Streetwise Professor

Interesting to note that Ken Singleton and I are commonly being used to personify contending sides in the commodity speculation debate.  One example is this piece from the FT on Wednesday.

Before going into substance, I need to set the record straight.  Javier Blas is flatly incorrect to say that I criticized “the CFTC’s decision to invite academics who mainly defended only one point of view.”  Flatly incorrect.  I have never said that either publicly or privately, and I defy Mr. Blas to prove otherwise.

Indeed, I was invited, so I know the statement to be untrue and I would not make it becuase (a) I just wouldn’t, and (b) I’m not so foolish as to make a statement that could easily be proven wrong.   I decided not to attend the event for a variety of reasons, most of them personal.

So, a retraction and correction is warranted (though I’m not holding my breath).

Now that’s out of the way, let me revisit one more time why the Singleton paper is being grossly misinterpreted, though not by Ken (at least in ear/eyeshot of me).

To recapitulate, Singleton finds that a measure of index fund participation helps predict future returns on oil futures positions.   This measure has serious, serious problems, as Scott Irwin and Dwight Sanders have shown.  Singleton has acknowledged some of the problems.  But that still leaves a puzzle, as why would a very noisy measure of speculative participation have predictive power?  But I’ll leave that puzzle aside and take as given that speculation leads prices.

The question is: why?  Does this mean that speculation has distorted prices?

In a rather stinging response to Singleton, the IEA does a nice job of summarizing my views as to why it does not necessarily support this conclusion, and could support the exact opposite one:

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability  of returns, it might be advisable to reduce constraints on the flow of speculative investment to  commodity markets, rather than limiting them.

(The entire IEA piece is worth reading.)

Singleton advances another argument–and it is only that, because his evidence cannot distinguish his explanation from that just advanced–based on various behavioral finance/learning stories.  There are indeed asset pricing models in which investor learning can lead to self-reinforcing price movements.  The key phrase here is “asset pricing models.”  The key question is whether such asset pricing models are applicable to commodities.

I am highly, highly skeptical.  Assume for sake of argument that speculative activity in a commodity derivatives market has distorted the price of the commodity; convergence implies that if nearby futures prices are indeed distorted, physical prices have to be distorted too.

Millions–and in some cases billions–of individual consumers, and myriad producers, face these prices.  If these producers and consumers are not playing the same learning game that is going on in the futures market, the price distortion will affect their production and consumption decisions.  All else equal, if speculators cause the price to be too high, consumption will be depressed, and production will increased.  This will lead to an accumulation of inventories.  If the price distortion is large, the inventory accumulation is likely to be large.

Now, there are circumstances in which it may be difficult to detect empirically the inventory accumulation.  If supply and demand are extremely–extremely–inelastic, large price moves may result in small inventory changes that are hard to detect in the noisy stock data that are available for some commodities.  Moreover, all else may not be equal.  As Singleton (perhaps cleverly) notes, my research shows that a decline in fundamental uncertainty could lead to a decline in inventory that masks the speculation-induced change.  (Although more plausibly, higher fundamental volatility leads to greater speculation, which would lead to an increase in inventory that could be blamed on speculative price distortions.)

But there are historical episodes–like the Hunts in silver and government price-support programs–in which price distortions have been associated with huge accumulations of inventory.  Those claiming speculative distortion need to provide a credible explanation whenever an alleged price bubble is not accompanied by a rise in inventories.  It can happen, but it’s unlikely–so show me how.

So, for the Singleton story to work, it has to be the case that consumers and producers–or at least a big chunk of them–are playing the same learning game as the investors.  I find this wildly implausible, particularly for consumers.  Would consumers really buy more gasoline today–gasoline which they are going to consume, not store in anticipation of profiting from price appreciation–for speculative reasons because prices have been trending up?  Really? (Perhaps you could argue that they would engage in intertemporal substitution, but this also stretches credulity.)  It might be somewhat more plausible that suppliers would not produce more today in response to a speculative price bubble in anticipation that they can sell at a higher price in the future.

These stories–and they are just that–are not logically impossible, but they are just implausible, to me anyways.  The consumer side is particularly implausible.  To emphasize: most consumers of gasoline or copper or corn or whatever cannot store the commodity, and hence cannot earn a speculative profit.  Thus, they should respond parametrically to prices, and respond to higher prices by reducing consumption.  The decline in consumption in markets (like the US) where consumers are subject to price changes (because there are no price controls or subsidies) during the oil price spike of 2008 supports this view.  So price distortions should lead to inventory accumulation.

This is an excellent illustration of why commodities are a good place to test theories of speculative distortion.  The speculators may play their games in the financial markets, but if they affect prices, consumers and producers who don’t play the game alter their behavior.  Looking for evidence of behavioral changes–consumption and production changes–is a great way to detect price distortions.  That is not possible in asset markets.  Consumers and producers are canaries in the coal mine.

Which all means that to persuade, Singleton, and those who are using his paper to say Eureka!, need to provide a plausible explanation of how learning/behavioral finance effects change the behavior of producers and consumers in ways that what would mean that price distortions do not lead to noticeable changes in quantities like inventory.  That is, he points to models of asset markets in which there are no consumers; to make a realistic and testable model, you would need to include producers and consumers as well–not just demand for a stock of assets, but flow demand and supply.

One last thing.   The Singleton paper has “boom and bust” in the title, and many behavioral finance/learning models predict boom and bust patterns in speculative prices.  There was a boom and bust in oil prices and other commodity prices–but the bust in 2008 was not plausibly the kind of speculative bubble bursting that occurs in the models.  It was definitely driven by a huge collapse in demand resulting from the financial crisis.  Thus the “bust” part of the price movements should not be used as evidence in favor of the theory.  Instead, it fits far better a fundamentals-based story.  As I told many reporters as prices peaked in summer 2008, when they asked what would bring down prices: be careful what you ask for.  A major recession would be the most likely cause of a big price decline.  That’s what happened–not the bursting of a speculative bubble.

Relatedly.  Prices that positively cannot be driven by asset pricing bubbles–because they are are definitively not assets–boom and bust.  During the same period that oil prices were booming and then busting, shipping rates were doing the same thing.  Space on a ship is not an asset.  It is not storable; you use it or lose it.  You can speculate on the price of the ship, but the price of the services of the ship cannot be subject to asset pricing bubbles–because these services are not an asset.  The spike and thudding collapse of shipping rates in 2007-early 2009 is indicative of a rise and fall in the demand for commodities (which are transported by ship), and cannot be explained by speculative distortion induced by learning, etc. Put differently, booms and busts occur in markets in which asset price bubbles are impossible.

To summarize.  1. Singleton’s results are perfectly consistent with rational pricing, no speculative distortions, and financial market frictions.  2.  The conditions that would reconcile the kind of learning/behavioral finance model that would be necessary to explain the lack of inventory accumulation are highly implausible.  If somebody wants to tell a more convincing story about commodity price bubbles, it is necessary to do more than just genuflect to models devised to explain things like the dot-com bubble.   You have to create a model that includes flow demand and supply, and derive testable implications of investor/speculator learning or irrationality for quantities produced, consumed, and stored.   Only then will it even be remotely possible to determine the real implications of these learning models for commodities.

I consider the entire $500 million plus squandered on solar panel manufacturer Solyndra by Obama the Beneficent to be an appalling combination of green (as in money)-worshipping crony capitalism and green unicorn-worshipping foolishness.  That said, I am deeply uneasy over the Masky Raid that was unleashed on the company soon after its bankruptcy.  Like R, I find it all too redolent of Russia (pace BP’s and Prokhorov’s recent tortures).

Perhaps there is a crime here, but given the increasingly pronounced predilection of prosecutors and law enforcement to engage in what appears to be more headline seeking than serious attempts to deal with true wrongdoing, I have my doubts as to whether the company engaged in serious malfeasance.

Either alternative explanation of recent events is disturbing.  Under one explanation, Solyndra was not a criminal enterprise, but just not an economically viable one that the government pumped nearly half-a-billion into.  In that case, there is no justification for a raid.  Under another explanation, Solyndra’s management was engaged in criminal acts–but the Department of Energy (which participated in today’s raid) couldn’t figure that out when it gave the company $585 billion in March 2009, or when the company restructured mere months ago.

In other words.  Case 1: an economically unsustainable but legally clean company is harassed by Big Brother.  Case 2: Big Brother is so incompetent that it couldn’t figure out that it was shoveling hundreds of millions of dollars into a criminal enterprise, and didn’t engage in proper oversight of such a huge debtor, and hence financed the operation of a criminal enterprise.   Hard to see another alternative.

The incompetence alternative gets a boost from Nobel Prize winning Secretary of Energy Chu.  DOE’s Inspector General participated in the raid, but Chu apparently thinks that Solyndra is a success.  Yes.  You read that right.  A success:

Mr. Chu’s spokesman argued that “the project that we supported succeeded. The facility was producing the product it said it would produce, and consumers were buying the product.”

Then I guess every firm filing through bankruptcy court is really a success.  Chu is obviously a brilliant physicist and an economic numbskull.  Which wouldn’t be the first time that’s happened.

Seeing what has transpired with the spawn of the first stimulus, by all means, let’s “pass the bill” so we can watch Son of Stimulus.  By Chu’s standards, it’s guaranteed to be a smashing success.

Gillian Tett has apparently discovered (via JP Morgan) that commodity production costs are a fundamental.  Who knew?

August is over, but Russia suffered another devastating aerospace disaster: the crash in Yaroslavl of a Yak jet carrying a KHL hockey team.  Forty-three people perished, including an international roster of hockey players and coaches (such as Pavol Demitra, formerly of the St. Louis Blues).  My condolences to the victims and their families and friends.

Medvedev made a stop at the crash site, and before the cause of the crash was known, was already dispensing solutions, including the old Russian standby of industry consolidation.  Like that wasn’t predictable–and pathetic.

Insofar as causes are concerned, one report blames the crash on poor quality fuel:

Poor quality of aviation fuel could be one of possible reasons for why the Yak-42 plane crashed in Central Russia on Wednesday, killing more than 40 people, a source in the aviation industry said.

“The aircraft failed to gain the required engine takeoff speed and fell from a low height on a Volga riverbank. Refueling the plane with low-quality fuel is seen as a priority reason for the engine malfunction,” the source said on the condition of anonymity.

This is all the more interesting given this story from last week:

Deputy Prime Minister Igor Sechin gathered government officials to formulate a response to looming fuel shortages at the nation’s airports on Tuesday. Media reports had earlier speculated that Moscow airports’ fuel reserves had dropped to critical levels over recent days. Sechin announced at the meeting that a 10-day fuel reserve was to be created for the capital’s airports.

Rosaviation had earlier said that they would call on Rosrezerv to send 180,000 tons of fuel to Moscow airports in order to avoid a collapse in flight scheduling. Vladimir Putin was set to sign the order if necessary, his press-secretary, Dmitry Peskov, said on Tuesday.

Fuel in airports running out?

Kommersant reported on Friday that there was only three days worth of fuel in the capital’s airports. Sheremetyevo reserves were reportedly boosted to four days — about 20,000 tons — but it was done at the expense of other Moscow airports. The fuel crisis in the airports was first reported on Sep. 2 when Moscow airports announced that there was a kerosene shortage and supplies would run out in several days’ time.

Further recall that since the spring Putin has been browbeating refiners about the pricing of petroleum products, and that refiners had duly pledged to keep prices low.  There are no formal price controls (though the government did slap on high export duties to try to keep fuel prices lower in Russia), but in a place like Russia, a threat emanating from Putin can be a very close substitute for formal controls.

The events of the past week give credence to that interpretation.  What are the two predictable effects of price controls?  1. Shortages.  2. Declines in product quality (including adulteration).  Put it all together: government pressure to keep prices low, shortages, and if the cause of the Yak-42 crash indeed turns out to be a fuel quality problem, a decline in product quality.  It fits.

At this point, this is all conjecture.  But the conjecture is a plausible one, especially viewed in the context of the way Russia works.  The government intervenes–through scary threats–in a market.   Predictable consequences follow.  Sometimes these consequences are paid in inefficiency and inconvenience.  Sometimes they are paid in blood.

If one could trust the results of any investigation, it would be interesting to know whether fuel quality was indeed the cause.  The potential nexus between government conflict with refiners will make it even more difficult than usual to place any credence on the official findings.  That could cut both ways.  The government could want to use this as another cudgel in its ongoing battle with the refiners.  But on the other hand, such a finding could raise serious doubts about the wisdom of Putin’s bigfooting petrol prices.

So I will just say that this explanation is a plausible one, but that more definitive resolution is unlikely ever to be forthcoming.

There has been a lot in the news lately about the bankruptcy of solar panel maker Solyndra, the recipient of both massive Federal largesse (a mere $535 million), and lavish praise from Obama as the exemplar of the potential for green jobs and Federal programs to support them.  “The future is here” spake Obama (starting about the 9:00 mark):

Now, I actually have to agree completely with Obama on this one.  It is indeed a great example of what we can expect when subsidizing “clean energy” companies. Incredible potential to propel our economy for years. Right. But in which direction?

But that issue has been well-covered by others.  I want to focus on a narrower issue.  Remember in 2009, when the secured creditors of Chrysler were expropriated (that’s a nice way to say “hosed”) when that company went into bankruptcy?  Their purportedly senior claims were in fact subordinated to junior, unsecured creditors.  The secured creditors were the subject of vitriolic criticism from Obama personally, and from the administration and its media water boys.  It was an early indicator of the crony capitalism to come.

In the Solyndra case, a major Obama bundler George Kaiser–from very red-state Oklahoma, of all places–is an investor in Solyndra.  More to the point, when the company was in trouble back in March, it borrowed $75 million dollars, in part from the George Kaiser Family Foundation.   Crucially, this loan was made senior to most of the outstanding debts owed to the Federal government ($385 million out of the $535 million in total provided by Uncle Sucker).

So it will be quite interesting to see whether Kaiser, the Obama donor, gets the Chrysler secured creditor treatment, or whether the administration will have found a strange new respect for the virtues of strict adherence to priority rules in bankruptcy.

Izabella Kaminska writes very interesting posts at FTAlphaville.  She finds unusual things in the markets, including the commodity markets, and writes about them intelligently and provocatively.  I have to take issue, however, with one of her more recent efforts.

She takes as her inspiration an article by the improbably named (to an American ear, anyways) Hilda Ochoa-Billembourg.  Izabella’s takeaway from HOB (you didn’t think I was going to type that again, did you?) is that the Achilles heel of QE2–which, remember, was specifically designed to produce some inflation–was that it did not produce the right kind of inflation (something which Bernanke adamantly, and not too plausibly, denies):

If you work with the premise that QE2 led to what has been described as ‘bad inflation’ — inflation being exported into commodity and emerging market securities rather than domestic ones — you could argue the Fed has always had an interest in sterilising that inflation effect.

What to do then?  Have the Fed intervene in the commodities markets by selling longer-dated futures, of course!  Kaminska suggests that the Fed–or some Government Body To Be Named Later–did this, although her argument here is highly circumstantial and, uhm, speculative.  Now that deflation fears are reviving given the European tumult and the palpably slowing US economy, she suggests that it could be just the right time for the Fed or GBTBNL to buy commodity futures.

Or not.  I have problems with the argument from start to finish.  It is predicated on the view that speculators are driving the curve (although Kaminska admits that it doesn’t affect spot prices)–a highly dubious proposition.  It presumes a sort of disconnect between the Treasury market and the energy (and other commodity) futures markets (“One might even say that the market has shifted from expressing inflationary views via the Treasury market to the oil market.”  If so, there’s money to be made!) Although she recognizes–blessedly–that speculators affect the risk premium embedded in futures prices, she confounds a risk premium with an inflation expectation effect (which should be impounded in the interest rate terms structure in any event).  Most notably, she makes the all-too-common mistake of confusing Keynesian contango/backwardation–which is a difference between a spot price and an unobserved expected future spot price–and contango/backwardation of the observed curve, which is the difference between traded prices.  (An expected spot price is not traded.)    The risk premium can change without having any impact on the shape of the futures curve; the effect of the risk premium–and hence hedging/speculative balance–on the futures curve is indirect, operating through the effect of the risk premium on inventory decisions: roughly speaking, more Keynesian backwardation (hedgers pay speculators a greater risk premium) leads to less inventory which tends to reduce the contango/increase the backwardation in the curve.  But detecting this effect is hard even in a simulated market, let alone in a real one.  Her story also depends on an implausible relation between speculation and the Brent-WTI spread.

But put all that aside.  Assume it’s all correct.  Do we really want the Fed, or any other GBTBNL, monkeying around with still more relative prices?  Really?

Several times I’ve recounted the story of the great economist Sherwin Rosen, who in 1982 startled an 830 AM section of his Econ301 class at Chicago by shouting: “And that’s the problem with inflation.  It FUCKS UP RELATIVE PRICES.”  Well, of late the Fed apparently thinks that effing up relative prices is its job.  Heretofore, its efforts (unless Izabella is right that the Fed has been active in commodity markets as well) have focused on the yield curve and inflation expectations: twisting this rate relative to that–or is it torquing?

How is that working out for us?  Trivial growth in the H1 2011.  And how about that last jobs report!  Or should I say, that no jobs report?

We really don’t need it attempting to affect–to f*ck up–the relative prices of commodities or anything else.  Indeed, the now common diagnosis of the failure of QE2 (which you might have read here first, well before its end) is that the Fed’s intervention screwed up relative prices: forcing down the dollar, which induced other countries to intervene to prevent undue appreciation of their currencies, thereby sparking inflation in emerging markets, which has led to yet further policy responses; forcing up commodity prices, which put a drag on developed economies.  So we should now believe that there will not be any unintended consequences on other relative prices from an attempt to intervene into the commodity markets?  Really?

The probability that the Fed could somehow tweak relative prices just right this time based on a theory that would do Professor Irwin Corey proud, and which could use a good trip to the barber for a shave with Occam’s razor, is vanishingly small.  The probability that it would wreak yet additional havoc through such an intervention approaches one.

The problems are almost beyond numbering.  There is the knowledge problem: how could the Fed possibly know what the “right” relative prices are?  There is the implementation problem: how could the Fed actually achieve the relative prices it wants to, if by some miracle it could divine what they should be?  There is the strategic/expectations problem: how could the Fed succeed given that it would not be acting on automotons, but on live, thinking, reactive, strategic actors who respond to the Fed in ways that are hard to predict?

No, as Sherwin might say if he were still alive: the Fed has f*cked up relative prices enough, thank you.

So Ben, et al: Stop before you do even more damage, and inject more uncertainty into an economy that is already reeling from it.  We need no more Sorcerer’s Apprentice interventions.  Don’t just do something, stand there.  Become what you were intended to be–a lender of last resort to address liquidity problems and banking crises–and stop trying to be some grandiose central planner that manipulates price signals to achieve some “aggregate” outcome.  It hasn’t worked up to now, and it won’t work any better if you double down.  Do more by doing less.  Go away and leave us alone.

In brief, we may need to revise Reagan’s statement of the ten scariest words in the English language: now, it should be “I’m from the Fed, and I’m here to help you.”  With help like this . . .

The French–who were not shy about criticizing American motives in Iraq–have no compunction in profiting from their intervention in Libya:

French Foreign Minister Alain Juppé said he thought it would only be reasonable if French companies benefited from preferential access to Libyan contracts given that Paris, together with the U.K., led the foreign military offensive in Libya.

“The NTC has said very publicly that, in the reconstruction effort, it would give preferential treatment to those who supported them,” Mr. Juppé told French radio RTL. “That seems quite logical and fair.”

Bien sur.  Tres, tres logique.

This is very French, and very predictable.  Just keep it in mind, though, when evaluating French pronouncements on the motives of other nations.  Faites ce que je dis, pas ce que je fais.

The Russians have been even more shameless than usual.  Medvedev reluctantly decided not to veto UN authorization of military force in Libya, which set off fierce criticism within his country.  When it became evident that Gaddafi would lose, there was much wailing and gnashing of teeth–about how disastrous this would be for Russian commercial interests.  Now they are trying furiously to reverse field, and cozy up to the National Transition Council, which they just recognized as the legitimate government of the country.  For one reason only: the oil.  And whereas they were intent on securing privileged access to Libya when Gaddafi ruled the roost, and were highly critical of NATO’s efforts to remove him, now they want everybody to share:

Russia, which abstained when the United Nations Security Council passed its March resolution authorizing the use of force in Libya, has said the U.N., not a small group of countries, should take the lead in supporting Libya’s reconstruction.

Good luck with that.  The mercenary (e.g., the French, the Italians) can see their like coming from a mile away.

The whole Libyan episode has been a tag team between cynicism and incompetence.  What could have taken days if done with a will took months, at the cost of numerous additional civilian deaths–the prevention of which was the stated purpose of the intervention.

And if the past is any guide, it will only get worse from here.

Today’s big news was the announcement of a exploration joint venture between ExxonMobil and Rosneft.  This is widely being portrayed as a substitute for the abortive BP-Rosneft deal, but there are crucial differences.

First off, though let me say that it is unfortunate that western majors deal with unreliable Russian partners, and in so doing finance the kleptocracy that is Putin’s Russia.  In a better world, a modern version of medieval guilds consisting of major energy companies would boycott Russia in the aftermath of expropriations and other hijinks until Russia put safeguards in place that would reduce the hazards of doing business there.  In an even better world, companies would not be tempted to fund corruptocracies, individually or collectively.  But in this fallen world, achieving such cooperation is virtually impossible, so it is inevitable that companies will take the political and legal risk in order to get access to the physical resources.

That said, in my view ExxonMobil is less likely to get strongarmed than BP.  ExxonMobil has much more heft, much more pull, and is far less desperate.

Due to those features–notably the lack of desperation on XOM’s part–the deal is also structured in a way that gives much less to Rosneft. Recall that Sechin crowed about how the BP-Rosneft deal involved a share swap that gave Rosneft a large piece of BP stock, and board representation.  That was the crown jewel for him: the proof that Rosneft had arrived as a major player.  No such share swap here.  On this basis alone, this is a pale imitation of the BP deal.

Some are drawing an analogy between the share swap in the BP deal, and the agreement with Exxon in which Rosneft gets an equity participation in developments in the Gulf of Mexico and Texas tight oil.  Not even close.  Indeed, I think this misinterprets the purpose of this aspect of the deal.

I view this part as a hostage exchange.  If Rosneft/Russia screw around with XOM in the Arctic and western Siberia, they have assets at risk in GOM and Texas (and perhaps elsewhere).  Hostage exchange is a well-known way of supporting transactions that are difficult to enforce through formal legal channels.

Moreover, this should be viewed as Exxon putting its toe in the water.  The dollar number in the deal–$3.2 billion over several years, a sum that presumably includes a previous XOM-Rosneft agreement for development of Black Sea prospects–is not chump change, but it is small relative to XOM’s approximately $30 billion/year capex.

Over the years we’ve seen many Russian energy deals announced with great fanfare.  The follow through is usually far less impressive.  Shtokman comes to mind.  (How’s that working out for you, Total?)  Russia, thy reputation precedes thee.  I am sure that XOM will tread very carefully, and protect itself every step of the way.  The hostages will likely come in very handy.   But regardless, I would wager that this is the high point of the deal, and that this is another deal that will fade away.

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

Three companies are at various stages of planning new capacity to ship oil from the Midcontinent to the Gulf.  A fourth is looking to redirect flows from Cushing to Houston.  The addition to capacity would total 1.4 mm bbl/day if all were completed.  Since that’s more capacity than is needed, not all the projects will go to completion.  But regardless, over the medium term it is likely that new pipelines will break the bottleneck and crush the differentials between WTI and LLS, MARS, and Brent.

The main obstacles that the WTI contracts face are enviros and Coasean challenges.  Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas.  The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts.  The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time.  So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s.  Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns.  Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract.  The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago.  Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode.  In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials.  For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk.  In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades.  This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users.  (Cash settlement based on a variety of crude streams would produce a similar outcome.)  In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically.  (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.)  Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing.  Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests.  The case of Chicago grains is illustrative.  As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design.  The committee had representatives from virtually every affected party.  Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem.  Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons).  This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months.  The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts.  (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows.  The representatives from ADM and Cargill took him outside to cool down.  I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later.  Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

Gazprom’s customers are continuing their fight against its pricing practices.  Apparently never having heard of Marshall Field (“the customer is always right”), Gazprom is blaming the buyers for their stupidity and mistakes:

OAO Gazprom said it isn’t responsible for its customers’ “strategic mistakes,” signaling Russia’s gas-export monopoly may not compromise in a pricing dispute with European utilities.

“In 2010, strategic mistakes were made in assessing the market outlook, with hopes for very cheap gas and further collapse of spot prices,” Sergei Komlev, head of pricing and contract formation at Gazprom’s export division, said in an interview at his Moscow office. Buyers are seeking “one-off help, given the difficult situation they found themselves” in.

. . . .

“Some of our partners expected they’d be able to sell gas to their clients cheaply by mixing Russian and spot gas, which turned out to be wrong,” Komlev said. “The first thing our clients have to do is admit the mistake they have made during the sales campaign of 2010. The general market obsession with low spot prices has proved to be a wrong strategy.”

This is so much gibberish.  Gazprom’s customers’ problem is that its prices are linked to oil prices (gasoil and fuel oil prices, actually, on a lagged basis), and oil prices have diverged from world gas prices.  Yes, perhaps the increase in spot prices has hit European customers, but these prices are still well below the oil-based Gazprom price.  For instance, the gas price at the TTF hub in the Netherlands is about $350/mcm, and has hovered around that level since December of last year (The price quoted in Bloomberg is per MWh, which can be converted to a price per MCM).  In contrast, the German Border Price for Russian gas is about $450 (it was $400+ last month).

Gazprom’s sweetheart spokesman Komlev (check out the video–and note the liar’s look down and to the left when answering the question about whether Russian gas prices are too high) has this to say:

“A deep connection between oil and gas prices has remained and even grown stronger.”

The gap between spot and contract prices isn’t as “gigantic” as it was in the past two years and will narrow closer to winter because of seasonal demand, Komlev said.

The only thing deep is the manure Komlev is spreading.  Well, that and his homey from ING Financial:

“The problem with the spot market is that it is not liquid enough and spot prices are highly volatile,” Igor Kurinnyy, an oil and gas analyst at ING Financial Markets in London, said by e-mail. “The oil link in Gazprom’s price formulas will stay in place for the time being.”

Insofar as a “deep connection” is concerned, the data clearly say otherwise.  Gas and oil prices have diverged.  And if there’s such a deep connection, then it should be a matter of indifference to Gazprom as to whether it prices off of oil or off of spot prices.

I guess not.

As for liquidity, (a) liquidity is increasing, (b) liquidity would increase substantially if Russian gas were priced off of spot, and (c) there are numerous markets in the US where large quantities of contract gas are priced off of spot prices with modest levels of liquidity.

Gazprom’s testiness over its pricing mechanism reflects the fact that it is increasingly under siege, and not just from European utilities.   Gazprom has played divide-and-conquer for years.  It has repeatedly tried to scare the Europeans by threatening to sell gas to the Chinese.  But that’s no longer working.  The Chinese are bargaining hard, and have lined up large quantities of gas from Central Asia.  So in order to try to put pressure on the Chinese by convincing them that they’ll send gas elsewhere, the Russians are reaching out to one of the charter members of their Coalition of the Losers, North Korea (other members–Venezuela, Syria, Libya–whoops, scratch that one), with a truly risible proposal to build a pipeline through North Korea to sell gas to South Korea.  Like the South Koreans are going to put themselves at the mercy of Kim Jong Il and the nutocracy to the north.  And like the Chinese need the gas.  I’m sure they’re rolling on the floors in Beijing.

So it can’t play the Chinese against the Europeans.  It can’t play the Koreans against the Chinese. The threat from the spot market is growing with gas supplies around the world. So Gazprom is left to treat its European customers like Otter treated Flounder:

Time and the markets are not on its side. It can insult now, but more options are becoming available, which will put increasing pressure on the oil-linked pricing mechanism. Which means that the company will have to come up with somebody a helluva lot slicker than Komlev to make their case in the future–because it will have no case.