Streetwise Professor

I doubt that he’s making the trip in a sealed train, but an important and shadowy Russian figure is leaving Geneva, Switzerland to return to Russia.  That would be Gennady Timchenko, co-owner of the trading firm Gunvor.  You know, the one that is frequently linked with the guy Timchenko claims to know only slightly, Vladimir Putin.

Now, this isn’t comparable to Lenin returning to Russia to foment a revolution, but why would anyone in their right mind want to leave Geneva for Moscow?  And no, starting a construction holding company is not a good reason.  At least he didn’t say he wants to spend more time with his family.

A major risk that commodity trading firms face is legal risk-particularly if they deal with unsavory regimes.  Gunvor’s activities in the Congo are one example that has apparently drawn the scrutiny of Swiss investigators. Gunvor was also the subject of an article in the Economist about oil price manipulation, specifically, manipulating the market for Urals crude.  That has apparently attracted scrutiny of the Justice Department here in the states.  Although some have said that this is likely to be a civil investigation, that’s not my read: CFTC handles civil manipulation cases under the CEA, but Justice handles criminal. (Ask BP.)

And I wonder if there is any connection between the questions about Gunvor’s manipulation of the Urals market and its recent failure to win any tenders in that market, which it once dominated:

Trading house Gunvor – dubbed by dealers the king of Kremlin oil – has been left with no Russian crude to sell. That was the surprise outcome of the latest big Russian crude oil sales tender, for long routinely won by Gunvor.

The result has sparked an intense debate in the industry about whether Gunvor’s co-owner Gennady Timchenko is out of favour with the Kremlin – or whether the firm is merely fine-tuning its strategy before embarking on yet another phase of spectacular growth.

Could be a coincidence, but an interesting one, no?

Given the legal heat, perhaps there’s good reason for Gennady to decamp to a far chillier, but more legally congenial, climate.  A place where he almost certainly has protection from the chief protector, and one that doesn’t extradite.

Very much worth watching.

The NYT has a very long piece on how E&P companies are singing the blues about the low prices following on the unexpected surge in natural gas production.  Stop the presses.

What’s interesting to me is a point made in the article that I’ve seen raised repeatedly, and which I find curious, given my Coasean bent.  Specifically, that lease terms force companies to continue drilling to maintain leases, even if the wells can’t make money in a low price environment.  That is, the leases have use-it-or-lose-it-clauses:

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases.

. . . .

Exco, Chesapeake and others initially boasted about how many acres they had managed to lock up. But after paying bonuses of up to $20,000 an acre to the landowners, the companies could not afford to lose the leases, even if the low price of natural gas meant that drilling more wells was a losing proposition.

. . . .

The bust has certainly hit the Haynesville hard. Some local landowners, having spent their initial lease bonuses, are now deeply in debt. Local restaurants and other businesses are suffering steep losses now that so many drillers have left town.

The Coasean reply is to say: if drilling is inefficient, why not negotiate out of the use-it-or-lose-it-clauses?  There is a pot of money-the costs of excessive or premature drilling-that could be divided between the company and the lessor.  Why can’t the lessors and the lessees strike a deal to split that pot of money?  What are the transactions costs that preclude renegotiations that reduce excessive and premature drilling/production?  Is it the large number of lessors?  That is, are the costs of renegotiating each lease bigger than the benefit to be gained from rationalizing drilling and production?  Then why don’t companies like Cheseapeake just offer a standard deal to lessors, such as a fixed payment, or a fixed fraction of the original lease, or a fraction of the royalties from production, and let lessors take it or leave it?  Why are these clauses in the leases in the first place?

Interesting TCE questions.  I’d love to hear some answers, because I’m stumped.

Speaking of Haynesville, Gregory Kallenberg, the director of the movie Haynesville, has produced a series of short films (sponsored by Shell) about the future of energy.  The series is called “The Rational Middle.”  I appear-briefly-in several of the films, which can be viewed at the link.  I participated in a screening/panel discussion in Houston last Wednesday, and recorded material on conservation and efficiency that may appear in the next round of pieces.

The jaw-to-jaw square up moment during last night’s Presidential Debate was over energy policy, of all things.  Politicians discussing energy is usually less than edifying, and last night was no exception.  But Obama took the prize for ignorance, complete with a huge dollop of arrogance-always a charming combination.  But it is his métier, non?

Specifically, in response to Romney’s attacks on administration policy regarding drilling leases on public land, Obama lauded the administration’s move to “use-it-or-lose-it” leases.  So let’s get this straight, absent his genius, oil companies would spend money to buy leases, and just sit on them out of spite?  Or something.

A lease is essentially an option.  It is an option to explore, develop, and produce.  There is optionality within each of these steps.  For instance, a leaseholder can undertake some preliminary exploration, and conditional on the results of that, decide to engage in additional exploration.

The value of this option depends on its maturity.  It also depends on the uncertainty regarding the geology.  Crucially, it depends on market prices-the price of oil or gas, the price of inputs needed for exploration, development, and production.  It also depends on the volatilities of these prices-which is true of any option.  It also depends on the amount of time required for each “sub-option”, e.g., each step of the exploration process.  This depends on the particular property at issue.

Use-it-or-lose-it basically means to shorten effective lease terms.  This reduces the value of the option.   By how much depends on all the factors I just mentioned.

So to the extent that “use-it-or-lose-it” means anything, it means that the administration is shortening the effective maturity of leases.   This reduces the value of the option . . . which reduces the amount companies will pay for leases . . . which reduces government revenue.  So Obama is bragging about a policy that reduces government revenue.  Got it.

Indeed, some companies will figure the leases are worth zero under the restrictions.  So leasing will decline.

There’s another way to see why this policy is so wrongheaded.  The E&P business is pretty competitive.  And E&P companies are not in the business of leaving money lying around.   If there’s money to be had by leasing a property and developing it optimally, a lot of companies will compete to do that.  In this competitive environment, lease prices will reflect pretty well the value of the property and the value of the options to develop it.  Inefficiently constrain those options, and competition will force down the prices of leases.

But we know that Obama has no clue as to how businesses, competition, and markets work.  This is just another superfluous data point in that empirical exercise.

That’s not all.  When you look at output, and the pattern of output over time, inefficient restrictions on the terms of options will lead to lower production, and inefficient exploitation of resources over time.  Some resources will be developed too quickly.  Others too slowly, or not at all.

This will, in turn, tend to increase prices.

And a bonus: inefficient production of hydrocarbons fro public lands will reduce government royalties from production.  Another revenue hit.

In summary: Obama bragged about a policy that is completely counterproductive.

But he is the smartest president EVAH.  Just ask him!

Idiocy updates: Some other Obama energy gems from last night.

The complete dodge on the Keystone XL pipeline:

And with respect to this pipeline that Governor Romney keeps on talking about, we’ve — we’ve built enough pipeline to wrap around the entire earth once.

That’s called bait-and-switch: asked about one thing, he answers about something else.  Furthermore, the other pipelines are neither here nor there.  Keystone should be evaluated on its own merits, which are quite strong.  And who is this “we” he is talking about?  Are he and Valerie and Michelle moonlighting on pipeline construction crews?

Favoring throwing good dollars after bad renmibi and Euros.  With respect to renewables, he said:

Because China, Germany, they’re making these investments. And I’m not going to cede those jobs of the future to those countries.

Yeah, they’re making these investments.  And losing money hand over fist on them.  Note to Barry: you don’t gain “jobs of the future” by taxing people engaged in wealth-creating activities to pay subsidies to those who engage in wealth-destroying activities.  Yeah, you might see the guy working on the wind farm (but don’t look at the dead bats!) but you don’t see the people who aren’t working, or who are working less, or who are working less productively because of the deadweight losses of taxes needed to finance the Green Unicorns.

It is beyond pathetic that solar companies-in China, the US, German, Spain, wherever-can’t make money even if they are subsidized.

This is something to imitate?  No.  This is something to observe-and avoid like the plague.

But the Genius President knows bettah.

I have long been a bear on China.  Prior to 2008 because of the shakiness of its banking system; post-Crisis, because of my deep skepticism about the effects of the huge stimulus program-including its impact on the banking system, or more properly, the shadow banking system.

I am not alone.  The Bank of China is warning about the country’s shadow banks:

A senior Chinese banking executive has warned against the proliferation of off-book wealth management products, comparing some to a Ponzi scheme in a rare official acknowledgement of the risks they pose to the Chinese banking system.

China must “tackle” shadow banking, particularly the short term investment vehicles known as wealth management products, Xiao Gang, the chairman of the board of Bank of China, one of the top four state-owned banks, wrote in an op-ed in the English-language China Daily on Friday.

“Unsurprisingly, although Chinese banks’ non-performing loans are at a low level of 0.9 percent, the potential risks are worse than the official data suggest,” Xiao wrote, adding that a problem could come as indebted borrowers face cash flow problems or enter default, straining the banking system.

“The music may stop when investors lose confidence and reduce their buying or withdraw from WMPs,” he said, referring to wealth management products.

He warned of a mismatch between short-term products and the longer underlying projects they fund, adding that in some cases the products are not tied to any specific project and that in others new products may be issued to pay off maturing products and avoid a liquidity squeeze.

“To some extent, this is fundamentally a Ponzi scheme.”

Xiao’s op-ed is in line with similar warnings issued by outsiders, particularly the Fitch Ratings agency whose China banking analyst Charlene Chu has long warned of a maturity mis-match and the threat to the Chinese banking system of products with various terms and interest rates.

Moreover, there is a widespread belief among investors in these products that banks are offering liquidity puts:

Although the products are technically more risky than deposits, most investors believe they are backed by the banks’ implicit guarantee and they are marketed aggressively in bank branches nationwide. Xiao acknowledged this perception posed a risk for banks’ bottom line.

“The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back,” Xiao said.

In June, People’s Bank of China vice governor Liu Shiyu said many banks are not transparent enough about the risks wealth management products carry.

“China’s shadow banking system is complex, with a close yet opaque relationship to the regular banking system and the real economy,” Xiao concluded by saying.

“It must be tackled with care and sufficient flexibility, but it must be tackled nonetheless.”

Recall that the movement of SIVs back onto bank balance sheets was a major channel by which problems in the shadow banking sector were communicated to US banks.

These “wealth management” products grew up as a direct result of the intervention of the supposedly wise direction of the Chinese state.  It wanted to restrict bank lending that had been stoked by the 2009 stimulus, in a step-on-the-gas-whoops-step-on-the-brakes maneuver so common to attempts to “fine tune” economies.  The bank credit was basically redirected to the informal sector.

I’m sure it will work out swell.

For more background on the crazy-quilt Chinese banking sector, and all its fragility, this is a decent source.

Another reason for my bearishness is my innate skepticism-based on long experience-of state efforts to guide resource allocation.  Case in point: China has gone all out to promote investment in renewables, and has been awarded with huge losses:

hina in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war.

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost ofsolar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy.

The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.

Well played.  Remind me again why should we compete by throwing good dollars after bad renmibi?

(As an aside, to illustrate the absurdity of subsidy politics, Solyndra is suing Chinese solar panel makers for predatory pricing.  Predatory pricing suits are almost always meritless.)

A substantial fraction of measured Chinese growth in the recent past has been accounted for by investment.  But the relevant question is whether this investment is going to pay dividends, or whether it has been misdirected into white elephants.  The solar (and wind) experience suggests the latter.  Historical experience with politicized investment suggests the latter.  The influence of corruption and the political influence of the elite on the investment prices also suggests the latter.  I’m going with the latter.

The WSJ has a long piece on a Chinese economist who is similarly skeptical about the ability of the Chinese state to direct investment:

Mr. Zhang’s academic colleagues were all praise for the “China Model,” but in 2009 he was giving speeches entitled “Bury Keynesianism.” Then a top administrator at Peking University, where he now teaches economics, he argued that since the financial crisis was caused by easy money, it couldn’t be solved by the same. “The current economy is like a drug addict, and the prescription from the doctor is morphine, so the final result will be much worse,” he said.

. . . .

Ultimately, Beijing’s stimulus fed a false investment boom that stoked asset bubbles—then the morphine wore off while the government tightened. Officials claim the economy grew at 7.6% year-on-year between April and June this year. Skeptics think the real number is closer to 4%. (One London research house says 1%.) Meanwhile, industries dominated or favored by the state, such as steel or solar power, are idling from overcapacity. Countless sheets of copper are reportedly stacked in warehouses, blocking doorways and exemplifying Hayek’s notion of “malinvestment.”

It’s actually worse than merely Hayekian/Austrian malinvestment, IMO.  That arises from decisions made on the basis of false price signals that result from monetary stimulus.  That is surely present in China in spades.  But there is also a good deal of state-directed investment, or investment channeled to state enterprises, or investment influenced by corrupt and connected members of the elite.

A good analysis of these issues is to be found at Michael Pettis’s blog, including examples like this post.  He aims the following, trenchant questions at China bulls:

1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
3. What mechanism can be implemented to increase the growth rate of household consumption?

All very good questions.  China’s recent GDP growth has really been driven by what are properly considered costs: the amount of money invested.  The relevant issue is the value produced by those investments.  Given the state domination of the process of making these investments-either directly, or via distortions of the price system through monetary stimulus and financial repression that distorts interest rates-I am dubious, in the extreme, that these investments will pay.

The sunk cost post mentioned filling the vacuum left by the American withdrawal from Iraq.  I specifically mentioned Iran.  But look who else is taking advantage:

Russian President Vladimir Putin will on Wednesday meet with Iraqi Prime Minister Nuri al-Maliki to discuss joint energy projects and ways to expand investment cooperation between the two countries.

Al-Maliki is in Russia on a working visit on Putin’s invitation. He has already met with Russian Prime Minister Dmitry Medvedev and State Duma speaker Sergei Naryshkin.

Cooperation in the oil and gas sector and the power industry remains a key direction in bilateral relations. Large Russian companies Lukoil, Gazprom Neft, Bashneft and others work on the Iraqi market.

And there’s this too:

Russia announced on Tuesday it has signed $4.2 billion in arms deals with Iraq, making it the largest weapons supplier to the Middle East country after the United States.

The deals, disclosed in a Russian government document issued at a meeting between Prime Minister Dmitry Medvedev and Iraqi Prime Minister Nuri al-Maliki, give Russia a big boost at a time when the future of its arms sales to Libya and Syria is uncertain.

And, of course, the Alfred E. Newmans at the State Department have no worries:

In Washington, the U.S. State Department signaled it was not overly concerned by the Russian deal.
“Iraq overall has initiated some 467 foreign military sales cases with the United States. If all of these go forward, it will be worth over $12.3 billion, so obviously our own military support relationship with Iraq is very broad and very deep,” State Department spokeswoman Victoria Nuland told a news briefing.

Look.  Russia has every interest in making trouble in this region.  Their deepening involvement in Iraq only increases their ability to do so. Is that so hard to understand?  In Foggy Bottom, apparently so.

And the State Department projects this “what me worry” attitude in the face of a clear alignment of Iraq and Russia on Syria:

Nouri al-Maliki, Iraq’s prime minister and the country’s most powerful politician, came out with some ground breaking statements in Moscow – not only on military-technical cooperation with Russia, but also on the worsening Turkish-Syrian conflict. Previously seen as a neutral party to the internal conflict between the government and the rebels in Syria, the Iraqi prime minister cracked up to be a staunch opponent of NATO’s interference in Syria – especially if the intervention takes place under the pretext of fending off a Syrian “aggression” against Turkey.

In an interview to the Russian news agency Interfax, al-Maliki dismissed the “tales about Syrian planes dropping bombs on the Turkish territories.” “Even if something like that happened, these stories are blown out of proportion,” the Iraqi prime minister is quoted as saying. “There is no need to use it as a pretext for a war and to get a whole organization, such as NATO, involved in Turkey’s defense. There is no threat to Turkey.” Al-Maliki said.

The statements of the Iraqi prime minister were made on the background of an unprecedented arms deal between Iraq, fresh from saying good bye to the American occupation force, and Russia. The deal, which envisages supplies to Iraq of Russian MIG29M/M2 fighter jets, anti-aircraft systems and MI-28NE assault helicopters to the tune of $4.2 billion was described as “a breakthrough” by the Russian news agency RIA Novosti defense analyst, Konstantin Bogdanov.

In other words: Maliki is parroting the Russian/Iranian/Chinese line on Syria.  So of course this arms deal and other chumminess is completely benign.  No worries!

And speaking of making trouble, consider this, FWIW:

The regime of Syrian President Bashar al-Assad and his allies have sought to destabilize the neighboring kingdom of Jordan by manipulating peaceful demonstrations there and turning them into deadly violence, leaked files obtained by Al Arabiya show.

. . . .

If Syrian President Assad had conspired to “create chaos” in neighboring Jordan, the high-classified documents leaked to Al Arabiya expose Russia and Iran of being involved in the plot.

Gas prices in California are topping $5/gallon, and politicians are in a frenzy, making claims of manipulation.  Diane Feinstein is taking the lead:

Feinstein, in a letter to the Federal Trade Commission (FTC), called for the agency to implement broad monitoring of oil-trading markets and investigate possible “collusion.”

“Publicly available data appears to confirm that market fundamentals are not to blame for rising gas prices in California,” she wrote, citing state data that showed gasoline production last week was almost as high as a year ago and that gasoline and blending components were equal to this time last year.

The California senator cited Reuters’ Friday report on the “short squeeze,” in which traders said refiner Tesoro Corp had to scramble to buy fuel from other companies to meet commitments.

While traders told Reuters that no single party appeared to be withholding supply intentionally and that there was no suggestion anyone conspired to drive up prices, Feinstein wrote: “An FTC investigation is likely the only way to determine whether this reported squeeze took place.”

Look.  I’ve seen this movie many times before.  There is a localized spike in gasoline prices.  Politicians start screaming “We must do something about this at once! Immediately! Immediately! Harrumph! Harrumph!”  The FTC scurries to do an investigation, and finds that fundamentals explain the spike.

They also find something I’ve included in my classes for 10+ years: that Federal environmental policy is directly culpable.  The key here is that these spikes tend to be localized.  Why? Because due to EPA regulations, there are highly localized formulas for gasoline.  Which means that when there is a supply disruption in a particular locale that requires a specific gasoline blend, supplies can’t be shipped in from other markets because the refineries serving those markets produce a different blend.

This happens in the Chicago area with some frequency.

You may think that the environmental benefits of customized gasoline blends are sufficiently great to justify the occasional-and inevitable-price spikes that such a system produces.  If so, you should STHU about the price spikes. But then you wouldn’t be a politician, who wants it all ways all the time.

This story brings up another pet peeve of mine.  (Yes, there are many.  I know.)  Specifically, the promiscuous and imprecise use of terms related to manipulation.

Feinstein seized on a statement in a Reuters report that Tesoro had been the victim of a “short squeeze.”  Now, this term can refer to a a manipulation, in which the holder of a large long forward position-a position larger than the quantity that can be delivered at the competitive price-demands excessive deliveries of the commodity, driving up the price, and liquidating some of its long position at the supercompetitive price.  The demand for excessive deliveries is an exercise of market power.  The firm demanding delivery is deliberately squeezing the shorts.

This term is also commonly used to refer to a situation where a firm or firm is short, and has to cover under tight supply conditions, but where nobody exercises market power. Here the short is squeezed by tight but competitive market conditions.

Note that the same term is used to refer to two very different situations: one in which somebody exercises market power, and one in which nobody does.

I strongly suspect that Tesoro was caught in the second kind of squeeze.  One way to determine this is to see if Tesoro bought back contracts.  If it delivered on 100 percent of its contractual obligations, one of the longs to whom it had sold couldn’t have exercised market power: that requires the liquidation of some contracts at the supercompetitive price.

But use of ambiguous terms that can have diametrically opposed implications fuels political fires from the likes of Feinstein.  (Scary thought.  She’s the smarter and more honorable of the two senators from CA.)

So my prediction. Much harrumphing for as long as prices stay high in CA. The FTC will dutifully investigate. It will conclude that the spike was produced by an adverse supply shock that could not be ameliorated by increasing supply from other markets. The politicians will greet this report with stony silence. But the harrumphing will begin anew with the next spike.

But you’ll never get a harrumph from this guy. Not until there is credible evidence of manipulation.

I had a chance to read Judge Wilkins’s decision in the position limits litigation on a flight over to London, where I am speaking on the impact of financial regulation, at a conference put on by Lloyds Bank.

There is virtually no economics in the opinion-it is a highly technical analysis of issues related to administrative procedure, statutory interpretation, and the like.  The perfect thing to read while trying to get sleepy as part of my jet lag management strategy.

How technical?  The placement of commas technical.

There are essentially two parts to the decision.  The first relates to § 6a(a)(1) of Frankendodd.  This part is straightforward.  Judge Wilkins ruled that it was unambiguous that the CFTC had to make a finding of the necessity of position limits.  It didn’t.  Back to the drawing board, GiGi.

The second part relates to sections 6a(a)(2), (a)(3) and (a)(5).  Here you have to get into the weeds.  These Judge Wilkins found to be ambiguous.  The ambiguity relates to the words “as appropriate,” as in:

Section 6a(a)(2)(A):

In accordance with the standards set forth in paragraph (1) of this subsection . . . the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person . . .

Section 6a(a)(3):

In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits –

(A)on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and . . .  [Emphasis added.]

What Judge Wilkins could not determine unambiguously was whether “as appropriate” referred to the setting of limits at all, or the specific quantity of the limits.  The plaintiffs (ISDA and SIFMA) argued that the CFTC had to determine whether it was appropriate to set limits at all.  The CFTC argued that it had to set some limits, and Congress directed it to set the specific quantities appropriately.

This is where the commas come in.  I won’t bore you with the details, but if you are planning any intercontinental travel, I direct your attention to pp. 29-30 of the ruling.  You don’t have to thank me for easing your jet lag.

This matter of ambiguity turns out to be mightily important under the Chevron doctrine which determines whether a court need show deference to an agency’s decision.  And here the CFTC (and yes, I’m looking at you, Gary) is hoist on its own petard.

For the CFTC claimed that the language in the statute is NOT ambiguous.  Citing the Peter Pan (!) case, the Judge ruled that by claiming that the ambiguous wasn’t, the CFTC wasn’t owed any deference, and that there is precedent in his Circuit to vacate and remand the rule:

It is well-settled in this Circuit that “deference to an agency’s interpretation of a statute is not appropriate when the agency wrongly believes that interpretation is compelled by Congress.” Peter Pan, 471 F.3d at 1352, 1354 (internal quotation marks and citations omitted) (vacating and remanding agency decision because agency “premised its construction on the plain language of the statute, which it treated as unambiguous, and because we find that the statutory language is in fact ambiguous . . . .”).

Whoops.  By adamantly asserting that there was no ambiguity in the relevant sections of Frankendodd that the judge did find ambiguous, the CFTC lost any claim to deference.

Where do things go from here?  Probably a ping pong game, with the rule bouncing back between the agency and the courts.

Presumably the CFTC will stitch up some justification for a necessity finding, and go into a long disquisition to meet step two of the Chevron test:

“[I]t is incumbent upon the agency not to rest simply on its parsing of the statutory language. It must bring its experience and expertise to bear in light of competing interests at stake” to resolve the ambiguities in the statute.

I don’t know whether a justification of a necessity finding that is based on bad economics or bad (or no) empirical evidence is vulnerable to legal challenge.  I suspect it would be difficult for the plaintiffs to get the rule overturned because of a weak justification for the necessity finding.  I also suspect that CFTC will be able to pass the Chevron tests if it does recognize the ambiguity-which makes me wonder why they didn’t so recognize it at the outset.

My guess, therefore, is that the CFTC can, after yet more hearings, and comments, and time, correct what Judge Wilkins found wanting.  But that doesn’t mean that it’s out of the woods yet.  Not by a long shot.  For the plaintiffs made four additional challenges of the rule.  The judge did not feel it necessary to rule on these additional charges because he found sufficient grounds in the first to remand the rule back to the agency.

Notable among the additional grounds for challenging the rule is “Insufficient Evaluation of Costs and Benefits under 7 U.S.C. § 19(a).”  Will the CFTC stand pat on its existing cost-benefit analysis, which gives the word “perfunctory” new meaning?  Or will it feel obliged to gin up something better, given that the court was obviously not impressed with some of its other legal reasoning, and given that the SEC has lost a major case due to its failure to do a proper cost-benefit analysis?

The other challenges relate more to the specifics of the rules.

In brief, they have not yet begun to litigate (apologies to John Paul Jones).  The position limit rule has a long, long way to go before it becomes a reality.

This also raises the question of whether other Frankendodd-spawned rules will be challenged.  I’m guessing yes.  And there will be much rejoicing-among lawyers, anyways.

It is a good thing when bad rules are stopped.  The ongoing uncertainty pending definitive legal resolution is more problematic, however.  But that’s our reality, and will be for some time, on position limits, and other aspects of Frankendodd.

The title of my 2010 Regulation piece on CFTC position limits characterized the agency’s attitude as: “No Theory? No Evidence? No Problem!”  I had a problem with that attitude.  So did a couple of industry groups, ISDA and SIFMA, and they sued seeking to block imposition of the limits.  And Federal District Court Judge Robert Wilkens has a problem with it too.  He vacated the rule and remanded it to the agency for reconsideration, and granted the plaintiffs’ summary judgment motion against the rule.

The decision turned on whether the CFTC had to find that position limits were necessary to prevent and diminish excessive speculation.  The agency said no: it had no discretion, that Congress had mandated that it impose limits.  The plaintiffs said yes: the plain language of the statute requires the CFTC to make a finding that limits are necessary because speculation is excessive and is causing unwarranted fluctuations in prices.

The agency further argued that imposition of limits were mandatory, whereas plaintiffs pointed to statutory language saying that Congress had granted the authority to impose limits “as appropriate.”

The judge was quite firm in his findings regarding necessity:

The precise question, therefore, is whether the language of Section 6a(a)(1) clearly and unambiguously requires the Commission to make a finding of necessity prior to imposing position limits. The answer is yes.

But the plaintiffs’ victory was not so clearcut as has been portrayed in the initial reporting on the decision.  The judge noted that the two sides had unambiguous, but diametrically opposed interpretations of the statute.  The judge disagreed with both, finding the statute ambiguous:

In sum, although each party believes the statute is clear and unambiguous, their respective “plain readings” compel different results. Ultimately, however, this Court need not choose between the competing interpretations. As explained below, Section 6a is ambiguous as to the precise question at issue: whether the CFTC is required to find that position limits are necessary and appropriate prior to imposing them. Because the Position Limits Rule is based on the CFTC’s erroneous conclusion that the CEA is unambiguous on this issue, the Court “may neither defer to the agency’s construction nor endorse plaintiffs’ construction.” See Humane Soc’y of U.S. v. Kempthorne, 579 F. Supp. 2d 7, 15 (D.D.C. 2008). Instead, the Court must remand this rule to the agency.

As a result, he chose not to choose between the parties’ diametric interpretations.  So the rule will go back to the Commission.  Presumably it will make a finding of necessity based on some attempt to stitch together some empirical evidence on the adverse impact of speculation.  Presumably the plaintiffs will find this evidence unpersuasive (with good reason) and challenge the Commission’s finding, thereby setting up a further round of litigation.  The results of this litigation would presumably depend on what is a satisfactory basis for a finding of necessity by the Commission.  This seems to me to be a potentially far more contentious issue in which the courts may be more likely to defer to the agency’s discretion and judgment.

This decision does not address another challenge to the limits: that the CFTC failed to perform an adequate cost-benefit analysis as required by statute.  That’s another big issue that would require a more discriminating critique of the substance of the Commission’s analysis by the courts.

So this decision is not the end of position limits.  It is probably the end of the beginning, at best.

The concrete results in the short and medium term are beneficial, however.  A bad rule that has no firm grounding in good economic thinking or empirical evidence, and which would impose substantial costs on markets and market participants, will not go into effect next week as planned.  The Commission will be forced to confront these economic and empirical issues, and defend its judgments on these grounds: “Congress made me do it” will not suffice.

No doubt this process will be time consuming.  It will certainly extend well past the election, and depending on the outcome of the election the matter may become moot.  A Republican CFTC is much less likely to pursue position limits with the Javert-like intensity of a Gensler-led agency.  But even under a Democratic administration, the CFTC’s will to pursue position limits will be sorely tested.  It now faces a greater burden of providing some theory, and providing some evidence, or else it will continue to experience big problems in court.

A good day, a good result, but not a final one.  The position limit wars will continue, but the battlefield looks far different today than it did when Frankendodd lurched out of the castle on The Hill, and when the CFTC did what it perceived to be the monster’s bidding.

Meaning “High Frequency Blogging.”  Some quick takes on things that caught my eye.

1. Echoing my looking back, looking forward point (made in July) re Libor, lawyers are very nervous that changes in the rate setting mechanism will call existing contracts-with outstanding amounts in the mere hundreds of trillions-into question.  Yeah, it’s broken, but be damned careful how you fix it-especially if you expect those “fixes” to be retroactive, and affect existing contracts.  Unless you want to subsidize corporate litigators and wreak widespread economic havoc.
2. OTC derivatives rules may be delayed due to “squabbling” among international regulators.  What a shock.  I mean, Carnac the Magnificent couldn’t have seen that coming.
3. The White House is backing off on its claims that the Mohammed video is the sole cause of the assaults on US diplomatic facilities throughout the Middle East.  On 9/11/12.  Jay Carney has a new explanation: an absence of gun control.  Seriously.  When asked about the attack on the US Consulate in Benghazi in which US ambassador Stevens was killed, Carney said: There is an abundance of weapons, including heavy weapons, and there are certainly groups that carry those weapons and look to take advantage of those circumstances—as there are around the region and the world.”  So, on 9/11, some heavily armed dudes were just walking around and decided: “Hey.  Let’s attack something.  Eenie, meenie, meiny, mo [NOT referring to Mohammed, mind you]-The American Consulate!”  Totally random.  Totally.  Not anti-US.  Not at all.
4. The Taliban attack on a US airbase in Afghanistan that destroyed six USMC AV-6 Harriers was a total clusterf*ck.  But O didn’t let that interrupt Jay-Z, Letterman, etc.  Priorities.  Have to have priorities, dontcha know.
5. This piece on China’s Solyndra Economy echoes several points I made in my earlier post recommending that we lose any competition with China on green energy technology.
6. The very excellent Michael Pettis rightly points out dangers for commodities emanating from China’s fraught economic condition.  Like me, Michael is somewhat amazed that people who would decry central planning and heavy handed government efforts to direct the allocation of capital in the US or Europe are in awe of Chinese genius in using central planning and heavy handed government efforts to direct the allocation of capital in China.  This will not end well.  Yeah, I’ve been saying that for a while, but I am convinced that in a few years (if not sooner) China will wish to have Japan’s problems.
7. Finally, to that point, consider the fact that large quantities of inventories of steel in China-allegedly in China, I should say-don’t exist.  And if it happens in steel, it can happen in copper or soybeans or whatever, and likely does.  Phony warehouse receipts have been used to collateralize billions of loans-or the same warehouse receipts have been used to collateralize billions in loans.  Either way, China’s shadow banking system-which depends heavily on loans collateralized by commodities inventory-arguably is far more shadow than bank.  Remember that even modest slowdowns in economic activity can unravel fraud schemes in a hurry.  Such a slowdown is happening in China right now, and it is extremely likely that numerous such frauds will be revealed.  Given the dependence of China on shadow banking, the consequences of this could be seismic.  What say you, Tooltime Tom Friedman?

And on that happy note, I am pulling the kill switch on this HFB experiment.

The regulatory and trading world is all up in arms over the big price drop in WTI, Brent, HO and RBOB on Monday. Fat finger? Runaway algo? Round up the usual suspects!

I say none of the above, especially in light of yesterday’s  story that Saudi Arabia is going to increase oil output.

The price pattern is not typical of a liquidity event, such as arises from a trading or algo error.  In such an event, the price usually retraces quickly to its pre-error level.  That is, price impacts are almost purely transitory if it is understood that the order was an error, or simply a demand for liquidity.  Indeed, a paper by Bayuksahin, Haigh and Harris documents that prices of trades subsequently identified by the exchange as errors reverse well before the official announcement: the market participants figure it out on their own.

Here, the price fell dramatically, then only partially recovered.  Thus, there was a persistent/permanent component to the price move.  This combination of temporary and persistent price impacts means that market participants viewed that there was some likelihood that the order/orders was/were submitted by somebody with private information. (The fact that the move occurred on all major energy markets simultaneously supports that view, although with algorithmic trading one cannot be as confident: one can be more confident it wasn’t 4 or 5 fat human fingers.)

Put that together with yesterday’s Saudi announcement (into which they were probably dragooned by a threat from the IEA and the administration to tap the SPR) and the most likely explanation is that the announcement was leaked, or that the individual or individuals behind the decision decided to make a little money on their information and control.  Which they did, because prices traded off more after the story was released publicly.

Therefore, IMO Monday’s event was an oil leak: somebody spilled the news of the Saudi decision, and that triggered a big trade that pushed down prices.

Not a tech issue.  Just old fashioned front running of an announcement.