Streetwise Professor

The more I learn about  the implementation costs and burdens of Frank-n-Dodd, the more monstrous the thing appears.  These burdens will be immense, and affect virtually every company that touches derivatives, regardless of the extent of their involvement.  IT.  Compliance.  Reporting.  And on and on and on.

But Frank-n-Dodd’s chief evangelist, Gary Gensler, has often said not to worry.  The greater transparency created by the law, via the mandating of swap execution facilities and clearing, will drive down execution costs for derivatives.  The savings will offset the burdens of the regulation.  Transparency will make the market more competitive, to the benefit of end users.

Gensler repeated this mantra in an interview in the WSJ:

I think that the core of Dodd-Frank is to bring the benefits of transparency and risk reduction to this marketplace, which has existed for 150 years.Right now, when you enter into bilateral swap transactions, probably most of you have a handful, at most 10, counterparties that you go to. And it might be three or four. And they’re the largest financial institutions.

And I think that openness and competition will come into this marketplace because of transparency, and because for most of the market, it will have to be centrally cleared.

But later he becomes extremely equivocal about these benefits:

MR. FINK:Offstage you mentioned profits of $30 billion that Wall Street makes on derivatives. You figure that would decline to $27 billion?

MR. GENSLER: No, I don’t know what it will decline to. It might go up. What we know is that the derivatives marketplace today is concentrated among large financial institutions.

Dodd-Frank modestly shifts the needle on information because Congress thought that markets are safer and more efficient with that transparency. After the transaction, you will be able to get real-time reporting of transactions in various ways. That’s the new law, called post-trade transparency. Some portion of the market also will have some pretrade transparency, where buyers and sellers meet in platforms.

Those two forms of transparency will modestly shift some of the information advantage. When you do that, you democratize the markets a bit more. The smaller banks might compete for business with some of the larger banks, and so forth.

“[Dealer profits] might go up.”  “Modestly shifts the needle on information.”  “Modestly shift some of the information advantage.”  “Democratize the markets a bit more.”  “The smaller banks might compete for business with some of the larger banks.”  Hardly stirring stuff there.  Pretty limp justification of the competitive benefits of Frank-n-Dodd.  Not exactly the kind of thing that suggests these transparency benefits will offset all of the other massive costs arising from the law.

The title to the WSJ article is “Keep on Hedging.”  Gensler is apparently taking that advice to heart, as he is quite strikingly hedging his advocacy of the cost-reducing effects of improved transparency.

And even these benefits are likely oversold, and perhaps chimerical.  Here’s just a list of some of the reasons to doubt that Dodd-Frank will actually increase competition in a way that reduces end user transaction costs, let alone by enough to overcome the huge regulatory overhead the law creates:

• Post-trade transparency–especially real time post-trade transparency, which the Commission is advocating–need not improve liquidity.  Indeed, it can have the opposite effect.  Liquidity suppliers will be reluctant to trade in size when their trades are exposed immediately after they are made.  This will widen spreads and reduce depth.
• It is not plausible that end users are at a substantial information disadvantage for vanilla products traded in volume, such as vanilla interest rate swaps in major currencies.  They have access to quotes from multiple sources, and can compare quotes for OTC trades to contemporaneous prices for closely related exchange traded products, like Eurodollar futures (for interest rate swaps) or NYMEX futures (for NYMEX lookalike swaps–go figure).
• Spreads on vanilla OTC products are very small.  Margins on these products are razor thin.
• It is well known that institutional traders in many markets prefer to trade on dark markets rather than transparent ones.  This is because their execution costs are lower on these markets.  And “dark market” is a misleading term: as I’ve noted before, there are different kinds of transparency.  Exchange trading, or SEF trading, has pre-trade and post-trade price transparency, but counterparty opacity: the prices are lit, but the counterparties are in the dark.  OTC dealings, or dealings in dark markets, or dealings in block markets, have less price transparency, but more counterparty transparency.  The latter works to the benefit of those who are known to be unlikely to be trading for information-driven reasons.  Forcing trading onto anonymous platforms, especially order driven platforms, raises the trading costs of the verifiably uninformed, which includes many hedgers and end users.  It is categorically false to say that price transparency and counterparty opacity–exchange trading–lowers the trading costs of all liquidity demanders.  Some are made worse off: that’s why they choose to trade off exchange.
• This helps explain why many, many end users oppose the various mandates.  It raises their costs.  They aren’t stupid.  They aren’t victims of battered spouse syndrome.  When they oppose the mandates, they are talking their books.
• Gensler talks like 10 big counterparties is a small number.  Not too many other industries with 10 major competitors.
• And if you believe those 10 firms are colluding, or would like to collude, tacitly on spreads, forcing them to trade through markets with pre-trade transparency is a great way to facilitate such collusion.  Collusion is harder to sustain when buyers and seller strike deals in private.  The colluders can chisel on the agreement through secret price cuts without being caught.  Harder to do when prices are posted publicly: you can see when cheating occurs.  When cheating can be detected, it can be punished, meaning that price transparency can facilitate collusion.  Cf. NASDAQ antitrust case, Stigler’s seminal articles on collusion, the fact that the Justice Department looks with deep suspicion at price sharing arrangements, the fact that public auctions are more susceptible to collusion, etc.
• Order driven markets are prone to tipping to a single dominant platform, which can exercise market power and charge supercompetitive prices.  Surely Genlser is aware that virtually every single futures and futures option contract in the US is dominated by a single exchange.  Mandating exchange-like, order driven markets for vanilla OTC derivatives is likely to result in the same tipping process, and with the charging of supercompetitive trading fees by the winner-takes-all platforms.
• It is almost certain that any benefits arising from compressed spreads–to the extent that they exist, which the foregoing suggests may well not happen–will be distributed very differently from the cost burdens of Dodd-Frank.  As I noted earlier, any firm that is at all involved in derivatives will have to incur substantial costs to comply with the law.  These include IT expenses associated with record keeping, reporting (including the reporting of trades and positions to data repositories), regulatory compliance, oversight, etc.  With regards to regulatory compliance, to achieve any relief from position limits it will be necessary to show that every transaction is a hedge, as opposed to showing that trades are “normally” used to offset price risks.  Similar record keeping burdens will be necessary to demonstrate whether a company is a swap dealer or major swap market participant or not.  It will be necessary to perform all these tasks, and invest in the people and IT overhead needed to perform them, if you trade modest amounts of derivatives or large amounts.  Those who trade smallish amounts will not generate sufficient benefits in terms of lower trading costs–even if those costs materialize, which I doubt–to offset the regulatory overhead.  Some will choose to stay away from derivatives altogether–which may be easier said than done.

In brief: (a) even Gensler is much more guarded in his predictions about the cost-reducing effects of transparency, and (b) for many market participants, transparency and mandated exchange-like trading will actually increase their trading costs.  What’s more, the regulatory burden–you know, the costs that the CFTC adamantly refuses to estimate despite the requirement that it perform a cost-benefit analysis of its rules–is very likely to be crushing: you talk to people in industry, and you realize that they are afraid.  Very afraid.

So remind me again why all this stuff that isn’t remotely related to systemic risk is a good idea.  And only non-masochists may answer, please.

I predicted that the Singleton study would be seized upon as evidence of the malign effects of commodity speculation, and my prediction was borne out. That’s ironic, in a way, because the Singleton paper is really about predictability and forecastability. It finds evidence that excess “returns” on crude oil futures are predictable conditional on measures of speculative activity.

The question is: what explains this predictability? Many of the possible answers to that question–answers that are consistent with Singleton’s results–do not support the view that speculation has distorted prices. Indeed, some of the explanations mean that there is too little speculation.

Predictability can arise when risk premia are forecastable.  Speculation involves a transfer of commodity risk, rather than the commodity itself.   Based on this fact, you would expect that speculation affects the price of risk, rather than the spot price of the commodity.  The price of risk–the risk premium–determines the “drift” of a commodity futures price over time.

Why would the market price of risk–the risk premium–be predictable?  More specifically, why would information on speculative positions help forecast the risk premium?  In a frictionless capital market,  you wouldn’t expect speculative positions to help predict returns.  For instance, in a capital asset pricing model (CAPM) world, risk premia depend only on beta, and hence on the covariance between returns on individual investments and the market portfolio (whatever that is, or if you can measure it).  (Katherine Dusak’s 1973 JPE paper is the first to apply CAPM to commodity futures.) Other asset pricing models have similar implications.

But in a market with frictions, this no longer holds.  This is most readily seen in the Keynesian model of commodity speculation.  In that model, speculators hold undiversified positions, and restrict their speculative activity to a single commodity: this implicitly imposes some sort of friction that limits the positions that speculators can hold.  Hedgers want to sell futures to hedge inventory.  To accommodate this hedging, speculators take on the associated price risk, which they cannot diversify away.  So they demand a premium to bear the idiosyncratic risk.

If hedgers want to sell more futures, speculators have to buy more.  They demand a larger premium to bear the risk.  This may involve attracting more risk averse speculators to the market to bear the additional risk, or requiring the same population of specs to hold more risk.  Either way, with this increase in hedging demand (a) the risk premium goes up, and (b) speculative futures positions rise.

This results in a relationship between the risk premium–and hence the trend or drift in futures prices–and the size of speculative positions.  Thus, a model in which there are frictions that limit speculative participation in the futures market, and variations in speculative positions are driven by shocks in the demand to hedge (i.e., speculative positions vary to accommodate variations in hedging demand), speculative positions are going to have predictive power, and a rise in speculative long positions predicts a higher rate of “return” on futures.

David Hirshleifer’s work in the 1980s makes Keynes argument more rigorous, and integrates the Keynesian perspective (which predates portfolio theory and modern asset pricing) and asset pricing theory.  Hirshleifer assumes that there is a fixed cost of speculating in a commodity futures market.  This friction limits but does not eliminate diversification, and in equilibrium, both beta and idiosyncratic risks affect returns.  Crucially, however, the association between speculative positions and returns discussed above holds.

Other kinds of frictions can lead to similar results.  A recent paper by Duffie and Strulovici posits a different kind of friction, and generates price and return behavior that is inconsistent with asset pricing models that assume frictionless markets for risk.

We should not be surprised that there are frictions in capital markets.  Evidence for such frictions abounds.  Premium cycles in insurance markets (an example that motivates the Duffie-Strulovici paper) is an example.  Insurance premiums rise after insurers suffer big losses even though those past losses have no power to predict future losses.  The cycles arise because capital market frictions make it costly for insurers to raise new capital to replace capital paid out after a spate of unexpectedly large losses. Since they have less capital to absorb losses, their capacity to offer insurance goes down, and premiums rise to clear the market.

Indeed, hedging–the supposedly saintly use of futures markets, in contrast to that devilish speculation–only makes sense due to the existence of financial frictions.  If capital markets were frictionless, a la Modigliani-Miller, financial policy would be irrelevant, and firms would have no need to manage risks.  They could just pass those risks on to investors (purchasers of the firms’ securities) who could manage the risks themselves by forming diversified portfolios.  Financial engineering and hedging are valuable only because of financial frictions.

One way of conceptualizing this is that when choosing financial policy/capital structure, firms face a choice between frictions.  They incur costs to allocate risk via the securities markets because of frictions in those markets; these frictions could include moral hazard and adverse selection.  They incur costs to allocate risks to speculators in the futures markets: these costs arise in part because of frictions that impose costs on speculators, and come in the form of risk premia paid to speculators.  Speculators have to raise capital, and they face adverse selection and moral hazard too.  Depending on the relative costs, firms will choose how to divvy up their risks.

But the basic point is that when there are frictions that create hedging demand but at the same time make it costly for speculators to take on risk from hedgers, commodity markets and the broader financial markets can be imperfectly integrated.  In these circumstances, speculative positions can predict/forecast changes in futures prices.

My research on the pricing of electricity derivatives provides an excellent example of that.  When I started this research in the late-1990s, I (and my co-author Martin Jermakyan) documented that the market price of risk in the price of electricity forward contracts was huge.  It was on the order of 50 percent of the forward price for on peak delivery during summer months.

This made sense.  At the time, participation in the market was limited almost exclusively to producers and consumers of power.  Financial/speculative participation was almost completely absent.  Moreover, contrary to the situation posited by Keynes, in electricity conditions tend to make long hedging predominant.  The distribution of electricity prices is highly right skewed: prices can spike upwards, and impose substantial financial costs on firms that are caught short.  This means that firms may be willing to pay a large premium to avoid the financial distress of having to buy power during a price spike.

Case in point.  In 1998, Illinois Power’s Clinton plant was down for maintenance.  Rather than buying power forward to cover its load obligations, the company bought power on the daily markets.  It did so because it believed the forward prices were far higher than it could expect to pay buying spot.  (That  is, it perceived there was a big risk premium that it didn’t want to pay.)  On June 25, 1998, a cascade of events resulted in a huge price spike in power prices in the Midwest.  Prices, usually in the $50/MWh range spiked to as high as $7500/MWh.  Illinois Power saw an entire year’s earnings wiped out in a single day as it paid these high prices to meet its obligations.

Without speculators, the only way to clear the market when long hedging would greatly predominate at a forward price equal to the expected spot price is for the risk premium–the price bias–to grow, thereby encouraging some companies to sell forward and choking off long hedging demand.

But that premium is also a reward to speculation.  And during the 2000s, speculators, including many financial firms, started trading electricity.  Electricity became increasingly “financialized.”  System operators actually introduced features into their markets that made it easier for financial players to participate.  Most notable among these is “virtual” or “convergence” bidding.   These allow participants to buy in a forward market (e.g., the day ahead market) and automatically cover in the real time market without making or taking delivery.  This mechanism creates cash settled forward contracts that speculators can trade.

The last time I looked closely at this, around 2006, risk premia were still large, but had declined appreciably.  In PJM, they had fallen to about 15 percent of the total forward price, as compared to 50 percent less than a decade earlier.  This is a clear demonstration of the benefits of speculation in a commodity market.  It made hedging substantially cheaper–very substantially.  I am not familiar of any other case in which the benefits of speculation can be measured, and turn out to be so large.

The data isn’t available (to my knowledge) to carry out this test, but the empirical implication of the foregoing analysis is straightforward: the positions of speculators in electricity markets should predict the movement in forward prices.

This predictability doesn’t mean that there is too much speculation in the market.  If anything, it means there is too little.  The predictability reflects the frictions that still impede the transfer of risk.

This explanation for the predictive power of speculative activity for commodity futures returns does not–repeat, not–provide support for measures to restrict speculation.  Quite the reverse.

Other explanations, including behavioral or learning-based explanations, may–repeat, may–have different implications.  But (a) the existing empirical evidence of predictability does not show that these factors, rather than financial market frictions, are the sources of predictability, and (b) even if they were, it is highly doubtful that commonly proposed measures, such as position limits, would mitigate the price biases they create, or that their effect on behavioral/learning-driven biases would more than compensate for their adverse consequences for risk bearing.

In sum, that measures of speculative activity have predictive power over commodity futures returns does not imply that there is too much speculation, or that speculation has distorted prices.  Frictions that prevent complete integration of financial and commodity markets can generate–no pun intended–this result.   If such frictions are indeed the source of predictability, policy should seek to reduce constraints on the flow of speculative capital to commodity markets, rather than attempt to increase them.

This means that any finding of predictability should be the beginning of any inquiry, rather than the end.  What is crucial is to identify the cause of that finding.  I confess that I find financial friction explanations to be the most plausible, in part because of my familiarity with the evolution of electricity markets which provides a very powerful example of how reductions in frictions can erode risk premia, and in part because there is a huge literature that identifies plausible sources of friction and documents their impact on a wide variety of economic behavior.  I find other explanations less appealing, but do not reject them out of hand.  Policy should be predicated on understanding, and therefore research on speculation in commodity markets should be focused on understanding the sources of predictability, and in particular, seeing if it is possible to distinguish empirically between friction-driven and behavioral-driven predictability.

Apparently “orthodox” is the sneer du jour.  A couple of weeks back I noted that IMF candidate Agustin Carstens was being denigrated as orthodox and therefore unfit to head the IMF.  And today, in a story about the Singleton oil market study I blogged about last week, Reuter’s John Kemp dismissed me, Scott Irwin, and Jeff Harris as a cohort of orthodox economists who dismiss the role of financial speculators in affecting commodity prices.

I’m only PO’d because Kemp listed Irwin first.  That wounds me to the quick.

Apparently I’m a member of an “establishment”–when do I get promoted to mastermind of an evil cabal?–that Svengali like, induced the CFTC, IOSCO, the FSA, the OECD, and presumably the IEA (though Kemp doesn’t mention it) to conclude that speculation had not distorted energy prices, or the prices of other commodities.

Who knew the vast influence I wield over official bodies world wide? I certainly didn’t.

Regarding orthodoxy, my views are certainly not considered orthodox, on say, Capitol Hill.  Or on the Champs Elysee.  Or in Brussels.

No, “orthodox” is shorthand for People Who Don’t Agree With John Kemp, whereas those who do are Brave Challengers of the Consensus.

Now to the substance of what Kemp has to say, such as it is.

First, as I made clear in my post on Singleton’s piece last week, I do not deny the possibility that speculation has “influenced prices,” as Kemp insinuates.  In fact, such a contention would be absurd, and Kemp is absurd for insinuating it.  What I have been on about is whether speculation has distorted prices.

Big difference, John.

There have been specific allegations that speculation has led to substantial distortions in commodity prices, particularly energy prices–by 10, 20, hell 50 percent.  That is what I have been responding to, and I stand by my contention that there is no evidence of such an effect.

Nor does anything in Singleton’s piece support such claims.

Variations in measures of speculation can have predictive power over returns–that is, they can influence prices–without implying that speculation has distorted them.  As I noted in my post on Singleton’s piece, limits to arbitrage-type stories predict that shocks to speculator balance sheets or hedger balance sheets can lead to associations between speculative activity and the drift of commodity prices.  This is perfectly consistent with a refinement of Keynes’s normal backwardation theory that Kemp identifies with the dreaded orthodoxy.  (Truth be told, I made an argument along these lines in a presentation at the FMAs in October of 2002.  And I’ve made it year after year in my PhD seminar on derivatives, in my discussions of incomplete markets.)

Insofar as the behavioral stories are concerned, yes,  they can also imply that variation in speculative activity have predictive power over returns.  They also can predict boom and bust cycles.  But it is notoriously difficult to determine whether these sorts of behavioral effects are what explains the predictive power of measures of speculation.

I would also note that purely rational storage models can also generate booms and busts.  Indeed, a rational storage model can match the behavior and time series properties of prices and inventories–I show that in my forthcoming book.  This is true for both pre-2004 and post-2004.  It is just flat wrong to say that the price and quantity movements observed in recent years cannot be reconciled with rational, fundamentals-driven models.  So the existence of commodity booms and busts–which way, way antedate the financialization of commodity markets–does not refute fundamentals-based explanations, or prove the existence of behaviorally driven anomalies.

Singleton points out–and Kemp emphasizes–a series of theoretical possibilities and some evidence that is consistent with theories that generate these possibilities–but which are also consistent with other explanations.  A very weak basis indeed to justify wholesale intervention in the markets.  Especially given the very vital role that speculation plays in achieving an efficient allocation of risk.

The behavioral theories are also not sufficiently well-developed to generate testable predictions about co-movements between prices and quantities and the dynamics of forward curves.  Predictions about quantities are particularly important.  As I’ve stated on numerous occasions, commodities are consumed in the here and now (in contrast to say, internet stocks), so distortions in prices should show up in distortions in quantities (notably inventories).  Do behavioral models predict this?  I haven’t seen any that have even tried.  If they do–the evidence doesn’t support it.  If they don’t–then why should we really care, as this would mean that speculation is not distorting consumption and production decisions?

And how can Kemp seriously say that Singleton’s paper “offers a richer and more realistic view of how real markets operate than the rather stylized formulations that have been popular with the old guard”?  [And who are you call old, boy?]  Has he ever looked at any of these behavioral models?  You want to see stylized?  Case in point–the Hong-Yogo model, which reverse engineers an extremely contrived–actually, artificial–behavioral setup that mimics the empirical result already produced.  Sorry, but that’s not science: model first, then test.  Moreover, as I just noted, these behavioral models don’t make any predictions about quantities, forward curves, and other crucial aspects of commodity markets.  How can you possibly consider models that don’t make predictions about such crucial variables “richer” and “more realistic”?  Especially given that these quantity predictions are what is really relevant in determining the welfare effect of speculation.

Contrast that to my work on commodities.  I take a rigorous model, derive (computationally) its implications for prices, forward curves, quantities, quantity-price comovements, volatilities, and forward price correlations, and take those predictions to the data.  I reject many of the implications of the models, and use those rejections to help understand the true richness of how prices behave.  If I’m orthodox–that’s the sense in which I am orthodox.  I’m not wedded to the models.  As I say in the introduction of the book, I look to break the models and to learn from the pieces.

And as I noted in my post on Singleton’s paper, the policy implications of the behavioral theories are ambiguous–and certainly don’t support a role for position limits on large speculators.  As I noted, if you overlook the cheesy model and believe the Hong-Yogo behavioral interpretation of their empirical evidence, behavioral effects have long been present in these markets–long before financialization.  What’s more, the behavioral models suggest that prices depend crucially on the composition of traders in the marketplace.  Policymakers can’t micromanage that composition to achieve more “rational” pricing through blunt tools like position limits.

So as I predicted in my Singleton post, people would seize on his study to advance their regulatory agenda, even though it provides only flimsy, equivocal support for that agenda.   Not surprisingly, John Kemp is leading that parade, giving further proof to  the aphorism that a little knowledge is a dangerous thing.

I have written often of “Putin’s Purgatory” and the “hamster wheel from hell”, meaning that under Putin and Putinism, Russia is destined for stasis and stagnation.  As the country slouches towards its next presidential election, or the simulacrum thereof, this conclusion is becoming widely accepted.  Medvedev warns of stagnation.  First Deputy Prime Minister Shuvalov says stability is overrated.  The IMF says that Russia is recovering, but its post-crisis economic performance is “unimpressive” (not that Russia is alone in this).  The IMF analysis focuses on conventional macro issues like budget deficits, but acknowledges the crippling effects of Russia’s yawning institutional deficits:

Compared with its emerging market peers, Russia experienced a greater degree of economic instability during the past decade and a larger output loss in the recent crisis, owing to its continued dependence on commodities, poor governance, and procyclical economic policies rooted in weak policy frameworks. Unless these weaknesses are addressed forcefully, growth is likely to be modest—less than 4 percent in the medium term. Moreover, the economy will remain highly vulnerable to external shocks. For example, a sharp drop in the oil price would trigger another recession and reduce medium-term growth further.

But as if to prove it still doesn’t really get it, the IMF encourages Russia to use the opportunity given by high oil prices to push institutional reform:

But Russia can do much better, if it leverages the commodity boom to strengthen policies. The challenge is to overcome the complacency that in the past has set in when oil prices are high. The high oil price affords Russia an opportunity to build buffers and introduce growth-enhancing reforms which could lift medium-term growth to 6 percent or more. The focus should be on further scaling back the anti-crisis measures as the economy recovers, reducing fiscal vulnerabilities, reining in inflation, promoting a stronger and more competitive banking system, and creating a better environment for investment. Improvements to policy frameworks and a reinvigoration of long-stalled structural reforms should be central elements of this strategy, and would send a positive signal to investors and boost Russia’s growth potential. This would also generate positive economic spillovers in the region.

But insofar as real and constructive institutional change is concerned, high energy prices are a bug, not a feature.  They permit the present system to function and survive: when oil prices are high, the country has the free cash flow problem from hell that enables all sorts of dysfunctional practices to survive.  Crisis concentrates the mind: high energy prices encourage complacency.  In other words, the IMF is delusional to think that high energy prices provide an opportunity to transition to a more modern economic system: to the contrary, they perpetuate the stint in purgatory.

The ability of the Putin model to produce a vibrant economy is becoming far more widely recognized, as the contrast between the vibrancy of other BRICs and Russia is becoming more and more manifest:

Russia is falling behind other BRIC economies in global competitiveness and growth, according to The Russia Competitiveness Report 2011, released Monday by the World Economic Forum.

The country ranked 63rd out of 139 countries based on the report’s 12 pillars of competitiveness.

The report noted that Russia can improve its poor ranking by reforming its institutions, improving the quality of education, stabilizing financial markets and moving away from a focus on natural resources.

“It is becoming increasingly evident that the current growth model, which is centered on high oil prices and leveraged facilities, is no longer effective,” Sberbank chief executive German Gref wrote in the report. “New drivers of growth are needed for Russia to achieve sustainable development.”

But the WEF commits the same mistake as the IMF:

The report’s authors recommended taking a “three-plus-five” approach to increase Russia’s competitiveness. This approach involves capitalizing on Russia’s three key economic advantages and addressing its five key challenges.

Natural resources, the size of the domestic and foreign markets, and a highly educated population are listed as Russia’s key strengths in the report. Challenges include inefficient and corrupt institutions, quality of education, low market competition, unstable financial markets and unsophisticated business practices.

Again, the problem is that one of the “key economic advantages”–natural resources–is a crucial driver of what the report euphemistically calls “challenges”–most notably “inefficient and corrupt institutions” and “unstable financial markets.”

Meanwhile, dinosaur-like, Putin lumbers on, promoting the status quo.  His most recent statements have touted that Russia will recover to pre-crisis levels “by next year.” (Russian Railways head Vladimir Yakunin apparently missed the memo, as he has stated that full recovery will not occur until 2013.)

Even that is not that impressive, as it means that Russia will still be far below trend (again, the country is not alone in this.)  Putting it as optimistically as possible, if the country recovers to 3Q 2008 performance by the end of 4Q 2011, given a pre-crisis growth rate of about 6 percent per year, the country will be about 21 percent below trend.  (If Yakunin is right, the number is closer to 33 percent.)

Nonetheless, Putin promises the country a rosy future:

“And, as for GDP per capita, to increase this figure from $19,700 to more than $35,000 per capita [in the next decade], per person.  But, to do this, we need to increase the productivity two times …and in non-raw material, high-tech sphere three or four fold.”

But he provides absolutely no concrete steps to achieve these lofty visions.  He states goals, never means to get there–the classic con man shtick.  He yammers about creating 25 million new high tech jobs.  Just how, exactly?  Especially with an aging and dying workforce, and a hollowed-out education system?   Doubling productivity in 10 years requires productivity to grow at 7 percent per year: how do you do that with capital fleeing?

So Medvedev and his minions give speeches about modernization, but the hamster wheel just keeps spinning.  And more and more people are noticing.

About three and a half years ago I wrote a post discussing how Russia routinely uses “vapor pipelines”, “vapor contracts”, and other “vapor investments” in order to deter entry that would pose a competitive threat to Russian energy businesses, most notably Gazprom.  Today’s NYT runs an article about the South Stream pipeline which asks rhetorically “could the plan to build the world’s most expensive natural gas pipeline turn out to be an elaborate bluff?”  That is, is South Stream a viable investment for transporting gas, or is it so much vapor?

On its face, South Stream makes little economic sense.  For all of the scorn that Putin and Medvedev have heaped on Nabucco’s lack of gas supply, South Stream has the very same problem–only worse, because it is bigger.  It is very expensive to build.  It is getting more expensive and more unrealistic by the day as Gazprom has on multiple occasions boosted the the planned capacity on the line.  It makes sense only as a means of sowing fear, uncertainty and doubt about the prospects of Nabucco, and to put pressure on Ukraine with regards to transit deals and gas prices on sales to that country.

I found two bits in the article entertaining.  South Stream’s CEO scoffed at the idea that Russia is spending real money on the pipeline, and wouldn’t do that if it were merely a bluff:

Marcel Kramer, the Dutch-born chief executive of South Stream, denied during a recent interview that his pipeline was little more than Moscow’s attempt to squash Nabucco.

“To do such a major exercise as a sort of defensive move would be highly irrational,” Mr. Kramer said. “There is no doubt that this is very serious, and money is being spent — considerable amounts of preparatory money is being spent — by Gazprom itself.”

This conveniently overlooks the fact that with Russia generally, and Gazprom particularly, much of that “preparatory money” being spent is likely being vectored into the pockets of those doing the spending, or their buddies.  With Gazprom, wasteful spending is more feature than bug.

Here’s the other amusing bit:

“Frankly, neither of these pipelines make economic sense,” said Massimo Di Odoardo, a senior global gas analyst at Wood Mackenzie, an energy consulting firm. “It would be much cheaper for Russia and Europe to accept their interdependence and get to work making Ukraine an even more reliable gas corridor.”

Yeah.  That will happen.  Back-to-back monopolies located in distinct and highly corrupt countries in which contracts are inconveniences rather than commitments are antithetical to “reliability.”  These conditions are the ingredients in a classic recipe for conflict.  South Stream and Nabucco would make no sense in sensible countries, a category that does not include Ukraine and Russia.

So don’t expect South Stream to die anytime soon.  It creates FUD, and FUD has its uses.  It provides a vehicle that can be used to tunnel funds out of Gazprom.  Those are more than enough reasons for Putin et al to keep it going.

A perhaps more interesting question is whether Nabucco will keep going.  Waiting for it is like waiting for Godot.  I’m not holding my breath–especially given that the Euros have other much bigger fish to fry.  Like whether there’s going to be a Euro or a Euroland, for instance.

Cheniere Energy is back in the news–and arguably, back from the dead.  Cheniere has been on a roller coaster for about 5 years–right along with the gas market.  In the mid-2000s, when the conventional forecast was that the US was facing gas shortages and persistently high prices, Cheniere was investing in facilities to import liquified natural gas and re-gasify it.  But then the financial crisis and the shale boom caused gas prices to crater, and Cheniere’s import terminal at Sabine Pass looked to be a white elephant.  But prices fell so far in the US relative to the rest of the world that the opposite play appeared promising.  And indeed, a couple of weeks back the company received permission to export LNG.  Its stock price doubled on the news.

Cheniere is looking to configure its facility to be capable of importing or exporting gas.  Like many physical assets, Cheniere’s facility is a real option.  Under the original plan, it was an option to transform foreign gas into domestic gas with a strike price equal to transportation and gasification costs.  With the ability to import or export, it is an option to transform foreign gas into domestic gas, or domestic gas into foreign gas, again with a strike price determined by transportation and transformation costs.

These options can be quite valuable given the volatility of relative prices in the US and elsewhere, with relative price volatility being driven by technology shocks, the development of new fields–and notably, politics.  Developments like Germany’s shutting down of its nukes or the UK’s imposition of punishing taxes on North Sea extraction can have profound effects on relative prices that affect the profitability of real options like those possessed by Cheniere.

Although political developments and uncertainties generate volatility that enhances the value of real options like Cheniere’s facility, politics may also pose its greatest challenge.  Greg Meyer of the FT, who wrote a good article on the company’s change in fortune, pointed out to me this language in the Department of Energy’s decision approving Cheniere’s application to export gas:

We intend to monitor those conditions in the future to ensure that the exports of LNG authorized herein and in any future authorizations of natural gas exports do not subsequently lead to a reduction in the supply of natural gas needed to meet essential domestic needs. The cumulative impact of these export authorizations could pose a threat to the public interest. DOE is authorized, after opportunity for a hearing and for good cause shown, to take action as is necessary or appropriate should circumstances warrant it. Furthermore, DOE/FE will evaluate the cumulative impact of the instant authorization and any future authorizations for export authority when considering any subsequent application for such authority.

This is mercantilist.  No–it is Putinist.  It is a threat to do in the US gas market what Putin did with the Russian grain market–cut off exports in order to depress domestic prices in order to favor particular domestic constituencies.  It is a threat to micromanage trade–transactions undertaken by consenting adults for mutual advantage–through coercion.  It is contrary to free trade principles that the US often piously promotes in lectures to others, but all too often flouts in practice itself.

It is also a piece with this administration’s modus operendi—what Richard Epstein calls “government by waiver” in this typically incisive article.  A government agency arrogates to itself the discretion to permit or disallow individuals and firms to engage in voluntary transactions, with only the vaguest statement of the criteria it will use to make these decisions.  Decisions that can make someone wealthy–or ruin them.  Note that there is not even an assertion–let alone a proof–of a real externality (as opposed to a pecuniary, distributive one) to justify this threat of intervention.  This is purely a threat to use coercion to achieve a politically desirable distribution of wealth between producers and consumers of natural gas.

“Good cause.”  “Threat to the public interest.”  “Essential domestic needs.”  In whose eyes?  Under what criteria?  What public?

All this really means is: we will do what we want when we want for whatever damn reason we want.  It is, as Epstein argues, the antithesis of the rule of law in which general principles are applied uniformly and impersonally; it is a return to the personalized, arbitrary, natural state.  It bears creepy similarities to Putinism.

And as such, it will have–is having–the same consequences.  The DOE’s ominous statement puts Cheniere and any other company thinking about exporting natural gas on notice that a sword of Damocles hangs by a hair over its head.  But this is just one company, one hair, one sword.  There are tens of thousands of swords, tens of thousands of hairs, tens of thousands of companies.  More even: as Epstein notes, Obamacare dangles a sword over every company–and every person–in the US.  Dodd-Frank does the same in financial markets.

The threat of arbitrary government action poses grave risks to every company subject to it.  Which is to say every company, with the risks becoming greater by the day.

This cannot fail to have a depressing effect on investment and hiring.  Given the moribund recovery from the Great Recession–a recovery that was never robust, and which is sputtering noticeably today–it is reasonable to conjecture that there is a link between the hyperactive regulatory policies of this administration and anemic economic performance.  Robert Lucas notes that what made the Great Depression great was not its initial severity, but the failure to recover from it, a failure that persisted for almost a decade.  Lucas conjectures (and he is not alone in this*) that the hyperactivity of the Roosevelt administration–and yes, the Hoover administration before it, conventional wisdom on this score being laughably wrong–prevented recovery from a crash initially caused by faulty monetary policy.  He further conjectures that the eerily similar failure of the US economy to bounce back from the Great Recession is the direct result of “harmful real policies” and “the demonization of business.”

His list of destructive policies, which mirror’s Epstein’s, makes depressing reading:

• Believe it is more accurate to say that the problem is government is doing too much

• Again, I see analogies to the U.S. of the 1930s

• Likelihood of much higher taxes, focused on the “rich”

• Medical legislation that promises large increase in role of government

• Financial legislation that assigns vast, poorly-de?ned responsibilities to Fed, others [this is another example of the Epstein discretion point]

• Are these conditions that foster a revival in business investment, consumer spending?**

Are they indeed.

When every regulator at every government agency has the power–and the active encouragement of the political authorities–to say “Nice little business you got here.  Wouldn’t want anything to happen to it, would you?” one should not be surprised that these businesses are reluctant to invest or hire.  Not in Putin’s Russia.  Not in Obama’s United States.

* Robert Higgs has been the most forceful advocate of this view.  Harold Cole and Lee Ohanian have performed substantial empirical research that supports this contention.  With respect to the L-shaped “recovery” in the US, I argued here on SWP early in the Obama administration that its regulatory onslaught would lead to such an outcome.

** The list could, of course, be expanded dramatically.  It could include, for instance, the flouting of bankruptcy law and the expropriation of creditors as with Chyrsler and GM, and the outrageous decision of the NLRB to prevent Boeing from opening an assembly line in South Carolina.

From The Oil and the Glory, inspiration for a great test question:

Shale gas is the main fashion. Companies are in a drilling frenzy in Texas, Oklahoma, Pennsylvania. This is not so much because the market demands so much of their product — there is in fact a glut — but because drilling is required by many of the leases. U.S. natural gas prices are below $5 per thousand cubic feet, and the futures market expects the price even five years from now to rise to just $6 per thousand cubic feet — insufficient for most of the fields to break even. So when those leases expire, the boom could shrivel — the companies could look forward in time and decide the risk simply doesn’t justify continued production. [Emphasis added.]

What conditions must hold for the italicized statement to be true?  That is, what must exist in order for the contractual requirement in gas leases identified in the article lead to the claimed inefficient excess production of gas?

For extra credit, at the risk of giving away the answer to the above questions, and presumably directed at people in the real world: (a) what transactions costs, if any, impede the renegotiation of leases?, and (b) are leaseholders attempting to renegotiate?

Western European utilities are pressuring Russia and Qatar to eliminate long term gas supply contracts with prices tied to crude oil in favor of a spot market mechanism:

Russia and Qatar are under growing pressure from Europe’s biggest utilities to scrap a 40-year-old system that links natural-gas prices to oil after Brent crude’s 23 percent surge this year.

As delegates from countries that hold two-thirds of the world’s reserves gather in Cairo tomorrow for a one-day meeting of the Gas Exporting Countries Forum, customers from France’s GDF Suez SA to EON AG of Germany are urging producers to link prices to spot markets instead of insisting on long-term contracts that shadow the fluctuations of oil. Contract prices will rise about 15 percent in the next quarter alone, according to Wood Mackenzie Ltd., an Edinburgh-based energy consultant.

“The European contract price of gas is going up,” said Thierry Bros, a senior analyst at Societe Generale SA in Paris. “Utilities won’t sign new oil-linked contracts.”

But Gazprom says nyet, no, never!:

Spot markets don’t have enough trading to ensure adequate supply, Alexander Medvedev, deputy chief executive officer of Russia’s OAO Gazprom, the world’s biggest producer, said May 13.

“There has never been any transition to spot-priced market structure, and never will be, because spot market liquidity is insufficient,” Medvedev said in Slovakia’s capital, Bratislava. As soon as economies began to recover from the financial crisis, “it became clear that the market will work as before.”

The Other Medvedev is either an ignoramus or a liar.  Check that–he’s probably both.  Regardless of the explanation, his “analysis” is bunk.

First, there has been an extremely successful transition to a spot market structure: in the US, in the 1990s.

Second, the liquidity of the spot market is endogenous.  Believe me, the elimination or even phasing out of oil-linked contract terms would lead in very short order to the development of a robust spot pricing mechanism.  The ability to trade gas spot, and the reliance on spot prices to index contracts will initiate a virtuous cycle that will result in spiraling liquidity.  Just as occurred in the US with the elimination and phase-out of take-or-pay contracts and the elimination of gas price controls.  Just as occurred in oil in the late-1970s when OPEC abrogated oil equity contracts: there was no spot market in oil to speak of before that, but once OPEC transitioned to a different pricing mechanism, the oil spot market developed quickly.  (Note the launch of the NYMEX crude contract followed the elimination of equity contracts in oil by less than three years.)

There is no reason why, in the current environment, with current technology, that a robust spot price in gas cannot and will not develop in Europe.  The existing pricing mechanism is an anachronism rooted in a very different legal and regulatory environment, and one that is plainly unnecessary in light of the development of vibrant spot markets in myriad types of energy since the late-1970s.

Gazprom–surprise, surprise–is just talking its book.  Oil and gas prices have diverged, with oil prices rising and gas prices remaining stagnant or even falling since the end of the financial crisis.  Thus, the pricing mechanism provides a windfall to Gazprom in the existing environment.  Note TOM’s linking of “the market will work as before” to the end of the crisis.  Oil prices plummeted during the crisis, making the linking mechanism less profitable for Gazprom, but with the rise of oil prices, that mechanism works very well for the company.

But very poorly for its customers.  The linked article mentions the woes of E.ON, RWE, and GDF Suez.  Those woes will only become worse with the craven decision of the Merkel government in Germany to shutter the country’s nuclear power plants.  Merkel will soon be in a difficult position, between the Russians she habitually appeases (often at the behest of German companies, including, ironically, E.ON and RWE) and German companies, notably the just-mentioned utilities.   She has jumped from the greenie frying pan into the energy fire.

The current situation is not sustainable.   Wide divergences between prices and values like those seen between the contract price of gas and the spot price of gas cause contract disputes and market breakdowns.  Something will have to give.  Gazprom insists it won’t.  But if the divergences remain wide or even widen, it may find itself without customers and forced to give.

Here’s hoping.

FT Alphaville has an interesting post on metals warehousing that resonates with my earlier post on the subject.   They call attention to a BBC report on commodities.

Recall that I dismissed the concerns about leveraging market power, and said that the crucial issue was information.  Given the availability of statistics on metals inventories, I downplayed the information advantage that warehouse owners have, but the Alphaville post suggests I was hasty in that judgment:

MR [BBC reporter Michael Robinson]: Steinweg is the last independent warehouse. Does it give them [the banks which own warehouses] an unfair advantage?

MR: John van der Lek told me he’s relieved that the Steinweg group is still independent, he says he’d like to avoid any suspicion of conflict of interest.

MR: “But what’s wrong with a bank owning a warehouse?”

ST [Warehouse operator Steinweg’s head of metals John van der Lek]: “I don’t know why they want to own warehouses. There must be a reason for that. But I don’t know why they do.”

MR: “Is it good business for a bank?”

ST: “Could be, but I don’t know, I don’t think so. I don’t have an idea what their feeling for taking over a warehouse.”

MR: “The danger is pretty obvious. That the bank has more information than other traders because it owns a warehouse?”

ST: “Yeah. That is to a danger for the traders. Maybe so we’re in a situation where people get more information out of the warehouses, but we are here independent and we would like to keep it that way. And we hope our customers appreciate that.”

All that said, trading is about information flows, and integration of traders into physical assets is ubiquitous–and has been for a long time–for exactly that reason.  Again, recall that major grain merchants did–and still do–operate the main delivery warehouses for CBOT/CME Group contracts.  Banks have been going into physical asset ownership in energy in recent years.  BP always viewed its asset ownership as a key to its trading operations.  That’s the way the game is played.

Anybody who owns the physical assets like storage facilities will have an information advantage when it comes to trading.  The relatively recent move of financial institutions into this area reflects a complementarity between access to this information flow and the ability to operate and finance trading operations.

In other words, it’s not about leveraging market power.  It’s about putting information and capital together.  That’s the essence of trading.  It’s the financial equivalent of a Reese’s Peanut Butter Cup.

It strains credulity to believe that Igor Sechin (who would be perfectly cast playing his namesake in a remake of Frankenstein!) did not know that the TNK-BP shareholders agreement required BP to undertake all Russian operations via TNK-BP:

Deputy Prime Minister Igor Sechin, who this week saw the crowning achievement of his career as Russia’s energy tsar thwarted by rival businessmen, shows no sign of conceding defeat.

. . . .

“I wouldn’t say that anyone contributed to the deal’s collapse. It’s just when there is no full information, when Rosneft had no opportunity to become familiar with the (TNK-BP) corporate agreement, it’s hard to make a decision,” he added.

I have been trying to track down what was public about the shareholder agreement going back to when it was revised in 2008-2009, but it’s hard to troll through all the material that’s out there.  I do have a distinct recollection that during the time of the pre-September, 2008 face-off between Dudley/BP and the AAR people (which, remember, featured raids by masked security personnel), there was mention that the shareholder agreement restricted BP’s operations in Russia.  At the very least, somebody–many somebodies, actually–should have asked.

But even if the details were not public, are we really to believe that the shareholder agreement details were concealed from a Russian government headed by an ex-KGB/FSB agent, and a Russian oil company headed by someone with a similar pedigree?  Really?  Especially since per Wikileaks, the US government was apprised of the behind-the-scenes dealing involved in the renegotiation of the agreement?  If the State Department had its sources, is it at all plausible that Putin, Sechin, et al, didn’t have theirs?  Please.

I don’t know exactly what went on here.  I am virtually metaphysically certain, however, that the public stories by Putin and Sechin are risible.  There was–is–some game within the game within the game.  I would wager that Sechin–and perhaps Putin–told BP that the shareholder agreement wouldn’t be a problem.  Then it was.  Why it was remains in the realm of conjecture.  Was it Sechin playing Lucy-and-the-football in an attempt to extract more out of BP?  Did the AAR oligarchs play a card that Sechin (and perhaps Putin) didn’t expect?  (Perhaps a card involving the upcoming election campaign?)  Again, I don’t know.

But I do know that Sechin does a very poor Gomer Pyle imitation: