Streetwise Professor

Some weeks ago I opined that it was foolish for Poland to lock itself into a very long term contract with Gazprom (going out to 2037) given the prospects for shale gas.  I did a little digging (or should it be drilling?) for information on shale gas prospects in Poland, Ukraine, and elsewhere in Europe, but other things (e.g., life) intervened and I didn’t follow up.  Fortunately, Deutsche Welle recently ran a piece on the subject that contains some interesting data and commentary:

The largest deposits of shale gas in Europe are assumed to be located on Polish territory. New technology from the United States could make it possible to exploit these gas reserves. Test drillings are planned all across the country.

According to geologists, Poland could become the largest gas supplier in Europe after Norway and Russia. It would make the eastern European country rich – much richer than previously assumed, said energy expert Pawel Nierada from the Sobieski Institute in Warsaw.

“Conservative estimates already show that Poland could suddenly become a serious exporter on the European gas market,” Nierada said. “The reserves exceed our country’s consumption many times over. It’s hard to imagine what it would be like if the more optimistic estimates of the US government were to turn out to be true. Then, here in Poland, we would have more gas than Norway.”

Specifically, estimates are that Poland has 3 trillion cubic meters of recoverable gas.  This is a small quantity compared to Russian reserves, but (a) it’s relatively large compared to Polish consumption, and consumption in adjoining countries, (b) it’s close to market, rather than locked in forbidding locations in northern Russia, and (c) it’s not in the tentacles of the gas octopus, and hence not in the clutches of one of Poland’s historical enemies.

There are skeptics, of course:

But many people are skeptical about this procedure, Nierada said.

“There are also critical voices which say that the technology is still in its infancy – the experts from the Russian gas company Gazprom, for example,” he said.

Gazprom, expressing skepticism?  Go on.  Tell me another one.

In fact, the company has acknowledged in word and deed that the shale revolution in the US has already derailed some big plans, and the extension of that revolution could truly rock Gazprom’s world, and not in a good way.  So the company has every incentive to play skeptic in the hope that this will slow down the shale juggernaut–and every sentient being should discount its skepticism as heavily as the market discounts its stock price.  Indeed, Gazprom is actively looking to get into shale plays in the US.  At the very least, this indicates that it (quite sensibly) wants to learn more about the details of the technology and the performance of shale plays so that it can plan accordingly.  Alternatively, it could indicate that the company knows very well that shale is for real, and wants to get into the game.  Either way, it belies its skeptical public statements.

Yes, there are uncertainties about shale.  The environmental concerns, from what I have learned, seem over-hyped: and there are firms out there who have every incentive to try to hype fears in order to impede shale gas as a competitive force.  More substantial questions relate to the production profile of shale wells, specifically, that production tends to fall more rapidly from shale wells than traditional ones.  But this is an evolving technology, so the possibility that additional innovations will mitigate that problem.

But as I wrote in my earlier post, the very fact that there is considerable uncertainty with an appreciable upside potential means that it is wise to avoid locking into long term commitments until that uncertainty is resolved.  Poland specifically, and Europe generally, are in the very early days of the shale experiment.  There is some uncertainty about how the technology that has worked in the US will perform in European formations, in addition to the technological and production uncertainties just mentioned.  But the US experience, in which shale has completely demolished the conventional wisdom about the future of the North American gas market in a period of less than 4 years, and which has made earlier major investment plans based on this conventional wisdom costly failures (e.g., LNG import terminals in the US–shed a tear for Cheniere; Gazprom’s abortive plans to export LNG to the US), should make everybody everywhere extremely chary about entering into expensive long term commitments.  There is a real option value here–a value to waiting–and greater uncertainty actually makes that option to wait more valuable.

But I guess “everybody” doesn’t include the Poles, and “everywhere” doesn’t include Poland.  For they tweaked their deal with Gazprom to meet EU objections, and leapt into a long term commitment with Gazprom.  This was incredibly foolish.

The impression of foolishness is only reinforced by some of the rationales advanced by Polish officials:

Production in Poland could begin in ten years at the earliest, gas companies said. But experts think it could start earlier. Then, the country could fulfill a dream it has had for hundreds of years: to be economically – and therefore also politically – independent from Russia.

In spite of that, though, politicians across the spectrum have been slamming on the brakes, such as economics minister Waldemar Pawlak.

“Up till now, shale gas has been more of a media phenomenon,” Pawlak said. “We still don’t know how difficult it will be to produce in Poland. It will also be more expensive than gas from conventional sources, because more drilling is necessary for the same amount of output.”

Poland’s president Bronislaw Komorowski has been skeptical, too. He said that all those production towers across the country would be an eyesore.

Economic factors drive skepticism

Even if there are factual reasons for the skepticism, experts have long criticized Polish politicians for being too passive. For years, Poland has relied on imports from Russia without even considering the exploitation at least of conventional gas resources in the country. This was mainly due to the monopoly of the state-owned gas firm PGNiG.

“The company was never interested in producing gas itself,” Nierada said. “It earned its money very easily, after all, by buying gas from Russia and simply adding its margin. The company didn’t care about how high the final price was.”

An economics lesson for Economics Minister Pawlak (there’s a joke in there somewhere):  “We don’t know” is a reason to avoid long term commitments until you find out: that’s the implications of real options theory, in a nutshell.  Moreover, even if it takes more wells in Poland to produce the same gas that could be produced in the frozen wastes of Russia, costs (to Polish consumers) could well be lower because (a) it’s a damn site more expensive to explore, drill, and produce in many of the godforsaken places Gazprom will go to produce gas to meet its contractual obligations, (b) it’s expensive to transport gas from godforsaken places in the frozen north to Poland, and (c) Gazprom is likely to exercise considerable market power if unconstrained by competition from Polish or European sources.

And I would add, Mr. Pawlak: $4-$5 gas is not a media phenomenon.  It’s the real deal.  Yes, declining demand resulting from the financial crisis has had something to do with the cratering of the price of gas in the US.  But that’s not the whole story.  Increased production has had a very huge impact.

As for President Komorowski.  Please.  You’re embarrassing yourself.  Visit DFW some time.  Hell, I can see oil wells from my office in Houston.  And production towers go up, and then they come down, and producing wells are barely noticeable.  It’s no big deal.  Really.

Indeed these objections from Polish officials are so pathetic that it raises darker suspicions.  Such as: they have been, er, suborned by Gazprom/Russia.  The alternative explanation is cluelessness.  Not a happy choice.

But Poland has made its bed, and will have to lie in it.  Maybe shale gas will prove to be a flash in the pan.  But maybe not.  And the fact that the “maybes” are so divergent means that Poland’s hasty decision to betroth itself to Gazprom for the next decades was unwise, and extremely so.

This is one of those stories (h/t JRL) that can be read on many levels:

Meeting of the Security Council chaired by President Dmitry Medvedev will discuss energy security in late November. The necessity of a federal law “On energy security of the Russian Federation” and legislative and organizational measures will be considered at the meeting.

The state aspires to complete information on oil and to control over it. The Interior Ministry is supposed to combine  efforts with the Energy Ministry in prevention of oil thefts. By and large, the matter concerns establishment of Oil Control, a system that is supposed to shut down the black market of oil products. Work on this mechanism has been under way since earlier this year, when oil companies complained to the president against countless illegitimate mini-refineries that were making fuel of dubious quality and selling it domestically and abroad.

A source within the government announced that approximately 10% (about 50 million tons) of all oil made annually disappears without a trace. “As matter stand, oil companies do not want the state to know exactly what they have. The intended involvement of law enforcement agencies is not going to make them happy at all.”

Political Information Center Director General Aleksei Mukhin allowed for the possibility of a connection between the idea to establish a control mechanism and the notorious YUKOS affair. Mikhail Khodorkovsky and Platon Lebedev are facing charges of theft of 350 million tons of oil. The verdict will be passed in mid-December. “The state wants control over commercial activity of the fuel and energy complex,” said Mukhin. “The Interior Ministry
and Federal Security Service have some serious lobbyists working for them. With information on the movement of fuels in Russia and abroad available to them, these structures will be able to influence oil companies’ marketing policies… Reorganization of the Interior Ministry is about to put an end to police generals’ business ventures. They need something else… I suspect that losses of oil will only increase now.”

On the one hand, I would not put it past some Russian oil businesses to attempt to escape the country’s onerous tax burden on oil.  On the other hand, this gives the Interior Ministry access to extremely valuable commercial information that they can utilize for various nefarious purposes that just happens to line the pockets of Ministry personnel.

It seems that some firms in the oil industry were too clever by half, asking the state to intervene to crack down on some dodgy competitors, only to find that the Interior Ministry would take this as an invitation to get up close and personal with all of their businesses.  Proving yet again that it’s very dangerous to give the slightest opening to the operators of protection rackets, as they will take what you offer plus anything else that they feel like taking.  You give an inch, they’ll take miles.

Testifying before the Senate in 1928, Texas cotton broker William Clayton responded to an accusation that he had manipulated the market with this drily arch remark: “The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

I’m sure Mr. Clayton is long dead, but his spirit lives on in the CFTC’s just proposed manipulation rule.  It is broad, sweeping–and maddeningly vague.  It basically promulgates a we’ll-know-it-when-we-see-it-and-tell-you-when-we-do-(with-a-subpoena) “standard.”

The rule itself just regurgitates the language of Frank-n-Dodd.  The explanation of the rule contained in the Federal Register provides ample evidence that the Commission views the rule as a fishing license to catch pretty much anything that damn well strikes its fancy.  Some key quotes:

Likewise, the Commission proposes to interpret CEA section 6(c)(1) as a broad, catch-all provision reaching fraud in all its forms–that is, intentional or reckless conduct that deceives or defrauds market participants. [Emphasis added.]

. . . .

The Commission proposes to continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to improperly [sic] influence the price of a swap, commodity, or commodity futures contract. [Emphasis added.]

. . . .

Consistent with judicial interpretations of the scope of SEC Rule 10b-5, the Commission proposes that subsection (c)(1) be given a broad, remedial reading, embracing the use or employment, or attempted use or employment, of any manipulative or deceptive contrivance for the purpose of impairing, obstructing, or defeating the integrity of the markets subject to the jurisdiction of the Commission. [Emphasis added.]

. . . .

The Commission proposes to continue interpreting the prohibition on price manipulation and attempted price manipulation to encompass every effort to influence the price of a swap, commodity, or commodity futures contract that is intended to interfere with the legitimate forces of supply and demand in the marketplace.   The Commission reaffirms this broad reading of the term “manipulation” with respect to new CEA section 6(c)(3), while also recognizing that manipulation cases are fact-intensive and that the law in this area will continue to evolve largely on a case-by-case basis.

It is quite clear from all this that the Commission wants broad authority, and the maximum discretion and flexibility, to reach any operation of the market that does not suit it at the moment.  Willie Clayton lives.

I’ve written before that by attempting to craft anti-manipulation rules that are so broad to catch everything, Congress and the Commission in fact make it very difficult to catch anything, including the most egregious manipulative conduct.  That is a real risk under the new rule, which just compounds the vagaries and definitional imprecision of the existing laws, regulations, and precedents by adding new ones.  What is a manipulative contrivance or device?  I have no clue–and the proposed rule provides none.

The Commission gives itself an out by saying that manipulation cases are fact intensive, and that “the law in this area will continue to evolve largely on a case-by-case basis.”

Well, that’s the problem, isn’t it?  Anti-manipulation laws have been on the books since 1922, and there have been quite a few cases brought under the laws.  But to characterize the result of this process as “evolution” would be far too charitable. “Chaos,” “confusion,” “muddle,” and/or “devolution” would be far more apposite.  And it got that way precisely, exactly, because Congress and the various regulators charged with enforcing the law did not provide any real structure or guidance, again acting under the misguided notion that a broader, less precise law would be a more effective one.  The problem is not that the CFTC has not possessed the powers to reach truly damaging manipulative conduct; it’s that it has employed these powers in a scatterbrained way.  And that has happened, in large part, because the relevant statutes are vague and provide no structure or guidance.

I’ve written ad nauseum for almost two decades on the problems in the law relating to market power manipulation.  Despite the fact that economics provides the logical and empirical basis to permit determination with considerable precision whether a market power manipulation has occurred; who committed it; and whether he intended to do so, the Commission has never succeeded in bringing a successful market power manipulation case.  (As the discussion in the Federal Register notice makes clear, the CFTC’s much ballyhooed victorious DiPlacido case was not a market power manipulation case.)  That is particularly disturbing because market power manipulation is likely to be the most damaging and socially costly type of manipulation that can occur in derivatives markets.

I’ve advanced recommendations as to how it would be possible to craft fairly specific rules that would make it easier to prosecute market power manipulations.  More specificity would make it more likely that the CFTC could actually crack down on truly damaging conduct.  Laying new broad, vague terms on top of old broad, vague terms won’t do that.

Just how, exactly, will the new rule address the problems that have stymied the Commission in cases like in re Indiana Farm Bureau? How does it correct the problems (most notably vagueness) that Judge Miller tellingly identified in Radley?  (It does address some of the issues relating to jurisdiction.)  Answer: not at all.  Meet the new rule, same as the old rule–at least in its defects.

Moreover, the vagaries of the new rule will inevitably create uncertainty in the minds of market participants about what conduct is and what conduct is not a “manipulative contrivance or device.”  More legal risk is not exactly what the markets need right now.

In other words, the new rule will raise the frequency of both Type I and Type II errors.  Truly manipulative conduct will continue to go unpunished, and perhaps aggressive but legitimate conduct will not suit some enforcement guy at some moment.  The new rule threatens to make all too real the old lawyer’s joke: “I won half the cases I should have lost, and lost half the cases I should have won, so justice was done.”  Not really.

In brief, the new rule doesn’t fix the well-known problems with the existing regulations, statutes, and decisions: it just repeats them, and arguably adds some more.  Since the reach of the new rule will be far greater than the old one–extending to every swap, for instance–the potential for damage is commensurately greater as well.

I found one part of the FR notice particularly amusing.  Specifically, there’s this “we don’t need no steekin’ economists” language:

The conclusion that prices were affected by a factor not consistent with normal forces of supply and demand will often follow inescapably from proof of the actions of the alleged manipulator.

. . . .

Cases of this nature, where distorted prices foreseeably follow from the device employed by the manipulator, do not require detailed economic analysis of the effect on prices.

Yeah.  And then there are all those other cases where conduct is not sufficient to infer price distortion.  Which happen to be the far most important ones.

I understand that a lot of lawyers don’t like to have to rely on economists.  I will pass over in silence why that’s true.  Suffice it to say that the lawyers would be more successful if the laws and regulations reaching economic conduct were based on coherent, precise economics, rather than gassy generalities about “devices” and “contrivances.”

Several Gazprom related stories, with a common (and all too familiar theme): the company’s rather unconventional ways of trying to win friends and influence people.  Unconventional, except for the Mafia, perhaps.

First, Mr. Charming, Oleg Sechin, went to Turkmenistan along with Medvedev, and went on at length as to how Ashgabat should run its gas business.  Don’t ship gas to Europe.  Don’t ship it to China.  Ship it across Afghanistan (!) to Pakistan and India.  Oh, and by the way, if you “choose” the latter alternative, of course Gazprom is willing to “help” in whatever way it can:

Russia’s top energy official, Igor Sechin, who accompanied Medvedev and met the Turkmen president, said Russia was interested in taking part in Turkmenistan’s Subcontinent pipeline project.

The Turkmenistan-Afghanistan-Pakistan-India (TAPI) gas pipeline, conceived in Soviet days, never got off the ground. But last month plans to build it were revived after the four countries signed an new framework agreement. [ID:nSGE68J0M0]

“The issue of Gazprom’s participation in the TAPI gas pipeline was discussed during this visit,” Sechin, told reporters.

“Gazprom may participate in this project in any capacity — builder, designer, participant, and so on,” said Sechin, adding Gazprom, (GAZP.MM), Russia’s state-owned energy giant, would consider importing more gas from its southern neighbour.

Sechin pointedly suggested that Turkmenistan fuggedabout sending gas to Europe:

Sechin, however, went out of his way to discourage Turkmen gas exports to Europe. He insisted that European gas markets could hardly absorb Turkmen gas in the years ahead, due to depressed demand and diversification of supply from sources other than Turkmenistan. He stated, repetitively, that the EU-backed Nabucco project had “no future” due to insufficient gas supplies (an outcome that he promoted by trying to discourage Ashgabat from participating). Moreover, Sechin claimed, Russia’s South Stream project will advance faster than Nabucco, preempting gas resources and making Nabucco redundant. He implied that Ashgabat shared his views; an insinuation rebuked six days afterward in Ashgabat’s statement.

There is some dispute about what Sechin said, or implied, about Turkmen gas shipments to China.  Two analysts quoted by Reuters assert that Russia wants to divert Turkmenistan from China:

“And second, it is in Gazprom’s interest to divert Turkmen gas flows away from markets desired by Gazprom, from Europe and from China. China is a coveted market for Russians and Turkmenistan has already taken out a big bite,” Nesterov said.

In December 2009 Turkmenistan commissioned a 1,833-kilometre (1,139-mile) China-bound gas pipeline, which runs through Uzbekistan and Kazakstan to China’s north-western Xinjiang region.

China receives 24.5 million cubic metres of Turkmen gas a day via the pipeline. In 2012-2013 this will equal 40 bcm, almost as much gas as Russia used to import. Meanwhile, Russia is also attempting to boost its own gas exports to China.

“If Turkmenistan gets its own pipeline to India, or an alternative route westward, like it did with China, Gazprom can no longer negotiate from a position of power,” said Alexei Kokin, an oil analyst at Ural Sib.

Vladimir Socor claims, however, that Sechin strongly encouraged Turkmenistan to pursue opportunities in China:

Conversely, Sechin encouraged Turkmenistan to increase gas exports to China, an “almost infinite market” that could absorb both Turkmen and Russian gas.

Some comments.  First, it appears that Sechin doth protest too much about the poor export opportunities to Europe.  His remarks in this regard were clearly just another sally in Russia’s ongoing campaign to choke off competition for Russian gas in Europe, and to keep the Europeans in Gazprom’s thrall.  If the European market is so bad, why is Gazprom so eager to build not one but two pipelines there?  Second, Russia wants to hamstring Turkmenistan’s efforts to direct its gas to Asia and the Indian subcontinent, and what better way to do that than to get Gazprom involved in some way. Gazprom involvement in a pipeline means (a) higher costs, (b) chronic delays, and (c) the ability to interfere with the marketing of Turkmen gas.  Turkmenistan would be well advised to steer well clear.

And it may be doing just that.  Ashgabat responded sharply to Sechin’s remarks, basically telling him–and Russia–to shove it:

urkmenistan’s Foreign Ministry accused Russia of interfering in the country’s attempt to develop international energy ties following Russian claims that the European gas market had no place for Turkmen natural gas.

“Turkmenistan views the published remarks as an attempt to interfere in the normal course of international energy relations, and cast doubt on our responsibilities to our partners,” the Turkmen ministry said in a statement on its website today.

. . . .

“Deliveries to Europe have become more realistic ever since Russia lowered its purchases of Turkmen gas,” the ministry said in the statement. “Turkmenistan will continue to develop European aims in its energy policy.”

Smart move.  Turkmenistan seems to have learned its lesson from The Producers episode of April, 2009, during which Russia caused an explosion in the pipeline from Turkmenistan because it no longer wanted to pay for the gas that it thought it had been so clever buying the year before.

I once said that Turkmenistan was so close to Russia, so far from God.  I can’t speak about its distance from God, but it is clear that it is moving away from Russia, which is a good thing.  Hopefully that even the Europeans and Americans are not so clueless as to miss out on this opportunity to put a crimp in Gazprom’s plans.

Second item: Gazprom wants India’s stake in Sakhalin I, and will supply LNG in exchange:

OAO Gazprom is considering supplying liquefied natural gas to India in exchange for the 20 percent stake in the Sakhalin-1 project held by state-owned Oil & Natural Gas Corp., the Indo-Asian News Service reported citing Stanislav Tsygankov, the head of foreign relations at the Russian company.

Gazprom is considering this, you see.  Uhm, what about the Indians?

Given Gazprom’s track record in Sakhalin, most notoriously Sakhalin II but also it’s leaning on XOM to prevent it from selling Sakhalin I gas to China (something I wrote about last year) makes me very skeptical about Gazprom’s motives in this case.  Moreover, reading “Gazprom” and “LNG” in the same sentence pegs my BS meter.  The gap between Gazprom’s talk and its walk on LNG is huge.  Essentially Gazprom is asking ONGC to give up something valuable today on the promise of getting something that Gazprom has a poor track record of delivering.  India should take a pass.  It will be interesting to see, though, whether Russia will let it take a pass, or whether this is one of those offers not to be refused.

The last item: apparently the new bonds of fraternal friendship between Great and Little Russia, I mean Ukraine, don’t extend to gas:

Russia and Ukraine were unable to agree a new gas supply deal sought by the cash-strapped Ukrainian government on Wednesday, leaving the threat of a new year gas war hanging in the air.

In January 2009, a pricing row between Moscow and Kiev resulted in a stoppage of Russian gas flows to Europe for about two weeks, tarnishing Russia’s image as a reliable exporter and spurring a European quest for new suppliers.

The two ex-Soviet nations will continue gas talks, senior Russian officials said on a visit to Kiev on Wednesday, indicating Moscow continues to seek control over Ukraine’s transit pipelines as a condition of a price discount.

Ukraine depends heavily on imports of Russian gas, governed by a 10-year deal struck in 2009. But Kiev, which tranships 80 percent of Russian Gazprom’s (GAZP.MM) gas bound for Europe, says the current agreement is unacceptable.

Winter is coming.  I hope the Europeans have topped off their storage.

CFTC Chairman Gary Gensler gave an extended interview with Reuters on Friday.  A good part of the discussion revolved around budgetary matters, but this gem caught my eye:

The agency likely will stagger deadlines for traders to become compliant with the new regulations — including speculative position limits, Gensler said, declining to give any details about a long-awaited proposal that the agency will unveil in the next month.

Investment funds, which make up as much as quarter of trade in markets like cattle, have already looked for alternative ways to buy commodities, with some buying physical products instead of futures and swaps.

That’s OK by Gensler.

“Congress asked us to do a job, we gotta do what Congress asked us to do,” he said, adding cash markets are not part of his mandate.

Wait just a cotton pickin’ minute.  The whole point about limiting speculation in derivatives markets is that such speculation allegedly distorts prices for the commodities that consumers actually buy and producers actually sell.  That is, that such speculation allegedly distorts cash prices.  Listen to all the crying and moaning and gnashing of teeth about the alleged effects of speculation, and the tales of woe focus on the impact of speculation on cash prices.

I remember distinctly when I testified before Congress on speculation in the summer of 2008: criticisms of speculation at the hearing focused on the impact of derivatives trading on physical commodity prices.  Battling Bob Etheridge of NC took time out from assaulting college students to bewail the plight of trucking companies in his district forced to pay higher fuel prices due to speculation.  The head of the Industrial Energy Consumers of America claimed that chemical producers and others had to pay higher prices for natural gas and crude feed stocks because of speculation in derivatives.

I could multiply these examples by the hundreds, and probably the thousands.  In the 1930s, speculative limits were rationalized as a way of bolstering the prices farmers received on the cash market for their grain.  Suffice it to say that it is beyond cavil that the drive to restrict speculation in derivatives is all about the cash markets.

For Gensler, at this late date, to claim that’s not part of his (or his agency’s) job description beggars belief.  Congress mandated the imposition of position limits for the express purpose of reducing the impact of speculation on cash market prices.  That’s what Congress “asked” CFTC to do.  To proceed with a plan to impose speculative position limits on derivatives, without regard to how said limits could have the unintended consequence of distorting cash market prices is both irresponsible, and at odds with the purpose of the regulation.

Now, obviously, I do not agree with the beliefs underlying the legislative mandate for speculative position limits.  But given that the mandate exists, and that Congress has delegated to the CFTC the authority to implement said limits to achieve a purpose set out in the statute, you’d think CFTC should devise those limits with an eye as to their real effect.  There is now substantial credible evidence that one effect of limits on derivatives will be to shift some activity into the physical markets directly in a way that has more potential for adverse effects on these markets.  It is therefore incumbent on CFTC to take that into account when designing its limits, as otherwise it would impose restrictions that would be directly contrary to the entire purpose of the limits in the first place .

I mentioned the JPM physical copper ETF.  BlackRock just announced another.  This is a growing trend.

Goldman and Standard Chartered argue that physical ETFs should have a limited effect on the market.  In most circumstances, I believe that’s true.  But we’ve seen in the Treasury markets that the limited “float” of some Treasury issues that results from bonds and notes being locked up in pension funds and other buy-and-hold investors can lead frictions that distort prices, and in particular can make it easier to squeeze the market.  Physical ETFs could have the same effect.  Moreover, as a general matter, and as I opined in my original piece on the subject, whereas with derivatives investors can get exposure to particular risks without holding the actual underlying, if physical ETFs are the only way to get exposure to particular commodity price risks, there is an additional constraint that can effect prices as operating under the constraint, to meet portfolio objectives investors may decide to hold inventories of copper that would be released for consumption had investors been able to achieve these objectives through the derivatives market.

At the very least, CFTC should investigate thoroughly the effect of speculative limits on the scale of physical ETFs, and the effect of physical ETFs on the cash markets.  But Gensler’s remark in the Reuters interview makes it evident that he, at least, considers the entire issue irrelevant to the entire position limit exercise.  That’s wrong, and just plain wrongheaded.

You might argue that this development was unintended by the drafters of Frank-n-Dodd.  You can no longer say that it is unanticipated.  Regulators should attempt to determine how market participants will react to their dictates, and plan accordingly.  Saying “it’s not my problem, man” doesn’t cut it.

Unintended consequences, that is.

ETFs have been a big deal for several years now, including commodity ETFs.  Heretofore, the big commodity ETFs have been in energy, but now several firms have metals ETFs in the offing.

Most traditional ETFs have bought futures contracts.  So the US Oil Fund, for instance, buys NYMEX light crude futures.  As the contracts it holds near expiry, it rolls forward into deferred contracts, buying the deferred and selling the nearby.

But the new metals ETFs will invest in, and hold stocks of, physical metal rather than derivatives.  FT Alphaville, quoting from a JP Morgan prospectus for its new copper ETF, has the details:

Firstly, being physically backed and not futures-based — the trust will escape all regulatory restrictions governing the size and scope of its speculative commodity positions (since there’s no exchange presence). No USO or UNG implosion danger here.

As the documentation states:

The Trust will take delivery of Physical Copper in the form of LME Copper Cathodes. Because the Trust will not trade in copper futures contracts on any futures exchange, the Trust will not be regulated by the CFTC under the Commodity Exchange Act as a “commodity pool,” and will not be operated by a CFTC-regulated commodity pool operator. Investors in the Trust will not receive the regulatory protections afforded to investors in regulated commodity pools, nor may the COMEX or any futures exchange enforce its rules with respect to the Trust’s activities. In addition, investors in the Trust will not benefit from the protections afforded to investors in copper futures contracts on regulated futures exchanges.

Note, too, that as a result it is likely that the ETF will not be subject to position limits.  And I think this is a big part of the reason for going physical.

The construction of the fund to avoid regulation is clear as day.  The effects are not likely to be good.  The advantage of using derivatives (futures or swaps) to construct ETFs is that it makes it possible to achieve an arbitrarily large exposure to the price risk of the underlying (oil, or copper, or whatever) without ever handling the physical.  That is, derivatives allow the unbundling of the price risk and the holding of the physical product.  This lowers transactions costs, and crucially permits investors to achieve portfolio and risk objectives without being constrained by the size of the physical market.

In contrast, physical ETFs cannot exploit this unbundling.  But apparently, the benefits of avoiding position limits and other regulatory costs are sufficiently great to justify the loss of efficiencies associated with this unbundling.  (If the bundled risk-physical solution were better than the unbundled one, you would have seen physical ETFs when the regulatory constraint wasn’t a real threat.)

There is a perverse irony here.  The whole rationale (supposedly) for position limits is that speculation somehow distorts physical markets.  There is precious little evidence, outside of a few extreme examples (e.g., the Hunts) that this is a real problem.  But by driving those that want exposure to metals prices, either for speculative reasons, or for portfolio balancing reasons, regulations are making it more likely that speculation will distort prices and the physical markets.

I’m not saying this will happen, or will be chronic.  Only that distortions are more likely in the bundled world than the unbundled one in which ETFs trade in derivatives rather than the physical.  ETFs that roll aren’t in the physical market, rolling out of expiring positions before they can go physical.  This limits, and likely eliminates, their effect on prompt prices and consumption, production, and storage decisions.

In contrast, ETFs that hold the physical are by definition in the physical market, and there can be a conflict between the risk and profit objectives of physical ETF holders and the efficient allocation of physical supplies; those desiring exposure to metal price risk might hold onto stocks when it would be optimal to consume them instead.  Conversely, in an unbundled world, traders can maintain exposure to the price risk without having any influence on the use of the metal.

I can also imagine some manipulation strategies that exploit the physical ETF.  For instance, somebody could obtain a big physical position via the ETF, and use that to create or enhance market power in the derivatives market.  That is, the ETF can be a way of “locking up” metal that would otherwise be available for delivery, thereby enhancing market power in the derivatives market.

I said this was a perverse irony.  It’s actually more perverse than ironic.  A policy intended to reduce (probably chimerical) distortions in the physical market actually increases the likelihood that such distortions will occur.  That’s the kind of havoc that Sorcerers’ Apprentices wreak.  Get used to a lot of that going around.

Last Friday the WSJ ran an interesting article comparing the ruble to other commodity currencies.  Whereas the Australian and Canadian Dollar, South African Rand, and the Norwegian Kroner have rallied smartly against the dollar since June, with double digit percentage gains, the ruble is down about 6 percent.  This is symptomatic of a sluggish economy.  There is other information consistent with this interpretation:

Russia does not believe that the crisis is over – whatever the government spin might say.

And while the official line is that the country is open for business and investment is not only welcome but safe and secure, both incomes and spending are falling, says the Federal Statistics Service (Rosstat), and this is bumping up inflation as goods stay on the shelves.

“Demand is now in a state of crisis,” warns Association of Retail Companies (AKORT) executive director Ilya Belonovsky.

“We’ll be doing well if mid to late 2011 we return to the pre-crisis levels of consumer spending that we had in 2007-2008,” he told gzt.ru.

The economy is at a standstill and worried Russians are squirreling money away for a rainy day as instability stretches further into the future, creating a vicious cycle, Komsomolskaya Pravda reported.

Talking themselves into trouble

Rosstat’s gloomy prognosis does more than make the government look unreasonably optimistic. “[Prime minister] Vladimir Putin has regularly said that everything is in order, that the economy is going uphill. In actual fact there are no grounds for these kinds of statements,” Higher School of Economics (HSE) scientific director Evgeny Yasin told gzt.ru.

All it means is that when people see that the good news is not true people will be disappointed and not believe the next swathe of promises, he says. “There is no correlation between what is really happening and what our leaders are saying.”

Russia truly is the sick BRIC.  It should be benefitting from the growth in other emerging markets and the resultant increase in demand for its raw materials.  If it is benefitting, its lagging overall performance indicates even more acute problems elsewhere in the economy; that is, the raw materials sector is obscuring a truly bleak picture in other sectors.

Indeed, emerging markets are the primary beneficiaries of Helicopter Ben’s insanely loose monetary policy.  Their currencies are appreciating too as investors are taking dollars, buying EM currencies, and investing in those countries.  But the ruble is missing out on this: indeed, as the WSJ article shows, private capital is actually flowing out of Russia.  Benchmarking this outflow against the surging inflows in EMs (including other BRICS) makes the Russian performance look even more anemic.

This is another indication that putting Russia in the company of China, India, Brazil, and other emerging markets is flawed.  The comparison is not at all flattering to Russia.  Putin can brag as much as he wants, but the numbers tell a far less optimistic story.

If there is a silver lining in this for Russia, it is that the leakage of US monetary stimulus to EMs puts a lot of stress on those economies.  They tend to bubble, and those bubbles can–will–burst.  Russia isn’t bubbling, to say the least, so it has no bubble to burst.  That’s good news in a way, and reduces some of the pressure on Russian policy makers.  But a bursting EM bubble wouldn’t do Russia any favors, as that would hammer demand for its exports (think 1998).   Not a pretty thought.

This FT Beyond Brics post raises an interesting issue:

BP is having to eat humble pie. Two years ago, it fought a bitter battle with Fridman and his partners in AAR, the holding company that holds their TNK stake, over influence at TNK-BP, which ended with a truce after Bob Dudley, the joint venture’s chief executive fled Russia. Among the points of dispute was whether TNK-BP should be a Russia-focused company, as BP wished, or go international, as the Russian partners demanded.

Even before Macondo, it was clear that Fridman and friends had come out on top, with BP’s Dudley being replaced by a Russian chief executive. The latest deal sees the Russian shareholders gaining further ground – putting the joint venture’s hard cash into international expansion. [Emphasis added.]

Interesting, isn’t it, that it’s the Russian owners of BP-TNK who are so anxious to invest outside of Russia?  (Ditto Rosneft’s recent splurge for PDVSA refining assets in Germany.)

That desire by Russian firms to invest cash flows generated inside Russia outside the country even in the energy business (where Russia presumably has its greatest attraction because of the often-touted untapped oil and gas reserves there), says a lot about the investment climate there.  And it doesn’t say anything good.  We’re constantly lectured that Russian assets are undervalued; the investment prospects there are amazing; there’s a lot of money just lying around to be picked up.

If all that’s true, why don’t Fridman et al pick up the money and buy all those undervalued assets in Russia?

If Russian oligarchs aren’t too wild about investing their capital in Russia, Putin’s new initiatives to attract foreign investment are facing a serious uphill climb.  That’s especially true in light of stories like this one:

After an arduous 17 years in Russia, Motorola is finally throwing in the towel – and for good reason. Once the country’s leading mobile phone producer, Motorola saw its market share drop from 20 per cent to 1 per cent in a few years, while it became embroiled in a local scandal.

Motorola’s exit is another reminder of why multinationals get so nervous investing in Russia – and it comes in the very week when the government launched a new drive for foreign investors.

Motorola’s troubles date back to 2006 when a $20m-shipment of its phones to local retailer Yevroset was seized by the interior ministry’s economic crimes department. The phones were first declared contraband, then counterfeit, and finally, when the other two claims were disproved, a health hazard.

Putin’s plan to address these kinds of horror stories?  Appoint an ombudsman.  In my experience, “ombudsman” means “reputational window dressing: somebody appointed to make it look like an authority with a reputation problem is doing something, but really isn’t.”  Ombudsman also means no real authority, no resources, and no power.

So yeah, that’ll work.

This story has many SWP angles.  Economist–check.  Gazprom–check.  Death by gunshot–check:

A senior economist at Russia‘s biggest company, Gazprom (GAZP.MM), was found dead in his car with a gunshot wound to the head, the company and police said on Monday.

Sergei Klyuka was chief economist in the finance department at state-controlled gas monopoly, which is also the world’s biggest gas producer.

“(Klyuka)…was found dead,” Gazprom said in a terse statement. “The police are inquiring into the cause of the death.”

Klyuka’s body was found early on Sunday in the front seat of his Range Rover in an underground garage in Moscow, with a gunshot wound to the head, the Interfax news agency cited an unidentified police source as saying.

Police suspect suicide, though there was no suicide note, Interfax cited the source as saying. A Czech-made handgun was found near the seat, the report said.

I ask this question in all seriousness, and in full knowledge that the suicide rate in Russia is very high (as is the murder rate): do Moscow police ever not immediately suspect suicide if they have even the shakiest pretext for doing so?  I’m sure investigations of the violent deaths of relatively high up people (albeit in a staff role) at companies like Gazprom could be time consuming, and could lead to places that could create, shall we say, complications.  So just rubber stamping “suicide” on the case makes things easy and tidy.  And knowing that, a murderer (especially a pro) knows that just dropping the weapon at the side of somebody he’s (or she’s) just popped is an easy way to give the cops an excuse not to probe too closely.

Yes, this may sound cynical, but I’ve been following and writing about Russia for long enough to realize the wisdom of Lily Tomlin’s words: we try to be cynical, but it’s hard to keep up.  (BTW, reading “The New Nobility” only stokes the cynicism.)  And it’s a sad commentary that the credibility of the militia is so low that one is predisposed to doubt any statement they make.

Halloween is fast approaching, and Gazprom is getting into the spirit (no pun intended) of the holiday by trying to scare the children in Europe.  (No trip to the costume shop required.  Gazprom is a monster in real life.)

Specifically, Gazprom is telling lurid horror stories about what would happen if, heaven forfend, the EU limits Gazprom’s ownership and control over a pipeline from the Yamal Peninsula through Poland to Europe, and Europe moves away from long term contracts to spot contracting:

Medvedev said the EU initiatives forced Gazprom to change its operational routine to adjust to new rules under which customers have the right to change their nominations once, on the day before supply instead of several times a day. Gazprom now maintains backup transmission capacities to meet the quickly changing demand but under the new rules this is unfair competition, he said.

“It will be very difficult to provide the envisaged reliability and flexibility of supplies without such backup capacities… Taking into account seasonality and an extremely uneven demand throughout the day – reliability and flexibility are of paramount importance for the gas industry,” Medvedev said.

Medvedev also criticized EU plans to switch to a spot market mechanism of gas supplies from long-term contracts favored by Gazprom saying the new mechanism would lead to higher prices.

“Without long-term price contracts the volume of gas coming to the market starts depending on the price appeal. The gas will be available when the price is high. If the price is low, volumes may outflow to more attractive markets or stored until better times. Hence, the reliability of European gas supply will be determined by the competition with other global gas markets, primarily, with Asian ones,” Medvedev said.

He said there were also risks for the development of gas transmission and storage capacities which required heavy investment with a long payback period unattractive to anyone but gas companies.

I’m sitting in the airport waiting out a delay, so I have a lot of time–which is a good thing because The Other Medvedev’s (“TOM”) economic epistle is so chock-full of silliness it will take a while to deconstruct it.

My favorite part is the paragraph beginning: “Without long-term price contracts the volume of gas coming to the market starts depending on the price appeal.”  Uhm, isn’t that the whole idea?  Aren’t prices supposed to guide the allocation of resources to their highest value use?  Is TOM saying that gas currently doesn’t flow to the highest value users?  Isn’t it the point that high prices signal high demand and that volumes should respond accordingly?  And that the reverse is true?

A very telling example of Gazprom’s market-phobia.

Note the use of the scare word: “reliability.”  This suggests that gas will be turned off in a spot market regime.  Hardly.  If gas is scarce, the price will be high, but you can get it if you want to pay for it.

Furthermore, TOM could use a little schooling on the Coase theorem.  A long term contract with the Europeans gives them the right to receive the gas.  But if there is a higher value use for the gas–consuming it later, selling it to another market–those holding that right have an incentive to forego consumption and enter into transactions that ensure that the gas flows to that higher value use.  Basically what a long term contract would do is let the fixed price buyer capture the value of the gas when that value is high (and above the contract price), whereas Gazprom could capture it in a high price regime; the flip side is that the fixed price buyer overpays when the value is low (below the contract price).  So, to a first approximation, the form of contracting won’t affect where and when the gas flows, but will affect the allocation of surplus among the parties.

This analysis, of course, assumes that the parties adhere to the terms of a long term contract.  But Gazprom has an incentive to–and has in the past–acted in an opportunistic fashion.  When the value of gas exceeds the contract price, Gazprom has an incentive to renege opportunistically in order to capture the surplus that would otherwise go to the buyers under the contract.  If the shoe is on the other foot, of course, Gazprom will insist on rigorous adherence to the contract.  Opportunism is costly, as are the governance mechanisms to control it.

Insofar as price certainty is concerned, the development of a robust spot market for gas will facilitate the parallel development of a robust derivatives market for allocating price risk.  A spot market plus derivatives market facilitates efficient allocation of physical gas and gas price risk, while economizing on the contracting hazards inherent in the kinds of long term deals that Gazprom favors.

Note how Gazprom rattles the Asian market skeleton to scare the kiddies–another nice Halloween touch.  Sorry.  That’s getting a little old.  And especially when you’re talking about gas from Yamal, which is way out of position relative to China and other Asian markets.

Insofar as operational efficiency and flexibility are concerned, TOM acts as if he’s never heard of the vibrant North American market for natural gas that has been operating on open access principles for going on 25 years now.  Common carrier pipelines with markets for capacity, gas, storage services, and no integration of producers, transporters, and buyers work incredibly efficiently in North America.  Believe it or not, weather in North America can shift dramatically, leading to equally abrupt changes in the demand for gas.  Moreover, there can be supply disruptions (e.g., hurricanes, pipeline blowups).  Nonetheless, the price mechanism and the array of markets for the myriad, complementary services required to get gas from where it is to where it’s needed deal quite effectively with this fundamental volatility, and on a continental scale.  Gas flows from the frozen Canadian plains and the semi-tropical waters of the Gulf to every point in between on the continent, and can respond fluidly to the twists and turns of the weather, production, and industrial demand.  In short, the post-1986 experience in the US demonstrates that it is possible to achieve the “reliability and flexibility [that are] of paramount importance to the gas industry” without monopoly and vertical integration.

As to “risks for the development of gas transmission and storage capacities which required heavy investment with a long payback period unattractive to anyone but gas companies,” is TOM saying that Gazprom is willing to accept rates of return that do not compensate adequately for risk and the time value of money?  If so, that sounds like another reason to support a market-oriented approach that will employ capital more effectively.

And again, the US experience demonstrates that investors responding to market price signals are perfectly capable of making appropriate investments in transmission and storage.  Indeed, financial players have found investment in storage or acquisition of rights to use storage facilities quite profitable, and have used their knowledge of optionality to maximize the returns to such investments.  (There are a lot of real options in a storage facility, most notably over choosing the timing of inflows and outflows.)  And in the bargain, this rigorous approach to understanding and exploiting the optionality of storage has served to enhance market efficiency, flexibility, and reliability.

In brief, TOM is either a blinkered ignoramus with no knowledge of economics or of the gas market outside his cozy little (well, not little) monopoly, or he is shoveling it fast and furious. Sounds like a pick ’em to me.

This means that nobody should be scared of Medvedev’s Tales from the Crypt.  Indeed, the very developments that Gazprom fears would be a boon for its consumers.

The headline of the Ria Novosti article is “Gazprom says EU gas reform a threat to the company,” which makes it clear that Gazprom is the one running scared.  That threat may well may be a very real one.  And that would be more like Christmas than Halloween, at least to those currently dependent on Gazprom for a good share of their gas.  So this is a RN headline that I hope comes true.