Streetwise Professor

The Ukraine-Russia gas-lease deal is hugely controversial within Ukraine.  The passage of the bill in the Rada was accompanied by civil disobedience, not to say near riot.  It is also somewhat controversial in Russia.  Putin has claimed that it will be extremely expensive for his country, but that it is necessary to cement ties between the two countries.

Independent commentary is broadly split.  Alexander Golts argues that Yanukovich took Medvedev and Putin to the cleaners:

The Duke of Wellington used to say some victories are worse than defeat. I suspect that President Dmitry Medvedev’s “brilliant diplomatic victory” in Kharkiv on behalf of Russia’s Black Sea Fleet will in reality create very serious problems for Russia in the future.

. . . .

Mindful of how they got burned by Bakiyev and Lukashenko, Medvedev and Putin decided not to fall in the same trap with Yanukovych. But this is exactly what happened. With the lower gas prices to take effect immediately, Ukraine can now save roughly $4 billion annually, whereas the lease extension will only take effect only after the current agreement expires in 2017.

At the same time, Ukrainian opposition parties have made it clear that once they come to power, they will annul the agreement.

. . . .

Yanukovych has already made the Kremlin a hostage to his hold on power — and he has been in office for only two months. Now Moscow has a deeply vested interest in seeing that Yanukovych or another member of the Party of the Regions remains in power right up through 2042. And the $4 billion per year in gas discounts that Russia has already promised Ukraine could turn out to small potatoes compared with the sums Yanukovych could demand from Russia in the years ahead, knowing that he has the upper hand in the relationship.

Conversely, Stephen Blank (whom I consider the most trenchant American commentor on Russia), believes this is a major coup for Russia:

However, in numerous ways this short-term deal represents a defeat for Ukraine and a massive victory for Russia. Kyiv loses because the BSF and its accompanying socio-political-economic-cultural infrastructure enable Russia to keep the Crimea, and thus Ukraine, in a permanent condition of de facto circumscribed and limited sovereignty. Moscow will retain all its points of leverage over Kyiv and gain more because the deal allows Russia to build two nuclear reactors in Ukraine and preserve its nuclear monopoly there (as an alternative to gas). Apart from this limitation on Ukraine’s effective sovereignty, Moscow also reinforces its tangible leverage over Kyiv by restoring its dependence on Russian subsidies and preserving Ukraine’s non-transparent gas economy. Third, it prevents Ukrainian democratization and market reforms. Fourth, it thereby inhibits Kyiv’s moves towards the IMF, and ultimately the EU. Fifth, given the lease’s duration of 25 years, with an option to renew for another five years, this deal all but ensures that future Ukrainian governments will be stuck with a minority controlled by Moscow in the Crimea, and will find it very difficult to move westwards towards the EU or NATO until 2042, if not later.

This deal also has profound implications for Ukrainian and European gas supplies. Russia is intensifying its work with Ukraine on the aforementioned consortium to restructure its gas network (RIA Novosti, April 22). Nonetheless, with Ukraine firmly dependent on Russia, Moscow will gain more leverage upon it because it is pushing hard for South Stream, which will essentially bypass Ukraine as regards supplying Central and Southeastern Europe. If South Stream proceeds, as Moscow hopes, it will isolate Ukraine from Europe even more.

The fundamental difference between Golts’s analysis and Blank’s is that Golts believes that the deal isn’t worth the paper it was written on, whereas Blank’s opinion is predicated on the assumption that Ukraine and Russia will adhere to the agreement.

In my initial take on the deal, I raised repeatedly the issue of performance on the agreement.  Consequently, I am very sympathetic to Golts’s take (although, unlike him, I view it as a potential feature rather than a definite bug).  There is a serious asynchronicity in performance under the deal.  Ukraine’s obligations don’t kick in until 2017, but Russia’s take effect immediately.  And with the uncertainty about what will happen in the gas markets in the coming years, with all the pipeline projects and shale gas and LNG, getting immediate price relief while retaining the option to act opportunistically in the future makes good sense for Ukraine.

It is also quite reasonable to conclude that Ukraine really didn’t give up anything.  Fast forward to 2017, and the expiration of the existing lease.  Can you imagine the potential for conflict?  Do you really think Russia would pick up and leave, willingly and meekly?  Don’t you think that there would be brinksmanship, blackmail, threats, bribery, political chicanery?  I would say that it was doubtful, at best, that Russia would leave, and if it did, it would only be after a period of substantial tension and uncertainty.

Most of the things Blank mentions would have remained with or without the deal.  Russia would have retained leverage over Ukraine (due to energy, and other things) without the deal.  Ukraine’s move west was pretty much a dead letter anyways, all the more because of Obama’s cosmic indifference to it, and his self-deluding man crush on Medvedev.

You also have to consider the alternatives.  Blank mentions three:

It had three alternatives: the first, which it pursued, was to offer Moscow a share in a consortium alongside Ukraine and the EU, to manage the reorganization of the Ukrainian gas distribution network. Moscow turned this down, not wanting to be part of a consortium in regard to reforming the Ukrainian gas network, because it would not have a controlling share and, equally importantly, opportunities for corruption in the current status quo constitute the foundation of much of Russia’s gas wealth and leverage upon Ukraine and other East European states. If there is to be a consortium, Moscow wants it to be one that it controls.

Kyiv’s second alternative was to bite the bullet and institute reforms within its gas economy (Kyiv Post, April 15). Yet, that course alienates President Yanukovych’s power base, which depends on cheap gas and non-transparent deals.

The third alternative is the deal that was struck.

Given that Ukraine is a deeply divided, and even more than typically dysfunctional ex-Sov polity, Blank’s second alternative (reform) is, no pun intended, a pipe dream.  Yes, it would be nice, but ain’t gonna happen.

Blank’s scorn of the Europeans is well merited.  They are hopeless when it comes to a robust, united stance on Russia.  Moreover, with the fissioning fiscal situation (Greece today, Portugal tomorrow, then maybe Spain, and Italy), Europe will be even more distracted, and less interested in getting involved in messy intrigues in the FSU.  Combine that with the don’t-give-a-damn attitude of the US, Russia will have little foreign opposition in its efforts to restore its suzerainty over its former dominions.  If the US doesn’t take the lead, nobody will.

The biggest risk to Russia in the deal is that Ukraine reneges–although, given that possession is nine points of the law, even absent a deal getting Russia out of Crimea would be dicey at best.

The biggest risk to Ukraine is that Russia reneges.  Indeed, I think that is almost inevitable.  This deal does not change the bilateral monopoly situation that characterizes the Russian and Ukrainian gas systems.  And any likely changes in the near term, e.g., the completion of South Stream, will enhance Moscow’s bargaining power.  There is little on the horizon that would enhance Kiev’s.  Russia will find many excuses to jack the price in the future, when it suits it.

So, my view is that this is just an interlude in the ongoing battle of bilateral opportunism between two fundamentally corrupt and unprincipled states.  Remember the old Soviet joke: “We pretend to work and they pretend to pay us”?  Well, I’d characterize this deal as “We pretend to give them a price break, and they pretend to extend our lease.”  All this deal does is create more promises to be broken.  And broken they will be.

Sergei Guriev and Ekaterina Zhuravskaya of Moscow’s New Economic School have produced an excellent paper comparing Russia with South Korea.  The starting point of their analysis is the superficial similarity between South Korean economic growth performance in the 1980s-1990s, and Russia’s performance in the 1990s and 2000s (i.e., lagged about 11 years).  This similarity is sometimes touted as evidence that Russia is the next South Korea development miracle.

Not so fast, there, say Sergei and Katia.  There are huge differences between South Korea and Russia.  Notably, virtually 50 percent the latter’s growth is (per calculations by Guriev and Tysvinski cited in the paper)  is attributable to natural resources (notably oil), whereas none of Korea’s is.

More importantly, the authors emphasize that when evaluating future prospects for growth, it is necessary to take account of the staggering institutional gap between Russia and Korea.  By all measures, both contemporary, and comparing Russia today to South Korea in the late-1990s, Russia’s institutions are extremely weak relative to Korea’s, and this weakness is inimical to growth.  Sergei and Katia argue that, without a substantial improvement in Russia’s political and economic institutions, notably its protection of property rights, Russia has no chance at being a Eurasian Tiger.  No chance.

And here’s where their analysis is particularly pessimistic.  They emphasize the interaction between the resource rents that have accounted for huge share of Russia’s growth, and the prospect for developing growth-supporting, modernization-supporting institutions; specifically, they note that the resource curse undermines the development of robust market-supporting institutions.  They further note that, consistent with the predictions of a good portion of the resource curse literature, the energy and resource boom in Russia has led the elites to take measures to reinforce the status quo in order to protect their access to resource rents.  That is, the resource boom has coincided with a weakening of institutions, and the still-birth of any modernization efforts.  (The reinforcement of the power vertical and the erosion of federalism are the main examples they discuss.)

None of this should be a shock to SWP readers.  Guriev and Zhuravskaya are advancing arguments and evidence that I’ve been making for the past four years.

For those giddy with the success of a bond sale, or the nascent signs of a Russian economic recovery on the back of strong oil prices, the Guriev-Zhuravskaya analysis should be a bracing corrective.   The long term prospects for Russia’s development as anything other than a resource appendage, at the mercy of the economic prospects of the rest of the world (which determine the demand for the country’s resources), depend crucially on the development of strong institutions that constrain kleptocracy, corruption, expropriation, and rent seeking.  But, ironically, the dynamics of a resource-oriented polity are inimical to the development of those strong institutions.

This implies, as G-Z state,

that Russia’s long-term prospets are rather bleak. . . . Russia is very likely to embark on a slow-growth trajectory.  Even in the best-case scenario, it will not catch up with the advanced economies in the foreseeable future, and in the worst case, Russia will follow the fate of the Soviet Union.

Put differently, in SWP-ese: Russia: In economic purgatory for the foreseeable future.

Three stories about Russia caught my eye.

Story number one: Playing the Sorcerer’s Apprentice comes with its own particular risks.  Not long after Putin played the cat with the canary over the Russian role in the overthrow of the Bakiyev government in Kyrgyzstan, Russia is now anxious since that country is at risk of spinning out of control.

Russia has already made noises about protecting militarily Russians in the Central Asian country.  Given that (a) Russia has already announced a policy that it reserves the right to protect Russians abroad, and (b) “protection of Russian citizens” was a pretext for the invasion and de facto annexation of Abkhazia and South Ossetia, this could be a prelude to a Russian military intervention in Kyrgyzstan.  But I doubt this is an appealing option to the Kremlin–or to the Russian White House (which is what probably matters).  Military engagement in Kyrgyzstan would be a far different kettle of fish from the invasion of Georgia, since (a) Kyrgyzstan is not continguous to Russia, and hence would present some serious logistical issues, and (b) intervening in a civil war in a backwards, Muslim country would bring back bad memories, and the prospect of a thankless and pointless task with no readily identifiable end game.

So, driven by its obsessive desire to hamper US and NATO operations in Afghanistan, and to deny the US any presence in Central Asia, Russia has contributed to the creation of a mess that it will present it with few appealing options.  (Not to mention that hampering US/NATO operations is completely contrary to its continued whinging about the NATO failure to eradicate, or even target, Afghan opium production.)

Be careful what you ask for: words to live by.

Story number two: Ukraine and Russia have apparently concluded a deal whereby Ukraine will extend the Russian lease on the Sevastapol naval base in exchange for discounted prices on gas.  Before commenting further, I should say that using “concluded” and “a deal” in any sentence involving either Russia or Ukraine, and especially involving Russia AND Ukraine, is quite dangerous.  No deal is ever really concluded when these jokers are involved.

In some respects, this is good news (again, to the extent that the deal is real, and not just the forum for ex post opportunism by one side, the other, or both in the months and years to come).  First, it provides Russia relief on gas prices without Ukraine conceding any control over its gas infrastructure to Russia.  (Though this means that that infrastructure could become a flash point in some future dispute.)  Second, it reduces the prospect for conflict in 2017, which would have been almost inevitable if Ukraine had attempted to force out the Russian Black Seas Fleet.   Third, it may also reduce tensions with Georgia (reduce, but not eliminate) because if forced from Sevastapol, Russia was considering building a naval base in Abkhazia, which would have created numerous problems in the region.  It is also probably a net economic winner for Russia, as it saves itself the cost of building a new base for its (shambolic) fleet.

Story number three: Gazprom earned the world’s largest profit in 2009, but was a distant 30th in market capitalization.  Little needs to be said of this: it is yet another testament to how aggressively the market discounts the future prospects of Russian companies, and for good reason.

As derivatives legislation wends its way through the Senate, with the Dodd bill and another being written in the Senate Ag committee, the battlelines are pretty well drawn.  The administration in particular is still on the clearing bandwagon, and is overtly hostile to any proposals to exempt end users from the clearing requirement.  The most strident rhetoric on this issue emanates from Gary Gensler (go figure), but also from Treasury.  Deputy Treasury Secretary Neal Wolin said: “we will oppose all attempts to create loopholes or carve-outs.”

By “carve outs,” he is referring to end user exemptions, primarily.  Which is all so ironic.  If you think through how clearing works in futures markets, it is primarily a mechanism to shift default risks from end user customers (the buy side) to the clearinghouse members.  That is, it is a customer protection institution.  But here many customers are adamantly opposed.  Thus, there must be some costs that offset–and indeed, more than offset–the benefits associated with this customer protection.

But instead of an effort to step back, and ask “why” and consider in an intellectually serious way what are the costs and benefits of clearing, the administration and many on Capitol Hill plunge ahead.  When they attempt to explain end user opposition at all, they stoop to asinine conspiracy theories.  Gensler, for instance, attributes the end user opposition to their being waterboys for the dealer banks.

Yeah, Caterpillar, etc., are just creatures of the banks.  Whatever, Gary.

But this is all so odd.  Gensler argues that the dealer banks routinely rape their customers, by exploiting the purported lack of transparency in the OTC market to extract supercompetitive spreads.

So, why would the rape victims (in one of Gensler’s narratives) be the willing supplicants of the banks (in another)?  Stockholm Syndrome?  Battered Spouse Syndrome?

Can we please have a serious discussion, with some serious analysis of trade-offs, rather than these dueling, and facially inconsistent, morality tales?

Yeah, I know.

But I will say that in Europe they are being far more serious and adult.  (And it kills me to have to say that.)  For instance, Jeremy Grant reports that European regulators recognize the legitimacy of end user concerns:

Industrial companies have won recognition from European regulators that they should be granted exemptions from sweeping regulation of the over-the-counter derivatives markets.

It marks a partial victory amid fears that a crackdown on off-exchange derivatives markets, blamed by some for exacerbating the financial crisis, could unfairly penalise corporate users of such instruments.

. . . .

In a “discussion paper” from the European Commission’s directorate general for internal markets, regulators say that “in principle, non-financial institutions could be exempt from the clearing obligation”.

It says the main mechanism for transferring risk to the real economy during the crisis was through the financial sector. “This suggests that the appropriate boundary for a clearing obligation is between the financial sector and the non-financial sector.”

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “This suggests that [the Commission] supports the need for an exemption for non-financial users. It is certainly the first time that we’ve seen such a clear statement.”

Eact in January sent a letter to Brussels, signed by 160 companies, warning that without exemptions there could be “a reduction in the amount of funds allocated to productive investment in the [European] economy”.

Just how to structure the exemption is still under discussion.  But at least there is a recognition that there are serious issues that deserve serious discussion.

Could somebody in Europe pick up the clue phone and give Gensler and Wolin and Dodd a call?

Grant also reports that the Europeans recognize that clearing is not the deus ex machina that will descend from the heavens and solve all the systemic risk problems.  Indeed, they understand that clearinghouses can create systemic risks, and hence it is advisable to proceed carefully in ordering a new market structure by fiat:

Watchdogs are concerned about the possibility that proposed linkages between clearing houses could pose fresh dangers to the financial system.

They fear two-way or three-way linkages between clearers could trigger a domino effect if one clearer was to default.

What?  You mean that clearing doesn’t eliminate interconnections in the financial system?  Who knew?  (I know who doesn’t know, sad to say.)

In fact, contrary to the bologna constantly ground out by Timmy! and Gensler et al, clearing creates a particular interconnection among financial institutions–the same financial institutions (by and large) that are too interconnected today in the OTC market.  Multiple clearinghouses creates another set of linkages.  These can by systemically problematic.

The Europeans haven’t sorted through all these issues yet.  But at least they recognize them.  We, alas, are governed by know nothings masquerading as know it alls.

Which suggests a new administration spokesman on derivatives market regulation.

Ralph Peters considers why Russia has not been able to “crush” its Islamists.  He also analyzes why Russia feels compelled to wage a bitter battle for a backwards corner of the old empire inhabited by poor and largely ignorant people who are truly alien to most Russians:

After 300 years, the Russians are still seen as occupiers — and see themselves as such. Yet Putin can’t bear the thought of letting Daghestan or Chechnya go — for two reasons: As a rabid nationalist, he won’t give up another inch of the Russian empire. And he fears that letting one small territory secede might trigger a rush for the exits on the part of other frustrated Russian regions.

Yes, nationalism, imperialism, and reputational effects are part of the Russian (and Putin’s) bloody minded determination to keep Chechnya and neighboring Daghestan and Ingushetia in the Russian Federation.  But remember, this is not only a Putinist determination.  Yeltsin, who was content to let the USSR collapse, and who didn’t thirst to maintain Russian hegemony over the wreck of the USSR (and the Russian Empire), launched the first Chechen War.  The motive for this war in the Caucasus lies at the heart of the Russian state.

There is something more going on here, and that something is energy.

With the construction of the Baku-Novorossiisk bypass in 1999, and the Azerbaijan-Georgia pipeline, the pipe through Chechnya was not the sole route by which Azeri oil could be transported.  This reduced Chechnya’s direct relevance in the oil game, but Chechnya borders Daghestan, and Daghestan borders the Caspian.  In the 1990s the war in Chechnya threatened to spread to Daghestan, and even today, Daghestan is rent by violence.

The division of the Caspian and its massive energy riches has been stalemated for years.  There are competing proposals on how to divide the Caspian seabed.  The Russian one would base the division on the length of coastline.  Without Daghestan, Russia’s claim would shrink by almost 80 percent.  Clearly not acceptable to a natural state whose elite subsists on resource rents, and which views energy as the key to its retaining at least a simulacrum of great power status.  So, poor, backwards, and essentially non-Russian Daghestan is a vital to Russia’s energy ambitions.  And since an independent, Islamicist Chechnya would destabilize Daghestan, it is war to the knife in Chechnya and its environs.

In brief, the overriding reason that the Russian government fights so ferociously for Chechnya (but really for Daghestan), is the overriding reason it does most everything: energy rents.  And it is willing to do so even though that routinely brings the war to Russia proper, at the costs of hundreds of lives.

In the aftermath of the Moscow Metro bombings, Russians should consider whether “????? ?? ?????” is such a good deal after all.

Work demands (go figure!) and some recent travel (some work-related, some not) have put a crimp on the blogging, and the reading to feed the blogging.  So, I only have time for a few quick hits on Russia.

First, the substance of Putin’s put down of Hillary, rather than just the atmospherics, is intriguing.  For one thing, Putin used an official forum with the cabinet member of the United States to make a special pleading for individual Russian oligarchs.  Tame ones, of course, who do Putin’s bidding.  (And, perhaps more.  Which makes me wonder whether it was a special pleading for . . . Vladimir Putin.)  So much for Putin, scourge of the oligarchs.  (No Ivan IV he, in this regard.)  For another thing, the whinge about the collapse in trade betrayed a certain desperation, as did the lament about the low level of direct US investment in Russia.  A leader convinced that his nation was in the midst of a robust recovery, particularly a prickly, nationalist one like Putin, would not be likely to engage in such a public whine.  But one who has deep concerns about the economic future, and who is known for his tendencies to blame his and his country’s miseries on anybody else, especially anybody else with the initials USA, would be.  Not exactly a “Russia off its knees” moment.  Intriguing indeed to wonder why.

And Vladimir, if you wonder about the plummeting of foreign direct investment in Russia, and you want somebody to blame: look in the mirror, and curse the vaunted power vertical.  Consider, too, this story about Conoco’s divestiture of half its stake in the Russian oil firm Lukoil:

But its apparent decision could reflect the shift in dominance of Russia’s energy sector towards state-backed companies such as Rosneft and Gazpromneft, the oil arm of Gazprom, the state-controlled gas group.

This has left Lukoil by the wayside since Conoco first bought into it in 2004, analysts said.

Chris Weafer, chief strategist at Uralsib investment bank in Moscow says: “When they bought into Lukoil it was a time when it was positioned as Russia’s premier oil company.

“At the time they expected they would be able to use that relationship to expand further into Russia.

“But today the rules of the oil game have changed in Russia; today you are not in it unless you are partnered with a state company”.

“The catalyst for the sale comes from their debt position but the reason they are selling is because the competitive position they had with this company when they acquired it no longer exists.”

Rosneft emerged as Russia’s foremost oil producer from the state break-up of Mikhail Khodorkovsky’s Yukos, the target of earlier failed efforts by Exxon Mobil and Chevron of the US to gain entry into Russia’s oil sector via tie-ups with a local company.

Rosneft, Gazpromneft and Kremlin-friendly Surgutneftegaz are now seen as frontrunners for new licences to develop big new fields, while companies with foreign participation are treated with suspicion by the government, analysts said. [You don’t say.  “Suspicion” would be a good day.  Some companies throw parties when they are get promoted to suspicion.]

And, relatedly, TNK-BP, where the “blatant” expropriation is apparently  that the company walks away with nothing, whereas the kinder, gentler, non-blatant Sechin appropriation is that the company gets its initial investment back.  Which is better than nothing, but is still theft because a good deal of the value of such a property is the value of the option to invest optimally in the future.  Look, Vladimir, when the upside is always at political risk, don’t be surprised if FDI lags.

Next!  Russia’s military “reform” is now widely recognized as an abject failure:

Although the interview Gen. Nikolay Markov, the chief of the General Staff, gave to “Rossiiskaya gazeta” attracted fare more attention, the press conference Krivenko gave together with Soldiers Mothers Committee of Moscow chief Tatyana Kuznetsova and VTsIOM sociologist Konstantin Abramov provided many more details.

Speaking first, Krivenko explicitly stated that “the failure of military reform in the form in which it has been conducted up to now is recognized by the leadership of the country.” The planned shift to a largely professional force has failed, and the draft, given the reduced length of service the government has allowed, is not working either.

Plans for contract service have failed so far “not as a result of financial causes but as a result of the incompetent administrative decisions of the Defense Ministry,” Krivenko continued, but plans to try to rescue the situation by boosting the salaries of professionals still further would bust the budget, particularly if the relative number of less-well-paid draftees continues to fall.

But their numbers appear bound to fall, at least in the next few years, given the small size of the cohort born in the troubled 1990s. If the number of soldiers is to be kept at 700,000 and if draftees are to serve only one year, then the military would have to draft 700,000 young people each year, a number far exceeding the number in the prime draft age groups.

One could address that, he says, but forcing people who avoided service earlier and who are still under 35 years of age to serve, “but for this would be necessary another kind of state, and one can imagine just what it would be like.” Such “a draconian variant” is something no one is now seriously considering.

Krivenko stressed that “the president and the government understand this. And they understand that ahead is a dead end,” one from which the country can escape either by spending more money on the military, increasing the length of service for those who are drafted, or cutting the size of the services still further.

Increasing the length of service is the easiest in some ways: after all, Moscow did it in the 1990s, boosting the requirement from 18 months to two years. But Krivenko argued that there are two reasons Moscow might not want to go in that direction. First, “the difference between one year and two” “is qualitatively different” than the earlier much-smaller increase.

And two, such an increase could exacerbate social and political tensions, possibly having an impact, he explicitly suggests, on who will occupy the position of Russian president after the 2012 election. Consequently, decisions on force structure are likely to become more not less political in the coming months.

Guess they’ll just have to wait for that huge baby boom generation to grow up.  Yeah, right.

Lastly, the something for nothing gang strikes again.  Ukraine is seeking a deal to give up partial control over its pipeline system, in exchange for getting gas at a discount from European prices.  Russia’s response?  Yeah, we like the control thing, but fuggedibout any quid pro quo:

Russia’s OAO Gazprom does not view participation in a joint venture to manage Ukraine’s gas pipelines as sufficient grounds to lower the price Ukraine pays for imports of Russian natural gas, Kommersant reported, citing officials with the knowledge of the matter.

The dynamics of the Russian-Ukraine relationship will be quite interesting to watch.  I’m guessing Russia overplays its hand, either out of habit, overconfidence, desperation, or a confidence of all three.

I have a couple more items, but they’ll have to wait.

Prior to the health care wars, I only knew of Bart Stupak for his sponsorship of the “Prevent Unfair Manipulation of Prices Act,” related to energy speculation, which led me to ask: What is fair manipulation?  Indeed, when I testified about energy speculation before the House Ag Committee in July, 2008, the first question I received was about Stupak’s testimony on the previous day, in which he had compared speculation in energy futures markets in the 2000s to the Hunt Brothers in 1979-1980.  That one was teed up for me: I replied that Rep. Stupak had it exactly backwards.  A comparison of the Hunts to what had transpired in the oil markets in ’07-’08 in fact demonstrated how speculation almost certainly was not causing artificially high energy prices.

Stupak’s statements on speculation just marked him as an idiot.  His star turn in the health care drama marks him as a hypocritical, unprincipled, posing, publicity slut.

After seizing center stage, gaining all sorts of press attention for being the leader of a group of representatives whose no votes threatened to derail passage of the health care bill,  and making it seem like his opposition was a matter of deep principles about life and abortion; at the moment when the publicity potential was greatest; Stupak agreed to vote for the health care bill in exchange for a promise that Obama would sign an executive order preventing the expenditure of any federal money for abortion. He gets the spotlight.  He gets to speak on the floor.  And his so-called principles get heaved overboard.

In a post earlier today (which has already gotten 28 comments over at SeekingAlpha), I quoted Mark Twain: “I never can think of Judas Iscariot without losing my temper. To my mind Judas Iscariot was nothing but a low, mean, premature, Congressman.”  Seldom were truer words ever spoken.  For at least Iscariot got 30 pieces of silver:  Stupak got a fig leaf.  And a phony one at that.  It is phony because an executive order cannot override a statute.  This is just something that Stupak can wave in front of the gullible; a way to have his cake and eat it too.  To pretend that he won a victory on abortion AND saved the health care bill.

In fact, he saved the health care bill, but at the cost of his purported principles, for as soon as night follows day, government funds will be spent on abortion under the bill that is about to pass.  But, no doubt, he will gull enough people in his district that the executive order is actually more than a worthless piece of paper, and bask in the limelight that he evidently craves so desperately.

It should also be noted that if it were genuine, Stupak’s “compromise” would in fact compromise a jealously guarded right of the branch of government he serves: it is the Congress that has the right to appropriate money, not the executive, and Congress would never willingly surrender that right to the president.  But since this is all theater, political cover, Stupak isn’t compromising that right at all.

Damn how I wish Mark Twain were alive today, for I think only his pen could do justice to the presumptuous, unprincipled, hollow men and women that go by the epithet “Member of Congress.”

The Futures Industry Association, a trade group for futures commission merchants and exchanges, has come out strongly in opposition to the CFTC’s proposed energy position limits.  The most interesting thing to me about the FIA letter is the fact that one of the central pillars of its argument is similar to an objection I’ve been raising for some months: specifically, that the CFTC doesn’t have a legal leg to stand on because (a) Congress has authorized the CFTC to impose limits when “it is necessary to diminish, eliminate, or prevent” the “undue and unnecessary burden” of “excessive speculation” that causes “sudden or unreasonable fluctuations or unwarranted changes in the price” of any traded commodity, but (b) CFTC has made no finding that excessive speculation that causes unreasonable price fluctuations exists, or has existed, in energy products.  Indeed, it’s worse than that.  CFTC’s attitude has been “we don’t got to show you no steenking evidence.”  CFTC, and notably Chairman Gensler, have also invoked repeatedly the idea that concentration is a danger that should be controlled through position limits.  But the Commodity Exchange Act is silent on concentration in this context.

The FIA letter is quite blunt: “Substantively in the absence of the ‘necessary’ finding, the CFTC lacks the statutory authority to adopt position limits.”  FIA also states that “[t]he ‘excessive concentration’ and ‘uncontrolled speculation’ themes the CFTC cites are both factually unproven and legally irrelevant.”  The letter states further that the “‘excessive concentration’ focus is misguided.”  I agree with all this, and have said and written as much over the past year (or more).  I further agree with the FIA’s statement that “FIA is not aware of any convincing or even credible evidence that large traders with speculative positions in energy futures markets have trumped fundamentals as the determining factor in energy futures prices.”  (Emphasis in original.)  Again, agreed.

To summarize, like the FIA, I believe that the CFTC position limit proposal is unjustified and legally dubious.  It is unjustified because there is no credible evidence, or logical argument even, that speculation has distorted prices.  It would be nice to make policy on the basis of, you know, evidence, wouldn’t it?  (Isn’t this the administration that said it was going to base policy on science, not politics?)  It is legally dubious because the CFTC’s authority to impose limits is not absolute.  The CFTC can impose limits pursuant to a particular purpose laid out in statute, but the CFTC’s justification for its proposal (a) does not show that its limits are in fact necessary to achieve that purpose, and (b) includes considerations that are altogether absent from the statute.

This is regulatory overreach based on no evidence.  Other than that, it’s great!  Kudos to the FIA for joining me in pointing that out.

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

First Eni, and now German giant E.ON have negotiated contracts with Gazprom that weaken, though do not break the oil price-contractual gas price link.  E.On has entered into a contract which ties the price for a fraction of its purchases to spot gas prices:

E.ON’s gas unit has agreed with Gazprom on taking a “low double-digit” percentage of its supply at tariffs linked to spot market prices, Handelsblatt said yesterday, citing E.ON Ruhrgas AG chief Bernhard Reutersberg. The outcome of discussions with Gazprom may have been “more favorable than expected for E.ON,” Oppenheim Research GmbH analysts said in a note yesterday.

Gazprom is at pains to point out that its fundamental contracting practices remain unchanged:

Germany’s E.ON Ruhrgas (EONGn.DE) said on Friday it had completed talks on more flexible gas purchasing contracts with Gazprom, allowing one of Europe’s biggest Russian gas buyers to get a chunk of its contracted supplies at spot prices. [ID:nLDE61I149]

The shares of Gazprom traded 1.1 percent up at 1512 GMT, in line with the broader oil and gas index .MCXOG of Russia’s top bourse MICEX .

“The agreements reached do not put into question the fundamental principles — the system of long-term contracts, the “take-or-pay” principle and the pricing system based on a peg to a basket of oil products,” the Gazprom source added.

That’s all well and good, for now, but if there remains a large disconnect between oil prices and spot gas values, the “fundamental principles” are maladapted to current market conditions, and Gazprom will be under substantial pressure to compromise on these principles.

The European gas market remains fragmented, and the spot market is still early in its evolutionary process; national boundaries still matter, slowing the development of a robust market like that in the US.  (Thanks to Michelle Hallack for a very informative update on European gas market developments.)  Nonetheless, spot market liquidity is improving, and the development of LNG and the lack of need for LNG in the US (freeing up cargoes for the European market) will speed that development.  Moreover, successful shale plays in Europe would also facilitate development of a broader gas market.  All of these developments will undermine the need for long term take-or-pay contracts linked to oil.  The E.ON and Eni deals therefore likely represent just the beginning of a revolution in gas contracting in Europe, a development that will not redound to the benefit of Gazprom.