Streetwise Professor

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.

The Russian invasion of Ukraine has not shocked and awed the Ukrainian military, but it has shocked and awed Germany, fo’ sho’.

In a period of hours over the weekend (and remember, German stores close promptly at 6 and are not open on Sunday), Germany announced that it will:

(a) Increase defense spending to 2 pct of GDP.

(b) Build two new LNG import facilities.

(c) Consider delaying decommissioning its nukes.

(d) Consider all options for energy, including gas, nuclear, and coal: there are no longer any “taboos” on energy sources.

What will Greta say?:

The Germans are saying, in effect: Go away girl. The shit just got real.

I note that (a) and (b) topped the list of Donald Trump’s harangues against Germany, which caused the ruling class to shriek in anger: how dare he insult our dear allies? Actions speak far louder than an apology.

Alas, this reality therapy has not penetrated the thick skulls of the Biden administration. When asked about reversing Biden administration anti-fossil fuel policies, spokesmoron Jen Psaki instead continued to ride the renewables hobby horse. She thereby reinforced the message of the Most Clueless Man in the World, John Kerry, whose big concern about Ukraine is that it might distract Vladimir Putin from focusing on climate change.

Yes, reality is a mother. Enough of a mother to snap even the dreamy Germans out of their green and pacifistic reveries. But not enough of one to do the same in the Biden administration.

When playing Spin the Bottleneck with my students I say to look at what lies between the price of a transformed and untransformed commodity to identify the bottleneck. In my earlier post on the gaping spread between European (and Asian) LNG prices and the price of US gas (which is on the margin for both destinations) I noted two possible constraints: shipping and liquefaction capacity.

Well, it ain’t shipping.

There is a surfeit of LNG shipping capacity. So much that LNG shipping is effectively free between the US and Europe (down from $273K/day in December). Yet the spread remains very wide. So the binding constraint is definitely liquefaction capacity, in the US in particular. Those who have the rights to that capacity–notably firms that entered into contracts with the likes of Cheniere or Freeport that buy gas at the US price and pay a contractually fixed liquefaction/tolling fee–are coining it. They capture the bulk of the existing spread between TTF or UK Balancing Point prices and Henry Hub. (The LNG companies are benefitting only to the extent that they reserved some of their capacity for their own trading, which is rather de minimis).

So in the short run liquefaction capacity is quite valuable. The question is what will its value be over the longer term? Will current events convince enough financiers to provide capital for a large expansion of US capacity? Given the long gestation period of these projects it is a hard issue for banks and equity to analyze.

One thing to note. Another thing I discuss extensively in my classes is the importance of government/regulatory bottlenecks. Such bottlenecks may be a constraint on expansion of US LNG capacity. Many of the projects under development do not have the requisite federal permits. The Biden administration is unlikely to grant more. Thus, like taxicab medallions in NYC, existing permits likely have a substantial scarcity value–thanks to a government-created bottleneck.

This has interesting implications for financing of US LNG projects. Financiers of a given project face less risk of a glut of capacity coming online in a few years, and this should make them more willing to finance already permitted projects. But, of course, they are taking on political risk by doing so: might a new administration change course post-2024? Or might political pressure induce a change in course by the current administration? There are already a lot of political risks in investing in anything fossil-fuel related (attributable to climate hysteria). This is a US LNG-specific risk.

Although conditions have eased somewhat, Europe’s energy situation is still fraught. It has experienced a winter of extremely high power prices and natural gas prices. Some luck with weather in January brought some relief, but who knows what the next months have in store.

As if demand and non-Russia supply fundamentals didn’t pose enough difficulties, Russia has proved a gas supply riddle, mystery, and enigma. The Ukraine situation has only made the situation more fraught, with a prospect that things could get very cold in Europe if the conflict between Russia and Ukraine goes hot.

In anticipation of this, the Biden administration has played its by now familiar role of supplicant, appealing to major LNG suppliers–notably Qatar–to increase output and divert supplies to Europe, and to major buyers (e.g., Japan) to direct supplies to Europe.

Good luck with that. There is nothing that can be done to augment global supplies in the short run, let alone by enough to address a material loss of gas from Russia.

The world LNG industry is operating at effectively full capacity. Although supplies produced anywhere can physically go anywhere, there are no more additional supplies to be had. So if Russian gas exports decline, LNG cannot fill the gap.

This is illustrated by the US, which recently became the world’s largest supplier of LNG. Note how US exports have remained essentially constant (at about 300 bn cubic feet/month) since around March 2021, despite skyrocketing prices for gas:

There’s another way to see that liquefaction capacity is the bottleneck. This is the spread between the price of LNG in Asia (JKM) and Henry Hub NG:

My teaching mantra (repeated last night to my Energy Derivatives students!) is that spreads price bottlenecks in the transformation process. The spread depicted here captures two potential bottlenecks in transforming US produced gas into gas delivered in Asia (or Europe): US liquefaction capacity and shipping costs. Shipping costs have increased, but not nearly enough to explain the rise in the spread in 2021, especially the explosion starting in mid-September. This is a clear indication that US liquefaction capacity is a binding constraint. The extreme volatility in the spread also demonstrates this. Shocks to demand in Europe or Asia can’t be accommodated by adjustments in supply, so all the burden falls on the spread. Thus, even slight demand shifts can lead to big spread moves.

As for reallocating supplies between Europe, Asia, and South America, Mr. Market can handle this, and is indeed handling it to a considerable degree. As the demand balance shifts between Asia and Europe, LNG carriers are changing destinations in mid-voyage. In an extreme case a ship that had already transited the Panama Canal en route to Hawaii reversed direction, transited the canal eastbound, and delivered its cargo in the UK. In short, what is going on is a classic example of how the price mechanism allocates resources to their highest value use, and how commodity traders optimize flows. (It also largely validates the predictions of my 2014 white paper on LNG.)

The main impediment appears to be contractual. Specifically, destination clauses in legacy contracts, specifically those for Qatar Gas. These clauses prevent the buyer from reselling the cargo to other markets.

Perhaps the administration was begging Qatar to relent on these, but if so, their appeals appear to have fallen on deaf ears (despite the US promoting Qatar to “major non-Nato ally). Qatar says it views its contractual commitments as sacrosanct:

“Keeping our contractual word is sacrosanct in Qatar,” said Kaabi, implying that it will not be possible to divert to Europe gas shipments already contracted for delivery to other countries without their consent.

This smacks of dishonesty. It is not the buyers‘ consent that matters here: if the price is right, Asian buyers would be happy to ship contracted gas to Europe if the price is right. And it appears that the price is right: the “arb” between Asia appears open (i.e., the TTF price is above JKM by more than the cost of shipment). So what’s stopping it from being closed? Almost certainly Qatar’s failure to consent to waiving the destination clauses (in its supersekret contracts). (Destination clauses limit the ability of the buyer to divert cargoes to other locations, and are basically a means of price discrimination.)

Relatedly, Qatar has said it is willing to sell gas to Europe . . . as long as the Europeans consent to destination clauses. Oh, and Qatar is exploiting Europe’s straits by demanding Europe “resolve a long-running EU probe into Qatar’s long-term gas contracts, for the EU to be less dependent on spot sales and more on long-term contracts to boost its energy security.”

Kind of Russian, when you think about it. When you have them by the short ones . . . . With “allies” like these!

In brief, Europe is SOL, especially if there is a material disruption in Russian gas supplies. The world capacity of LNG is maxed out and cannot fill any supply void. The market is working to allocate supplies efficiently, but that process is impeded by an opportunistic actor that really doesn’t want the spot market to work.

Meaning that the best that post-religious Europe can do right now is pray for balmy weather, high winds, and Russian forbearance. Good luck with that.

Vladimir Putin’s Russia has massed large forces on the border of Ukraine, and there are widespread fears that he is planning an invasion. This has led to calls from many in the United States (and to a lesser degree in nations that are actually closer to Ukraine) to deploy military forces–read, American military forces–to Ukraine, and to contest any Russian invasion if it comes to that.

This call to die for Donbas is demented.

It is useful to deconstruct the dementia by breaking the problem into two pieces: (1) whether defending Ukraine is in the strategic interest of the United States, and (2) what would be the costs of of doing so?

The red line that is apparently motivating Putin is the possibility that Ukraine will be admitted to NATO. Put aside whether a Ukraine in NATO would objectively pose a strategic threat to Russia, or whether this is a Putin phobia or part of Putin’s romantic desire to gather Russian lands and reunite brothers divided by a perfidious West. What matters is that he, and most of the Russian establishment (especially the security establishment) believes it. Putin has said repeatedly that it is a red line. We have to accept this as a fact.

If keeping Ukraine out of NATO is a strategic imperative for Putin, is putting Ukraine in NATO a strategic imperative for the United States?

Absolutely not. NATO’s mission from its founding was to keep Russia out of Western Europe. It succeeded. Adding Ukraine to NATO will not advance that objective.

So adding Ukraine would represent mission creep: redefining the part of the world that we want to keep Russia out of. Is it desirable that Ukraine remain independent? Probably, but mainly for Ukrainians. But it’s hardly a major strategic interest of the United States. How would American security decline if Ukraine was in Russia, or in Russian orbit? Hardly a whit.

So the stakes for Russia are high and the stakes for the United States are minuscule. It is never advisable to enter into a contest with such an imbalance of stakes.

And as I’ve written before, expanding NATO by adding countries that increase the alliance’s obligations without increasing its capabilities is idiocy. Indeed, it’s worse than that. Adding countries like Ukraine degrades NATO’s capabilities. As I’ve also written before, it is crippled by the need for unanimous decision making: adding members with divergent interests and concerns only magnifies the difficulties of achieving coherent action. It is inimical to the unity of command (something Russia possesses, by the way, and NATO already does not). Moreover, as (yet again) I’ve written before, adding countries that are unduly prone to Russian influence is a particularly stupid way to strengthen an alliance against Russia. (Hell, Putin might want to rethink his opposition to Ukraine in NATO just for that reason. I’m reminded of a story–the source of which I can’t trace so this is based on memory–that Napoleon actually rejoiced at the news that another country had joined a coalition against him, precisely because he knew this would undermine its unity of action.)

It is said about Mexico “so close to the United States, so far from God.” Well, it can be said about Ukraine “so close to Russia, so far from God.” It’s a tragic fate. But addressing that tragedy (which is only one of many tragedies around the world) does not advance American interests.

In addition to being far from God, unlike Mexico Ukraine is also very far from the United States. Which brings us to the second issue: the cost of defending Ukraine, even if it were deemed to be a potentially desirable object of American policy.

Soviet military strategists spoke of the “correlation of forces.” The correlation of forces is decisively on the side of Russia with respect to Ukraine.

Distance is of course a major factor. Ukraine is on Russia’s doorstep. It is thousands of miles and oceans away from the United States, and is even distant from deployable NATO forces in Western Europe. If Russia decided to move tomorrow, the invasion would be over before NATO could do a damn thing about it. And if NATO were somehow able to deploy forces before Russia moved in (which generously assumes that Putin would stand idly by to let such a deployment occur rather than using it as a pretext to launch an invasion) it would be operating at the far end of a very long and vulnerable logistical tail, whereas Russia would be operating with a short and relatively invulnerable one. This makes about as much sense as Custer charging into a huge Sioux and Cheyenne camp on the Little Big Horn, and would probably have a similar result: though Custer could be excused because of his ignorance about just how large the forces he was facing were, whereas NATO commanders could have no such excuse.

The choice would therefore be between abject defeat and a huge escalation that creates the potential for unimaginably horrible consequences.

And for what? (See above re the negligible stakes for the US and NATO.)

I should also note that the United States has a doleful record when it comes to attempting to defend and prop up dysfunctional and corrupt nations–and make no mistake, Ukraine is a Sovok sewer of corruption. Vietnam. Iraq. Afghanistan. In each case, vast amounts of American treasure and huge numbers of American lives were expended in the futile hope of creating functioning states out of dysfunctional ones. And the dysfunctions made the mission impossible, and moreover deeply damaged and corrupted the American military (cf. the Afghanistan Papers).

Uber realist Bismarck memorably said that the Balkans were “not worth the healthy bones of a single Pomeranian grenadier.” America needs to be uber realistic, and recognize that not only is Ukraine not worth the healthy bones of a single Texan Marine, it would cost many, many such skeletons.

This is a time when it is imperative to take a tragic view of history. Too often in the 100+ years the United States has taken a missionary, progressive, romantic, and idealistic view instead. It has always worked out horribly.

Can we finally learn our lesson?

A couple of political notes. First, there is a report today that the Biden administration is advising Ukraine to concede extensive Russian control over the Donbas. In light of the above, that is wise. But can you imagine the hue and cry if Trump had said that. Perhaps we are lucky Trump is not president–he would have been under much greater political pressure to intervene in Ukraine than Biden will be.

Relatedly, the call to defend Ukraine with Americans is an illustration of the Russia mania that has beset the American political “elite” in the past 5 years. It truly is a mental illness.

Second, it is no coincidence comrade, that the crisis is coming to a head when Nordstream II is ready for operations and Europe is desperate for energy. The former potentially allows Russia to have its Ukrainian cake and its gas revenues too. The latter makes the EU (aka the Fourth Reich) acutely vulnerable to Russia and therefore far less likely to intervene in any way–including sanctions, for that matter. (This also means that the US could not depend on Germany and other NATO nations for meaningful military support, even assuming that the Broomstick Brigades of the Bundeswehr have any to offer.)

For this the blame lays squarely on perfidious Germany and on Angela Merkel in particular. And ironically, exactly what Trump warned them about, and which Merkel and the rest of the European establishment dismissed haughtily, is coming to pass.

Due to the immovable object of price caps and the irresistible force of spiking natural gas and power costs, about 20 retail energy suppliers in the UK have gone toes up. Most of these have been addressed using what is called the Supplier of Last Resort (SoLR) mechanism, whereby customers of the failed firm are transferred to another supplier. (SoL sounds about right!) This mechanism effectively socializes losses:

Energy suppliers that rescue customers via the supplier of last resort can recoup their costs through an industry levy that is funded by bills.

Although the foregoing suggests that all UK energy consumers share in the costs, energy market regulator Ofgem suggests that the customers of failed firms may bear some of the costs:

Could bills go up?

When we appoint a new supplier using the Supplier of Last Resort process, we try to get the best possible deal for customers.

Suppliers we appoint will likely put you on a special ‘deemed’ contract when they take on your supply. This means a contract you haven’t chosen. A deemed contract could cost more than your old tariff, so your bills could go up. However, they are covered by the energy price cap Ofgem sets, which ensures you get a fair price if you are put on one. 

When contacted by the new supplier, it’s best to ask to be put on their cheapest tariff or shop around if you want to. You won’t be charged exit fees. This is a challenging time in the market and we know that there may not be many tariffs available when shopping around right now.

Deemed contracts can cost more because the supplier takes on more risk. For example, they might have to buy extra wholesale energy at short notice for new customers. So they charge more to cover these costs.

Up to last week, all the failures had been dealt with using this mechanism. But the failure of Bulb (Dim Bulb?) was evidently too big for Ofgem to deal with using the SoL mechanism. Instead, it resorted to a “Special Administration Regime” which basically nationalizes Bulb. This regime permits the government to “make grants and loans to the company in administration and may also give guarantees for any sum borrowed while it is in administration.”

That is, SAR is essentially a bailout/nationalization of losses and risk.

Ofgem notes:

The energy price cap, which sets a maximum price for customers on standard default tariffs, will remain in place to protect millions of people from the sudden increases in global gas prices. 

(Aside: It is impossible to protect millions of people from the sudden increase in global gas prices. It is only possible to determine–based on political mechanisms–which millions pay and how much. So this statement is typical government bullshit.)

Thus, given the price cap and the fact that Bulb is now owned by the UK government, Boris now has a big short position in natural gas. So how is he going to manage it?

I have heard that the government approached Vitol, which told them to fuck off. So . . . what next?

The company still has to procure energy at market prices and sell them at fixed prices. Since the government is now the residual claimant, it has a short exposure and can take this exposure on the balance sheet, as it were, and essentially run a naked short.

Or it can try to hedge by buying gas forward. But this is not a trivial problem. This is not a position of fixed size that faces only price risk that could be hedged using fixed quantities of swaps/forwards/futures. There is volumetric risk as well: cold weather increases both the price of gas and the amount of gas that must be supplied. A sophisticated hedge would involve both forward fixed price purchases and weather derivatives. Or through the purchase of a sophisticated structured product that has payoffs that depend on both volumetric and price variables.

I’m guessing that the government is not into sophistication, or frankly, capable of it. As a result, it is likely to be at a severe disadvantage in negotiating a price on a structured product or weather derivatives or long dated forwards.

It is also likely sweating out the hedger’s hindsight dilemma. If it doesn’t hedge and prices spike it will catch hell because of the large losses passed on to taxpayers. But if it hedges and prices don’t spike or in fact decline, it will catch hell too: you idiots overpaid!!!! Both of these judgments are based on hindsight, but even though hedging decisions should be evaluated ex ante on the basis of how they effect risk, inevitably they are evaluated ex post based on how they pan out.

Consider California in the aftermath of its 2000-2001 electricity crisis. It entered into long term contracts at what retrospectively was the height of the crisis, and thus paid higher prices than it would have had it procured on a short term basis. Of course, California attempted to recover by suing the contract sellers, claiming it was a nefarious manipulative scheme. Alas, it succeeded to some degree.

The best solution would be to do what clearinghouses do when a big member collapses–auction off the positions. This is what NYMEX did when the hedge fund Amaranth collapsed due to natural gas futures and swap losses in 2006: JP Morgan and Citadel assumed the positions in exchange for consideration. Similarly, when Lehman collapsed in 2008, the CME auctioned off its futures portfolio.

Even in these situations, however, there is always controversy about whether the price is right. Assertions that the buyers of Lehman’s futures positions received a windfall (i.e., bought on the cheap) led to litigation (filed by the Lehman bankruptcy trustee) and considerable controversy. (Here’s my take on the issue.)

Note that the factors mentioned above mean that the pricing in any putative auction of Bulb obligations is likely to be more discounted, and thus subject to more controversy, than the Lehman positions. As in the Lehman case, the positions will be auctioned in a stressed market. Moreover, as noted above, the exposures are far more complex and difficult to manage than Lehman’s rather vanilla (though large) futures positions. That complexity will bring a discount. Furthermore, apropos California circa 2001, the bidders realize that they are subject to government attempts to clawback any gains that result ex post due to favorable fundamentals (e.g., an unexpectedly warm winter). That is, the bidders may fear that the government will actually acquire a long option position, and hence they will be short an option: if prices spike, the auction “winner” will bear the brunt, but if they don’t the government will claim that it was exploited and over payed.

That is, unless the government can credibly commit to adhering scrupulously to the results of the auction, the auction may well fail to attract any bidders.

NB: credible commitment is not one of most modern governments’ strong suits. (This is likely one of the reasons Vitol told the government to bugger off. It realized that it was assuming a totally skewed position–heads they lose, tails they don’t win.).

According to the FT article linked above (amazingly factual and informative for a current day FT article, BTW) the government rejected two offers to assume the Bulb portfolio. I surmise that the bids were discounted heavily to reflect the factors mentioned above and Ofgem accordingly rejected them.

So I’m guessing the government will wear the risk. Perhaps it will try to manage it–and do it badly. Or more likely it will just let it ride. Maybe it will bet on Covid, thinking that the new variant or the new variant after that or the new variant after that will cause governments (stupidly) to lockdown again and crater economic activity and hence gas demand.

I note that Bulb might not be the end of the story. As noted above, the price caps remain in force, meaning that other suppliers may fail in the future–including those that have already gone through the SoL process. The government would be the ones SoL then. That is, the government not only has the Bulb liability–it has a big contingent liability that could dwarf Bulb.

Ofgem has already hinted at this:

In a letter to Kwarteng justifying the decision to pursue a special administration for Bulb, published on Wednesday, Ofgem’s chief executive Jonathan Brearley said the supplier of last resort mechanism was already “under considerable” strain from managing the failure of 20-plus other energy companies in recent months.

So Boris’s already big short could get bigger.

And perversely, it could influence government policy on COVID. Doing something (like lockdowns) that would crush energy demand would benefit its short energy position (existing and contingent). Talk about moral hazard.

Good luck with that Boris! Or should I say, good luck with that, Limeys?

For well over twenty years in my various energy pricing and policy classes I have pointed out that every energy price spike leads to accusations of manipulation and gouging and a call for an FTC investigation . . . which is always announced with great fanfare but never finds anything–something that is announced sotto voce, if announced at all.

And lo and behold, right on cue, due to the rise in energy prices in recent months Biden (or more likely, Howdy Joe’s ventriloquists) has asked the FTC to investigate rising gasoline prices:

President Biden called on the Federal Trade Commission to investigate whether oil-and-gas companies are participating in illegal conduct aimed at keeping gasoline prices high, in the latest effort by the White House to respond to public concerns about costs for everything from fuel to groceries.

Sisyphus would understand the drill. “Time to roll the price gouging rock up the hill again.”

And for the most idiotic, demented hot take, let’s turn to Lizzie Warren, speaking on Joy Reid’s show (talk about a singularity of stupid*):

Prices at the pump have gone up. Why? Because giant oil companies like @Chevron and @ExxonMobil enjoy doubling their profits. This isn't about inflation. This is about price gouging for these guys & we need to call them out. pic.twitter.com/kxiQkC2tYa

— Elizabeth Warren (@SenWarren) November 20, 2021

Recall, this is about a change in prices. So if the change in prices is due to gouging by oil companies, it would have to be due a change in gouging behavior. (I think even Joy and Lizzie should be able to follow this, it’s so basic: but maybe I’m too generous.)

But let’s follow that thread. It would imply that until recently, oil companies were not exploiting the opportunity to “double their profits” by price gouging.

So what happened? Did one day a few months ago the CEO’s of Chevron and ExxonMobil et al have a V8 moment, and slap themselves on the forehead and say “Wow! I could have doubled my profits by jacking up prices!”

So if they could screw consumers at a whim by jacking up prices why did they let oil prices go to single digits in 2020? Why does the urge to gouge seem to wax and wane?

This is so incandescently stupid. But I guess I should consider the sources, and remember that this sort of incandescent stupidity spikes every time oil prices do.

If the FTC exhibits the integrity it has in the past, this investigation will end the way all the others have, with a whisper not a bang, stating that fundamentals are the driver. But there is no guarantee that the current FTC will indeed exhibit such integrity, given how degraded government institutions have become (not that they were ever paragons, but everything is relative). Political imperatives and narratives, not realities, rule the day.

* Lizzie was dean of Harvard Law School, and a professor of law there. Joy Reid went to Harvard. God save us from Harvard.

No, this is not a post about baseball, with an outfielder running to the wall only to watch a home run soar over his head. It’s about the copper market, where backwardation (a positive difference between the price for immediate delivery–“cash”–and a futures price) has soared, and inventories have gone yard.

The peak of the frenzy was Tuesday of this week, when at one point the cash-threes backwardation on the London Metal Exchange (LME) soared to $1050/tonne (them’s metric tons, y’all).

LME COPPER FUTURES moved into a record backwardation on Oct 19 as available stocks in exchange-registered warehouses declined to the lowest level since 1974: pic.twitter.com/9IuO6r3jou

— John Kemp (@JKempEnergy) October 20, 2021

That was apparently an intraday price, because the official PM cash-threes back on that day was a mere $382.

The LME is unique in that it trades contracts for specific dates, and so there is a “tom-nex” spread too: the difference between the price for delivery tomorrow, and the price for delivery the day after that. Last Friday, this “daily back” reached $175/tonne–meaning copper delivered Monday was worth $175 more than copper delivered Tuesday. The tom-nex remained over $100 on Monday and Tuesday.

Backwardation on COMEX copper has also jumped recently. Here’s the October 21-January 22 spread(HGV1-HGF2).

Meanwhile, inventories have plummeted, declining to a mere 14,500 tonnes on Tuesday, down from around 250,000 MT in late-August:

So what’s going on? Let me first consider a fundamentals-based story.

The spreads between futures with different maturities for a storable commodity send signals on how to allocate resources over time. When demand is high/supply is low today relative to what is expected in the future, it is optimal to draw down inventories, and prices move away from “full carry” (i.e., spreads that cover the cost of carrying inventory) to incentivize this drawdown. With extreme (but expected to be fleeting) temporal imbalances, it can be optimal to consume all inventories and meet future demand out of future production (because future demand is expected to be lower or supply higher than at present). These extreme temporal imbalances lead to large backwardations to punish storage.

As an aside, that’s why this statement in a Reuters article is incorrect:

Backwardation is supposed to attract metal but this week’s deliveries into LME warehouses have so far amounted to a meagre 9,775 tonnes despite the biggest incentive in the market’s history.

No! Backwardation punishes stockholding–it’s an incentive to move stuff out to be consumed today rather than hold it into the future when it is anticipated to be more abundant.

In some respects, what is going on in copper is similar to what happened in lumber, which I wrote about some months ago. The lumber market went into a huge back due to tight fundamentals and inventories were low.

The good news here is that these price signals indicate that the extreme imbalance is expected to be temporary: copper is scarce today relative to what is expected to be the case some months from now. That’s pretty much what happened in lumber.

So why the temporary scarcity (relative to expected future scarcity)? One plausible explanation is energy prices, which are high now going into the high-demand winter season in the Northern Hemisphere. Due to supply responses that can occur in a period of months but also the seasonal decline in heating and power related energy demand, these prices are likely to fall. Metals refining is energy intensive, so such a rise in energy prices pushes up the metals supply curve today relative to what’s expected in the future: this can produce exactly what we’re seeing in copper, and is also becoming evident in zinc, nickel, and aluminum.

China is of paramount importance in metals refining, so the artificial shortage of power there (caused by price controls and high fuel prices) is exacerbating this problem. Power cutbacks to intensive energy consumers are exacerbating the short term supply disruption.

This points out how the world is hostage to Chinese policy–and Chinese policy mistakes. China has become so important in this area not because it sits atop large, cheap supplies of ores. Low labor costs made it cheaper to locate refining there, even taking into account transport costs. But also, Chinese subsidies of various sorts–financial suppression that makes capital cheap and subsidized power prices–have attracted arguably excessive amounts of capital to metals refining there. And add to that the relative indifference of China to pollution–and metals refining can pollute the air, the water, and the earth: lower environmental standards lead to lower costs and a great incentive to locate production in China.

The fallout from a concentration of metals refining capacity in China is reverberating around the world right now. Not just copper but a variety of metals are going haywire because of the energy-driven supply disruptions in China. Magnesium is just another example.

The former is a fundamentals-based story (albeit one in which central planning has distorted the fundamentals). Is this all that is going on?

Corners can also cause soaring backwardations. The LME was sufficiently concerned about the situation in the market to impose a limit on the amount of daily backwardation to .5 percent of the cash price (which is still a 180 percent annual rate boys and girls). The cash-threes backwardation has fallen by almost two-thirds (to $116/MT today) in the days since.

Fingers have been pointed at Trafigura for loading out large amounts of inventory, thereby exacerbating the tightness. Trafigura says it did so to meet obligations to customers. This would be consistent with the fundamentals story.

But . . .

It is not unknown for firms with large inventory holdings to remove them from the LME to create an “artificial” tightness, or to provide a cover story for a corner. Moreover, if a single firm owns enough inventory to be able to deplete stocks materially on its own, it doesn’t take too large a paper position for it to have a literal corner. Or even if one firm hasn’t cornered, a small number of firms with large physical and paper positions can have a nice little oligopoly that allows them to exercise market power, of which large backwardations are a symptom–and a source of profit. Think of how much money the holder of a large prompt position could make rolling that over at $100+ per day, day after day.

Put differently, fundamental tightness can create market power, and the exercise of this market power can greatly exacerbate backwardations.

The sharp drop in the cash-threes back after the LME intervened lends some plausibility to this explanation. However, a definitive diagnosis requires a deep dive into who was doing what that is not possible based on currently available public information. I am just laying out possibilities here.

Exercising market power in a tight market is sometimes referred to as a “natural corner” and has given some firms that have exercised market power a “get out of jail free” card in the United States.

I’ve just completed a paper on “natural squeezes” that critiques this flaw in US manipulation law. I’ll post it soon.

But when all is said and done, what is going on in copper now is possibly such a natural squeeze: a temporary tight supply and demand situation exploited to exercise market power. Maybe someday we’ll find out.

Churchill called Russia “a riddle, wrapped in a mystery, inside an enigma.” Those following the natural gas market, particularly in Europe, during the Great Spike of 2021 have no doubt agreed wholeheartedly. What is Russia’s (specifically Gazprom’s) game? Why haven’t they increased sales/output to profit from the spike? Because they can’t due to output constraints? Or because China is outbidding Europe for supplies? Or because they need to build domestic stocks?

Or because they are deliberately withholding output for some strategic purpose, a la 2006?

Yesterday Putin unravelled the riddle/mystery/enigma quite a bit: it’s the latter.

Specifically, Putin said Russia would be more than happy to send Europe more gas. But, only via Nordstream 2, not via currently operating pipelines, through Ukraine in particular. Too expensive to send via Ukraine, you see.

Nordstream 2 was just completed, at the insistence primarily of chief Putin-Versteher, Angela Merkel (whose energy policies have been boneheaded from start to finish), and against the determined efforts of Trump and Congressional Republicans. Biden caved recently on the issue and, waived Trump-imposed sanctions, thereby allowing the completion of the pipeline.

But there are still major disagreements between the European Union and Gazprom regarding the pipeline so gas is not flowing yet. Specifically, the EU has ruled–and EU courts have agreed–that Gazprom must “unbundle.” That is, there must be a separation between control of pipeline capacity and ownership of the gas. Meaning that Gazprom must auction off its capacity on NS2:

The Nord Stream 2 gas pipeline is not exempt from European Union rules that require the owners of pipelines to be different from the suppliers of the gas that flows in them to ensure fair competition, a German court ruled on Wednesday.

The Duesseldorf Higher Regional Court rejected a challenge brought last year by the operators of the Gazprom-backed (GAZP.MM) project to carry gas from Russia to Germany under the Baltic Sea. They had argued the rules were discriminatory.

.

“Russia’s Gazprom will be forced to auction pipeline capacity, which could delay deliveries further,” said Refinitiv gas analyst Xun Peng.

EU rules require the companies that produce, transport and distribute gas within the bloc to be separate, or “unbundled”. They aim to ensure fair competition in the market and to prevent companies from possibly obstructing competitors’ access to infrastructure.

This means that the company transporting the gas must auction its capacity to third parties.

Gazputin no likey!

And now he has a desperate gas short, winter-dreading Europe by the balls.

Did you really think he would pass on an opportunity to squeeze?

So he’s squeezing. Hard. The threat is clear: if you want more gas, cave to me on unbundling.

“Nice little continent you have here. Shame if something happened to it. Like, you know, freeze.”

In other words, Putin is not the Riddler, or a mystery, or an enigma after all. He is just playing to type. Where type includes adding sanctimonious snark to sugarcoat his threat.

Putin hasn’t changed a bit. The circumstances have changed, and Putin, in his oft-proven opportunistic fashion, is playing the scorpion in Aesop’s fable the Frog and the Scorpion. “I couldn’t help it. It’s in my nature.” Gazputin is back, baby.

For precisely this reason the Europeans–and Merkel in particular–have no one to blame but themselves. They are the ones who put the scorpion on their backs. One would think this sting would be a lesson. But given how many times they’ve been stung in the past, and continued in their course, that will almost certainly not happen. So I for one am shedding no tears.

*The title is an homage to Chicago Bears great Gale Sayers, and his commercials for Cheker Gas stations, in which the closing line was always: “That Cheker, it’s a gas.”

Back oh-so-long ago, during the California electricity crisis and its aftermath, I would say that California wanted to deregulate its power market in the worst way, and succeeded. (Wanting to keep up my ESG score, I recycled this line to describe Gibbering Joe’s Afghanistan exit.)

The main design failure of California’s restructuring (a more accurate description than deregulation) of its power market was that it capped retail prices for the two largest utilities in the state (SoCal Edison and PG&E) while requiring them to acquire power at market-determined wholesale spot prices. (San Diego Gas and Electric had met criteria to allow it to enter into long term forward purchase contracts and as I recall was not subject to the same retail price cap.). Thus, SCE and PG&E were massively short wholesale (spot) power. When those prices spiked, due mainly to fundamental factors, the utilities hemorrhaged cash and hurtled towards bankruptcy. Their financial distress led to further dislocations in the California market (and the western US power markets generally).

The world is currently undergoing what is being called an “energy crisis,” focused on power markets, and their inputs, mainly natural gas and coal. There are two parts to this “crisis,” one fundamentally driven, the other driven by ill-conceived regulatory and political factors redolent of California circa 1999-2001.

The most pronounced indicator of the fundamental-driven stress is the price of liquified natural gas (LNG), which has reached dizzying heights.

That price spike is in early “shoulder” months, boys and girls. Lord knows what the peak demand months have in store.

And that’s the nub of the problem: storage.

Historically, natural gas has been a “spikey” commodity. The shale boom mitigated spikeness in US natural gas prices, but periodic price spikes are an inherent feature of storable commodities. The truly motivated can read about it in my book, but the CliffsNotes version is this. It is optimal for inventories to run out periodically: if inventories were never exhausted, some of the commodity would never be consumed, which makes no sense. So “stockouts” will occur periodically. When they do, it is impossible to accommodate demand increases or supply declines by drawing down on inventory. Instead, prices bear the entire burden of adjusting to a demand shock (for example). Thus, periodically stocks will be tight, and when they are, a demand increase causes prices to rise dramatically (because inventories can’t cushion the blow).

The cover illustration in my book, based on a purely theoretical model of a storable commodity market, illustrates the point. Note the periodic spikes.

That is, price spikes are inherent in storable commodities.

The magnitude of the price spikes is amplified by the nature of natural gas production and consumption. Both demand and supply are extremely inelastic. The inelasticity effects optimal storage decisions, but when natty inventory constraints bind, inelasticity means that price impacts of shocks are extreme.

This is why going short natural gas (or shorting the calendar spread especially in the winter) is referred to as a “widow maker” trade.

There are lots of widows out there today. In essence, a hard winter of 2020/2021 depleted stocks. The 2020 COVID demand collapse and subsequent price crash (JKM traded at $2.20/mmBTU in May 2020) cratered drilling, constraining current supply (as wells drilled then would have been producing now) making it difficult to build stocks. Warm summer weather in 2021 drained stocks and impeded stock build. Outages in Norwegian production, and a wind drought in the UK (which required greater utilization of gas generation) stoked demand. Stocks are now at historically low levels, setting the stage for even bigger spikes this winter.

The gas market–due to LNG–is now international, meaning that shocks in any region impact prices around the world. Asia (especially China) and Europe are now playing tug of war for gas, and prices are spiking in both places.

Since gas and coal are substitutes, the price spike in gas is resulting in a price spike in coal:

Oil can also be used to generate power, although this has become relatively rare in recent years. However, the spikes in gas and coal are making fuel switching to oil more attractive, and additional gas/coal price spikes in the winter will likely result in more use of oil in electricity generation, which will put upward pressure on oil prices too.

This is all fundamentals driven, and exactly what occurs periodically in storable commodities. There’s nothing really that can be done about it, policy wise. But that won’t stop governments from trying.

You’ve no doubt read of energy “shortages” in recent days and weeks. Well, low supplies and high prices are not a “shortage” per se. A true shortage is a failure for a market to clear, resulting in queueing for the good. That is, a shortage occurs when the price is kept to low, leading to a gap between the quantity demanded and the quantity supplied.

Think gasoline lines in the US in the 1970s.

That’s where regulation comes in. Various regulations, adopted for political economy reasons, create shortages and the other dysfunctions currently observed in world energy markets.

Take China. The authorities have implemented power rationing. The reason commonly given is a “coal shortage.” Yes, coal prices are high in China (and the world), but that doesn’t create a true shortage. What has? Power prices are capped. The big increase in input costs (both coal and LNG) mean that Chinese generators can’t sell profitably, so they restrict output, leading to a true shortage.

What this means is that the shadow price of power–the price that market participants would be willing to pay for an additional megawatt–is (a) above the regulated price, and (b) above the market clearing price. Consumption would be higher in the absence of the price cap.

High coal prices do not reflect a “shortage”, properly defined. Yes, they represent constrained supplies, but that is not a shortage.

And do not forget that China’s coal supply constraints (and high prices) are in large part a result of their brilliant central planners. China imposed quotas on coal production some years back. The reason was–wait for it–coal prices were too low. Now the government is winking at the quotas in order to encourage production–because prices are too high.

India is another country where the Californiaesque capped power price/uncapped input price problem is rearing its ugly head.

France is going to cap gas and power retail prices, but make suppliers whole (though how it will do so remains unstated as of now). Compensating suppliers (effectively having the government pay the difference between marginal cost and the capped price) will prevent true shortages, but will have the perverse effect of exacerbating the spikes in gas and coal prices because at the capped price consumers will not internalize the true scarcity of fuel, and will overconsume.

The UK is experiencing another echo of California. Several of its retail gas suppliers have imploded because they are required to sell at a capped price and chose to cover their sales commitments by purchasing wholesale spot. The price cap made no sense: competition among retail suppliers would have kept prices in line. Adding the price cap just put the competitive retailers at risk of bankruptcy. (Admittedly, such can occur when retail prices are not capped if retailers offer fixed prices to consumers and don’t hedge, as occurred in Texas this last winter. But price caps make that outcome more likely.)

The UK is also suffering a true shortage of gasoline–excuse me, petrol–a la the US in the 1970s. A true shortage, because there are lines:

Man heads to the petrol station with his horse to 'stir up' some laughs pic.twitter.com/NsPiW8Ijcg

— The Sun (@TheSun) September 29, 2021

Scarcity of truck drivers to distribute fuel is at the root of the problem. But that can’t lead to a true shortage–lower supplies and higher prices yes, but not a shortage with people waiting in line. So what gives?

Apparently there was an information cascade about impending shortages, which led to a panicked run for gas stations. This evidently started with a leak (probably politically motivated) of cabinet deliberations.

A sudden demand increase of this magnitude can lead to true shortages–queueing–if prices do not rise to clear the market. This raises the question of why petrol sellers didn’t increase prices. I’m not aware of formal caps, but I surmise that fear of allegations of “gouging” led retailers to choose to allow customers to pay the high price implicitly (through the time cost of sitting in line) rather than raise price to reflect the sudden (and perhaps contrived) scarcity.

For storable commodities like natural gas, coal, and refined petroleum products, price spikes can last for some time. That’s what we are experiencing today: it’s just one of those spikes like on the cover of my book that happen in commodity markets. Given that we are going into a peak demand season with constrained supplies, the prospect for a continuing spike–and indeed, a higher spike–is very real indeed.

Governments can’t change this fundamental reality. Market prices are sending a signal about underlying conditions. Governments don’t like the message the prices are sending, and will try to do something about it. Alas, their knee-jerk response–to shoot the messenger by capping prices–will make things worse, not better. But because governments can’t help themselves, look for many 1970s energy market flashbacks in the coming months.