Streetwise Professor

I am adding a new entry to my list of phrases that put me on guard that someone is trying to con me: “balanced approach.”  Obama is always blathering about balanced approaches to fiscal matters.  And in today’s WSJ, Dow Chemical CEO Andrew Liveris pleads for a “balanced approach to shale gas exports.”

To say that “balanced” is highly subjective is the understatement of the century.  In Obamaland, “balanced approaches” mean large tax increases now, and hazy promises of spending cuts in some distant future.  In Leveris’s oped, “balanced” means imposing restrictions on exports of natural gas to lower the cost of his most important input.  Funny, ain’t it, that things seem to tip the way of those advocating “balanced approaches”?  In other words, if it helps me, it’s fair and balanced!

Liveris couches this as a means of stimulating employment in US manufacturing and increasing GDP:

Moving manufacturing facilities back to the U.S. from abroad—the trend known as “reshoring”—could create up to five million American jobs over the next seven years, according to the Boston Consulting Group. This figure is so high partly because in the chemical industry jobs created by investing in domestic manufacturing are eight times more beneficial to gross domestic product than are simple gas exports, as documented by the American Chemistry Council.

To which I reply: Bull.  National income is maximized when goods are allowed to flow to their highest value use.  If domestic gas prices are $3/mmBTU and foreign prices (net of transportation, etc.) are $4, that means that at the margin 1 mmBTU of gas consumed in the US-including by Dow-generates $3 of value, and if consumed overseas it generates $4.  Letting that mmBTU go overseas therefore generates $1 of value-of income.  No BCG or American Chemical Council mumbo jumbo can change that simple fact.  And I’m sure that the ACC is totally objective.  Totally.

Leveris pleads that all he wants is a rule-based system:

The truth is that every firm in every sector benefits from exports and rules-based free trade. But what are the rules for exports of liquefied natural gas? Who sets them? Oil and gas companies, states, Japanese government agencies? Or are they part of rules-based free-trade agreements that the U.S. government has negotiated so as not to disadvantage domestic consumers, manufacturers and workers?

Here’s a balanced rule for you, Mr. Leveris: Producers can sell to whomever offers them the highest price.  Short. Simple. Easy to understand.  No bureaucrats required.  And to show what a broad minded guy I am, I propose that the rule be applied to Dow.

But Leveris wants to insert bureaucrats into the process:

The Department of Energy has already received applications for the export of half the gas consumed in the U.S. today. Under a 1938 law, the department must determine if those applications for exports are in the national interest (taking into account all segments of society).

Several manufacturers, including Dow, are calling for faithfulness to current law. We are concerned that hasty government action, coupled with growing domestic and international demands for natural gas, will trigger a severe supply pinch that will send the U.S. back to the days of higher and more volatile domestic natural-gas prices.

Ah.  “The national interest.”  That’s the ticket.

The 1938 law inserts a government bureaucracy that can distribute rents among rent seeking supplicants-such as firms like D0w-based on political calculations.  Resources are wasted in the influence process: e.g., chemical companies and energy companies engage in an influence arms race employing lobbyists and other resources to importune the bureaucrats.  More resources are wasted as this process inevitably leads to inefficient outcomes.  The uncertainty generated by the vagaries of this process also serves to damp investment.

So here is my balanced proposal: scrap the 1938 law.

Everywhere you look you see that energy is highly politicized.  Politicians and bureaucrats exert a huge influence over the allocation of energy resources.  Look at Keystone XL.  Look at cockamamie subsidies for solar and wind.  I could go on and on.  These interventions destroy huge amounts of value.

Balance is a relevant concept here, because politicians and bureaucrats balance competing political interests when choosing policies that divide up the pie.  But that “balanced” process destroys wealth.

We need less politicized energy market.  Allowing free export of US natural gas-and oil-should be a no brainer if your object is-as Mr. Leveris claims his is-to maximize national income.  But that’s not his real objective.  His real aim is to maximize Dow’s income, to redirect wealth from the shareholders of E&P firms to his shareholders.

Leveris’s piece is a gaseous plea for mercantilism, though of a rather apostate form since traditional mercantilism advocates the maximization of exports.  But the essence of mercantilism is government control and manipulation of trade.  And moreover, one staple of mercantilist thought is that domestic raw materials should only be used in domestic manufacture because manufactured goods are more valuable than raw materials.  Leveris repeats this long discredited fallacy in his oped.  Proving that few things live longer than bad arguments.

Sadly, it is likely that the chemical industry, and other energy consuming industries, will exert some influence and succeed in restricting the exports of natural gas.  That’s the way things work, alas.  But don’t buy the bilge that these restrictions are part of a “balanced approach” that advances (ill-defined) “national interest.”  Instead, they are inherently unbalanced and advance very specific economic interests.

And one last word of advice: when anyone says they are only advocating a “balanced approach”, grab your wallet and call bull.

Gensler and Chilton are taking up the cudgels again for position limits-this in spite of the spanking from Judge Wilkens last year.

Chilton, as usual, is most outspoken on this issue:

Today, energy costs for most families have risen more than 20 percent since 2001. This hurts not only American households, but also American business—like many of your businesses—that rely on energy. According to the Energy Information Administration (EIA), nearly nine percent of our economy or $1.4 trillion is spent on energy annually. Imagine if that figure dropped by just ten percent—$140 billion freed up for investment and economic growth.

So that’s why I continue to lead the charge for position limits—to help keep the markets working for you. The efforts to stop position limits will ultimately fail. Congress told us in no uncertain terms to get it done, and I intend to see that we do that, before more families and businesses go into the “red” column on their balance sheets.

First of all, 20 percent in 13 years is less than 2 percent per year-that is, less than the rate of inflation: the CPI is up almost 30 percent over those 20 years, meaning that the real price of energy has fallen.   I say again: the real price of energy-per Chilton’s own numbers-have fallen.

I also note Chilton’s continued focus on the rise in oil prices, and his complete refusal to acknowledge the collapse of natural gas prices precisely during the period in which his Massive Passive bogeymen have allegedly driven commodity prices generally, and energy prices particularly, far above what they “should” be.   If “speculation” by “massive passives” (or whoever) can cause prices to become completely unhinged from fundamentals, why has natural gas moved in the exact opposite direction from oil?

Chilton’s egregious errors of omission and commission must be caused either by a lack of intellectual capacity, or a lack of intellectual honesty.  I really see no other alternative.

Obama and his acolytes flatter themselves as sophisticates, reality-based devotees of science.  They look to Europe for inspiration.  If only they would actually pay attention to the reality of Europe, as opposed to their fantasy vision.

Obama brought his supporters to paroxysms of joy-near orgasms, in fact-with his call in the SOTU speech for action on “climate change.”  Action that he said he would take if Congress does not-the Constitution be damned.

Would that he actually look to what his Euroheroes are actually doing  Which is to realize that their alternative energy initiatives have proved to be very expensive unicorn hunts.  Both Germany and Spain have realized that alt-energy is outrageously expensive and inadequate to achieve any meaningful impact on climate:

More than a decade ago, Germany and Spain created similar laws to aggressively promote the adoption of renewable energy. The two countries were again marching in step on Thursday—this time to fix a web of subsidies and compensations they created for green energy that had the unintended effect of driving up household electricity bills.

. . . .

Fearing a voter backlash from anger over the lopsided financing of green energy, Ms. Merkel’s government on Thursday proposed putting a cap on the green-energy surcharge until the end of 2014 and then restricting any rise in the surcharge after that to no more than 2.5% a year. The government also plans to tighten exemptions, which would force more companies to pay, and achieve a cut in green subsidies of €1.8 billion ($2.42 billion). The plan is a quick fix pending comprehensive reform after the election, government officials said.

. . . .

The Spanish parliament took a similar step on Thursday, passing a law that aims to curb rising household electricity costs by cutting aid to the renewable-energy industry.

Renewable-energy producers “are going to receive less revenue, but these measures are better for consumers” said Energy Minister José Manuel Soria.

In other words, Germany and Spain are retreating posthaste from their former grandiose commitments to green energy.

But despite this rather flagrant example of the economic bankruptcy of subsidies for renewables, Obama is intent on playing the David Farragut of greendoggles: Damn the reality! Full speed ahead!

It’s bad enough that Obama ignores what is going on in Euroland.  He should have plenty of examples closer to hand.  Like Solyndra. (Do you really need links?  Seriously?)  Like Tesla (ditto). Compact Power. LG Chem: read it and weep.  You’d  get more satisfaction out of taking $175mm in $100 bills and setting them alight.

But we are likely to be subjected to yet more of these monstrosities, because there is nothing that the reality-based community likes to do more than deny reality.  Especially when it stares them in the face.

Not only are we almost certain to chase green unicorns, we may well deny ourselves of very real energy sources.  This weekend saw protests against the Keystone XL pipeline, and I would say that the odds are better than even that he delays or kills it: the cabal of enviros and Warren Buffett will be pretty hard for Obama to oppose.  (The calculations of my earlier post imply that Keystone XL-which will last for decades-will pay for itself in less than 600 days-and that’s conservative because a good fraction of the $20mm/day in surplus generated by Cushing-Gulf pipelines is attributable to the oil that Keystone XL could transport.)  In contrast we’ll be paying for greendoggles for many multiples of 600 days.

It is quite instructive to view the contrast between the European’s concession to reality, and Obama’s denial thereof.  Just when the Euros are beginning to concede that green unicorns may not exist, Obama is hell bent on chasing them.

God help us.

Rosneft is scrambling to finance its acquisition of TNK-BP.  The means it is resorting to speak volumes about the gulf between its aspirations to be a supermajor and reality, and also about the risks that lenders perceive in dealing with Russia (and perhaps Rosneft specifically).

Rosneft is raising $10 billion through an oil pre-pay deal with Vitol and Glencore.  Rosneft agreed to sell the oil forward, with deliveries starting this year, and Vitol and Glencore used those contracts as collateral for loans for $10 billion.  The money goes from the banks, through Vitol and Glencore, and then on to Rosneft which will use it to pay AAR and BP.  The use of oil to secure the Rosneft-Vitol/Glencore deal is interesting.   Rosneft cannot borrow the money on its own promise to repay: it did borrow $15 billion from banks on that basis, but individual banks were not willing to take more than $1 billion in exposure to the Russian company: that limited appetite for Rosneft credit risk (which given its asset base is driven by political and legal risk) is quite telling.

Rosneft has to use prepays-a kind of financing usually extended to less creditworthy commodity traders, producers, or processors-to get additional funds.  Big commodity houses like Vitol and Glencore frequently use prepays and offtake agreements to provide funding to smaller producers and refiners.  It’s not the way real supermajors secure credit.

Oil is particularly useful as collateral, because if Rosneft tries to renege on its commitment to the Swiss houses (as it might be tempted to do if oil prices spike well above the agreed price), it will have a difficult time selling the oil as anything it tries to sell would be subject to seizure.  It’s a lot easier to seize oil in tankers or in storage facilities in Rotterdam to collect on a debt than it would be to try to seize a refinery in Russia.

Rosneft is also going back to the China well.  It has approached CNPC for $25-$30 billion dollars, again backed by sales of oil at fixed prices.  It originally denied it was in talks with CNPC, but this appears to be a “meaning of is” thing.  It might not have been in talks right at the instant that the Reuters reporter called them last week, but today Igor Sechin is in Beijing talking to the Chinese about a deal.  That’s not the kind of thing that is stitched up over a weekend.

This is a reprise of a $25 billion loan from CNPC and the China Development Bank to Rosneft and Transneft to fund construction of a pipeline extension to China negotiated at the depths of the crisis in 2009.  As I predicted at the time, that deal soon unleashed conflict between the Chinese and the Russians over the price of the oil that the Russians sold to secure the loan, and the transportation cost. The battle raged for several years, until the Russians agreed to sell the oil at a $1.50/bbl discount to the price they charged other customers buying off the ESPO pipeline.

Again, doing a large loan secured by oil, especially with a counterparty with whom the Russians have had numerous pricing disputes (they still haven’t negotiated a price in a gas deal that was first inked in 2006), is hardly the mark of a supermajor.

I fully expect that any new deal with China will spark future price disputes.

The quite evident limits on Rosneft’s borrowing capacity will constrain its ambitions to expand production in Russia, especially in offshore projects in the Arctic.  Hence, it will be very reliant on JVs with companies like Exxon who will no doubt drive very hard bargains.

The means that Rosneft must resort to in order to finance its purchase of TNK-BP says a lot.  It can’t borrow agains the assets it is acquiring, or its other assets.  Beyond the $15 billion syndicated loan, the only thing that lenders feel comfortable lending against is the oil that Rosneft must sell.  That’s the way middling-to-marginal commodity firms get funding, not supermajors.

A member of my vast, globe-straddling network of sources informs me that at this morning’s session of International Petroleum Week in London, John Kingston of Platts referred to my estimate of the economic surplus created by new pipeline investment.  That number is almost a year old, and Kingston’s mention prompts me to update that computation.

It is a basic welfare triangle calculation that depends on quantity-pipeline capacity-and price differences between LLS and WTI.  At present, the LLS-WTI spread is slightly north of $20/bbl.  The forward spread is above $7/bbl (and nearly $8/bbl) as far out as December 2015.  (These are based on settlement prices from CME Clearport.  There aren’t a lot of trades that far out, so those numbers have to be treated with some caution.  That they are in the ballpark of the forward Brent-WTI spread provides some confidence, but of course, CME might have used the Brent-WTI spread in calculating the settlement price for forward LLS-WTI spreads that didn’t trade.)

According to the EIA, there are 1.150 mm bpd of planned pipeline capacity additions from Cushing to the Gulf, and another 830 m bpd planned capacity additions from Permian to the Gulf (back in the day much Permian oil flowed into Cushing, so the Permian capacity additions are another way of easing the Cushing bottleneck)

Given the uncertainty about when that capacity will come on line, I will make a couple of calculations that will bound the value they create.

If all the capacity is expected to come online by December, 2015, the welfare gain is (.5)($20+$7)(1.98mm)-($2)(1.98mm)=$22.77mm/day.  (The $2 is an assumed marginal cost of transportation.)  Note that there is remaining value to adding even more capacity under these assumptions.  If Q additional bpd of capacity is required to drive the spread to marginal cost, the gain from adding this Q units of capacity is (.5)($7+$2)Q-($2)Q=$2.5Q.

If the capacity is expected to come on line sometime after December, 2015, and it is expected that the spread will go to marginal cost when it does, the value of the capacity is (.5)($20+2)(1.98mm)-($2)(1.98mm)=$17.82mm/day.

Big numbers.

It is possible to calculate a similar number for pipeline capacity going into the Midcontinent.  EIA reports that 1.19 mm bpd of capacity from Canada to Midcon is planned.   Western Canadian Select quotes are available via CME only through February, 2015, and are under -$20/bbl for the entire 2 year period: the nearby number is $-26/bbl.  I’ll make a WAG as to what the spread should be once the transport bottleneck is eliminated (because there are quality differences, and the distances are substantial, I don’t know off the top what that should be)-my WAG is $5/bbl.  That gives us (.5)($26+$5)(1.19mm)-($5)(1.19mm)=$12.5mm/day.  That number swings (.5)(1.19mm) for every dollar change in my WAG.

Frankendodd runs hundreds of pages.  The regulations written to bring it to life run to thousands more.  Every word on every page has the potential to wreak havoc: hell, apropos the position limit case, even the commas matter.

Case in point, the CFTC’s proposed rule on protection of customer funds, most particularly Section 1.22.  Some of the relevant language:

The Commission proposes to amend § 1.22 by clarifying that the prohibition on the FCM’s use of one futures customer’s funds to margin or secure the positions of another futures customer, or to extend credit to another person, applies at all times.

. . . .

Further, the Commission is proposing language providing a clear mechanism to ensure compliance with this prohibition, which is to require an FCM to maintain residual interest in segregated accounts in an amount which exceeds the sum of all margin deficits for futures customers.

This is very inside baseball, but has seismic implications.

The basic thing is that some customers are late in meeting margin calls.  This gives rise to margin deficits.  Under the traditional omnibus model used in futures markets for donkey years, futures commission merchants (brokers-“FCMs”) can cover customers’ margin deficits with the margins of other customers.  Effectively, customers lend one another money to address the timing issues that the rigorous mark-to-market and variation margin processes inevitably create.  Moreover, the FCM is ultimately on the hook to cover the losses of a defaulted customer.  The FCM’s customers can lose only if there is a default by a customer that the FCM can’t cover (resulting in an FCM default).

That is, customers effectively lend to one another, and thus there is “fellow customer risk”-a solvent customer can lose as a result of the default of another customer. The CFTC rule is intended to eliminate this risk.

Problem: the risk can’t really be eliminated, merely shifted around.  Related problem: the likely reaction to this attempt to shift risk.

The CFTC seems to want to shift the risk to the FCMs: the “residual interest” language means that the FCM has to have enough of its own money on hand to cover any margin deficits.  This will require the FCM to hold substantial precautionary balances, because (a) the magnitude of margin deficits is likely to be quite variable, and particularly will be large in the aftermath of a big price move (that can’t be predicted in advance), and (b) there are serious penalties to being undersegregated.  Alternatively, FCMs are likely to require customers to post margins far in excess of exchange margin levels, thereby reducing the likelihood that any customer’s account will have a margin deficit, and the amount of residual interest the FCM must hold to cover any such deficits.

Either way, there will be a substantial increase in the amount of cash tied up, and the needs for customers and FCMs to have access to contingent liquidity.  The omnibus model was an effective way for customers to supply liquidity to, and obtain liquidity from, other customers.  Yes, there are risks, but there are corresponding benefits: the near universality of the omnibus model in futures markets, and its survival for decades, provides compelling evidence that the benefits far exceed the costs.

But apparently that’s not good enough for GiGi and the Gang.

The clearing and collateral mandates-combined with Basel III and other regulatory measures-are already requiring substantial increases in the amount of collateral-liquid assets-that will be tied up to support derivatives trades.  This will just add to that.  And insofar as being a customer protection mechanism: uhm, customers will pay for it.  Don’t act as if your are doing them a big favor. (Raising the question if its so valued by customers, why hasn’t some FCM adopted voluntarily what the CFTC wants to impose by fiat?  If it’s so great, customers would flock to firms offering that model.)

It also comes at a terrible time for the FCM industry.  The economics of the business are terrible.  ZIRP has blown a hole in a major source of revenue, volume is down sharply, and competition is intense.  A recent Celent study details the carnage:

“The leading FCMs in the US are struggling with falling revenues and profits,” saysAnshuman Jaswal, PhD, Senior Analyst with Celent’s Securities & Investments Group and author of the report. “This puts them in an unenviable position, especially when we consider the overall impact and related costs of various regulatory implementations taking place in the next couple of years.”

Another data point: SocGen just wrote down its investment in big FCM Newedge.  This is not a thriving industry, and ladling more costs onto it won’t help it one bit.

The ostensible purpose of this new regulation is to prevent another MF Global or Peregrine situation.

Seriously?

MF Global broke every rule in the book about segregation and the treatment of customer money.  Peregrine’s owner ran a huge fraud for 20 years. So creating more rules for troubled or criminal FCMs to break will help?  If the CFTC or SROs couldn’t enforce the old rules and thereby prevent losses of customer funds, why should we expect they’ll do any better with the new ones?

It’s also hard to see how these rules, if they had been in place, would have prevented either the Peregrine or MFG situations.  Furthermore, there are other ways of attacking the exceptional-and MFG and Peregrine were exceptional-without imposing crushing burdens on the ordinary day-to-day operation of the markets, FCMs and their customers.  For instance, the Peregrine fraud could not have continued if Peregrines regulator (the NFA) had direct electronic access to the firm’s accounts, thereby preventing Wasendorf from altering the paper statements he sent on to regulators to cover up his fraud.  Hell, in the MFG case, having more excess margin in customer accounts would have just increased the money that Corzine could have tapped to cover the company’s losses and own margin calls: it is just that excess margin that disappeared somewhere, somehow.  I would further note that since an FCM is most likely to be tempted to get at customer funds when it is in financial jeopardy (which is what happened with MF), adding to its financial burdens could create more problems than it solves.

The cost-benefit analysis the CFTC advanced in support of the rule is just the kind of joke I’ve come to expect.  This is actually a problem that is amenable to calculation.  Collect data on the distribution of customer margin deficits under current rules.  Figure out the 99.9th percentile of this distribution.  (Importantly, condition this distribution on market conditions-find out what that percentile is during very volatile periods.)    Given the rigor of the rule, it is plausible to assume that additional funds equal to this 99.9th percentile will have to be held by customers, FCMs, or both will be held to ensure compliance.  Calculate the return on this sum lost because customers and FCMs are required to hold low-yielding assets in order to comply with the rule.  That’s one component of the cost.

Another cost is the additional operational cost required to ensure compliance.  This will not be trivial: indeed, one reason FCMs might require substantial increases in customer margins is to reduce the operational burdens required to maintain compliance.

One cost that is important is hard to quantify.  As I’ve written repeatedly, spikes in liquidity needs during periods of market stress can be systemically destabilizing.  This rule will: (a) restrict one vital source of liquidity, namely, intracustomer loans; (b) result in far more liquid assets being tied up in brokerage accounts; (c) lead to increases in liquidity demand during periods of high volatility, as FCMs will either have to hold more liquid assets, or will force customers to hold more excess margin, during high volatility periods in order to maintain compliance (i.e., the 99.9 percentile is much bigger during high volatility periods, requiring more margin to meet this threshold-the distribution of liquidity demand spikes caused by this could be calculated); and (d) result in position unwinds by those unwilling to incur the cost of the elevated margins.  All of these effects are pro-cyclical, and tend to exacerbate market instability/volatility.  Liquidity problems are what create or exacerbate crises.  Derivatives market “reforms” have already imposed substantial liquidity burdens: this will only add another.  That is systemically risky.

Benefits?  Uhm, hard to ascertain.  As noted above, the rule is ill-suited to address either a Peregrine or MFG problem, even though those are the examples the CFTC repeatedly invokes in their support.  Moreover, it must be noted that reducing the amount of loss arising from the default of fellow customers is not necessarily a benefit.  This is primarily a transfer of wealth from one party to another.  The relevant issue is whether one risk sharing rule is better than another.

This is another example of the pernicious effects of attempts to “fix” high profile problems such as MF Global and Peregrine.  In response to truly extraordinary episodes, we get “fixes” that (a) don’t really do anything to address the problems they are supposed to be fixing, and (b) impose substantial burdens on the ordinary operations of the markets, operations that have gone on swimmingly for decades under the old way of doing business, thank you very much.

As a rule of thumb, I think it wise to be very suspicious of rules designed to prevent recurrence of an extreme event or events.  That is especially true in this case.   Another example of all pain, no gain.

Is that the CFTC’s motto now?

There has been a great deal of optimism regarding the future of oil and gas production in North America, and the US in particular.  Fracking has already turned the gas world upside down, and is starting to do the same in oil.  The IEA has made very optimistic forecasts, and the main cloud it sees on the horizon is that the US is not investing enough midstream and downstream to absorb the unexpected upstream bonanza.  Citigroup’s oil analysts just released a similarly sunny prognostication.  (I usually don’t see eye-to-eye with Ed Morse on the speculation issue, but he is very credible on the fundamentals of the physical market.)

OPEC is taking a contrarian view in its latest monthly report:

In its latest report, the group of major oil producers forecast the shale boom in the U.S. would help increase oil production by 520,000 barrels a day this year, giving the U.S. the highest production growth among the non-OPEC countries, but it also played down the positive side of these developments by warning of the challenges facing the industry.

“There are remaining risks associated with the growth forecast on the back of weather, technical, environmental and price factors,” the report said. It said that the heavy decline rate associated with the first year of shale oil production from individual wells in the first year was a major factor that could impact growth.

The decline rates are well-known, and E&P companies are basing their drilling investments based on the best available information.  Yes, decline rates could be faster than assumed, but they could be slower too.  Moreover, the technology here is extremely dynamic, and there is a substantial potential for advances in drilling and reservoir management that could make the forecasts of IEA and others appear unduly conservative.   Learning by doing and the accumulation of knowledge on how to exploit fracking technology, generated by the experiences of numerous companies, lay the foundation for positive productivity shocks.

OPEC’s sour attitude on unconventional oil bears an uncanny resemblance to Gazprom’s initial reactions to shale gas, reactions that were hardly persuasive early in the boom, and which look more pathetic by the day.

It seems that like Gazprom, OPEC is trying to spread Fear, Uncertainty, and Doubt about unconventional oil, in an attempt to try to scare off investment.  Their efforts are likely to be no more successful than Gazprom’s.  The people committing the capital know more about fracking and the formations where it can be used than OPEC, and are learning more every day.

And while we’re on the subject of OPEC and uncertainty, perhaps it could address things it might actually know a lot about, like the reliability of Saudi reserve estimates and the effects of political risk on production in places like Venezuela and Nigeria.

Sunshine: The New Subprime.

Spain can no longer afford greendoggles:

The Spanish government’s latest bid to cut its growing debts to the country’s energy sector is expected to slash profits at renewable energy companies as Madrid continues to grapple with a €28bn deficit built up through years of subsidies.

Spain’s most recent reform to the energy sector will force renewable energy operators to choose between a fixed price or market price for their power – and remove a previous subsidy – while renewables subsidies will also be delinked from consumer price inflation and instead aligned with Spain’s core inflation measure.

Shares in Acciona, Spain’s second largest wind power operator, have tumbled almost 20 per cent, with Abengoa, Spain’s largest solar thermal power plant developer, also falling sharply since the changes were announced at the end of last week.

This story about the travails of the Utility Formerly Known as TXU doesn’t mention renewables-notably wind-but it should:

Energy Future Holdings Corp., the struggling Texas power company involved in a record leveraged buyout, could end up splitting as it faces significant choke points on debt and seeks counsel from Wall Street restructuring advisers.

The former TXU Corp. has been getting advice from big-name law firms and investment banks ahead of May, when it must start making cash payments on certain debt. In addition, the company faces nearly $4 billion in debt maturing in October 2014. The Dallas-based company was purchased by the private-equity firms and others in 2007 for $32 billion plus about $13 billion of debt.

After a series of complicated transactions over the past several years that rearranged its finances, the company now appears poised to start contemplating a major debt restructuring, be it through a bankruptcy filing or another means, according to a person close to the situation.

The article rightly notes that the collapse in natural gas prices has cratered generating margins (spark and dark spreads, and especially the later).  This is the main reason for EFH’s problems, but not the only reason.  The large increase in wind generation-which benefits quite nicely from  federal subsidies-has put downward pressure on power prices in Texas, and has led to negative prices for power with some regularity.  This is particularly important because Texas operates an energy-only market, with no capacity market, meaning that capital costs must be recouped from energy prices.  With wind subsidy-supressed prices, traditional generation has a hard time paying for itself.  As PUC Commissioner Donna Nelson said:

Federal incentives for renewable energy… have distorted the competitive wholesale market in ERCOT. Wind has been supported by a federal production tax credit that provides $22 per MWh of energy generated by a wind resource. With this substantial incentive, wind resources can actually bid negative prices into the market and still make a profit.

We’ve seen a number of days with a negative clearing price in the west zone of ERCOT where most of the wind resources are installed…. The market distortions caused by renewable energy incentives are one of the primary causes I believe of our current resource adequacy issue… [T]his distortion makes it difficult for other generation types to recover their cost and discourages investment in new generation.

The impact is greatest in the western part of the state, but wind weighs on prices throughout the state.  Except when it’s hot, because that’s when the wind doesn’t blow-but the power is particularly needed.  And wind also imposes substantial reliability challenges, requiring backup generation resources-which find it difficult to recoup costs due to prices that are often artificially low due to the wind subsidy.

The subsidies completely distort price signals, which in turn distort investment incentives and raise the serious risk of shortages of reliable generation resources that can operate hot or cold, rain or shine.

Other than all that stuff, wind is great.

But regulators are hell-bent on tipping the scales in favor of wind:

It’s no secret why FERC is likely to rule against the homeowners in Iowa and Minnesota. The Obama Administration’s green vision is to make wind and solar an ever-larger share of U.S. electricity production, regardless of costs. Think high-speed rail for the electric power network. The only way to make that happen without a political backlash is to spread the costs far and wide.

Wind and solar power are too expensive to compete with natural gas, coal, nuclear and hydropower without government help. The wind lobby already won an extension of its $12 billion production tax credit as part of the recent tax increase. More than half the states also have renewable energy standards forcing residents to purchase wind power. And now the greens want another subsidy for transmission lines.

Because wind makes such economic sense.  The fact that subsidies (and, in some places, the indoctrination of children) are required to support wind development tells you just how much economic sense it makes.  It is a greendoggle of the first order, and one that you might want to think about when the lights or AC go out, especially in Texas on a hot summer’s day.

There has been a spate of world-turned-upside-down stories about the US as a potential exporter of oil and refined products.  The explanation is quite simple.  Supposedly menopausal North American geology has produced a surprise energy baby.  Or, I should say “babies”, for this is a multiple birth, in fact: oil and gas in different locations.

This has resulted in substantial changes in price relationships in oil and gas.  The most visible of these is the Brent-WTI spread, which blew out again to over $20/bbl (better than 20 percent of the WTI price).  But all sorts of spreads have reached record or near record wides.  Canadian oil sells at a deep discount to WTI at Cushing, which sells at a deep discount to the price in the Gulf.  Refining margins are wide.

Commodity trading is all about transformations in space, time, and form.  Spreads price transformations: they are the shadow prices of transformations.  Time spreads price the cost and benefit of transformations in time (through storage).  Locational spreads measure the marginal cost of transformations in space (through transportation).  Spreads between processed and raw materials price the costs of refining/processing.

The spread blowouts in energy  are highly visible evidence of how the spike in domestic energy production, and notably its location and quality, has been at odds with the energy transformation infrastructure that has developed in the US in the past decades.  That transformation infrastructure was-and crucially still is-configured to transform foreign and heavier/sour crudes into refined products for domestic production.  The main direction of movement of crude was south to north, from import points at the Gulf to refineries in the Gulf and Midcontinent.

The new production is in the north, or in Eagle Ford in Texas.  It is sweeter and lighter than the oil that most domestic refineries are configured to process.  Refineries in position (in the Midcon) to process this new output (especially the Bakken) are operating at capacity, giving them fat margins.  The transportation capacity to bring the oil to the Gulf (and to East Coast refineries, many of which have been shuttered in recent years) is highly limited because it was structured to bring oil inland, not ship it to the coast either for refining or (when the law permits), export.

Meaning that in the short run, quantities cannot adjust in response to the oil output shock: there are bottlenecks in transportation, storage, and refining.  Since quantities cannot adjust, prices bear the burden, leading to dramatic movements in spreads that price these transformations.

These spreads are signals about the locations of bottlenecks in the value chain, and the value of making investments in transportation, storage, and refining capacity to ameliorate them.  These investments are expensive, and take time.  Hence, historically anomalous spread levels are like to persist for some time.

Moreover, some investments can exacerbate other bottlenecks.  For instance, building Keystone XL (which will bring oil from Bakken and Canada to the Midcontinent) without adding more Midcon refining capacity and/or more capacity to move oil from Midcon to the Gulf (and perhaps the East Coast) would actually exacerbate the refining and outbound transportation bottlenecks in the Midcontinent.  This would, most notably, cause the Brent-WTI spread to widen further.  There is essentially a race between production capacity in the Midcontinent on the one hand, and the outbound transportation and refining capacity there.  Right now production is winning.  This will tend to cause spreads to change in ways that discourage too much output expansion, and encourage expansion in the ability to consume what is produced in the Midcon.  But there will be a minuet between production and consumption that will go on for years: prices/spreads will play conductor of the music that producers and consumers dance to.

There are economic considerations that limit the speed with which quantities will respond to these price signals.

For one, investment takes time.  You can’t snap your fingers to build a pipeline or add refining capacity, and have it arrive instantaneously in a puff of smoke.

Uncertainty is another.  The ability to invest in refining or pipeline or production capacity is a real option: in the face of uncertainty, it is often optimal to delay decisions to invest pending the arrival of new information about the economic value of those investments.

Sadly, politics is another.  Whether it is a politicized pipeline approval process, Byzantine environmental laws that give enviros and nimby-ists the ability to impede energy investments, or laws that restrict exports, the legal and regulatory systems in the US inflate the cost of investment in energy infrastructure, and crucially add an element of considerable uncertainty that also slows investment due to the real option considerations I just mentioned: the vagaries of politics and political influence are volatile, hard to predict, and can have first-order effects on the profitability (or not) of an investment.   It would have taken some time regardless to make the investments necessary to reconfigure America’s energy infrastructure to accommodate the huge shock to the location and quality of oil production.  Politics and regulation will only slow that response, and make it less efficient and complete than it should be.

And it should be noted that even though much of the law and legislation will be cloaked in the language of public interest, notably environmental paeans and invocations of “jobs, jobs, jobs”, it is largely the product of nakedly self-interested calculations.  This is most notable in the debate over natural gas exports, in which domestic petrochemical producers are trying to prevent-or at least sharply constrain-in order to reduce the cost of their feedstocks and thereby increase their margins.  Similar arguments are already starting to appear in oil just as the prospect of oil exports is being mooted.  It is also notable in transportation: is it any surprise that oil pipelines (notably Keystone) are the target of much opposition, given that Warren Buffett is making oodles of money transporting oil by rail, due to his ownership of the BNSF RR and a major manufacturer of rail tank cars.  (Sort of OT: speaking of Buffet, could the fact that the USDOJ is going after S&P but not Moody’s, despite the fact that their conduct during the pre-crisis period was almost identical, have anything to do with the fact that Saint Warren has a big stake in Moody’s?)

In other words, naked rent seeking is going to play a big role in the speed and efficiency with which firms make the investments necessary to respond to the unexpected domestic energy production shock.  Sadly, the intensely politicized nature of energy, and the swollen nature of the US government and regulatory apparatus (which deems that everything is its business) will dramatically impede this adjustment process.  Meaning that we are likely to be in a world of wide spreads for some time to come.

When the government is the bookie, it’s very hard to beat the spread.  Especially when that government is all too often indistinguishable from the mob.

FWIW, there’s been something of a kerfuffle over Medvedev’s statement Davos that Gazprom’s export monopoly may end.  And WIW? Not much: remember, it’s Medvedev.  In Davos.

Let’s go back to basics.  The creation of a state-owned export monopoly (or any monopoly, for that matter) is fundamentally the result of the lack of a state’s fiscal capacity and ability to raise revenue through the tax system.  If a state could collect taxes costlessly, the best way to exploit a resource like natural gas would be to encourage ruthless competition in exports: the competition would minimize costs and maximize the surplus to be created.  A state that can collect taxes costlessly could then maximize its take by charging a tax on exports.

However, an inefficient or corrupt tax service means that the state would never realize much of this revenue.  Firms would conceal sales or income, or bribe the tax authorities, and most of the tax revenue would just vanish, to Cyprus, etc.

An export monopoly can achieve the same revenue outcome.  If it’s easier and cheaper for the state to audit and monitor the state export monopoly than a bevy of exporting firms that are supposed to pay tax, the state will prefer such a monopoly even if it is less efficient.  There is less leakage.  Not no leakage, but less leakage.

Moreover, powerful people in the state can often control and tap into the rent stream of the state firm more easily than a bunch of competing firms, some of which might just be fly-by-night shells of trading firms.

State grants of monopoly privileges are common in polities with relatively undeveloped fiscal and tax systems.

There is a political economy angle too.  Look at oil export taxes in Russia.  Oil companies exert political pressure on the state to reduce export taxes because a ruble not collected by the government goes into the pockets of the owners of the oil companies.  State ownership reduces the power of incentives to lobby for tax reductions.

What this all means is that the elimination, or not, of Gazprom’s export monopoly will be driven by fiscal, taxation, and corruption considerations.  If Putin and the siloviki (Medvedev?-please) deem that  the Russian state has developed sufficient fiscal capacity and capacity to tax, they will substitute a combination of free export and taxation (similar to what is observed in the oil business) for Gazprom’s export monopoly.  Relatedly, if they deem that they can siphon off the tax revenue more effectively than Gazprom’s cash flows, they will treat Gazprom like they are beginning to treat Assad: “Do I know you?”

This is the natural state in action.  The natural state imposes restrictions in order to create a stream of rents that can be distributed to the elite, or to buy political support for the elite.  There are different kinds of restrictions.  Taxes-including export taxes.  Monopoly licenses-including export monopolies.  In a world with no transactions costs, there are a variety of alternative means of generating the maximum stream of rents: setting price or output are perfect substitutes.

Things are different in a world with positive transactions costs, in particular, when monitoring and measuring output/revenue/profit and/or collecting taxes are costly.  With transactions costs, measurement, monitoring, and collection technologies are crucial in determining the best way of creating a stream of rents.  “Best” from the perspective of the elite, and where the stream of rents reflects the cost of monitoring, measuring, enforcement and collection.

These considerations will drive Gazprom’s fate.

Medvedev did say one sensible (though obvious) thing. “But we mustn’t lose money, that’s the important thing.  Money comes first.”

The crucial thing is who is this “we”, kimosabe? It is the elite, notably Putin and the siloviki.  The technology of transforming natural resource rents into income/wealth for the elite.  Sometimes a grant of monopoly privilege is the most efficient way of making that transformation.  That is often true in relatively crude polities with underdeveloped or corrupt taxing capacity.  That has been a fair characterization of Russia for a very long time.  That is what drove collectivization under Stalin.  That was the rationale for the commune system in tsarist times.  That has been the case with Gazprom since the fall of the USSR.  Gazprom will continue to exist as as long as the taxation capacity of the Russian state is relatively weak, and it is easier to direct Gazprom’s cash flows to elite pockets than it is to direct state tax revenues to that destination.

So don’t expect Gazprom’s monopoly privilege to disappear any time soon.  It is an inefficient monstrosity in some ways: it wastes land, labor, and capital in prodigious amounts. But it is the most efficient way to achieve the rent seeking objectives of the Russian elite.  It is their money that comes first.  They are willing to live with a wretchedly wasteful monopoly that dramatically shrinks the size of the pie, if it allows them to get a bigger piece.

Update: There’s another reason to doubt Gazprom’s monopoly privilege is going to end anytime soon.  The Russian oil industry was originally highly fragmented.  There is no export monopoly (though Transneft does have a monopoly: Gazprom is different because it is integrated upstream and downstream) and the industry was largely privatized starting with the collapse of the USSR.  Instead, Russia has collected taxes (export taxes and income taxes) from oil companies-and often had a difficult time doing that.  Moreover, as mentioned in the post, there has been a good deal of conflict over oil export taxes.  But in recent years, the industry is becoming increasingly consolidated under state-owned Rosneft, with the acquisition of TNK-BP making Rosneft by far the dominant company in the industry.  There has been talk of partially privatizing Rosneft, but Sechin has succeeded in preventing this and Putin has been unenthusiastic.  The main supporters have been in Medvedev’s circle.   Thus, the oil industry is moving towards the state-owned model, with Rosneft paying large dividends to the state.  There is thus something of a convergence of the gas and oil models: it would be passing strange if the state company became increasingly dominant in the oil industry and less dominant in gas.