes.  The concern was that unprecedented buying pressure from index investors created massive bubbles in commodity futures prices, and these bubbles were transmitted to spot prices through arbitrage linkages between futures and spot prices.  The end result was that commodity prices far exceeded fundamental values during the spikes.  Dwight Sanders and I labeled this the “Masters Hypothesis” in honor (dishonor?) of the central role that hedge fund manager Michael W. Masters played in pushing this line of thinking.   It is crucial to understand the key features of the Masters Hypothesis.  First, it implies that index buying in commodity futures markets created massive price bubbles—20, 30, 50% overvaluations (take your pick).  Second, it implies the price bubbles were long-lived, measured in months if not years.  These features have driven the acrimonious debate about “speculation” in commodity markets that first erupted in 2008.  Without the charge of massive and long-lasting bubbles the intense public policy debate about speculation limits would not have taken place.
2. My position on the validity of the Masters Hypothesis has been consistent from the earliest days of the controversy.   In fact, in an ironic twist, one of my earliest publications on the controversy was an op-ed that Dwight Sanders and I jointly authored—drum roll please—yes, in the NYT in July 2008.   A few quotes:  “Over all, there is limited evidence that anything other than economic fundamentals is driving the recent run-up in commodity prices…The complex interplay of these factors and how they affect commodity prices is often difficult to grasp immediately, and speculators are a convenient scapegoat for the public’s frustration with rising prices. That’s unfortunate because curbing speculation — and hobbling the ability of businesses that rely on futures markets to reduce their risk — is counterproductive.{
3. If my work was somehow tainted by associations with “Wall Street,” then why the editorial endorsement by the Paper of Record in 2008?   It also seems convenient that this little fact was omitted in Mr. Kocieniewksi’s recent article.   I made sure he was aware of my previous NYT op-ed article when he interviewed me. I suspect he was already aware of it given his exhaustive background research on the two of us.
4. The academic research pertaining to the Masters Hypothesis since 2008 has been overwhelmingly negative.  I submit that there is very little credible academic research that is consistent with the basic tenets of the Masters Hypothesis.  That is, index buying is not associated with massive and long-lasting price bubbles in commodity futures markets.  There are no “accidental Hunt Brothers.”   Some unnamed persons (one has the initials GG) like to characterize academic research on the subject as being roughly equally divided between studies that find a positive impact of index positions on prices and studies that fail to find an impact.  This characterization is misleading.  Yes, some studies find evidence of a positive impact but the impacts are invariably small and fleeting or do not line up with the spikes of 2007-2008.  This type of evidence does not support the Masters Hypothesis.  So, when properly interpreted the evidence to date is not divided equally, but instead overwhelmingly rejects the Masters Hypothesis.  And this is what is important from a public policy perspective—small impacts do not provide much justification for costly new regulation of commodity futures markets.
5. My approach to research on the market impact of index investment has always been to go where the data lead.  My co-authors and I have sliced and diced the available data many different ways and we cannot find a smoking gun (a full list can be found here).  As I like to put it, if the Masters Hypothesis is true then the relationship between index positions and commodity futures prices should literally jump off the page.  It does not.  Importantly, there is also limited evidence of bubbles in commodity futures markets independent of whether or not they are associated with index investment.   My co-authors and I could not find evidence that bubbles have become larger or longer-lasting since index investment came on the scene.  If anything they have become smaller and less frequent.
6. If my research on speculation is slanted/biased/tainted then it sure has fooled a whole bunch of academics who serve as journal editors and reviewers.  I have published 13 papers since 2009 dealing directly with the speculation controversy in 9 different academic journals.  And several more are currently under review.  Yes, under review.  This means the articles don’t get published unless they first pass muster with reviewers and then a journal editor.  I don’t know exactly how many editors and reviewers I have dealt with on these papers (several were invited submissions but still subject to peer-review), but it is safe to say that it must be at least 20-30 people.  So, we are to believe that my biased research ran this gauntlet of editors and reviewers and the bias managed to go undetected the entire time?  Give me a break.
7. Just for the record, I want to state in public that I did not even know about the Chicago Mercantile Exchange (CME) donations to the business school here at the University of Illinois when the donations were made.  I only became aware of them in the last year or so through conversations with our development staff.   (OK, I should actually be a little embarrassed by that last statement given my work on commodity futures markets.)   In any event, to draw an inference between the gifts to the business school from the CME and my research really is ridiculous.  I made this clear in my interviews with Mr. Kocieniewksi.
8. I do have a long working relationship with the CME, and before that, with the Chicago Board of Trade (CBOT).  This after all is my research area.   The CME has not funded any of my research since 2007.  However, I did work on a commissioned white paper for the CME in 2005 when the grain contract convergence problems first erupted.  My co-authors (Phil Garcia and Darrel Good) and I were paid a total of $15,000 for the work, which we split equally.   I did accept a position on a new Agricultural Advisory Council that the CME started in late 2013.  The council will meet three times a year at various locations around the country and serve as a sounding board for various issues that come up with regard to agricultural futures markets.  I will receive the same $10,000 annual stipend for this position as the other members of the council.   That is the sum total of my financial ties to the CME.
9. I have had numerous interactions with CME staff in recent years on a host of issues related to commodity futures markets, including, of course speculation.  Sometimes I have reached out to them and sometimes they reach out to me.  Most of the time it is the former and involves pretty obscure questions about things like how the grain delivery process works or help in getting some data.  My research would be far less interesting and useful without this help.  I have the utmost respect for the professionalism of the CME staff and I have never been asked for any type of quid pro quo.  Never.  When I have agreed to participate in presentations, write blogs, etc. I have done so because I believed my research and analysis contributed to better understanding of the issues.
10. My other research on commodity market speculation has been funded from three main sources.  First, the Laurence J. Norton Chair that I hold here at the University of Illinois provides earnings each year that go to support my research program (thank you U of I!).  Second, I have had two grants from the Economic Research Service of the USDA on commodity speculation related topics since 2008.  The first one included work directly on speculation while the second focused on convergence in grain futures contracts. Both have been completed.  Third, Dwight Sanders and I did a commissioned study for the OECD in 2010.  I lost track of the emails with the exact amount we were paid but I know it was only a few thousand dollars.
11. Yieldcast is a product of T-Storm Weather that I helped develop with a former graduate student, Mike Tannura, and Darrel Good.  Yieldcast provides “real-time” U.S. corn and soybean yield forecasts for subscribers.  My main role is to build the statistical models that form the basis of the forecasts and to prepare the weekly forecasts during the growing season.  As indicated in the NYT article I do not have direct contact with Yieldcast subscribers.  I am fortunate that side of the business is ably handled by Mike Tannura through T-Storm.  It is really laughable to think that I have somehow been rewarded through this channel by Wall Street as a payoff for my speculation research.  I know how hard Mike has worked to build the base of subscribers for this product, and if it only were that easy!  I have never seen one email, one voice mail, or absolutely anything that connects my research on speculation to taking out a subscription for Yieldcast.
12. As the NYT article indicated, Dwight Sanders and I did conduct a study in 2012 for Gresham Investment LLC on the market impact of index investment.   Given the political sensitivities surrounding the speculation issue, I gave considerable thought as to whether I ought to pursue the consulting project.  I knew some would see taking any funding from a commodity firm as being a conflict of interest.  But, the project provided access to detailed firm level position data that has previously been unavailable to researchers and this made it worthwhile in my mind.  Sure, I didn’t mind getting paid as well.  The NYT article got it wrong when it said I was paid the full $50,000.  Dwight and I split that equally so I was actually only paid $25,000.  We are working on several interesting papers based on this new dataset.
13. If the charges (really, innuendoes) in the NYT article are baseless, then readers might reasonably ask what does motivate my “defense of Wall Street”?  Good question.   I am indeed a “freshwater” economist that became convinced early in my career that commodity futures markets were an invaluable market institution that improved the discovery of prices and the ability of market participants to shift risks.  While these markets are by no means perfect (as Craig’s work on manipulation highlights), on balance, the good vastly outweighs the bad.  So, when the current speculation controversy erupted in 2008 I was struck by the similarity of the present controversy and those that have buffeted the industry in the past.  Change only the names and dates and not all that much is different.  This has been a reoccurring theme in my own writings since 2008 (including the July 2008 NYT article…could not resist).  And I admit that I made an intentional decision early on to play a more public role in the present controversy.  Three of my professional heroes are Holbrook Working, Tom Hieronymus, and Roger Gray, who spent much of their illustrious academic careers defending futures markets.  All the motivation I needed.

Scott Irwin

University of Illinois

It is common to speak of “oil” as a homogeneous commodity, but it is anything but.  Oil produced from different fields differs on myriad dimensions, including most notably sulphur content and density.  Some oil is light and “sweet” (i.e., has little sulphur).  Some oil is heavy and sour. What’s more, refineries are configured to process particular kinds of oil.  A refinery equipped to process very heavy Venezuelan crude is not suited for processing something light and sweet, like WTI.  Much domestic oil production was in light and sweet varieties like WTI, and many foreign crudes are heavier and sour, so with the decline in US output refineries upgraded to refine the heavier imports.

So when you read stories about the fracking-driven oil boom in the US, you have to keep in mind that it’s not just the amount of oil that’s being produced–which is truly remarkable–but the type.  The oil gushing from the Bakken, Eagle Ford, and the Permian is very light, and sweet.  It has displaced imports of of lighter crudes, like those from Nigeria, but capacity best configured to refine it–especially on the Gulf Coast–is running pretty much full out.  So even though the US is still a net importer of oil, most of that is heavy and sour crude, and we have a surplus of light sweet.

Price signals tell the tale.  Light sweet crudes on the Gulf (like Louisiana Light Sweet) are selling at a substantial discount to lighter foreign crudes, notablyBrent.  These price signals are screaming “export light sweet oil”, but with limited exceptions, under laws passed in the 1970s, such exports are banned.

Those laws never made much sense, but they were never much of an issue as US production continued its inexorable decline until the mid-00s.  But the stunning reversal in this trend now means that the law is a seriously binding constraint. Just as of last week, moves are afoot to relax the restrictions on exports.

Economically, this is a no brainer.  The price gap between domestic and foreign light crudes means that there is a gain from trade to be realized.  But exploiting that gain from trade will not make everyone better off. It will tend to cause the price of crude to increase in the US.  It will also cause the price of refined products to decline overseas, as the cheaper American crude is run through foreign (notably European) refineries.  This would bad news for US refiners, especially those oriented to processing lighter crudes.  These refiners are making money hand over fist (especially compared to their lackluster historical financial performance) refining the new Texas and Dakota production, and exporting large amounts of refined products (notably gasoline), primarily to Europe.  Relaxing the export ban would shrink their margins, by raising the crude price and reducing prices of refined products in foreign markets (as they increase their output using US oil.)

So this promises to be a rough and tumble political fight, as the upstream and downstream segments of the US oil industry slug it out.  No doubt this fight will be heavy on the demagogy, if the early salvo from New Jersey Senator Robert Menendez, who claims that ending the export ban would be a win for “big oil” and would hurt American consumers, is any indication.  The foregoing analysis makes it plain that “big oil” is not a single entity with a single interest, but has factions (refiners, producers) whose interests are at odds.  This is mainly a battle between these factions.  Insofar as US consumers are concerned, Menendez’s claim is unpersuasive.  The marginal barrel of products is being exported, and the price of that barrel is being driven by prices in export markets.  Exporting US crude should reduce foreign prices, and lead to lower exports of products, which should actually put downward pressure on the prices of refined products in the US.

No, this isn’t about helping US consumers.  This is basically a battle over the margins of US refiners, especially the independents.  I have no idea how the politics are going to play out.  Some sort of compromise, no doubt, rather than an outright repeal of the export ban.

I note that Russia uses various means to attempt to reduce exports of crude oil, in order to bolster domestic refining.  Let’s not follow their example.

So what’s the moral of the story?  Perhaps that it is possible to have too much of a good thing, especially if you can’t trade it to someone who values it more.