Streetwise Professor

With the catastrophe at the Fukushima reactors in Japan has led to additional scrutiny of nuclear power plant construction projects around the world.  This is indeed prudent, but we should hope that the reviews are done soberly and carefully, rather than in a Chicken Little fashion.

For instance, the “no nukes of any kind anywhere” position advanced by people like Rep. Ed Markey from Massachusetts is a premature over-reaction.  “No boiling water nukes on seismically active coastlines vulnerable to tsunamis that could destroy emergency generators needed to operate cooling pumps” is sensible.  Just where between those extremes the line should be drawn depends on myriad factors, not least of which is the nature of new nuclear power technologies.  (Spare me the Chernobyl references: even Fukushima analogies are inapt when discussing more modern reactor designs.)

We should, in brief, keep in mind what Puddin’ Head Wilson said:

We should be careful to get out of an experience only the wisdom that is in it — and stop there — lest we be like the cat that sits down on a hot stove-lid. She will never sit down on a hot stove-lid again, and that is well; but also she will never sit down on a cold one any more. [Emphasis added.]

In other words, when evaluating the future of nuclear power, we should not be like Wilson’s cat.

And another Twain phrase also comes to mind while following these events:

If you don’t read the newspaper, you are uninformed; if you do read the newspaper, you are misinformed.

And that goes double for the internet.  (Present company excluded, of course.)

The spread between Gulf Coast oil prices (such as Louisiana Light Sweet) and West Texas Intermediate (at Cushing, OK) remains wide.  The March LLS-WTI spread is $14.42/bbl, and is above $10/bbl through October, 2011.

The key to restoring spreads to more typical levels is breaking the logistical bottleneck south of Cushing, thereby permitting Canadian oil that is weighing on prices in the Midcontinent to flow to the Gulf.  The extension of the Keystone pipeline will help do that, but not for a couple of years.  Another way to ease the logjam is to reverse the Seaway Pipeline, now flowing from the Gulf to Cushing, to carry crude in the opposite direction.

This can have large social payoffs.  Here are some back of the envelope calculations.  Assume the marginal cost of moving oil on Seaway is $1/bbl, and a LLS-WTI spread of around $12/bbl when no oil flows south.  Also assume that the relevant derived demand curve for oil in the Gulf and the supply of oil to Cushing are linear.  The capacity of Seaway is 350,000 bbl/day.  The standard welfare triangle analysis implies that the opening of the pipeline would increase the sum of consumer and producer surplus by at least $1.925 million per day.*

I have been digging for estimates of the cost of reversal, and haven’t found any.  I did find that the reversal of the smaller but longer Spearhead pipeline cost $20 million.  The reversal of Line 9 in Canada cost $100 million.

At a reversal cost of $20 million, the investment would pay for itself in 10 days.  Even at $100 million, it would pay for itself in less than two months.  From a social perspective, this is a no brainer.

But the half-owner of Seaway, Conoco Phillips, says it is not interested in reversal:

ConocoPhillips isn’t interested in reversing the Seaway pipeline that brings crude from the U.S. Gulf Coast to the fuel hub in Cushing, Oklahoma, where inventories of crude oil reached a record high last month.

“We don’t really think that’s in our interest because we need more crude in the area” to supply the company’s refineries in the Midcontinent, Jim Mulva, ConocoPhillips’s chief executive officer, said during a conference call hosted by ISI Group today.

“We don’t think that’s in our interest.”  Which points out that the opening of the pipeline would have distributive effects.  Those are fairly straightforward to figure out.  Opening Seaway would raise crude prices in the Midcontinent, and reduce them in the Gulf, although probably only slightly (as the marginal barrels will be imported).  Gulf refineries are suppliers of the marginal refined barrels in most markets in the Midwest, South, and East, so product prices would probably fall slightly too.

These changes would benefit Gulf refiners (probably slightly), and harm Midcontinent refiners.  Due to the crude price differential, Midcon refiners are operating at higher rates of utilization than Gulf refiners; through February PADD II refiners were working at mid-90s utilization, PADD III in the low 80s, although that differential narrowed in the last couple of weeks with Midcon utilization falling into the mid-80s, probably due to the rise in crude costs resulting from the Mideast turmoil.  Opening Seaway would raise Midcon crude prices, harming refiners there (which would be reflected in reduced utilization).

The main beneficiaries of the rising Midcon prices resulting from a Seaway opening would be Canadian and Bakken crude suppliers.  So the opening of Seaway would transfer wealth from Midcontinent refiners to firms supplying crude to the Midcontinent.

Although the opening would redistribute wealth, the calculations above show that the pie would get bigger.  This means that there is the potential for a Coasean bargain** that could make refiners (including Conoco) and crude suppliers better off.  Roughly speaking, the deal would involve crude suppliers buying Conoco’s 50 percent of Seaway.

Easier said than done, of course.  There are costs of assembling the coalition of buyers (because there are multiple suppliers of crude), and costs of negotiating a deal with Conoco.  The negotiating costs exist in part because there are information asymmetries: Conoco, for instance, knows more about how the profitability of the refinery varies with the price of crude than would the purchasers of Seaway.

But the potential for the expansion of the pie is an enticement for doing an deal.  Perhaps Conoco’s expressed indifference is just a bargaining pose.  Perhaps somebody will make a bid that will make it worth Conoco’s while.  The money is there–on the order of $2 million per day.  Who will structure the deal to make it happen?

* .5 x 350,000 bbl/day * ($12/bbl-$1/bbl)=$1.925 mm.  Note this assumes that  when Seaway operates at full capacity, the LLS-WTI spread equals the marginal cost of shipment.  This means that the shadow price of capacity is zero.  If at full utilization the difference between LLS and WTI exceeds the marginal cost of shipment, the shadow price of capacity is positive and the welfare gain from opening Seaway is greater: there is a welfare trapezoid that contains the welfare triangle whose area I just calculated.  If in equilibrium Seaway operates below capacity, the welfare gain is smaller that I calculated.

** A phrase Coase dislikes, but which is widely used.

Historically, oil prices and stock prices were negatively correlated, or exhibited a close to zero correlation.  During the financial crisis, the equity-oil correlation spiked.  In recent weeks, it has plunged, and become sharply negative.

Some people try too hard to explain this pattern.  To me it has little to do with QEII, and the explanation is relatively simple.  It depends on what are the important shocks at any particular time.  When macro demand shocks predominate, correlations will be positive; when oil supply shocks are important, correlations will be negative.

During the financial crisis, there was slack oil production capacity, and price movements were demand driven.  Prices plummeted when demand crashed in the post-Lehman days.  Prices rebounded when economies around the world started to recover.  The economic crash and recovery drove stock prices lower then higher.  So during the crisis and recovery period, the state of the macroeconomy drove oil demand, and drove stock prices and oil prices in the same direction.

In contrast, the Mideast turmoil has generated oil supply shocks.  Declines in oil output, and increased likelihood of greater future output declines cause oil prices to go up.  These output declines also tend to reduce economic growth, and if severe enough, can tip economies into recession.  Thus, these adverse output shocks tend to cause stock price declines  because stock prices reflect the health of the broader economy.

In brief, the historically high positive correlation between oil and stock prices during the late-2008-early-2010 period reflected the fact that the primary shocks driving both markets during that period were macro shocks that influenced the demand for oil.  The negative correlation we observe now is due to the fact that the predominant shocks are oil supply shocks that will adversely affect the real economy.

The title of the FTAlphaville piece I linked to asks whether the correlation breakdown is “permanent.”  I permanently wonder why people have a tendency to believe that the most recent change will last forever.  No, the correlation shift is not permanent.  When supply shocks abate, and when (macro) demand shocks intensify, the correlation will tack again.

The estimable and experienced (not to say jaded!) Tim Newman at White Sun of the Desert feigns surprise at some revelations in a Transparency Watch-Revenue Watch Institute study of transparency among energy companies.  The Nigerian National Petroleum Company (motto: “We’re here to make Russia look good!”) earned a Bluto Blutarski GPA, which is to say in the immortal words of Dean Wormer, “ZERO POINT ZERO.”

Gazprom is in the Flounder range: “0.2… Fat, drunk and stupid is no way to go through life, son.”  Gazprom scored a zero on anti-corruption reporting.  To echo Tim:  I’m shocked!  Shocked!

Speaking of Gazprom and unsurprising developments, it picked up the Kovykta gas field for a song:

“They have got it virtually for free,” concluded one analyst after state-owned Gazprom triumphed with a $773m (£474m) bid for the giant field that is thought to contain enough gas to supply the world demand for eight months.

It certainly looks likes a good deal, at first glance, with Gazprom paying the equivalent of 6 cents per barrel of oil equivalent for the rights to extract the field’s estimated two trillion cubic metres of reserves.

BP’s shareholders should know the Kovykta gas field well: until recently, BP owned a 50pc stake in it through its TNK-BP joint venture. It was once one of the joint venture’s most promising prospects. One of the largest undeveloped sites in the world, positioned close to the growing Chinese market, City analysts put a $2bn price tag on the field.

Technically, Rosneft was in the running.   The results suggest that this was mere window dressing intended to give the charade a simulacrum of competitiveness.  There wasn’t arms-length bargaining in this deal.  Strong arming is more like it.

I especially like this part:

Gazprom initially claimed it wasn’t interested in bidding. “From the point of view of long-term balance we don’t see how gas from Kovykta can be used,” claimed executive Viktor Timoshilov just a few months ago. You can only assume that the Russian giant has since figured it out.

BP presumably believes that it has immunized itself against a repeat of this fiasco by dealing with state-owned Rosneft and Igor Sechin, rather than a group of mere oligarchs.  Maybe so, but worms have a way of turning in Russia.  Or, to mix metaphors, one’s roof can protect you today, and collapse on you tomorrow.

This is especially true in a country where with respect to corruption and investor protection you can look down on Nigeria.  Maybe.

The lack of a coherent Strategic Petroleum Reserve strategery has apparently been an issue for quite awhile.  John McCormack points me to something he wrote for Regulation in 1996:

Owners of above-ground crude oil and refined product inventories have an important role to play. It was just such a role that the Strategic Petroleum Reserve (SPR) was meant to serve but has not. While it has accumulated a crude-oil stockpile of well over half a billion barrels, the SPR has never had a coherent, systematic strategy for selling crude oil during periods when prices spiked upwards. Only small amounts were sold from the stockpile during the 1990-91 Persian Gulf War, and then only after prices had begun to decline from their peak. For the stock- pile to have been of any use during periods of distress, SPR managers needed to have a coherent strategy in place and should have communicated their intentions beforehand. Part of the Energy Department’s reluctance to sell barrels from the SPR resulted from fears that they would be reducing the stockpile before the shortage was greatest. They could have avoided this problem by doing time swaps that would not permanently reduce the stockpile.

The Senate Permanent Subcommittee on Investigations published a report in 2003 (almost exactly 8 years ago, in fact) that also ripped the SPR for its failure to act in a commercially reasonable way, thereby distorting oil prices.

Given that a Cato publication and a Carl Levin-chaired committee came to identical conclusions, I think it’s safe to say that SPR has not operated according to sound economic principles.

The SPSoI report also has a lot of stuff on manipulation, including a lot of quotes/cites from me before I was SWP 🙂  I talked extensively with one of the staffers who authored the report while he was preparing it.  I haven’t read it in years and on re-reading was kind of taken aback to see how much of what I told him made it into the final report.  So, even if I do say so myself, it’s a pretty good primer on manipulation generally, and oil market manipulation more particularly.

Today’s WSJ online has a short piece quoting Daniel Yergin counseling against tapping the Strategic Petroleum Reserve in response to Mideast turmoil. Yergin argues that it is desirable to keep the stockpile untouched as a hedge against the possibility of worse disruptions in the future. Insofar as commercial storage is concerned, economic theory highlights two factors that are relevant in determining the optimal timing of adding to or drawing from inventories. My forthcoming book goes into these factors in detail.

The first is that it is optimal to draw down on storage in response to adverse supply shocks that are expected to be transitory. This means that current supply is below expected future supply, making it less desirable to hold inventories to meet future consumption needs. Well-functioning markets move things from where they are relatively abundant to where they are relatively scarce. A temporary supply shortfall means that the present has become more scarce, relative to the future, making it desirable to shift some consumption from the future to the present. When some inventories are available, this intertemporal shift can be achieved by drawing down on stocks.

In contrast, supply shocks that are expected to persist should have minimal impacts on storage decisions as such shocks do not affect supply today relative to what is expected in the future. Since scarcity today relative to future scarcity isn’t affected by a highly persistent shock, there is little or no need to change inventory to move consumption from the future to the present.

The second factor is uncertainty about fundamentals. Inventories are in part a hedge against uncertainty about future demand and supply conditions, a buffer against adverse supply or demand changes in the future. An increase in uncertainty about future supply increases the precautionary demand, leading to an increase in inventory holdings. This is the factor that Yergin emphasizes, and which I analyze in detail in chapter 5 of the forthcoming book.

In the current situation these considerations are in conflict. It is likely that the effect of the effect of the loss of Libyan production will be relatively transitory as this production will be brought back on line when the situation, which appears to be reaching a climax, stabilizes, and because other suppliers, notably Saudi Arabia, have pledged to expand output. This would tend to cause a decline in inventories. On the other hand, the risk of future supply disruptions—not excluding major disruptions in Saudi Arabia—has increased dramatically. This would tend to lead to an increase in inventories.

Movements in the forward curve suggest that the first effect is dominating. The contango in WTI has declined and Brent has also moved into a backwardation. The WTI curve has become slightly humped at the short end. Such moves are associated with declines in inventories.  That said, the effect of the increased uncertainty has probably led to smaller stock drawdowns.

The foregoing relates to commercial storage decisions. SPR is not operated on a commercial basis. That said, it would probably make sense to take commercial considerations into account when making storage decisions, if only to reduce the cost to the taxpayer. The fact that SPR is not operated on commercial principles, but is a political animal with difficult to predict decisions likely has some feedback effects on commercial storage decisions; with respect to politics, some, such as MA Rep. Markey, are calling for the SPR to release supplies into the market. Commercial storers have to take into account their expectations about SPR actions when deciding how to make their own storage decisions.

It would seem to be very hard to predict what SPR will do given its political-military nature. Clarifying SPR’s operational methodology would assist private parties to make rational storage decisions that would assist in reducing price volatility.

In an interview with the WSJ, Igor Sechin pointedly suggested that Rosneft would like a seat on the BP board of directors (in exchange for a seat on the Rosneft board).

Seats on the board aren’t an “oh by the way” kind of thing.  They are the kind of thing that would normally be negotiated as part of a deal, and decided definitively before the deal was finalized.   Moreover, the I’ll give you a seat if you give me one is hardly balanced, given that as part of the stock swap Rosneft gets 5 percent of BP but the British company gets 9.4 percent of Rosneft.

So what does Sechin’s suggestion mean?  Is this hardball?: “Thanks for that deal.  Now I want more.”  With the implicit threat that if the request is not met Sechin and Rosneft may not be as accommodating as BP expected.

Or could this be a response to the BP’s difficulty with its TNK-BP partners?  Sechin discussed these difficulties during the interview.  One interpretation is that the board seat is Sechin’s price for making those troubles go away.  Or at least part of the price.

And if this is what Sechin is doing, I have to wonder whether he might have a hand in exacerbating those difficulties.  Perhaps not: perhaps he is just being opportunistic.  That would be in character.  But so would playing both sides against the middle.

Regardless, this rather audacious after-the-deal-is-supposedly-done proposal suggests that all will not be smooth sailing in the Rosneft-BP relationship.

Not that that should surprise anyone, least of all BP.

A few Gazprom stories have stacked up on my desk in the last 10 days or so.

The first one is that Putin told Gazprom to open its pipelines to independent users:

Prime Minister Vladimir Putin lashed Russia’s largest and most powerful company Gazprom on Wednesday for its failure to share its natural gas pipelines with independent producers.

Putin’s criticism of the world’s largest natural gas firm came during a meeting in which Gazprom reported disappointing export numbers that showed a small 2010 decline.

Gazprom deputy chief executive Valery Golubev said the company’s gas exports fell 1.5 percent to 138.6 billion cubic metres last year.

The company attributed the drop to lower European demand but Putin accused Gazprom of being inefficient.

“You either work in an efficient manner or we will be forced to change the existing rules and move in favour of a change in the legislation,” the RIA Novosti news agency quoted Putin as saying.

In some respects, its a mystery why Gazprom doesn’t exploit its status as a pipeline monopoly by merely charging a monopoly price for the pipeline, and letting anybody that wants to pay the monopoly price use the pipeline.  To the extent that other gas producers (or potential gas producers) have lower costs of gas production than Gazprom, or can market some gas more efficiently than the former Ministry of Gas, the company could earn a higher profit this way than by transporting and marketing only its own gas.

I suspect that this alternative is less attractive to Gazprom management because the present system permits them to engage in various corrupt tunneling schemes built around the marketing of gas, particularly through various intermediaries, and that such tunneling would be much harder to do through the sales of transportation services.

The politics of this are also interesting.  Why would Putin speak to Gazprom only slightly more politely than the way he addressed Mechel oligarch Igor Zyuzin back in the summer of 2008?  I see Sechin’s fingerprints on this one.

The FT asked Gazprom CEO Alexander Medvedev about this issue, but the question was lame, and the answer was even lamer and totally unresponsive.

The second story is that major European gas consumers are pushing for a move to spot pricing for gas, in lieu of long term contracts indexed to oil:

E.ON AG, Germany’s biggest gas importer, asked suppliers last year to sell it fuel at spot-market rates rather than at prices tied to oil products, two people with knowledge of the matter said this week. GDF Suez SA, operator of Europe’s largest natural-gas network, said in September it was negotiating a stronger link to spot prices for long-term purchases. North Sea Brent crude costs $55 a barrel more than U.K. gas, the most since May 3, according to data compiled by Bloomberg.

. . . .

“If E.ON is pushing for 100 percent spot indexation it suggests they believe the entire European market is moving to a fully liberalized structure as already exists in Britain and North America,” said Patrick Heren, a London-based consultant who founded Heren Energy Ltd., the European price-information service bought by Reed Business Information Ltd. to form ICIS Heren.

This would be a big deal for Gazprom, as the gap between the oil-linked price and the spot price could be on the order of 25 percent.  The increase in gas output worldwide, combined with rebounding demand for oil and stagnant production, has driven a wide wedge between oil and gas prices.

One of the objections to moving to spot pricing is that the spot market on the continent is relatively small and undeveloped.  Legal and regulatory changes, along the lines of what was done in the US in the 1980s and early-1990s could facilitate market development.  But there’s also a chicken-and-egg aspect to the situation.  Part of the reason that the spot market is small is that most gas is marketed under long term deals.  Moving to spot pricing would help kickstart the spot market, leading to increased volumes, increased liquidity, and more reliable prices.

One of the major sources of high gas supplies and depressed prices is shale.  CEO Miller is trying to cast doubts on the long-run impact of shale.  No wonder.

Medvedev says that shale gas is “a bubble.” He predicts a gas price of $8/mmBTU, whereas the forward curve out 5 years is below $6.  Since he’s talking his book, I’d discount what he says heavily.

One interesting thing in this article: Medvedev is sticking to his projection that Gazprom will supply 10 percent of the US market by 2020 (the magic year in virtually all Russian forecasts: it will soon be kicked out to 2030, I would wager).  He says, moreover, that he will supply the US from the Shtokman project, and that this project is on schedule to start deliveries in 2017.

The Russian government, however, is apparently of a different opinion:

Russia’s energy giant Gazprom may decide to delay the launch of its troubled Shtokman gas field by two more years because of the United States’ rapid development of shale gas, a report said Thursday.

The Barents Sea project has experienced repeated delays caused by the 2008 global financial crisis and the subsequent development of shale gas in the United States, Canada and other Western countries.

Originally due to go online in 2013, the field might now be only commissioned in 2018, Pyotr Sadovnik, the deputy head of Russia’s subsoil usage agency, was quoted as saying by RIA Novosti.

“There are questions being asked about delaying it until 2018, but there has been no final decision,” said Sadovnik.

“There is a risk that there will be no demand for the gas” produced at the giant field, Sadovnik said.

But here’s the really interesting part:

A source familiar with the matter told AFP that shareholders at the international joint venture in charge of the project where deadlocked over how to proceed.

“Everything is blocked,” said the source. “The (project) participants cannot make a decision on anything.”

Those shareholders would be Norway’s Statoil, French Total, and Gazprom.

Not that I’m surprised.  That’s something to keep in mind when evaluating the prospects for the BP-Rosneft tie up in the Arctic.

In a post titled “NOC! NOC! Who’s There?” I wrote in the summer of 2007 about the difficulties of joint ventures between national oil companies (NOCs) that control access to resources and the international oil majors that have the expertise and technology to develop challenging projects.   Interesting to read that Shtokman is supporting this analysis.   I put good odds on the BP-Rosneft collaboration providing more corroboration.

The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend).

Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years.

The WTI “disconnect” as it is sometimes termed reflects fundamental conditions in the oil market. (As an aside, those who obsess about the impacts of speculation should explain how speculation can wildly distort levels of prices but fundamentals drive intra-commodity price relations/spreads.) Increasing Canadian and US oil production has ensured that the US Midcontinent is well-supplied with crude. Indeed, along with demand that is still somewhat sluggish, this increased supply has led to increased inventories of crude in beautiful, windswept Cushing, OK. Cushing is the largest storage location in the US, and is the delivery point for the CL contract. At present, oil cannot flow from Cushing to the Gulf Coast. Gulf Coast refineries rely on US domestic crudes produced in the Gulf of Mexico (GOM) and imported crudes. The abundant supply of crude to the Midcontinent combined with the current inability of oil to flow from the Midcontinent to the Gulf has led to the widening basis.*

If you have been long WTI and short LLS (or some other Gulf Coast price) that relative price change is a problem (although it has been a boon if you have been short WTI and long the Gulf). But that problem is also an opportunity. It is a signal of the value of investments in capital that can move oil from the Midcontinent to the Gulf, and in refining capacity in the Midcontinent that can soak up some of that additional oil.

And indeed, a pipeline project–the third stage of the Keystone pipeline–is currently awaiting regulatory approvals.  With timely approval, the pipeline could go online in early-2013.

Indeed, adjustments are occurring even in the short run: the price relations are such that it is attractive to ship oil by rail–almost a throwback to the Rockefellar days–from the rapidly growing Bakken fields in North Dakota to the Gulf.  Moreover, Midcontinent refiners are operating at substantially higher rates than those elsewhere in the US.   (It is likely that in the longer run that refining capacity in the Midcontinent will expand relative to capacity in the Gulf to reflect the increased supplies of crude in regions tributary to the Midcon.)

Ironically, environmentalist opposition supposedly intensified by the Mocondo spill is the main obstacle to timely completion of Keystone.  Ironic because pipeline transportation is safer than deepwater production and seaborne transport (although it is not without environmental risk).  So delaying the pipeline only increases reliance on the riskier alternative.

So, like many economic “problems”, this one is self-correcting if the market is allowed to respond rationally to price signals.  Economic actors are ready to respond rationally.  Now it remains to be seen whether the political actors will do so.  Always a much more problematic proposition.

Several people have asked me whether it would be advisable to develop a new futures contract that would price off of seaborne crude or domestic production in competition with seaborne crudes: an LLS contract, for instance.

Having been intensely involved in the design of several commodity futures contracts, I am less than enthusiastic.  Sometimes the “long run” in designing a futures contract–going from the idea to the actual implementation–is longer and more treacherous than doing something like building a pipeline over hundreds of miles of Oklahoma and Texas prairies.  The implementation details are very difficult to get right.  Moreover, there are many parties with conflicting interests who try to influence the design to benefit them.  A futures contract is a one-size-fits-all endeavor, and it is very difficult to choose which suit gives the least bad fit to the most people.

Moreover, there is a kind of Heisenberg principle at work.  Designing a futures contract around a particular location and grade can change the pricing behavior of that location and grade.  You have to be sure that the logistics and infrastructure are robust enough to handle the demands of being a delivery point (or cash reference point).  That’s not easy to do.

What often happens is that dissatisfaction with one delivery design leads to inquiries which prove that that design is the worst possible one, except for all others that could be tried.

With respect to WTI, the economic factors that are the fundamental source of the current criticism could be a boon in the longer run, especially if the market is allowed to function and capital adjusts in response to changes in production and consumption patterns.  Historically, the US market was in supply deficit, and WTI traded at a premium to attract Brent in addition to other foreign crudes.  But currently the forward curves for WTI and Brent show WTI at a discount going out years.  This means that the market is anticipating that Cushing will be abundantly supplied for years–while Brent/North Sea production is inexorably declining.

The major problem that raises worries about the long run viability of a futures contract design is lack of supply.  Long run changes in grain marketing patterns put the terminal market in Chicago into terminal decline (no pun intended).  That caused serious difficulties with CBT corn, wheat, and soybean futures contracts.  Those problems took years to correct, and only after extremely rancorous infighting over how to change the contracts to address the problem.  (Efforts that I was involved in from 1990 through 1997–that timeline alone speaks volumes.  And I can speak authoritatively about the rancor, having had some of it directed my way–almost resulting in a fistfight with a prominent grain trader.  True story.)

The increased Canadian and North Dakota production, reflected in part by the forward WTI discount vis a vis Brent, suggests that over the longer term the Cushing-based WTI contract does not face the prospect of a similar supply problem.  Moreover, the delivery in-store (or through pumpover) design for the CL contract offers many advantages over the much more cumbersome and opaque Brent pricing mechanism, not least due to the fact that Brent trades in huge cargoes whereas delivery in-store at a market served from a variety of supply sources with a variety of demand outlets permits greater flexibility in logistics and trade sizes.

In sum, the conditions that have created the wide spreads are self-correcting:  those self-same spreads give the incentive to make adjustments in transportation (and also production and consumption) that will re-integrate Midcontinent prices with waterborne prices.  And it’s also important not to exaggerate the magnitude of the de-linkage.  As I documented in a study released about a year ago, even during the throes of the financial crisis when spread and basis relations were also well out of historical norms, WTI still exhibited high correlations with other crude prices, including LLS and Mars.  (I am working now to update the main results of that study.)

In a dynamic market, changes in supply and demand patterns are inevitable.  By necessity, futures contract designs are relatively static–particularly so for something like crude oil, where contracts are traded going out to ten years so you just can’t change contract designs willy-nilly and strand a lot of open interest in the out months/years.  This mismatch between dynamic markets and static contract designs means that from time to time the contract will get out of alignment with the fundamentals.  Sometimes that mis-alignment is likely to be enduring–as with Chicago-based grain and oilseed contracts, which necessitated a major change in design.  Sometimes that mis-alignment is fleeting, because the price effects of the mis-alignment lead to adjustments on various margins that tend to bring things back into alignment.  That will almost certainly happen with WTI–if regulators allow it to happen.

And one point deserves repeating: the change in supply conditions that is causing the changes in price relations that are drawing so much attention will also help ensure the long run viability of the WTI contract.  If the supply is there, you can build pipelines to get that supply from low price locations to high price ones.  But you can’t base a futures contract on a market with no supply.

*Note how this represents a fundamental, and salutary change over conditions in the 1990s.  At that time, declining domestic production was turning the Midcontinent into a deficit region, and the Seaway Pipeline was built to bring crude from the Gulf to Cushing and the Midcon.

Inflation is picking up in Russia–and elsewhere.  This presents a policy quandary for Russia.  Sadly, some Russian policymakers are considering the worst response: price controls.

Deputy Economics Minister Andrei Klepach said on Monday that the Economics Ministry may consider resorting to the tried-and-tested price control system to contain prices, but added that there were no plans to implement this in the near future. “This is a tool which can be used, and I do not rule out that such restrictions will have to be used this year,” Klepach told Interfax in an interview. Price caps, if and when introduced, are expected to affect staple foodstuffs like buckwheat, potatoes and other fruits and vegetables, he said. According to this seldom-used regulation, the government can impose price controls on certain food items for a period not exceeding 90 days if there is an increase in retail price of 30 percent or more in one or more regions.

Fortunately, however, some policymakers and market observers recognize the folly of these controls:

However, many economists, including the Russian Economics Minister Elvira Nabiullina, have rejected direct price control as a method to stabilize rocketing food prices. Nabiullina suggested during a one-to-one meeting with Prime Minister Vladimir Putin in September that the government could use other non-distortive means, such as market intervention from reserves, to keep prices down. Alfa Bank economist Natalia Orlova supports such views, adding that price control has never been an efficient way to keep down inflationary pressure. “Price control is a stop-gap measure meant to postpone the worst till later years,” Orlova said. “As Russia enters the election season, government officials believe such measures could provide temporary relief by keeping inflation below ten percent. But would it last?” The best that can be expected, she said, is a worsening of Russia’s trade relations with other countries. “For many companies, it will be no longer attractive to buy certain items from abroad – and even in the domestic market,” Orlova said. Ideally, Russia simply needs to increase the level of local competition in order to combat high prices, Orlova said. “One of the explanations for a high level of inflation in the country in recent years is that there is still a lack of competition in a number of markets,” Orlova said. “In both the construction and consumer markets, for instance, there are only a handful of big players and these players are able to dictate prices.”

Nadorshin, who heads market research at Jones Lang LaSalle, said placing price caps is hardly the most productive measures to contain rising inflationary pressure. “We have applied this method before in 2007 and again in 2008, and the effects on prices were quite negligible,” Nadorshin said. “Price control in the past has also led to hoarding by farmers and there is no guarantee that farmers would not do so this time around.”

Another hurdle before policymakers is that rising prices on staple foods is not peculiar to Russia, he said. Many developing countries including India, China, Malaysia and Indonesia are all facing similar problems. “If the problem is global, homebrew solutions can only exacerbate the situation,” Nadorshin said.

Overall, Russian macro policies have been reasonably sane in recent years.  The reluctance to employ price controls is a sign of good sense.

Russia, of course, is not the only nation struggling with food price inflation.  Emerging markets in particular are facing acute problems.  Food price inflation is arguably the issue that caused the widespread dissatisfaction with the governments in Tunisia, Yemen, and Egypt to coalesce into mass protest and revolt.  China is very uneasy about the political implications of rising food prices.

Some of this is driven by bad harvests in Russia, Argentina, and Australia.  But especially in emerging markets QE2 is a major factor.

On Friday I gave a talk at the Argus Americas Crude Oil Conference.  The title was “A Year of Living Dangerously.”  The basic theme is that there are many sources of uncertainty that will buffet economies and policymakers in the coming year.  A major one is QE2.  Although it appears to be having only limited success–if any–at achieving its stated purpose of spurring employment growth in the US, it is having huge collateral effects around the globe.  Again, in emerging markets in particular, hot money is putting pressure on governments and central banks; they don’t want to let their currencies appreciate relative to the dollar, which means importing inflation.  The policy responses are unpredictable.  There is gaming between countries.  Policy errors are more likely in such an environment.

And perhaps most importantly, as Sherwin Rosen said to my rather startled Econ 300 class at Chicago in the early-80s, “inflation F*CKS UP relative prices.”  Of currencies.  Of goods and services (most notably, of commodity prices relative to other stickier prices.)  This leads to distortions, resource misallocations, waste.

Some of the consequences are economic.  Others–pace Egypt–can be social or political.  And who can foretell what the consequences of monetary and policy gamesmanship between China and the US?

On its own terms, I think QE2 is dubious policy.  As I wrote soon after it was launched, it is designed to fight deflation, and prevent a Fisherian deflationary spiral–but who ever saw a deflation with spurting commodity prices across the board?  But its unintended consequences are ominous.  Bernanke is the Sorcerer’s Apprentice to top all Sorcerer’s Apprentices.  Just what will get inundated?