Streetwise Professor

Many Russia related stories to comment on, but not a lot of time, so here’s a quick recap.

Actions Speak Louder Than Words.  It is now apparent that Dmitri Medvedev’s anger over the Magnitsky killing was so much codswollop.  Or, if it wasn’t codswollop, recent events demonstrate just how irrelevant the President of the Russian Federation is.  Specifically, American lawyer Jamison Firestone, an outspoken critic of the Russian government’s criminal treatment of Magnitsky and the events that led up to it, has fled Russia because Interior Ministry personnel made two attempts to reprise the theft scheme that ultimately led to Magnitsky’s imprisonment and death:

Firestone, 44, a U.S. citizen and former board member of the American Chamber of Commerce in Russia, said Interior Ministry officials made two attempts to obtain $21 million in taxes that a company he’s a director of paid to the government. He said the perpetrators forged his signature and corporate seals to seek tax rebates, similar to the $230 million in claims made by funds expropriated from Hermitage Capital Management, a $1 billion investment firm run by his client William Browder.

The alleged fraud underscores Russian President Dmitry Medvedev’s challenge reining in what he has called “legal nihilism.” Perceived lack of law is one reason Russia has attracted less than one-fifth the investment in China and Brazil and half of what’s invested in India, its fellow members of the so-called BRIC group of emerging nations, according to three years of data compiled by Cambridge, Massachusetts-based fund- tracker EPFR Global. The nation’s economy shrank the most on record in 2009. [Perceived?  Like there’s any doubt?]

. . . .

“Corrupt law enforcement is the single biggest risk to business in Russia,” Firestone, co-founder of law firm Firestone Duncan, said in an interview in London, where he is looking for temporary office space. “Police have to stop being the mafia. These people are stealing the country.”

Magnitsky Death

Since Magnitsky’s death in November after a year in pre- trial detention and incidents such as a Moscow police officer beating a man to death, Medvedev has proposed reforms of law- enforcement agencies. The head of the Moscow police’s tax-crimes department, Maj. Gen. Anatoly Mikhalkin, and the chief of the Moscow prison division were fired.

Justice Minister Alexander Konovalov said at a press conference on Feb. 16 that the Russian government “is taking certain steps to ensure that the situation with Magnitsky will never be repeated.”

That’s not enough, said Browder, the 45-year-old U.S.-born founder of Hermitage, once Russia’s largest foreign investor.

“Those who have been fired were the least important part of the conspiracy to steal tax money and kill Sergei,” said Browder from London, where he has been based since Russia refused him entry in 2005. “We’ve written well-documented complaints to the top law-enforcement officers in the country that a number of police officers, judges, organized criminals and businessmen have been involved in the theft of almost $500 million from the state, and were involved in imprisoning Sergei Magnitsky. So far there have been absolutely no consequences for those people.”

. . . .

In an interview with Robert Amsterdam, Firestone makes it plain that Medvedev’s words mean exactly squat:

RA: Medvedev has ordered mass firings of prison officials and other gestures, yet you are literally back in the same position as before the death of Magnitsky. What are we to take away from this in terms of the position of the Kremlin on these issues?

JF: Well I can’t tell you what’s going on inside the Kremlin, but I can talk about what’s going on inside the Prosecutor General’s Office. I can specifically confirm that there are individuals within the Prosecutor General’s Office, such as Andrei Pechegin, who have obstructed the investigations into the Hermitage cases and the Magnitsky case and the attacks against me at every single turn. I think that Medvedev has a genuine interest in at least Magnitsky’s death, but any real attempt to investigate the MVD officers who were behind the theft of Hermitage companies and the theft of state budget, as well as those responsible for the arrest, torture, and eventual killing of Magnitsky has been completely obstructed. So what Medvedev did is fire a bunch of prison officials are tangentially responsible for the welfare of all prisoners, but he completely missed the MVD officers who had orchestrated all of this.

There’s the wonder of “centralized modernization” for you.

More Evidence of Medvedev’s Awesome Authority.  Medvedev has criticized the adulation of Stalin. Fat lot of good that does:

Muscovites will be able to learn about Soviet leader Joseph Stalin’s role in the World War II victory from street stands, a source in the Russian capital’s advertising and design committee said Wednesday.

“Information stands telling of Stalin’s role will be placed at sites where militia detachments were formed,” the source said, adding that the stands will be set up ahead of the 65th anniversary of the Soviet victory.

Stalin’s name, which has not been present in Moscow’s festive decorations since Soviet times, came to the focus of public attention last summer, when the Kurskaya station of the capital’s subway was under reconstruction.

Somehow I don’t think that Medvedev has to worry (or dream) about becoming the object of a personality cult.

And speaking of “centralized modernization.” Brian Whitmore had another quote from Surkov:

We have a school of thought that teaches that political modernization — by which is meant political debauchery and ‘anything goes’ — is the key to economic modernization. There is a different concept, to which I hold, which considers the consolidated state as a transitional instrument, a tool for modernization. Some call it authoritarian modernization. I do not care what it is called.

This is an even better example of the false choice that Surkov–and most other defenders of Putin, and too many commenters on this blog–offer to justify an authoritarian system.

Apology via Twitter will be acceptable.  In his every-word-a-lie-including-it-and-the oped in the NYT some time back, Russia’s Ambassador to NATO (with emphasis on the ass) Dmitri Rogozin slandered US and other NATO troops by claiming that unlike brave Soviet conscripts, US/NATO soldiers and Marines did not fight their adversaries face-to-face, preferring to bomb from on high.  The US Marines and NATO and Afghan allies are assaulting a fortified urban area, Marjah, in Afghanistan.  For a few takes on the close combat this involves, check here and here.  And for a view of urban combat from a major, major badass who knows it up close in personal, try this.    Oh, and Dmitri, if there’s not enough face-to-face bloodshed for your liking, it’s probably because all but the dimmest Iraqi or Taliban realize that tangling in close combat with a US or Brit or French or Canadian outfit is suicidal.   So, if you have the decency (yeah, I know), and since you like Twitter so much, why don’t you take a break from bragging about ass-kicking and Tweet an abject apology to those you’ve slandered.  Maybe your son can post it on his blog too.  (At least I’m pretty sure it’s his son.  But what’s up with the “!” Alexei! ?  Reminds me of Maury! Povich or something.)

Here we go again.  Again.  Even though BP has taken backseat in TNK-BP, that doesn’t protect it against expropriation.  Gazprom want gas.  TNK-BP have gas.  So Russia take gas.  Specifically, it looks like the expropriation of Kovytka is imminent. The trick this time?  Require that the firm develop its gas reserves in Kovytka to retain its license.  But deny it access to the pipeline necessary to ship the gas.  Then revoke its license because it didn’t develop gas it couldn’t sell due to lack of transport:

But Russia’s Natural Resources Ministry has consistently warned TNK-BP to speed up development or lose the rights to Kovykta.

The joint venture has argued that it cannot ramp up output to the required levels because Gazprom has a monopoly on exports to nearby China. It would need to build pipelines costing billions of dollars to reach its Asian markets.

TNK-BP was originally asked to sell its stake in Kovytka to Gazprom, the Russian state energy monopoly, in 2007 but talks stalled after years of wrangling on price.

Because Kovytka is a designated “strategic field”, it could fall automatically to Gazprom if TNK-BP is stripped of its licence as expected. TNK-BP and BP declined to comment.

FT adds:

The new pressure could signal that the Russian government is preparing finally to make a decision on Kovykta’s future, analysts said. “This is a sign they want to make progress,” said Chris Weafer, chief strategist at Uralsib, a Moscow investment bank. “It follows a familiar pattern of putting pressure on the other side to force them to make concessions. It is pretty much the modus operandi we saw in the other energy disputes of previous years,” he added, referring to a similar wave of threats that led to Royal Dutch Shell selling control of its Sakhalin 2 oilventure to Gazprom in 2006.

Gazprom has insisted it is no longer interested in Kovykta. But Russia is under increasing pressure to clinch a gas supply agreement with China, which is already signing up alternative supplies from Central Asia and potentially from Qatar.

Even as Gazprom has dragged its feet on Kovykta, its rival Rosneft, the state oil group, has been eyeing the field. Rosneftegaz, a Rosneft vehicle, is due to table a proposal on buying the field from TNK-BP in March, people close to TNK-BP said.

BP sees the field as a long-term prospect and has not booked the gas to its reserves.

Er, maybe they didn’t book the gas as reserves because they knew they’d never see a dime from it.

Going Down! Rusal’s reverse pop continues apace, with the stock down 30 percent since the IPO, and down the last 4 days, including a 6.7 percent drop on one day, after dropping 5.4 percent the day before.  Remind me not to take investment advice from this guy:

“The main problem with Rusal is its debt,” said Kenny Tang, an analyst at Redford Assets Management in Hong Kong. “It relies on the short-term funding and facilities from the banks for its operation, which might be a concern for investors. They are worried about Rusal’s cash flows after the listing.”

What, like the debt is a surprise?  Investors should have been worried about the cash flows before the listing–and then avoided it like the plague.

No wonder the HKEx figures that 10 or so Russian companies will do IPOs there: sounds like a great place to unload overpriced equity!

F22ski Dogfight.  There are diametrically opposed views on the viability of the Russian alleged 5th generation fighter, and hence the threat it represents to American air dominance.  (Still some comments pinging back and forth on my earlier post on the T-50).  First, from the Weekly Standard (via Air Power Australia):

In an open-source assessment of Russia’s Sukhoi PAK-FA, aka the Raptor Killer, Air Power Australia concludes, “once the PAK-FA is deployed within a theatre of operations, especially if it is supported robustly by counter-VLO capable ISR systems, the United States will no longer have the capability to rapidly impose air superiority, or possibly even achieve air superiority.”

. . . .

Can the Russians produce the PAK-FA in considerable numbers? The Russian defense industrial base is in sorry shape (think the Shkval torpedo that likely sunk the Kursk and the Beluva submarine-launched ballistic missile that has offered Moscow one spectacular embarrassment after another). But if the Russians can get the PAK-FA off the ground despite all that, maybe it’s not as hard to build a fifth-generation fighter as the Pentagon thinks.

A more skeptical view from StategyPage (which is, contrary to the assertions of some commentors, a pretty informed and reliable source):

Russia effort to develop an F-22 class fighter (the PAK FA) is going to require a lot of work. The prototype, that took its first flight recently, was clearly the basic Su-27 airframe modified to be stealthier. This included changing the shape of the aircraft to be less radar reflective, and providing internal bays for bombs and missiles. But there’s much more to do in order to achieve anything close to the stealthiness of the F-22. It took fifteen years for the F-22 to go from initial flight, to entering service. The PAK FA could proceed faster, learning from the F-22 experience (especially if some of the Internet based espionage carried out in the last decade was Russian). But such development speed has not been a Russian characteristic.Another problem is the engines, which were not ready for the first flight. Older model engines were used, because initial flights are mainly to confirm the basic airworthiness of the airframe. The new engines, also being used in the Su-35, are suffering development problems. The Russians have always had difficulties with their high end military engines, and that tradition continues. Currently, the Russians say it will take several years to perfect the new engine.

Russia will also need a new family of air-to-air missiles, as the current ones are too large for the internal bays on the PAK FA prototype. These are already in the works, along with more compact versions of air-to-surface missiles. There are also problems with the electronics and, well, you get the picture.

Given all the issues–the ability to do real stealth (for which the US has extensive experience, Russia zip), radar, missiles, and engines (the biggie)–I tend to lean to the SP view.  But y’all can talk among yourselves.

I’ll Bite Your Legs Off! Despite US happy talk that a nuclear arms control treaty with Russia is imminent, it is pretty evident that Russian demands on missile defense will make that very difficult, if not impossible (save a cave from Obama).  This part was amusing to me:

Russia recently embarked on a campaign of military muscle flexing. It regarded America’s missile defense plans in Europe as a threat, and threats must be countered with shows of strength.

Prime Minister Vladimir Putin said Russia must develop new offensive weapons to counter the proposed U.S. missile shield.

“You will see tactics of attack and shooting,” a Russian general said.

“Our soldiers are equipped with new machine guns and we have new tanks. We are far more mobile than before.”

I see.  Answer development of ballistic missile defense with “new machine guns” and “tactics of attack and shooting.”  Does this mean that before, Russia relied on tactics of attack and throwing rocks?  “Far more mobile”?  Uhm, Russian power projection potential beyond, say, Georgia, is basically zip, new machine guns or no.

Don’t Mention the War.  After viewing with shock and amazement the trollfest that broke out over at LR in response to her posts on the Winter Olympics, R beseeched me not to write about the subject.  I wasn’t planning on doing so anyways, but her well advised caution reinforces my intentions.  I’ll leave the critique up to the Duma.

Believe it or not, I could go on and on in this vein. But dammit Jim, I’m just a doctor, not a miracle worker, so I’ll leave it at this. Besides, there’s only so much I can take of this stuff. I think to relax, I’ll watch something that’s lighthearted by comparison, you know, maybe the documentary titled “Siberian Apocalypse” about to play on History International.

The last couple of days I’ve felt that when I wrote “Teleconnections” I was like that guy in the TV show “Early Edition” who got the paper (the Chicago Sun Times) delivered to him before it was published.  Yesterday Bloomberg had an article about a shale gas bonanza in Europe; today’s WSJ has an article describing how Italian energy firm Eni has renegotiated its contracts with Gazprom, as I suggested would happen in the post, because (a) oil prices and gas prices have delinked, due in large part to increased non-traditional supplies, and (b) the development of LNG has helped spur development of a spot market for gas:

In an interview, Eni Chief Executive Paolo Scaroni said the renegotiated long-term contracts will allow the company to counter deep changes in the economics of Europe’s natural gas market, which has weakened of late.

. . . .

For decades, steady gas prices allowed Eni and other distributors to purchase natural gas supplies from fields in Russia and Norway using contracts linked to the price of oil. Over the past year, however, oil prices have recovered from the financial crisis while demand for natural gas has not. That left European gas companies on the hook to purchase gas supplies at higher rates than their spot market prices.

Natural gas prices have also been hurt by the emergence of new supplies, including shale gas fields in North America and an abundance of liquefied natural gas projects, Mr. Scaroni said. “Around this, the drop in demand and the growth of liquefied gas, we renegotiated some characteristics of our long-term contract,” Mr. Scaroni said, declining to elaborate on the terms of the new agreement.

Gazprom head Alexei Medvedev was rather vague about the changes too:

Gazprom Deputy Chairman Alexander Medvedev told a press conference earlier this week that Gazprom had renegotiated the contracts with European companies taking “into account the trends in the European market and the crisis.” However, the “base principles” of the long-term contracts remained unchanged, Mr. Medvedev said without elaborating. Gazprom declined to comment on the matter.

I wonder just what “base principles” and “characteristics” mean. Reading between the lines, I would wager that it means that the pricing mechanism has been shifted (as conjectured in “Telecommunications”) from oil prices to spot gas prices.  It is also possible that the take-or-pay provisions have been altered, as a shift to a more accurate pricing mechanism would reduce the scope for opportunism that TOP clauses are designed to combat.

It is very interesting that even Eni is renegotiating.  The Italians have been particularly slavish in their dealings with Gazprom and Russia.  When Gazprom would say “jump”, Eni would ask “how high, boss?”  The fact that this company has succeeded in wresting contract changes from Gazprom is a very clear indication of how the bargaining power, and the perception of bargaining power, have changed.  And, methinks, the process has only begun.

As I noted in the original post, these changes will have geopolitical effects, not merely economic ones.  One interesting thing to consider is how it will affect Ukraine.  The eastern Europeans and FSU countries generally, and the Ukrainians specifically, will receive less direct benefit from LNG and other new sources of gas.  Moreover, to the extent that western Europe is less dependent on Russian gas–or, put economically, its demand for Russian gas is more elastic due to the availability of alternative supplies–Ukraine is less important to it.  This doesn’t seem to bode well for Ukraine’s ability to fend off Russian pressure.

Perhaps taking a cue from last night’s post “Telerconnections” 🙂 Bloomberg today reports on a shale gas rush in Europe:

Exxon Mobil Corp. and explorers including Chevron Corp. are securing land in Europe to exploit shale gas, a hard-to-extract deposit that could reduce global demand for liquefied natural gas, JPMorgan Chase & Co. said.

Exxon has shale areas in Germany, Hungary and had applied for permits in Poland while ConocoPhillips and Chevron are in Poland and Royal Dutch Shell Plc in southern Sweden to exploit gas trapped in rock formations and impervious to conventional drilling techniques, JPMorgan said in a Feb. 9 report.

“A land-grab has occurred in Europe over the last two years with majors such as Exxon, Conoco, Chevron and Statoil ASA all participating, not willing to miss out as they did in the U.S.,” said Mark Greenwood, a Sydney-based analyst with JPMorgan. “While it’s still early days for European and Chinese shale gas plays, its potential is yet another threat for the LNG supply-demand balance.”

Note to Putin: its potential is yet another threat to the pipeline supply-demand balance too:

The International Energy Agency said in November the world may have an “acute glut” of gas in the next few years because production of so-called unconventional fuel, which includes shale gas, is set to rise 71 percent between 2007 and 2030. Shale is a rock comprising layers of sediment from which oil and gas can be extracted.

The success of shale gas extraction in Europe and China may sap global LNG demand, reduce Europe’s dependence on Russian natural gas and force new Russian gas projects and Qatari LNG to compete with Australian LNG projects for Asian customers, Greenwood said.

. . . .

Qatar had earmarked 25 million tons a year of LNG for the U.S., which doesn’t “appear” to need the gas, according to the JPMorgan report.

Where’s that gas going to go?  Europe and Asia, most likely–in direct competition with Russian gas.  Combine this with the prospect for slow growth in North America and Europe (especially if the sovereign debt crisis continues, or turns for the worse), and it is likely that supply and demand will conspire to put a huge dent in Gazprom’s prospects.

My, how the worm is turning.  Which all goes to show the danger of putting all your chips on one number.

This shouldn’t be news.  The historical experience in commodity markets has been of shocks making a complete shambles of confident predictions.  In the 70s and early 80s, it was widely believed that oil prices would escalate inexorably, reshaping geopolitics as a result.  The exact opposite happened.  Geopolitics were indeed reshaped, but in a very different way.

Indeed, the USSR was the most prominent casualty of this shift.  (See Gaidar’s book for a blow-by-blow account of how the USSR’s fortunes waxed and waned with the upward spiral and subsequent collapse in oil prices.)  How soon some people forget.

Developments here in Texas are having consequences around the world, in places that couldn’t be more different–like Russia.  Specifically, Gazprom has announced that the massive Shtokman gas project in Russia’s frozen north has been postponed.  It may not be unpostponed any time soon.  Part of the reason for postponement is the lingering effect of the financial crisis on the demand for gas in Europe.  But another big part of the reason is that the economics of the project were predicated on exporting liquified natural gas (LNG) to the US.  With the massive production of shale gas in Texas, Louisiana, and Arkansas, the US will not be needing LNG imports any time soon; as a result, the US has supplanted Russia as the world’s largest gas producer.  Indeed, the US may become an LNG exporter.  The technology for accessing shale gas may also open up previously unreachable supplies outside the United States, some of which should be able to reach consumption markets by pipelines, and some in the form of LNG.

Given the centrality of gas to Putin’s (“Gasputin’s”) geopolitical schemes, these developments are to be welcomed.  They should be welcomed by Russians too (though not those feeding at the rent trough); anything that undermines the rents that support the natural state is a boon for those who suffer from its stultifying effects.  These developments may save the Europeans from themselves and their inability to devise a coherent, unified strategy to combat the gas weapon, and reduce the intensity of the Great Game in the Caspian region and Central Asia.   The development of new unconventional gas supplies should also but a serious crimp in any plans for a gas OPEC.  All good.

In other words, drill horizontally baby, drill horizontally.

The development of a more active spot market for gas in Europe, driven by LNG, should also permit a change in contracting for Russian pipeline gas.  Currently, contract prices for Russian gas are tied to oil prices.  Although oil and gas are substitutes, and exhibit some correlation in values, the connection is quite loose.  The development of a spot gas market would permit indexing contract prices for pipeline gas delivered to Europe to European spot prices.  This would reduce, and arguably eliminate, the divergences between gas values and contract prices that create incentives for opportunistic behavior that necessitate rigid contractual terms such as take or pay provisions that are currently the source of friction between Gazprom and European consumers.

The huge ramifications of the technology of drilling for natural gas bring to mind the 1970s James Burke show “Connections.”  What happens in the hot, humid Piney Woods country can shape destinies on the dusty plains of Central Asia or the frozen wastes of Russia.  Truly amazing.

No, not me–although I am sure that a few of you would disagree.  No, I refer to Senator Maria Cantwell (D-WA) and her confreres, who clearly have some deep seated neuroses and phobias when it comes to anything involving derivatives and speculation.

Cantwell actually earns a twofer today.

First, she is the co-sponsor of a new cap & trade bill.  Although cap & trade isn’t dead, it is coughing up blood; even Obama has recognized that it has no chance of passing soon.  Along with Senator Collins (R, sorta-ME), Cantwell has introduced a bill that would institute a cap & trade regime.  It is, blessedly, much simpler than the grotesquely bloated, complicated, and convoluted ACES bill that passed the House in 2009; apparently Cantwell and Collins believe that ACES is doomed, and that a simpler bill may be the only hope.  Conservation of paper is, alas, its main redeeming feature.

It isn’t really a cap & trade bill.  It’s better described as cap, definitely, trade, not so much.  And the latter feature is what lays bare Cantwell’s phobias.  To read what she and Collins have proposed is to enter bizarro world.  They impose onerous restrictions on the trade of emissions rights and derivatives on them, apparently out of a belief that (a) speculation is evil, and (b) derivatives can only be used for speculation.

There are two completely non-sensical provisions in the bill that relate to trading emissions rights, and derivatives on them.

First, the bill permits only emitters to own certificates, and to purchase them at (an annual) auction.  This means, specifically, that financial institutions cannot buy or trade certificates.  Presumably, this is intended to bar the market to those malign speculators.  But its actual effects will be to make the market extremely illiquid, and to make it unnecessarily costly for those who have more permits than they need to trade them with people who have fewer than they need; financial institutions would be the natural market makers and liquidity suppliers, and baring their participation would starve the market of liquidity.  This will hamper the efficiency of the market, and make it costlier to achieve the emissions reductions imposed by the cap feature of the bill.  Moreover, it is likely that absent such a restriction, certificates could be used as collateral and facilitate end user financing, an alternative that would be precluded under the bill, making it more costly for emitters to finance their purchases of certificates.

Second, and even more bizarrely, the bill prohibits those very end users from trading any derivative contract on emissions.

Let me repeat: the bill prohibits those very end users from trading any derivative contract on emissions.

Huh?

Under a cap and trade scheme (and I mean scheme), end users are exposed to carbon price risk, and over very long time horizons.  They are natural hedgers who need derivatives to manage that risk exposure, but the Cantwell-Collins bill would preclude them from doing that.  The bill creates risk by pricing carbon, but at the same time denies those affected by this risk the ability to manage it.  That borders on cruel and unusual, and just makes it unnecessarily costly to achieve carbon reductions.  Pain with no gain.

But note the bill doesn’t ban derivatives outright, so Cantwell and Collins are apparently perfectly willing to contemplate a carbon casino where only speculators can play (though not in the certificates themselves).  But the speculators will not be allowed to provide valuable risk bearing services to hedgers.  No, it doesn’t make sense to me either.

Seldom have I seen anything so inane coming out of Congress, and that is saying something.

Separately, Cantwell came out with a call for increased regulation of commodity derivatives generally:

The US commodities market should be freed from “reckless speculation” and abusive trading practices, a leading US senator has urged, as she attempts to stop the price of everyday items like petrol and food from being impacted by financial traders.

Senator Maria Cantwell, who is separately trying to revive the Glass-Steagall reforms of the 1930s which would prevent retail and investment banks from operating under the same roof, yesterday called for increased regulation of the commodities and derivatives market.

The Democrat politician is attempting to push regulation of the commodities markets – a hot topic in the summer of 2008 when oil prices topped $140 a barrel – back to the top of the political agenda.

She is calling for stronger powers for the Commodities Futures Trading Commission (CFTC), including the potential to police the unregulated over-the-counter derivatives market, which has worth $25 trillion at the end of June 2009.

And how, pray tell, does the Senator support her case?  By calling on the vaunted expertise of megatool Michael Masters:

Backed by hedge fund manager Michael Masters, of Masters Capital Management, she called for the proposed reforms to take their place alongside wider financial regulatory reforms currently being discussed by the US Congress.

Mr Masters believes that there is a strong correlation between the credit crisis and volatile commodity costs, which have seen a rise not only in oil prices but in basic food staples in recent years.

Correlation, causation.  Whatever.

Masters and I participated in a workshop on oil markets sponsored by the Energy Information Agency back in November.   I can state categorically that he doesn’t understand the economic function of derivative markets, or of the functions that financial intermediaries play in these markets.  He says things like (I quote from memory, but this is almost verbatim) “financial markets are for allocating resources over time, but commodity markets are to get goods from producers to consumers.”  Well, yeah, but commodity markets are also crucially about allocating resources over time, because the time patterns of consumption and production don’t necessary always match exactly.  In fact, they almost never do.  (Think about a seasonal commodity, like corn or natural gas.)

So even beyond risk shifting, you need futures and forward markets to encourage the efficient allocation of commodities over time; getting stuff from producers to consumers inevitably involves intertemporal trade.  What’s more, financial intermediaries are frequently the best able to perform the function of storing and financing commodities.  After all, what they do is facilitate intertemporal resource allocation, and commodity storage and financing is just a specific example of that.  But not in Mastersworld, evidently.

Talk about the blind leading the blind–or is it the phobic leading the phobic?  Maybe group therapy is available at a discount.

After Masters made this statement at the EIA workshop, I replied along the above lines.  Only less politely.  I started by saying something like: “I can’t believe you said that.  It’s one of the dumbest things I’ve ever heard.  Commodity markets are all about allocating resources over time.”  Always trying to win friends and influence people.

I doubt either of these measures is going anywhere.  Fortunately.  But they reveal a disturbing mindset that is all too common on Capitol Hill, and among the pilot fish that swim symbiotically with the senatorial sharks.

ExxonMobil is at loggerheads with the Russian government over the Sakhalin I project.  The issue is the one that eventually spelled Shell’s doom in Sakhalin II: development costs under the production sharing agreement (PSA):

The government rejected a proposal by ExxonMobil, the world’s largest company by market value, to invest $3.5 billion this year in the Sakhalin offshore fields, putting the oil producer’s plans at risk again, Sakhalin Governor Alexander Khoroshavin said Thursday.

Higher expenses in production sharing agreements — such as Sakhalin-1, which is operated by an Exxon-led consortium — would delay the government in receiving its share of revenues until the companies that develop fields recoup their investment.

“We believe it is an inflated amount,” Khoroshavin told reporters after a Cabinet session Thursday that discussed unrelated issues. “The consortium can’t substantiate it for us, this $3.5 billion.”

Exxon said it had to suspend work on a Sakhalin field for several weeks at the start of last year as it argued with the government about the 2009 investment budget for the project that it co-owns with Rosneft, Japan’s Sodeco and India’s ONGK Videsh. The consortium has been producing oil at a field off Sakhalin for a few years and is investing in another field.

An ExxonMobil spokesman said the company was working to respond to the government’s concerns and hoped to return to discussions on the matter in the spring.

Khoroshavin said Exxon would submit a revised spending plan to the government in March.

This negotiation takes place, of course, in the shadow of Gazprom, which needs the Sakhalin gas to meet its own commitments, and to achieve its ambitions to control the supply of gas to China:

The spending dispute has been recurring as Gazprom seeks to buy all future gas from Sakhalin-1 to prevent it from flowing to China, which would create competition for Gazprom’s own plans to sell gas on that market. Exxon has said the project would sell gas to the highest bidder.

Gazprom also needs the Sakhalin-1 gas to fill a pipeline that it is constructing from the island to Vladivostok to supply clean fuel in time for the Asia-Pacific Economic Cooperation forum in the port city in 2012.

“Much will depend on Sakhalin-1, that is, whether Gazprom can buy their gas for the pipeline,” Khoroshavin said, referring to the prospect of fully loading the pipeline by 2012.

ExxonMobil currently has the right to market the gas itself, an exception from Gazprom’s gas export monopoly that grates on the Russian behemoth.  Given these circumstances, there is good reason to be suspicious of these standoffs.  They are quite likely pretexts to holdup XOM, and wrest control of Sakhalin I gas.  Given the experience of Shell, it is hard to imagine that a canny company like XOM would inflate costs, knowing that this would give Putin the perfect excuse to crank up the “these unfair PSAs were negotiated when Russia was on its knees and now we’re standing tall and will take back what’s ours” rhetoric.  That may be coming regardless, but Exxon has every incentive not to provide Putin any ammunition.

This isn’t over.  It’s almost certain that the pressure will intensify, especially as the 2012 APEC date approaches, and Gazprom becomes more desperate for gas to cover its own falling production.

I was in NY today, giving a press conference at NYMEX about my WTI study.  After that, I went down to the floor for a (taped) interview about the study with CNBC.

Wow.  How the world has changed.  I haven’t been on an exchange floor in a while; increased security post-9/11 has made it much more difficult.  But I spent a good deal of time on the floors in Chicago in the 80s, and in the 90s.  I was at the CBT the day the new trading floor was opened for a dry run: I remember watching hundreds of traders lining up at the entrance, like marathoners before a race, then sprinting to stake out a place in the new bond and note pits.   There was an indescribable energy on the floor.  It escapes my powers of description, really.  It’s something you had to experience.

And the operative thing there is the tense of “to have.”  You HAD to experience it, because you really can’t experience it anymore.  And that’s what I experienced first hand at NYMEX today.  I was taping right next to the crude oil pit.  Back in the day, there is no way you could have stood there, and conducted an interview to be played on TV: the noise would have made it impossible.  No problem today.  The few handfuls of traders in the pit were all reading newspapers.  I was there probably 15-20 minutes, and didn’t see one trade.  Not one.

Yeah, there was some action in the options pit, but the futures pits were essentially D-E-A-D dead.

Above the pits were many Trading Technology* screens, which were reporting the action from the electronic trading.  That’s where all the action was.  If there was a visual symbol of the dominance of electronic trading, that would be it.  The blinking blue and red screens, lording over the pit, almost mocking it with their continuous movement symbolizing a live, moving (but disembodied) market while the pit itself was almost funereally still.

I have mixed emotions about this.  In the early-to-mid-90s I was pretty outspoken in my opinions that electronic trading would make the floor obsolete.  I was ridiculed, publicly and in print, by the CEO of LIFFE, for my research showing that the electronic DTB Bund futures market was as liquid as the LIFFE’s floor market; he was not alone in his views.  I resisted the temptation to return the ridicule 4 years later when EUREX (the successor to DTB) wrested the Bund business from LIFFE.  So, in some respect, the eerie silence on the NYMEX floor is a professional vindication.

But still.  There is something–was something–truly special about the floors.  They were fascinating economic and social systems–true ecosystems.  The informal norms of floor trading–the institutions–were amazingly complex.  And highly, highly entertaining.  Moreover, the floors were a connection to history; trading on the CBT in 1995 wasn’t that much different from in 1895–at least at the pointy end, where trades were actually done.  A bunch of guys (yes, almost all guys, even in 1995) yelling and gesturing at one another.  As a student of history, there is a sense of loss when such a tangible connection to the past fades away.

There’s a new movie, Floored, that depicts life on the floors in Chicago in their twilight.  I haven’t seen it, as it’s just playing at an art house in Chicago, but hope to do so if/when it comes out on DVD.  Some folks in Chicago are ticked off (no pun intended–and you know inside baseball if you even know that COULD be a pun:) that the film (if it’s at an art house, it must be a “film,” right?) focuses on the sex,drugs, greed, and rock & roll aspects of floor trading.  Yeah, it’s undeniable that that’s part of the culture, but it’s not the whole thing, or even a big part of it, so I can understand that those who love the markets would be dismayed by such a one-dimensional portrayal.  Perhaps I will be dismayed too when I watch it.  But sex sells, and there has to be a better way to understand some of the social complexity of the floor than watching Trading Places.   One would hope, however, that a serious filmmaker would team up with some serious social scientists and do a documentary that explores the anthropology/sociology/economics of the floors.  Or that the Smithsonian captures memories of traders, like it does of old blues players and such.  Before all the old traders just fade away.  Because it’s happening before our eyes.

* Full disclosure: TT is a consulting client.

I was talking to some folks at a research/policy institute at another university about regulation of carbon derivatives trading who are attempting to educate Congress (or, more precisely, Congressional staff) on the matter.  They told me that there was a widespread belief on Capitol Hill that customized, OTC derivatives offer little or no social benefit, and that as a result, their use should be highly restricted, if not eliminated altogether. The view is that these instruments create systemic risks, but confer no corresponding benefit that cannot be offered by exchange traded products.

I disagree, for reasons I set out in a Brookings paper released last fall.  But I don’t want to focus on the details of that argument here.  Instead, I just want to flash back to a historical example that demonstrates that limiting the contracting choices of commodity market participants can have extremely perverse effects, and can in fact create systemic risks.

The legislation that restructured the California electricity markets, AB1890, precluded the state’s major utilities from entering into long term contracts for power.  Instead, in order to ensure the “success” of the spot market for power, the utilities were required to buy electricity from generators through an exchange–the Power Exchange (“PX”).  The bill also capped the price that utilities could charge their customers for power.

This legislation created a huge short position for the utilities.  They were exposed to increases in prices on the PX, and could not pass on these costs to customers.  Most importantly, the bill prevented the utilities from managing their price risk by engaging in long term forward contracting.

We all know what happened.  Power prices spiked, and two utilities still subject to the constraints (SoCal Edison and PG&E) suffered huge losses.  PG&E went bankrupt.

The problem would likely have been less severe had the utilities been given the ability to hedge.  Indeed, the absence of forward contracts may have exacerbated the price spikes, because these contracts would have precommitted the generators to supply power, whereas they arguably had an incentive to restrict output on the PX when conditions became tight.

Moral of the story: limiting the ability of firms to manage risks can impose substantial dangers of financial distress on those companies.  Indeed, if they limitations are systemic (as they were in California), they create the risk of a systemic problem.

Now, the analogy should not be stretched too far.  In its infinite, tofu-fueled wisdom, California chose to favor one type of exchange trading (spot auctions on the PX) for different reasons than Congress in its infinite God-knows-what-fueled-wisdom is contemplating favoring exchange trading of carbon (and other) derivatives.  Moreover, the restrictions in California were particularly draconian, especially when combined with the retail price caps.

Nonetheless, the tale should be a cautionary one.  Firms use derivatives contracts to pass risks to others who bear them at a lower cost.  If you constrain their ability to do so, they will wear more risk than they would otherwise.  This raises the likelihood that they will suffer crippling financial losses.  The more draconian the restrictions, and the wider the scope of their application, the greater the likelihood, severity, and extent of these losses.

That is, by avoiding one risk, you create others.  Rational policy requires a prudent trade-off between these various risks.  But fixated as they are on the risk (largely chimerical, IMHO) of OTC markets, most policy makers in DC are blind to the risks they are effectively choosing.  Their ability to weigh these tradeoffs is, moreover, extremely limited due to a fundamental lack of information.  Carbon trading regulation in particular will have systemic effects: it will impact every producer and consumer of energy.  How could Congress possibly have the knowledge to evaluate the risks that they are forcing on such a vast and diverse group of companies when they restrict their ability to choose the instruments that they can use to manage that risk?  Short answer: they can’t.

I would hope that the California experience would at least make policy makers aware of the possibility that restrictions on the contracting choices available to market participants creates risks.  So far, however, the debate appears to have taken no recognition of this very real possibility.  Keeping their eyes fixed on the skies to reduce the risk of being hit by a falling object, they face the very real risk of stepping into an open manhole.

The CFTC floated its proposal to set energy futures & futures options position limits yesterday.  Here’s the NOPR, and here’s a cheat sheet and FAQ about the proposal.

The result is no surprise to me.  In the weeks leading up to the announcement, many reporters had called to ask for my take on the CFTC’s likely course of action.  I responded that the CFTC would do something, but that the limits it chose would be relatively generous.  The agency was between a rock and a hard place.  On the one hand, Congress clearly expected action; indeed, I strongly suspect that Gensler had to promise that he would act on energy position limits to get the job in the face of skepticism from Bernie Sanders and some others in the Senate.  On the other hand, it eventually dawned on the Commissioners that overly restrictive limits would just drive business to OTC, and perhaps overseas; given that Gensler in particular wants to rein in the OTC markets, this would be an extremely perverse outcome.  So, they did something, but not much.

Which isn’t the best alternative, but it’s not the worst either.  The best alternative would have been to take a principled stand like the FSA, which has remained skeptical on position limits because of the lack of any evidence that speculators distort prices.

Indeed, the entire justification for the CFTC action could be summarized as (with apologies to The Treasure of the Sierra Madre): “Evidence?  We ain’t got no evidence.  We don’t need no evidence.  We don’t have to show you any steenkin’ evidence!”

Don’t believe me?  Well, here’s what they say:

The Commodity Exchange Act directs the CFTC to act prospectively, as necessary, to curb or prevent excessive speculation . . . The CFTC’s notice of proposed rulemaking does not speak to whether there was excessive speculation in the regulated derivatives markets for energy commodities. [From the FAQ.]

The CFTC need not demonstrate that there has been excessive speculation in the regulated derivatives markets for the major energy commodities. [Emphasis added.]

I see.  There is no evidence that speculation has distorted prices in the past, but the Commission feels it is perfectly acceptable to act against the purely hypothetical possibility that it might in the future–even though the logical and empirical basis for the hypothetical is extremely dubious, at best.

A couple of other comments on the proposal.

First, it creates a tripartite classification of market users–bona fide hedgers that use futures to manage physical risks; swap dealers that use the contracts to manage financial risks, and speculators.  Swap dealers can hold positions equal to twice the limit to which speculators are held.  This seems like being a little bit pregnant.  The higher limit is an implicit admission that swap dealers do use these instruments to manage financial risks.  Indeed, many of these risks are transferred from the very same physical market players whom the proposed limits favor as bona fide hedgers.  (Swap dealers offer risk management solutions to physical players, and then lay off some of that risk through the futures markets.)  So then what’s the point on limiting the position swap dealers can hold to hedge their OTC books?  And why is “two” the magic number.

Perhaps this is best seen as a backdoor approach to push trading from the OTC market onto exchanges.  Not a good idea.

Second, some aspects of the proposal are intellectually incoherent.  For instance, (a) there are all month limits, and (b) the limit for cash-settled contracts is five times the limit on delivery-settled contracts for firms that hold only the former.

Now, if you believe that market power manipulation is the problem, and if you believe that delivery settled contracts are particularly susceptible to market power manipulation, then all month limits are unnecessary; a spot month limit would be sufficient to mitigate manipulation.  (It’s wrong, as I showed in a JOB paper some years back, to conclude that cash settled contracts are not susceptible to market power manipulation, but it is a widely held belief.)

So, by choosing all month limits, the CFTC must believe that market power manipulation alone is not the problem; speculation can distort prices in other ways.   But if you believe that (not that you should, but if you do), you should also believe that speculation in cash settled contracts could also distort prices.  (A lot of the hyperventilating about index funds, and OTC markets, is based on the view that people making bets affects the outcome of the race.)  But if you believe that, you wouldn’t privilege cash settled contracts through a much more generous position limit than for delivery settled ones.

Perhaps this incoherence shouldn’t be a surprise.  Given the complete absence of any credible theory or evidence as to how speculation distorts prices to guide policy making, silliness is inevitable.

How will this play out?   Apparently the Commission is quite divided.  Moreover, it has indicated that it will take its sweet time in evaluating comments on the proposal, and may revise it accordingly, stretching the implementation time line.

My guess is that this is a strategic decision.  The Commission at least recognizes that any coherent approach to limits (even if the coherence is based on flawed theories and evidence: I just mean intellectually consistent) must encompass both the OTC markets and the exchange traded markets.  If the Commission wants to, for reasons known only to its members, crack down on speculation generally, acting on the futures markets alone is doomed to failure.  But they are waiting on Congress for authority to act in the OTC market.  Slow walking the proposal gives Congress time to act, and may indeed goad it into action.

In brief: laws, sausages–and CFTC proposals.

I’m sure you’ve read about Putin and/or Medvedev reacting with high dudgeon to Ukrainian failures to pay for gas in full and on time.  Oh, the lectures they can give.  The moral outrage!  How dare they not pay what they owe!  The nerve!  The idea!

Keep that image in mind when you read this:

Poland and Russia have yet to sign a gas delivery deal for 2010 due to Gazprom owing Warsaw around 410 million dollars.

Poland still has not signed a deal on gas supplies with Russian energy giant Gazprom, which should have been agreed at the end of last year. Poland is delaying the signing because the Russian company owes it over one billion zloty (410 million dollars).

Gazprom’s debt of 350 million dollars results from paying lower tariffs for gas transit in Poland as required by the Energy Regulatory Office. Additional 60 million dollars debt results from not delivering gas to Poland by Gazprom’s middleman company RosUkrEnergo in 2008. Later, the Russian gas giant took over the company’s debt.

As for now, Gazprom is willing to sign a new agreement on condition that Poland will cancel a part of its debt. The Polish gas company EuRoPol Gaz, however, does not want to make concessions, claiming that it would violate Polish law.

Just another example of the for-thee-not-for-me Russian commercial mentality, as if we needed another.  (The Producers episode in which Gazprom cut off gas imports from Turkmenistan, causing a pipeline blowup rather than meet its take-or-pay obligations is another great example.)  Keep that in mind the next time you hear Putin or Sechin or Medvedev or anybody in the Russian government caterwauling about somebody being a deadbeat.