Streetwise Professor

I don’t watch much TV, and medical shows have always been near the bottom of my list of things to watch.  But one show that I find entertaining from time to time is House.  It’s about a quirky (and now, apparently, actually delusional) physician who, along with a team of young doctors whom he abuses continually, diagnoses strange afflictions.  In the couple of episodes I’ve watched, House and his team make several incorrect conjectures, before fixing on the correct diagnosis, thereby saving the patient du jour from a terrible fate.

Dmitri Medvedev is apparently auditioning for the Russian version of the show, and has delivered a devastating diagnosis–complete with medical metaphors–on the state of the Russian economy, and Russian society.  Indeed, it is so damning that if I, for instance, were to make it (and I have) I would be assailed with howls accusing me of the basest Russophobia.  Don’t believe me?  Read it for yourself, right here on the official Kremlin website:

The global economic crisis has shown that our affairs are far from being in the best state. Twenty years of tumultuous change has not spared our country from its humiliating dependence on raw materials. Our current economy still reflects the major flaw of the Soviet system: it largely ignores individual needs. With a few exceptions domestic business does not invent nor create the necessary things and technology that people need. We sell things that we have not produced, raw materials or imported goods. Finished products produced in Russia are largely plagued by their extremely low competitiveness.

This is why production declined such much, more than in other economies, during the current crisis. This also explains excessive stock market volatility. All this proves that we did not do all we should have done in previous years. And far from all things were done correctly.

The energy efficiency and productivity of most of our businesses remains shamefully low, but that is not the worst part. The trouble is that it seems that owners, directors, chief engineers and officials are not very worried about this.

As a result Russia’s influence in global economic processes is, quite frankly, not as great as we would like. Of course, in the era of globalisation the influence of any country cannot be unlimited. That would even be harmful. But our country must have substantial opportunities, as befits Russia’s historic role.

As a whole democratic institutions have been established and stabilised, but their quality remains far from ideal. Civil society is weak, the levels of self-organisation and self-government are low.

Every year there are fewer and fewer Russians. Alcoholism, smoking, traffic accidents, the lack of availability of many medical technologies, and environmental problems take millions of lives. And the emerging rise in births has not compensated for our declining population.

We managed to gather the country together to stop centrifugal tendencies. But many problems still remain, including the most acute ones. Terrorist attacks on Russia are continuing. Residents of the republics in the North Caucasus simply do not know peace. Military and law enforcement personnel are dying, as are government and municipal employees, and civilians. Of course these crimes are committed with the support of international criminal groups. But let’s face up to it, the situation would not be so critical if the socio-economic development of southern Russia were more viable.

To sum up, an inefficient economy, semi-Soviet social sphere, fragile democracy, negative demographic trends, and unstable Caucasus represent very big problems, even for a country such as Russia.

Of course we do not need to exaggerate. Much is being done, Russia is working. It is not a half-paralyzed, half-functioning country as it was ten years ago. All social systems are operating. But this is still not enough. After all, such systems only propagate the current model, and do not develop it. They cannot change current ways of life and therefore bad habits remain.

Achieving leadership by relying on oil and gas markets is impossible. We must understand and appreciate the complexity of our problems. We must frankly discuss them in order to act. In the end, commodity exchanges must not determine Russia’s fate; our own ideas about ourselves, our history and future must do so. Our intellect, honest self-assessment, strength, dignity and enterprise must be the decisive factors.

My starting point while setting out five priorities for technological development, offering specific measures for the modernisation of the political system, as well as measures to strengthen the judiciary and fight corruption, is my views on Russia’s future. And for the sake of our future it is necessary to liberate our country from persistent social ills that inhibit its creative energy and restrict our common progress. These ills include:

1. Centuries of economic backwardness and the habit of relying on the export of raw materials, actually exchanging them for finished products. Peter the Great, the last tsars and the Bolsheviks all created – and not unsuccessfully — elements of an innovative system. But the price of their successes was too high. As a rule, it was done by making extreme efforts, by using all the levers of a totalitarian state machine.

2. Centuries of corruption have debilitated Russia from time immemorial. Until today this corrosion has been due to the excessive government presence in many significant aspects of economic and other social activities. But it is not limited to governmental excess — business is also not without fault. Many entrepreneurs are not worried about finding talented inventors, introducing unique technologies, creating and marketing new products, but rather with bribing officials for the sake of ‘controlling the flows’ of property redistribution.

3. Paternalistic attitudes are widespread in our society, such as the conviction that all problems should be resolved by the government. Or by someone else, but never by the person who is actually there. The desire to make a career from scratch, to achieve personal success step by step is not one of our national habits. This is reflected in a lack of initiative, lack of new ideas, outstanding unresolved issues, the poor quality of public debate, including criticism. Public acceptance and support is usually expressed in silence. Objections are very often emotional, scathing, but superficial and irresponsible. Well, this is not the first century that Russia has had to confront these phenomena.

Other than that, things are just great!!!  And feel free to point out how what I’ve been saying for the last 3 years has differed all that much from what Medvedev is saying today.

Where Medvedev and House part ways, however, is in the cure to the properly diagnosed disease.  House being fictional, he always can come up with the life saving treatment right before the last commercial break.  Medvedev, in contrast, having to deal with reality, can do no more than prescribe a placebo:

I recently identified five strategic vectors for the economic modernisation of our country. First, we will become a leading country measured by the efficiency of production, transportation and   use of energy. We will develop new fuels for use on domestic and international markets. Secondly, we need to maintain and raise our nuclear technology to a qualitatively new level. Third, Russia’s experts will improve information technology and strongly influence the development of global public data networks, using supercomputers and other necessary equipment. Fourth, we will develop our own ground and space infrastructure for transferring all types of information; our satellites will thus be able to observe the whole world, help our citizens and people of all countries to communicate, travel, engage in research, agricultural and industrial production. Fifth, Russia will take a leading position in the production of certain types of medical equipment, sophisticated diagnostic tools, medicines for the treatment of viral, cardiovascular, and neurological diseases and cancer.

. . . .

These goals are realistic. The targets we have set for achieving them are difficult but attainable. We have already developed detailed, step-by-step plans to move forward in these areas. We will encourage and promote scientific and technological creativity.

The chasm between the description of the disease–or more properly, diseases–and the proposed treatment is vast.  And indeed, diagnosis and treatment seem diametrically opposed.  Symptom one of the Russian disease, according to Medvedev, is “economic backwardness and the habit of relying on the export of raw materials.”  But what is treatment one?   Hair of the dog: “First, we will become a leading country measured by the efficiency of production, transportation and   use of energy.”

Now I realize there are some differences here; for instance, Medvedev bewails Russia’s wasteful use of energy, and proposes to fix that.  But still, it seems rather difficult to overcome a crippling dependence on raw material extraction–notably energy extraction–by focusing on energy production and transportation.

The other proposals are fantasy absent some complete revolution in the way Russia works.  Dirigiste, corrupt, “vertical” economic systems with poor protection of property rights–including intellectual property rights–are not going to become leaders in marketable technology.  And for a country with as appalling a health system as Russia’s to become a leader “in the production of certain types of medical equipment, sophisticated diagnostic tools, medicines for the treatment of viral, cardiovascular, and neurological diseases and cancer” is, well, beyond fantasy.  When it comes to healthcare, I suggest that Medvedev should make more down-to-earth goals, like running water in all hospitals and access to basic treatments.

This season’s Medvedev may share something else with this season’s House–delusions.  What other explanation could there be for this?:

Russia’s political system will also be extremely open, flexible and internally complex. It will be adequate for a dynamic, active, transparent and multi-dimensional social structure. It will correspond to the political culture of free, secure, critical thinking, self-confident people. As in most democratic states, the leaders of the political struggle will be the parliamentary parties, which will periodically replace each other in power. The parties and the coalitions they make will choose the federal and regional executive authorities (and not vice versa). They will be responsible for nominating candidates for the post of president, regional governors and local authorities. They will have a long experience of civilized political competition: responsible and meaningful interaction with voters, inter-party cooperation and the search for compromises to resolve acute social problems. They will bring together in one political entity every element of society, citizens of all nationalities, the most diverse groups of people and territories of Russia endowed with ample powers.

The political system will be renewed and improved via the free competition of open political associations. There will be a cross-party consensus on strategic foreign policy issues, social stability, national security, the foundations of the constitutional order, the protection of the nation’s sovereignty, the rights and freedoms of citizens, the protection of property rights, the rejection of extremism, support for civil society, all forms of self-organisation and self-government. A similar consensus exists in all modern democracies.

This year we started moving towards the creation of such a political system. Political parties were given additional opportunities to choose those occupying leadership positions in the federal regions and municipalities. We relaxed the formal requirements for the creation of new parties. We simplified the conditions in place for the nomination of candidates for election to the State Duma. We passed legislation guaranteeing equal access to public media for parliamentary parties. A number of other measures were adopted as well.

Another yawning chasm between word and deed/fact. No need to belabor this point.

Indeed, the vast difference between what Medvedev says, and the facts on the ground and the government’s actual policies is the source of much skepticism, not to say cynicism.  For instance, in a post titled “Medvedev’s call for Reform Rings Hollow” James at Robert Amsterdam writes:

There is a reasonable argument that it is better to have this kind of empty dialogue rather than no dialogue at all, but when the former Chairman of Gazprom is the one voice to complain about the excess influence of the state in the business sector, then we know we have a problem taking it seriously.

Other observers have taken it a bit further.   My thanks to a commenter, who points us to this acerbic reaction to the Medvedev article by  Aleksander Ryklin:

“My first reaction when I read the piece was a desire to copy it and rework it a bit. For example, maybe put it on a pink background and decorate it with flowers here and there. To mark out particular paragraphs with lipstick kisses and others with smiley faces.”

Ouch.

The Ryklin article is brutal:

After all, no grown-up, self-respecting person should appear so pathetic. They shouldn’t so openly and publicly display their own helplessness.

On the other hand, people shouldn’t so brazenly and with such open, unconcealed cynicism demonstrate their complete contempt and spite for the intellectual abilities of the population temporarily under their power. He isn’t taking just me for an idiot, but everyone in the country. So I also felt discomfort on behalf of the country.

Playing For Laughs

As soon as I read it, I was asking myself: What is this? A cry of the soul? A suicide note? A letter to Vladimir Putin? To his wife? To posterity? To historians? No, no, my friends. This letter is addressed first and foremost to idiots. But you and I are not idiots. At least, not all of us.

. . . .

To be honest, I’m not very sorry for Medvedev. Because I don’t believe for a second that he is sincere. He wants to “cooperate”? Then he can start by firing Putin, by dissolving the Duma, and then we’ll see. He can’t, you say? Then what is he pretending for? So that maybe someday something will happen? It would have been better to stick his letter into a time capsule and bury it under the biggest Kremlin tower than to humiliate himself like this in front of all honest people.

I don’t know whether it’s pathetic, or cynical, or what, but the complete disconnect between the gravity of the diagnosis, and the lack of serious effort to treat the diseases doesn’t bode well for the future.

Indeed, after finishing reading Medvedev’s long piece carefully, what comes to mind is not the typical TV doc-drama ending with the patient saved in the nick of time, but the punchline to an off-color joke about a guy who gets bit in an unmentionable place by a poisonous snake: “You’re gonna die.”

The Moscow Times reports that the Russian Federal Audit Chamber had inspected the  Sayano-Shushenskaya dam two years ago, and reported that 85 percent of its equipment needed to be replaced.  The Chamber’s boss,  Sergei Stepashin, said that “the government and the Prosecutor General’s Office were informed about the results of the check at the time.”

This gives the lie to Putin’s post-disaster statement stressing the need to inspect Russian infrastructure to identify problems.  In the particular case that spurred the Putin’s demand, an inspection had been carried out.  The inspection had identified problems.  The government had been informed.  But nothing was done.  So . . . you can inspect all you want, but if you ignore the results of the inspection, what you get is a disaster.

Stepashin’s statement is probably a mere echo of a riot of finger pointing and ass covering going on behind the scenes in Russia.  Putin, by implication, blames the inspectors.  The inspectors reply “we did our job,” thereby directing the blame at the company.  The company (perhaps to the strains of Chuck Berry’s “It Wasn’t Me”) denies culpability:

RusHydro, the state-owned company that owns the plant, said it had studied the auditors’ findings and acted accordingly. “All the necessary measures were taken and reported to the Audit Chamber” after the check, RusHydro spokesman Yevgeny Druzyaka said, Interfax reported.

I guess it depends on what “necessary” means.  And if the report actually says that 85 percent of the equipment needs replacing, is the company saying that it replaced 85 percent of the equipment?  That’s certainly not the case.  So, the company is implicitly refuting Stepashin’s representations, by implying that the repairs the Audit Chamber deemed “necessary” were insufficient to prevent the disaster.

What’s the whole truth?  Who knows?  But whatever it is, it can’t be pretty.  Surely nobody is likely to come out looking good.

But the crucial thing is that it is clear that an inspection was made.  The results were not good.  The government was informed.  And the disaster happened.  Ultimate responsibility for that necessarily lies at the top of the “power vertical.”  Which makes Putin’s post-disaster performance, with its efforts to cast blame elsewhere, and the implicit suggestion he lacked information about Sayano-Shushenskaya, appear all the more craven.  But it appears that Putin wants to be responsible for everything, and accountable for nothing.

I don’t know whether to laugh or cry at Dmitri Medvedev’s stirring defense of the sanctity of contracts:

President Dmitry Medvedev on Monday accused Ukraine of seeking changes to a contract for the transit of Russian gas across its territory, the latest row over energy between the two feuding states.

Medvedev told the head of state-run Russian gas giant Gazprom that Russia would not accept any move by the Ukrainian authorities to demand advance payment for the transit of Russian gas to European consumers via its soil.

Gas supplies and transit have been a constant sticking point in relations between Ukraine’s pro-Western leaders and Moscow. A dispute over debts and payments sparked supply cuts which left parts of Europe freezing in January.

Speaking at a meeting at the Kremlin, Alexei Miller, Gazprom chief executive, told Medvedev that Ukraine had sought to change the terms of payment for gas transit fees.

He said that such a change was not stipulated in the current contract.

“As far as an idea of an advance payment for tariffs, then I would like to ask you a simple question — is it stipulated in a contract?” Medvedev asked Miller in televised comments.

After receiving a negative answer from Miller, Medvedev said: “Then don’t pay! There’s a need to act in accordance with the contract that has been signed.

“We’ve specially prepared it, it was born in the throes of pain, has been quite seriously developed and we are currently working in line with it.”

“There’s a need  to act in accordance with the contract that has been signed.”  Amen.  Words to live by:  what’s sauce for the goose is sauce for the gander, no?   Try it some time, Dmitri.

I suggest that Turkmenistan, or any of those who have suffered from Russia’s–and notably Gazprom’s–one-sided interpretations of contracts, throw those words back in Medvedev’s (or Putin’s) face some time soon.  And since this little dialog between Medvedev and Miller was recorded for posterity, the Turkmenis (or whomever) should be ready to do a Warner Wolff “Let’s go to the videotape” complete with slo-mo and reverse action in order to make it as embarrassing as possible.

And speaking of recording for posterity, I find these little dramas acted out in Medvedev’s office, or in Putin’s, to be extremely odd.  (I remember another scene, during January’s Gas War, involving Putin and Miller, that was similarly stagey.)  Can anybody offer an explanation as to why these kind of Kabuki plays are evidently so appealing to Russian audiences?  (I presume that Medvedev, Putin, and others would not repeatedly employ them unless they were effective.)

Exchange Traded Funds (“ETFs”) are attracting a lot of attention given (a) the CFTC’s clear signaling of its intention to impose limits on these funds, and (b) the reactions of fund issuers to this signal, most notably Deutsche Bank’s announcement that it was closing down some ETFs altogether rather than operate under the anticipated position limit regime.

So what’s the big deal?  As with most discussions of the issues surrounding speculation in commodities, the critics of ETFs are maddeningly vague in their criticisms, and don’t provide any evidence of a demonstrable deleterious effect.  The arguments seem to be that big must be bad.

Case in point.  On CNBC this morning I heard an oil trader say that the UNG fund (which trades natural gas futures) is a problem because it holds 30 percent of the nearby contract; routinely liquidates that position as expiration approaches; and that the liquidation of such a big position must be disruptive.

Call me Alfred E. Newman, but in response, I’m thinking: “What?  Me worry?”  This seems like something that the market is perfectly capable of diagnosing and addressing without any meat cleaver regulatory restrictions.

First, note that the operators of funds have strong incentives to minimize their disruptive effect.  If their liquidations are distorting prices, that is costing the funds money.  They would be moving prices against them–inflating the prices of what they buy and deflating the prices of what they sell.  They have an incentive to trade to minimize that impact.  After all, they have to compete for investor funds, not just with other ETFs, but an immense array of other investment vehicles.  If they become so big, or trade so badly, that their execution costs balloon, their performance relative to that of alternative investments will decline, and they will have trouble attracting investment.  So, they have an incentive to mitigate their price impact.

Second, and relatedly, to the extent that a given fund becomes so big that despite its best efforts its liquidations are messy and its execution costs are high as a result, that will serve as a natural constraint on growth.  Put differently, if these execution cost-related problems create diseconomies of scale, again in a highly competitive investment marketplace, the size of these entities will be limited naturally.  It means they have an efficient scale, and competition will constrain their ability to expand beyond that efficient scale.

All sorts of markets for all sorts of things have natural mechanisms for ensuring that firms operate at efficient scale.  Why should financial markets in general, or ETFs be any different?

Third, the CNBC critic and others who point to the large liquidations of big ETFs fail to recognize that there is a natural set of traders who are ready, willing, and able to buy what the ETFs want to sell when they roll: these are the traders who sold short in the first place in order to allow the ETFs to buy.  They almost certainly don’t want to make delivery, and are looking to liquidate/cover their expiring shorts just as the ETFs are looking to liquidate/cover their expiring longs.  That is, the ETF doesn’t need to find a new set of buyers to take its positions.  There is a natural set of buyers out there; the people who sold to them in the first place.  And wouldcha know it, they just happen to want to buy the exact same amount of stuff that the ETF wants to sell.  A match made in heaven.

The main potential problem is how to coordinate the activities of the ETFs and those they want to sell to at expiration.  If the ETF starts to sell when the natural buyers aren’t around, there can be a temporary price impact as liquidity suppliers must bridge the gap until the natural buyers turn up, and the liquidity suppliers demand compensation for the risks that they bear as a result.

But markets have myriad ways to facilitate this coordination.  Indeed, coordination is what markets are all about.

One way to facilitate coordination would be through block trading facilities.  These have been around in equity markets for a long, long time.  They have started to make inroads into futures markets, but exchange rules and government regulations have been less favorable to block trading in futures than in equity markets.  So, one response would be to put rules and regulations in place that make block trades easier.

Another way is through sunshine trading.  It’s been known for a long time (basically, since the mid-1980s when portfolio insurers used the strategy to reduce their execution costs) that a large, uninformed trader who is buying or selling for liquidity-related reasons, rather than because he has private information, can reduce execution costs by announcing his purchases or sales in advance.  If potential counterparties believe that the trader making the announcement is indeed uninformed, then (a) they will not charge transaction cost (in the form of price impact) to compensate for the possibility of trading with somebody with better information, and (b) they can make sure that they are there to take the other side of the announced trade, thereby ensuring that there’s a lot of liquidity available.

Yet another way is to develop crossing networks that don’t contribute to price discovery, but merely cross offsetting positions at some price taken from an exchange, e.g., the settlement price of NYMEX NG futures. Crossing networks are another way that uninformed traders can credibly signal that they are trading for liquidity reasons, and don’t want to have a price impact.  Stock crossing networks have been around for decades.

An alternative to a crossing network is a call market, which is essentially a one shot auction.  So, for instance, NYMEX could set up a call market in the expiring nat gas or WTI contracts.  The ETFs would submit offers to sell, and knowing that the ETF would be there, its natural counterparties could submit offers to buy.  (Since the ETFs look to roll positions, and hence want to buy the next month when selling the expiring contract, it might be desirable to have a call market in spreads.)

Still another way is to use cash settled contracts.  These contracts use “derivative pricing”–they take the price from another market, such as NYMEX, to determine the final value of the contract.  These contracts are essentially “self liquidating”; they don’t require a trade to close out the position.  The position closes out automatically by reference to another market price.

Indeed, UNG has already moved in this direction, using cash settled nat gas swaps as well as nat gas futures to achieve its exposure to natural gas.

In sum, there are many ways to mitigate price impact even of big funds.  Even if a fund controls 30 percent of the open interest in a contract and wants to liquidate, well, damn close to 100 percent of the opposite side of that open interest wants to liquidate too.  There is an almost perfect double coincidence of wants.  It’s just a matter of coordinating those traders.  There are many market mechanisms to do that, and market participants have the incentive to find the efficient mechanism–or more likely, the efficient combination of mechanisms, including efficiently scaled funds, the use of cash settled contracts, crossing networks/call auctions, block trading and sunshine trading, and stuff I haven’t thought of–to achieve this coordination and mitigate price impact.

The key thing to remember is that somebody internalizes the costs of these alleged liquidation-related disruptions.  As a result, that somebody has the incentive to use mechanisms that minimize that impact, and entrepreneurs have incentives to devise new mechanisms that further reduce the impact–if regulations or legal impediments don’t prevent that from happening.

One last thing.  The market share numbers, e.g., the 30 percent number mentioned by the CNBC talking head, don’t bother me in this context.  A big percentage translates into a big position which could pose a manipulative threat if–IF–the party holding it DOESN’T liquidate enough positions, but demands excessive deliveries.  That is, a big trader that liquidates his entire position–which is a big ETF in a nutshell–does not pose a manipulative threat.

So, let the market develop and employ the mechanisms that facilitate the accumulation and liquidation of large positions that individual investors obviously want to hold.  (Note that they are willing to pay premiums to get into some big ETFs.)  The challenge posed by ETFs is nothing new, and markets have figured out ways to address such challenges efficiently for years.   There’s no real need for the regulators to worry their pretty little heads over this one.

I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation.  Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.

Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation.  It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.

He starts with a wild mischaracterization of history:

For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators – for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil – the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.

This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon.  I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ.  Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”

This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market.  This is truly disturbing.  It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets.  This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.

Chilton also says: “The new speculators buy into the markets for years, and stay there.”  And we are to conclude . . . ?  And again, there have been many speculators that have made it their living for long periods.

Additional remark (9/2/2009): I find this criticism of Chilton’s ironic that the classical criticism of speculators is that they are quick buck artists that have no long term stake in any market or company, and hence trade on meaningless short term information.  Now, we have a class of speculators that are not short term, quick-buck traders, but are instead patient investors in the market for a long haul–but that’s bad too.  Damned if you do, damned if you don’t.

As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:

Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.

I (and others) suggest otherwise.  So where does that leave us?

Then he pulls out the “it’s possible” justification:

Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?

A lot of things are possible.  Some evidence would be helpful.  The role of evidence is to help sort out what’s probable from what’s possible.  You can’t make policy on the possible, since so much of the possible is contradictory.  X may be possible.  Not X may be possible too.  We’re right where we started.  Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions.  Identifying the possible is the beginning of an inquiry.  It clearly cannot be the end.

And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”

In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity.  That’s exactly what you’d expect in a market for a commodity like oil.  There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.

Indeed, the reason speculators are attracted to commodities is the volatility.  That’s a lot more plausible statement than to say that the speculators cause the volatility.

Now we get to the punchline:

Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.

There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009.  But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny.  Indeed it should be about the last.  In all major commodities, the big buyers have been China, China, and China.  China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc.  The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market.  If Commissioner Chilton is puzzled, he needs to read more.

And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.”  But the “if” remains just that.  Chilton certainly has not provided a scintilla of evidence to support that contention.  He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.

And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again (for the third time!):  he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.”  Again.  Many say it ain’t.  “Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.

Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:

The clear message is that physical commodities – like those in the agricultural, energy and metals arenas –  are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.

He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.

That doesn’t cut it, for at least three reasons.

First.  There is no common-sense use of the term.  That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post.  Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.

Second, this is sort of the immaculate conception theory of prices.  If trading activity doesn’t affect prices, what does?  Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation.  Moreover, some traders have private information, and trading on that information moves prices.  That tends to make prices more informative.  That’s a good thing.  It’s called price discovery.  How can you have price discovery if trades don’t affect prices?  I should also note that hedgers’ trades can affect prices.  Putting on a big hedge may require a move in price to find somebody willing to take the risk.  Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price.  And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact.  Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained.  So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation?  That question is only half in jest.)

In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense.  Such markets exist in textbooks, and nowhere else.

Additional remark (9/2/2009): Price impact may be a necessary condition for concluding that regulatory intervention is needed.  It is definitely not a sufficient condition as Chilton suggests.  A regulatory intervention should require a showing that a certain kind of trading moves prices away from competitive values.  Even if a price impact is demonstrated, it is absolutely wrong to conclude that this is inefficient.

Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws.  These laws make manipulation a felony.  They also subject manipulators to the prospect of heavy fines, and great reputational damage.  As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way.  In other words,  I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.

The term is provocative, and its use suggests that the markets have been manipulated.  People believe that manipulation is wrong, and many know that manipulation is a crime.  This creates a presumption that there is something wrong–manipulated–in the markets that need correction.

I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case.  I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators, and/or is inclined to see a manipulator lurking behind every trade.

It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.  But if the activities aren’t illegal, then what is the justification for the regulation?  And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is?  Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions?  And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.

I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line.  In fact, I think it’s far too little to ask.  But I’ll take it as a start.

Trying to figure out what is going on with the Chinese economy is a first-order issue.  Superficially, everything looks great; growth is right on official targets, and is at levels that the world would envy even during boom times.  In spite of that–no, because of that, among other things–there are many reasons for disquiet.

An article in today’s Reuters strikes a very odd note:

A report that Chinese state-owned companies will be allowed to walk away from loss-making commodity derivative trades provoked anger and dismay among investment bankers on Monday as they feared it may set a damaging precedent.

The State-owned Assets Supervision and Administration Commission, the regulator and nominal shareholder for state-owned enterprises (SOEs), told six foreign banks that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying in an article published on Saturday.

While the details of the report could not be confirmed, it was Monday’s hot topic in financial circles from Shanghai to Singapore as commodity marketers feared that companies holding underwater price hedges could simply renege on the deals, costing banks millions of dollars in profit.

This could be a very big deal.  A major default on derivatives by huge Chinese SOEs would hurt the banks on the other side of the deal, but more importantly, raise huge questions about the reliability of Chinese SOEs as counterparties not just on derivatives, but on other transactions as well.

But this is all very inscrutable (stereotypically?) as one of the companies allegedly involved denied it sent any letter.  From Bloomberg (no link yet):

China Eastern Airlines Corp., which  had $916 million of unrealized losses last year on wrong-way  bets on fuel prices, denied a Reuters report that it sent a  letter to banks about its futures contracts.

Air China Ltd. and China COSCO Holdings Co. also sent  letters to banks about futures contracts, Reuters reported today,  citing an unidentified Singapore-based banking executive who had  heard of the letters. Companies owned by China’s central  government may terminate derivative contracts with six foreign  banks that provide over-the-counter commodity hedging services,Beijing-based Caijing Magazine reported earlier on Aug. 29.

“No, we didn’t” write letters to banks about futurescontracts, China Eastern Board Secretary Luo Zhuping said byphone today without elaborating. Air China spokeswoman Rao Xinyu  declined to comment. China COSCO spokeswoman Yang Ling didn’t  immediately answer calls to her office today seeking comment.

Now, both stories could be true.  Note that Reuters reports that the threat came from State Assets Supervision and Administration Commission, which oversees companies like China Eastern.  The Reuters story does not claim that the companies wrote the letters on their own behalf: it claims instead that SASAC wrote the letters in its role of regulator of these companies.  So, the Reuters story could be true AND China Eastern’s denial could be true too.

But this raises the question of why would such a course be contemplated, let alone threatened.  One interpretation is that these companies are in financial trouble, and the government doesn’t want to spend its money making western banks whole.  Another interpretation is that the government wants to clamp down on speculation in general, and derivatives speculation in particular, by Chinese companies, and figures that raising doubts about the reliability of Chinese companies as counterparties is a very effective way to do that: It may be very hard to crack down on trading by Chinese companies directly, but if they have nobody to trade with because no banker in his right mind would take the risk of giving away a free default option, the “problem” is “solved.”  Although this may seem to be limited to Chinese SOEs, it will no doubt have the effect of raising doubts about the reliability of all Chinese counterparties, thereby making it costlier for them to trade, and perhaps shutting them out of the market altogether.

There is some hint of this in the Reuters article:

The warning from SASAC follows a series of measures from Beijing this year to crack down on the sale of derivative products by foreign banks to Chinese enterprises, principally big consumers, who bought protection against higher prices last year only to watch the market collapse — leaving them with losses.

There may also be an old school-new school battle going on:

SASAC took over the job of overseeing SOEs’ derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.

I would wager that SASAC is dominated by old school industrial types and party types who are not in the least financially sophisticated, and who are probably not all too down with the idea of derivatives anyways, thinking that they smack of speculation, even if they are used for hedging.  (I’ve taught at some Chinese SOEs, and the level of finance knowledge is pretty thin even among higher level execs–or should I say especially among such types.  I imagine that goes exponentially for the SASAC.)

But, if my conjecture that this is an effort to tamp down speculative trading, it would fit in with a good deal of other stories coming out of China that it is struggling mightily with its efforts to stimulate the economy.  These efforts are leading to manifest distortions, and reports suggest that the authorities are operating in a very ad hoc way to try to control the distorting effects of the stimulus.  Like a financial sorcerer’s apprentice, China has unleashed a massively power monetary, fiscal, and credit stimulus, but cannot control it.

The Chinese stimulus is immense, as I’ve written before. The fiscal stimulus is on the order of 15 percent of GDP.  Chinese banks have created huge amounts of credit:

In the first half of 2009, bank credits increased Rmb7,300bn, above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP. As a result, the inter-bank money market has been inundated with liquidity.

But these efforts have led to the growth of bubbles in real estate and the stock market.  The government is trying to tamp down on the flow of funds into these areas, and it is evidently having some effect: the Shanghai stock index was down 23 percent in August, far and away the worst performer among major world markets.  Moreover, the market is extremely sensitive to signs that the government is tightening credit.

Moreover, there is other evidence that the deluge of spending has led to severe dislocations in the allocation of resources.  Some amazing figures from the same FT article just quoted, by Chinese economist (and former central banker) Yu Yongding:

To maintain decent growth and avoid massive unemployment, the Chinese government was left with no option but to replace flagging external demand by domestic demand. But in the short run it is difficult to stimulate domestic consumption; investment demand became the only alternative. As a result of the stimulus package, the growth rate of fixed asset investment hit 36 per cent year-on-year in the first half of 2009, and China’s investment rate may have surpassed 50 per cent of GDP.

The government knows very well that the economy has been suffering from overcapacity. This is why government-financed investment in the stimulus package is concentrated in infrastructure, rather than new factories. However, there are still problems with an investment-centred expansionary fiscal policy. Due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous, and the prospective returns of this big push into infrastructure are less than promising.

Investing 50 percent of GDP, a nearly 50 percent increase from an already huge 36 percent of GDP, means that it is almost certain that many of the projects are hastily conceived, and ill conceived to boot.  I think that Yongdong is a master of understatement when he opines that “the prospective returns of this big push into infrastructure are less than promising.”  That is the gravamen of the analysis I gave on BNN (Canadian Business Television) earlier in the month.

And indeed, there is evidence that the government is trying to get control of the brooms its fiscal and monetary spells have brought to life.  Not so much in infrastructure, but in other parts of the economy:

China’s cabinet said it’s studying curbs on overcapacity in industries including steel and cement as policy makers seek to rein in investment growth fueled by a record credit expansion this year.

The government will also increase “guidance” over parts of the coal, glass and power industries, the State Council said on its  Web site today. Controls on stock and bond sales by companies in targeted sectors will be strengthened, it said.

China is aiming to prevent excessive investment in the world’s biggest user of steel and cement without imposing restrictions that may endanger an economic recovery. The nation’s  benchmark stock index has dropped 15 percent from its Aug. 4 high on concern banks may tighten credit after extending a record $1.1 trillion of loans in the first six months.

There is a very Austrian lesson in this Chinese story.  The government may be able to manipulate aggregates, but its attempts to do so can aggravate resource misallocations.  In the Austrian story, these misallocations eventually come back to haunt: eventually they result in a contraction that is necessary to force resources out of bloated sectors and into more productive uses.  The Chinese government apparently recognizes this, and is attempt to fall back to its comfort zone–state directed allocations of resources.  But that just raises another problem the Austrians were quite familiar with: the Knowledge Problem.  How can the central planner know where resources should go?  Answer: He can’t.

I don’t think this will turn out well.  There’s no Big Sorcerer to sweep in and undo Apprentice Sorcerer’s mischief.  The Apprentice learned, it’s easy to unleash the magic, but it’s very hard to direct it.  In the Chinese case, it’s easy to go on a spending binge, but it’s hard to ensure that the money is spent well.  It may result (especially given the idiosyncrasies of Chinese income accounting) in high rates of measured growth, but this growth is likely to be chimerical, and even destructive in the long run as resources spent today may prove very unproductive months from now when the world economy begins to turn around and the stimulus-driven investments are ill-suited to serve the resulting demand.

In other words, China may represent history’s biggest free cash flow problem.  (A reference to the finance literature that suggests that companies with free cash flow tend to fritter it away on unproductive investments).

The effects of this will spill over far beyond China, most notably in the commodity sector.  China has been on a commodity import splurge, but apparently that is another thing that is already slowing down, and likely to slow down even further soon.  And that is already having an effect on the canary in the commodity coal mine: shipping rates.  From another Bloomberg story:

Just as global trade starts to recover, the shipping market is crashing for the second time in a year as China reduces raw-material imports and record numbers of new vessels set sail.

The rate for leasing capesize ships, boats three times the size of the  Statue of Liberty, will drop about 50 percent from the current price of $37,865 a day to as low as $18,000 before the end of the year, according to the median in a Bloomberg survey of six analysts and fund managers. Forward freight agreements traded by brokers show the fourth-quarter average price will be 7 percent lower.

Shipping rates, which already fell 59 percent from this year’s high, are retreating as the  Organization for Economic Cooperation and Development predicts a 16 percent drop in world trade for all of 2009. China’s State Council called for curbs on steel and cement production last week.

. . . .

From their low of $2,316 in December, rates rebounded to $93,197 in June as China imported record amounts of everything from coal to  iron ore, used to make steel. Almost two in every five tons of steel are  made in China, according to the Brussels- based World Steel Association. The nation consumes the same proportion of the world’s coal, BP Plc estimates.

Industrial Overcapacity

Rates are poised to keep falling, the survey shows. China’s State Council, the nation’s cabinet, said it’s studying curbs on overcapacity in industries including steel and cement. The government will provide more “guidance” over parts of the coal, glass and power sectors, the group said in a statement.

Imports of refined copper fell 23 percent in July from the previous month. Coal shipments shrank 13 percent, customs data show.  Iron-ore purchases will likely average about 16 percent less in the remainder of the year than in the first seven months, according to  Will Fray, an analyst at Maritime Strategies International Ltd. in London.

“China could very easily turn the taps off,” Fray said. “Rates will keep sliding.”

The commodity import channel is the primary mechanism connecting the Chinese stimulus to the rest of the world.  It’s hard to explain the robustness of commodity prices in recent months (which has redounded to the benefit of Australia–and Russia) on the basis of conditions in OECD countries.  The EU, US, and especially Japan have hardly done well during that period, with the first maybe experiencing an anemic recovery, the second bottoming out at best, and the third still imploding.  The most likely explanation is that this is the direct consequence of the Chinese stimulus, and the related policy of accumulating strategic inventories of everything from aluminum to iron ore to oil to zinc.

But all of the foregoing suggests that this is coming to an end, if it hasn’t come to an end already.  And that’s why very peculiar stories like the one about a threatened default on derivatives trades may just be shadows of larger, looming developments.

Short answer: not much.  But here are some fun facts to know and tell that do tend to deflate any grandiose assertions about the effects of speculation on oil prices:

1. Changes in non-commercial positions did not Granger Cause crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods in bivariate Granger Causality analyses.  Not that this is a surprise; if one could predict future oil price changes based on the publicly released COT numbers, one could make money.  But it does belie the Medlock-Jaffe claim that non-commercial positions are a “leading indicator” for oil prices.
2. In a vector autoregression including crude oil returns, the percentage change in the Baltic Freight Index, the percentage change in the dollar index, and the change in non-commercial positions, the non-commercial positions do not Granger cause the crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods.  The percentage change in the BFI does Granger Cause crude oil returns in all three samples.  This might be surprising, at it would seem to suggest that one can make money in oil by making trades based on moves in the BFI.  However, it is more likely that the movements in the BFI forecast time varying expected returns.  The BFI is a proxy for industrial activity, and thus likely reflects systematic risk.
3. In the entire sample, crude oil returns Granger Cause (i.e., forecast) changes in non-commercial positions.  This is not true in the 2006-2009 period.
4. In the entire sample, commercial positions Granger Cause non-commercial positions, but the reverse is not true.  In the 2001-2009 and 2006-2009 periods, the causality runs both ways.
5. In regressions of crude oil returns against percentage changes in the BFI, percentage changes in the dollar index, and changes in non-commercial positions, all three explanatory variables are statistically significant in the entire sample and the two later subsamples.  Changes in commercial positions are associated with changes in crude oil prices of the same sign.
6. The magnitude of the coefficient on the change in non-commercial positions is relatively small, and has been declining over time.  In the entire sample, a one standard deviation move in the change in the non-commercial position is associated with a 2 percent change in the crude oil price.
7. However, by 2006-2009, the alleged period of speculative excess, the coefficient on the non-commercial position change is less than half its value in the entire sample.  During 2006-2009, a one standard deviation move in non-commercial positions (corresponding to about 17 mm bbls of crude in a week), is associated with a less than one percent move in the crude oil price.  Given that the standard deviation of returns (this is weekly data) during this period was over 5 percent, this is a relatively modest association.
8. Moreover, speculative positions rose and fell throughout the period of alleged speculative excess.  Using the estimated coefficient on the change in the non-commercial position from the multivariate regression, and the movements in non-commercial positions from the beginning of 2006 to the height of the oil prices in early-July, 2008, the cumulative effect of speculative trading on the price of oil was . . . wait for it . . . 2.56 percent.  Not 25.6 percent.  2.56 percent.  And this over a period when the price of oil rose from $63 to over $141 dollars.  That means, that speculation might have “caused” the price to move from $63 to not even $65.  Big whoop.
9. The correlation between changes in non-commercial positions was .36 in 1986-2000, .5 from 2001-2005, but fell to .3 in 2006-2009.
10. Thus, the data do not support the contention that speculation–at least as measured (or mis-measured) by the COT have played an increasingly important role in affecting oil prices.  Indeed, the association between non-commercial futures trading and oil prices was weakest during the period of time of the purported speculative Bacchanal.
11. Conversely, the relationship between the crude oil price and the dollar index has strengthened over time.  In the 1986-2000 period, the coefficient on the dollar index in the multiple regression was -.023; during the 2001-2006 period, -.77; and from the 2006-2009 period, -2.03.  During this last period, a one standard deviation move in the dollar index is associated with approximately a 2.5 percent move in the price of crude oil.

This all took about 40 minutes to figure out.

So what does it all mean?  Well, even without grappling with the causation issue, the data provide virtually no support for the hyperventilating assertions that speculation dominates oil prices, and that this domination grew over time, reaching a frenzied peak in 2006-2008.

In contrast the data provide better support for the view that the price of oil became more dollar driven.  Thus monetary policy should deserve more scrutiny, and speculation less, in trying to understand what happened to oil prices.  The attempt by Medlock-Jaffee to attribute the decline in the dollar to oil speculation is implausible.

But even though there is a modest, contemporaneous association between non-commercial positions and oil prices, that provides only the weakest support for the view that speculation distorted prices.  There is the correlation-causation issue.  What caused the changes in non-commercial positions?  Could they have moved in response to oil prices?  Could both have been driven by common factors?  Moreover, even if speculation moves prices, it can move prices towards where they should go.  That is, informed speculation tends to move prices towards their full-information value.

As I’ve written often, looking at prices alone is often inadequate to diagnose speculative distortions.  Prices are important because they provide signals that affect the allocation of resources.  That is, prices affect decisions about quantities.  If prices are distorted, quantities should be distorted too.  For the commodities allegedly affected by speculative excess in the 2006-2008 period, there is no evidence that this was the case.  In fact, for the commodities for which the data are best (industrial metals, where daily inventory data are available), the evidence is quite to the contrary.  The inventory data provide strong evidence of fundamental tightness, rather than speculative excess, as the cause of high prices.  (This will the subject of a chapter in my forthcoming book.)

The COT data are also dubious for a variety of reasons, including their crude categorization of traders, their lumping together of positions in all delivery months, and the fact that they cover only exchange-traded positions, and not the OTC market.

So, bottom line.  The association between speculative trading (as measured by the COT) and oil price movements is weak.  Given this association, and the movements in non-commercial trading during the 2006-2008 period, the cumulative impact of speculation on the price of oil during the spike was miniscule.  Moreover, one cannot conclude that the measured association quantifies a causal relationship, and even if it was causal, you can’t conclude that it caused prices to move away from a level justified by fundamentals.  The non-price (i.e., quantity) evidence for price distortion is lacking.

In one sentence: The COT data that have been used repeatedly to support contentions that speculation distorted oil prices provide no evidence whatsoever that speculation in the 2006-2008 time period materially contributed to the dramatic rise in the price of oil during this period.

In an apparent attempt to make Michael Masters look good, Rice University’s Baker Institute has released a report on oil speculation, that concludes that increasing volumes of speculation have caused oil prices to be higher than they would otherwise be, and in a novel twist, have caused a higher correlation between the dollar and the price of oil.  It also lays blame on everybody’s favorite whipping boy, the Commodity Futures Modernization Act of 2000.

In a nutshell, this report is bilge.  It relies on no rigorous economic analysis to support its contentions.  Moreover, it is unscientific, eschewing any serious statistical analysis.

The report first sets out its evidence that speculation has increased, and that this increase is due to the CFMA.  It attempts to argue that speculation increased 15-fold, while commercial trading only doubled, by adding non-commercial outright futures, options, and spread positions, as measured by the CFTC Commitment of Traders Reports.  The vast bulk of the increase in speculation is attributable to spread positions.

But it is odd indeed to argue that a massive increase in speculation caused higher oil prices when the bulk of this increase in speculation occurred in spread positions.  Such positions, which involve the purchase and sale of oil for different delivery dates, are speculations on the shape of the oil forward curve, not on the absolute price level.  Indeed, it is very difficult to imagine how such spread positions would cause prices to rise since they involve purchases and sales in equal magnitude.  Certainly the authors of the Baker study provide no rigorous justification for any such connection.  For that matter, they don’t provide any non-rigorous justification either.

Tying the massive increase in speculation as they measure it to CFMA is particularly bizarre.  As they note, the main provisions of the CFMA eased restrictions on trading on the OTC market, and in non-US markets.  As a result, if anything, the CFMA favored these other markets over NYMEX.  But all of the data in the “study” pertain to NYMEX futures markets.  How can you attribute a rise in trading on NYMEX, and a change in the composition of that trading, to regulatory changes that would tend to shift trading to venues not covered by the data?  (You could make an argument that the increase in off-exchange activity lifted NYMEX volumes due to arbitrage, or to the use of futures to hedge OTC positions.  But the Baker boy and girl don’t do that.  And if some non-commercial NYMEX positions are actually hedges of OTC positions, you can’t conclude the futures positions are speculative without knowing about the related OTC positions).

In other words, report authors Ken Medlock and Amy Jaffee play the drunk looking for a wallet under the lamppost.  The COT data is the only data relating to speculation that they can get their hands on, and they use it even though it is peripherally related to what they want to demonstrate, namely, that a set of regulatory changes that mainly benefitted non-NYMEX markets led to a dramatic increase in speculation.

This is the crudest post hoc, propter hoc reasoning.  CFMA happened in 2000.  Speculative futures positions increased, especially post-2003.  Therefore, the former caused the latter.  (Why the big lag?  Don’t bother looking for answers in the report.  You won’t get one.)  This is about as weak as it gets.

When they get to analyzing the effects of speculation on prices, the spreaders are out the window, and Medlock and Jaffee focus on net non-commercial positions.  (This could be viewed as a tacit admission that there is no basis to believe that spreaders could have an effect on price levels.)

Do the study authors utilize statistical techniques, like Granger Causality or the like, to document such a connection?  Surely you jest.

They use a much more sophisticated diagnostic instrument.  Their eyeballs.

Seriously.

They present a graph of net non-commercial positions overlaid on prices, and say:

Generally, movements in price over the last few years have coincided with trends in open interest by noncommercial traders.  We can see that during periods where [sic] speculators have been net short, prices typically declined, even if only slightly.  When speculators are net long, the general shift in the market has been upwards, in some cases to a dramatic extend.  Some exceptions have occurred when speculators were generally in a net long position, but were moving to liquidate positions.  In this case, such as the late spring/early summer 2008, prices responded by moving sharply lower.

Well, when I look at their Figure 5 with my eyeballs, I note numerous instances when the changes in net non-commercial positions were of a similar magnitude to what occurred in spring-summer 2008, and the price movements were nowhere as large as in the late-summer/fall of 2008.  I see other periods (fall, 2008) when net long positions spiked, but prices fell.

I just wonder: think the financial crisis might have had something to do with the collapse in prices?  What financial crisis you might ask, after reading the report: if this was the only information you had, you’d never know there was a financial crisis.

Also, why the asymmetry?  Why do net shorts often result in “slight declines” while net longs can lead to big spikes?  It is not obvious a prior that this should be the case, and Medlock and Jaffee certainly provide no explanation.

There is no way in hell that such a casual, visual analysis of that Figure can provide a basis for their grandiose conclusions.  To say that this is unscientific is far too kind.  It would be too kind to call it junk science.  It’s just junk.

Medlock and Jaffe also interpret the data, uhm, flexibly, in order to make their case.  On the one hand, they claim, prior to 2006 “the open interest of noncommercial players” was a “lagging indicator” of prices.  (If it lags, how can it cause?)  But then, in a “striking” development, it becomes a “leading indicator of price around January 2006.”

Do they present a rigorous test of this assertion?  No.

Do they provide a coherent explanation as to why it would go from a lagger to a leader?  They provide an explanation, but it is not coherent.  It is in effect the story of a perpetual motion machine.  Speculators buy so prices go up so people think prices will go up and so they buy and force up prices more yadda yadda.  This is, at best, ex post rationalization, fitting their story to the data rather than coming up with a rigorous hypothesis without peeking at the data and then testing it.

How do they address the problem that if COT data is really a leader, and leads by months (according to their eyeballs, anyways), why did all of these greedy speculators leave money on the table?  As soon as they recognized that COT data lead oil prices, they would trade on the COT data, and voila!, the relationship would disappear.

Again, the more obvious answer: there is no causal relationship between COT numbers and prices.

A more reasonable explanation is there is no connection between movements in net noncommercial positions and prices.  Sometimes positions lead price, then sometimes the reverse is true, but there is no causal connection, just chance in action.  This makes Jaffee and Medlock look like fools for randomness.

The asserted connection between oil and the dollar resulting from increased speculation is bizarre.  For starters, I contest their statistical results, such as they are.  They report a correlation between the dollar and the price of oil of -.82.  I can reproduce that number by calculating the correlation between the levels of the dollar index and the price of oil.  However, since both time series have unit roots, such high correlations are extremely suspect: highly persistent time series can be highly correlated even if, in fact, there is no economic relation between them.  This is the spurious regression problem.

A more reasonable method is to look at correlations between percentage price changes.  This number is much smaller (in absolute value) for 2001-2009: only -.22.  It is bigger than observed in 1986-2000, but so what?  What’s more, that -.22 isn’t nearly as eye-popping as -.8, is it?

And what theory do these people advance to explain why an increase in speculation would increase the correlation?  They tell a story–and it’s no more than that–about speculation causing high oil prices causing higher trade deficits causing a lower dollar.  There is no evidence supporting any one of these alleged causal connections.  And considering the trade deficit–like, have these two heard of China?  Or any other factor that might have influenced the trade deficit?  This is more post hoc, propter hoc mumbo jumbo, with myriad omitted variables.  A serious study would (a) estimate the relation between the trade deficit and the dollar index, controlling for other factors that could affect the dollar; (b) estimate the effect of the price of oil on the deficit, and combine this with (a) to get an effect of the oil price movements on movements in the dollar, and (c) estimate the effect of speculation on the price of oil, and combine with (a) and (b) to get an estimate of the contribution of speculation to changes in the value of the dollar.  Or include oil speculation as an explanatory variable in a model of the dollar that also includes other relevant explanatory variables.

But that would be, as I say, a serious study.  This one is a joke.

There’s also a serious issue regarding the direction of causality.  Why should it go from oil prices to the dollar?  A decline in the dollar represents a fall in its value relative to other currencies.  The factors that lead to such a fall (e.g., a US monetary policy that is looser than the monetary policies of other nations) also plausibly lead to a decline its value relative to goods, including oil.  A decline in the purchasing power of a dollar means that the prices of goods, including oil, rise in nominal terms.

Here’s a final, telling example of the level of rigor in the report: “While correlation does not imply causation [really?], the trends evident in the open interest data are impossible to ignore.”

Is that so?  Just watch me.

Blogmeister James at Robert Amerstdam was nice enough to link to нет дениг, нет проблем and say some nice things about it:

Craig Pirrong has a stinging piece [stinging? moi?] over at  Seeking Alpha on all the upcoming nastiness he expects out of the economic crisis in Russia, beginning with the Sayano-Shushenskaya dam explosion to Gazprom’s disappointing first quarter results.   It’s good article (especially the sharp rebuke against bullish analysts predicting a Gazprom rally)

But there’s a but (isn’t there always?):

but I think the eagerness to hold a parade over the collapse of the gas giant will only guarantee its next wave of revanchist corporate foreign policy strategy.   Gazprom has a lot of ways to still make money, and the full bore weight of the Kremlin helping it out.

I agree completely, James.  In fact, that was the thrust of my objections to Biden’s dismissing of Russia due to its economic and demographic weaknesses: namely, that these problems, and the desperation that goes with them, will make Russia more aggressive, not less.

When it comes to gas and Gazprom, that means that anyone touching Russian gas, or in a position to damage Gazprom’s interests better jock it up and get ready for battle.  It means that companies like ExxonMobil that have gas in Russia, and rights to sell it into potentially lucrative markets will face  intense pressure.  It means than even independent Russian companies can expect some smashmouth.  It means that a country like Turkmenistan that sells gas to Gazprom and prices that seemed like a good idea at the time, but no longer, should get ready for economic and even political aggression.  It means that Ukraine–and Europe–should look out come January.

Get ready to rumble, folks.

I asked a Russian friend how the financial and economic crisis had affected the regional art center in the Urals where she works.  She said that she and her colleagues were coping with typical Russian resignation, and had made “нет дениг, нет проблем” (“No money, no problem”) their motto.

The “нет дениг” part may fit the country as a whole, but the “нет проблем” part doesn’t, quite.  The    Sayano- Shushenskaya dam disaster is widely considered to be a harbinger of potential problems.  The direct economic consequences are severe, reducing Russian electrical generating capacity by 2 percent; this in fact understates the impact because the dam was an inframarginal (i.e., relatively cheap) source of power.  The costs of repair are very high. Estimates run to $1.25 billion, but being estimates, being early, and being Russia, it is likely that the final bill will be much higher than that.  (Just ask the Indians about how the estimates for the repair bill to the Admiral Gorshkov compared to the actual cost.)  That in itself represents about 3 percent of total Russian infrastructure spending in 2008.

But as bad as the direct cost of repairing this one dam is, the prospect that Russia is just waiting for many additional shoes to drop is even worse.  And all at a time when there is no slack whatsoever in the budget; the state investment funds are being depleted rapidly, the budget deficits are forecast to be at the very upper limit that the country can run without risking grave risks to the currency, and Russia plans to return to the debt markets soon to cover its existing shortfalls.  Nor can the country rely on foreign investors to step into the breach.  The combination of poor economic prospects and a history of mistreatment has exacted its toll.

Even the big cash cows are running dry.  Case in point: Gazprom.

Gazprom’s profits were battered by plunging gas sales to the European Union and Ukraine in the first three months of the year, it has reported in its latest  resultsunder international accounting standards.

A 62 per cent drop in profits to Rbs110bn (about $3.5bn, at today’s exchange rate), reflects steep falls in gas export volumes, which were down 31 per cent to the EU, and 61 per cent to the former Soviet Union countries, including Ukraine. The economic downturn, which has hit demand for gas, particularly from industrial users, in Europe and around the world, was part of the reason; supply disruptions caused by the interruption of flows to Ukraine during the pricing dispute in January were another.

. . . .

The company’s debts are continuing to rise. Borrowings were up 17 per cent by the end of March from the end of 2008 to Rbs1,191bn (about $38bn at today’s exchange rate), mostly because of the fall in the value of the ruble, which pushed up the ruble value of Gazprom’s foreign currency debts. Since then, it has made significant further expenditures, including $4.1bn buying a 20 per cent stake in its oil subsidiary Gazprom Neft from Eni of Italy, and $1.67bn buying 55 per cent of London-listed Sibir Energy.

Amazingly, some, like Sanford Bernstein analyst Oswald Clint are trying to gussy up this corpse:

Capital expenditures have been cut 15% in 2009, the 2008 proposed dividend was cut 86%, and capex hungry projects in the Yamal peninsula have been delayed. Combined, we now expect much improved balance sheet flexibility, and expect the company to generate positive free cashflow this year, which provides plenty of scope to re-grow the dividend. With added tailwinds of favorable government moves to boost domestic pricing tariffs by 15% in 2010, 2011 and 2012, the company is also likely to start generating profit for the first time from  292Bcm of gas sales (50% of total) sold in the domestic market.

So.  Let me get this.  The company is in such deep financial straits that it all but eliminates its dividend, sharply reduces its capital expenditure, and delays its big investments in new production.  And this is good news because this creates “balance sheet flexibility”?  I guess.  But flexibility to do what?

Talk about looking on the bright side.  “Other than that, how was the play, Mrs. Lincoln?”  “Well, there’s now one less mouth to feed.”

Even There’s-a-Pony-in-There-Somewhere Clint recognizes that Gazprom’s production, which fell sharply in 2009, will not reach 2008 levels until “late in the next decade.”  Which means 8-10 years.  And with the sharp drop in capital expenditure, the delays at Yamal, and the accelerating declines in its mature western Siberian giant fields,  that may be very optimistic.  Which means that, even given additional domestic revenue, the company’s prospects for generating the kind of positive cash flow that will not be able to (a) keep certain people living in the style to which they have become accustomed, and (b) more importantly, it will not be able to generate revenues for the Russian state to address its already pressing fiscal problems, let alone provide funds to shore up a collapsing infrastructure.

And in the aftermath of  Sayano- Shushenskaya even the higher domestic revenues may be in doubt.  Putin and Medvedev have already pledged that the state will prevent power prices from rising excessively due to the loss of capacity.  Which means that the on-again, off-again electricity tariff reforms are probably off again for a long time.  Moreover, given that the loss of hydro capacity will increase the demands placed on gas fired power plants, the imperative to keep power prices low will surely induce the power plant operators to pressure the government to keep gas prices low.  Furthermore, it is likely that the government will attempt to palliate consumers who end up paying higher electricity prices with the sop of lower gas prices, and will therefore delay full implementation of the scheduled gas price increases.

In brief, Russia faces a yawning capital gap.  The country has lived, after a fashion, on the Soviet inheritance, from huge hydro stations to massive gas fields.  “Deferred maintenance” became a modus operandi.  The  Sayano-Shushenskaya disaster is just a vivid illustration of the consequences of this.  It makes me wonder what the true rate of Russian growth in recent years would be, if the true depreciation/consumption of capital were taken into account.  The country has consumed much of its seed corn.

The country’s major source of cash–the energy business–has lived off the Soviet inheritance as well, so Russia can’t look to that for succor; indeed, that sector needs a massive infusion of capital too.  Foreign investors won’t step up.  Compared to other countries, Russia invested relative little as fraction of its GDP even during the seven fat years.

So, no money: big problems.