Streetwise Professor

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  “There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  “Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  “While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.

In the early-1990s Exxon entered into a deal with the Russian government to develop the Sakhalin I project.  As part of the deal, Exxon received an exemption from Gazprom’s legal monopoly on exports of gas from Russia.  Now, in a shocking development (irony alert), it seems that the exemption is under threat:

The government will step up pressure on U.S. major Exxon Mobil to sell cheap gas from Sakhalin, analysts said Thursday, a day before construction begins on a new gas link to the Pacific.Prime Minister Vladimir Putin will travel to the far eastern city of Khabarovsk on Friday to inaugurate the start of the pipeline to the Pacific port of Vladivostok, which will ultimately liquefy gas from Sakhalin Island for export to Asia.

“I think Exxon Mobil knows that they will twist their arm. It is pure pressure,” said Mikhail Krutikhin, an analyst with RusEnergy.

. . . .

Valery Nesterov, analyst at Troika Dialog, said that despite a growing belief among investors that the government’s grip over resources is easing after deals with Total and Shell in recent months, foreign firms will often remain under pressure.

“Exxon does not have a free choice. Past experience shows that if [Moscow] has a strong desire, the foreign partner has to agree,” he said.

The Khabarovsk-Vladivostok pipeline will run 1,460 kilometers, and Nesterov estimates its cost at $2.9 billion to $4.4 billion.

Sakhalin is already connected to Khabarovsk with a gas link, which is supplying local consumers.

Krutikhin said that even if Exxon is forced to sell all its gas from Sakhalin-1 to Gazprom, volumes will not exceed 7 billion to 8 billion cubic meters per year, while Gazprom is eyeing a peak capacity of up to 47 bcm a year.

“So to fill the pipeline, you need to discover new fields or build a pipeline from Yakutia,” he said.

Bloomberg adds some details:

OAO Gazprom, Russia’s state-owned natural-gas exporter, started building a pipeline in the Pacific Ocean that may damage  Exxon Mobil Corp.‘s plans to export the fuel to China.

Workers welded the first joint on the initial 1,350 kilometers (840 miles) of the pipeline at a ceremony attended by Prime Minister  Vladimir Putin and Gazprom Deputy Chief Executive Officer  Alexander Ananenkov. The pipeline will link Sakhalin Island with the mainland city of Vladivostok.

“The development of gas transportation infrastructure in the east will let us diversify our exports,” Putin said today at the event in Khabarovsk, which is on the pipeline’s route. “But I would like to stress that the domestic market will be a priority for the Far East and eastern Siberia.”

I repeat: “The domestic market will be a priority for the Far East and eastern Siberia.”  To translate: If XOM has a deal that allows them to export the gas, well, that’s just its tough luck.

So how will Putin bludgeon ExxonMobil into moving the gas to the domestic market–and likely at controlled domestic prices–rather than to a more lucrative export market?

With apologies to Elizabeth Barrett Browning: “How can I screw thee?  Let me count the ways.”

There’s environmental laws (Sakhalin II); licensing (BP, various mining firms, and perhaps now MOL); taxes (Yukos, and myriad others); blowing stuff up (Turkmenistan); legal harassment of employees, including accusations of espionage (TNK-BP); legal fraud and theft (Heritage Capital); abusive lawsuits in pocket courts (Telenor).  I could go on, but you get the picture.  If they want it, they will take it.  The only question is what they’ll pull out their bag of tricks.

So why does anyone invest there, let alone go back after getting bashed around before (Shell, most notably).  When I gave a talk to some Foreign Service and Civil Service officers with energy-related responsibilities who visited Houston earlier this week, the analogy that came to mind was battered spouse syndrome.  Hopefully Exxon will fight this hard, and won’t succumb to the same syndrome.

As I said in an earlier post, I expect that this will all be a prelim to big confrontations between China and Russia on energy.  Note that the China angle plays into the Sakhalin I issue.  Moreover, China is becoming increasingly aggressive, and successful, in areas that Russia considers its fiefdoms, notably Central Asia (especially Turkmenistan) and now Moldova, of all places.  And finally, the big one: the Rosneft/Tatneft-China oil pipeline/loan deal.  That one will turn very interesting once the pipeline is done, especially if oil prices are well above those at the time of the signing of the deal.  And absent another world economic catastrophe, that’s almost a given.

h/t R

Konstantin Sonin is an excellent economist at the New Economics School in Moscow.  (Obama spoke there during his visit to Moscow.  My friend Sergei Guriev is Rector of the school.)  Konstantin and Sergei wrote an excellent paper using media freedom as a measure of property rights.

Unfortunately, Konstantin’s article in today’s Moscow Times lays a couple of eggs.  First, he argues that (a) production sharing agreements (“PSAs”) in energy markets are a means of protecting investors against political/expropriation, and (b) Russia has no need for PSAs because it presents no such risks:

An economist would normally criticize Deputy Prime Minister Igor Sechin. He rarely says anything meaningful in terms of economics. But twice in the past two weeks, it was necessary to come to Sechin’s defense. First, he was right in saying that Russia does not need a production sharing agreement, or PSA. Second, claims that Russia’s agreement to provide China with oil is unprofitable for Russia might really turn out to be groundless. But the lack of understanding on the subject and the controversy surrounding it attests to the lack of transparency in the agreement. This is an unacceptable situation, particularly when it involves such an important strategic interest.

Russia currently has three PSAs that are intended to protect foreign investors from political risks. Such agreements were specially created to allow major international corporations to sign long-term contracts with unpredictable, authoritarian regimes. In many countries, these PSAs have proven at least partially successful at protecting foreign investors from changes in leadership. But there is a certain stigma attached to them since they are only needed in unstable countries. In stable states with a safe investment climate, foreign investors do not require special protection because all investors are protected equally.

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

First, PSAs are not in the first, second, third . . . instance a means of protecting investors against political risk.  Instead, they are a mechanism for sharing development cost risks.  Or, better put, they essentially put the development cost risk on the resource owner: the resource owner gets paid after the E&P company recoups its costs.  Second, even if they were intended to protect investors against political risk, how can Konstantin state seriously, in the aftermath of all that’s transpired in Russia (and the oil sector in particular) in recent years, that Russia poses no political or expropriation risks?  The risks there are huge.  Indeed, they are so large that I look in amazement when companies like Shell act like victims of the battered spouse syndrome and return to their abuser.  Third, if PSAs are intended to protect investors against expropriation and political risk, they do a lousy job of it.  Just ask Shell: it had a PSA for the Sakhalin II project, and a fat lot of good that did.  Indeed, PSAs have been used by the Russians to justify expropriation.

Konstantin’s second error in his defense of Sechin relates to the murky China-Russia oil deal consummated earlier in the year.  He argues that the deal was good for Russia, even though it was at below market prices, because it locked in prices, and therefore provided insurance (a hedge) against price fluctuations:

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

Thus, there might be good reason to consider Russia’s agreement to sell oil to China at $55 to $60 per barrel as some form of insurance, considering that the deal only becomes profitable at a price of $80 per barrel. The idea of any insurance policy is that it chews up a certain percent of the profit when everything is going well but saves the insured party from major losses if things go badly.

Now here, Konstantin is somewhat unclear on what he intends by the word “insurance” and the phrase “things go badly.”  If by “insurance” he means price insurance, and “things go[ing] badly” he means a price collapse, the deal still is priced extremely unfavorably for Russia.  The price involved was well below the forward curve for oil for the foreseeable future, and the forward curve gives the price a seller can lock in.

As I noted in earlier posts on the subject, the seemingly unfavorable pricing makes sense, because it reflects a big credit spread.  That is, at the time the deal was done, Russia’s credit was in the dumper, and since the stated interest rate on the loan used to finance the pipeline was at a premium to LIBOR well under the premium on Russian debt prevailing in the market at the time, the Chinese were only willing to make the loan if there was an offsetting benefit–a below market price of oil.  That is, although Sechin touted the low interest rate in the deal, this was in effect a “teaser” rate–the oil price discount represented a hidden interest charge.

That is, the pricing of the deal doesn’t reflect insurance–it reflects Russia’s credit risk at the time the deal was done.

Russia’s credit has rebounded since the deal was inked.  Note Gazprom sold Eurobonds at a pretty good rate last week.  This raises a possibility that I raised in my original posts, and reiterated in a presentation on Russian energy strategy to a group of Foreign Service people (including some folks based in Moscow working on energy issues) today: namely, that Russia will try to find a way to back out of the deal, or force renegotiation, when the market turns.  Both the oil market and the credit market are much more favorable to Russia today than when the deal is done–which means the the deal done then is much LESS favorable to Russia today (and hence more favorable to China today) than when it was signed.  I see the potential for a dispute arising very soon.  That would be VERY interesting to watch.

Konstantin does make one very good point in his article:

Thus, criticism rained down on Sechin from all sides for having orchestrated an unprofitable agreement with China. But its profitability can only be gauged once all the terms of the agreement are finally made public.

That disclosure process should happen as soon as possible. The rules are very simple: If an economic agreement is signed in the best interests of the country, there is no reason to hide anything. If the agreement is sound, it will naturally withstand criticism from political opponents, analysts and the press. The fact that leaders are afraid to reveal the terms is probably a sign that the agreement has problems. If the agreement with China is flawless, why keep it secret?

Russia already has enough corruption without adding speculation about whether the agreement with China was on the up and up. If, however, anything underhanded is involved here and the agreement is not sound, Sechin’s contract with China might go down in history like the notorious privatization auctions of the early 1990s.

Hear, hear.  There is considerable room for skepticism about the benefits of the deal to Russia, because of the dishonest way that it was spun publicly; notably, Sechin’s crowing about the interest rate, and obfuscating about the oil price.  Both pieces of information are needed to determine the REAL interest rate in the loan, and therefore to determine whether it was on-market or not, and how far away it is from the current market (probably a lot, given the changes in the credit and oil markets).

Given that the deal’s economics probably look far worse for Russia today than they entered into the contract with China earlier this year, I wouldn’t hold my breath waiting for the Full Monty from Igor.  The most likely way that information will come out is that if the unfavorable economics are used to justify abrogating the transaction.  That is, the only way that the details of the transaction are likely to be made public is if Russia decides to claim that the Chinese screwed them as a justification for walking on the deal, or insisting on renegotiation.

Which just may happen.

SWP in Pravda.  Yes, Pravda.  Well, I guess for once there’s something true in Pravda:)

Ironically, when I looked at the link (sent to my by a SWP reader), next to my deathless prose were a series of chest-thumping articles on the Bulava missile and Russian nuclear missile forces more generally.

A reader sent me an email about my post ridiculing Timothy Geithner’s admission that restructuring the OTC derivative markets is really complicated, telling me that (a) I was very mean, and (b) I can be a real smart ass.  (That said, she also thought it was very funny.)  Both (a) and (b) are true–especially the latter, I guess.  My wife is always telling me that sarcasm is the lowest form of wit, but there are some things that are so outrageous that sarcastic ridicule is perfectly appropriate.

And I think that Geithner’s admission that a complete re-engineering of the financial system is extremely difficult is one of those things.  He is playing the Sorcerer’s Apprentice, unleashing forces that he doesn’t comprehend.  Somehow dry, play-it-straight analysis doesn’t seem to be an adequate response to such dangerous arrogance.

Indeed, one of the very pillars of his argument for the need for “reform”, the interconnectedness of the financial system, is precisely the reason why care is especially warranted in this instance.  Highly interconnected, dense networks like the financial markets are complex systems.  Small shocks to such complex systems can lead to discontinuous responses.  And such changes are almost always impossible to predict.

These markets are so complex that one should proceed with great caution before making wholesale changes.  This is especially true when these changes are predicated on a simplistic, not to say incorrect, diagnosis of the nature of the system.  Fools rush in where angels fear to tread.

It would be useful if Geithner–and Obama, for that matter–would read Hayek’s The Pretense of Knowledge or Sowell’s Knowledge and Decisions.  Perhaps such reading would at least temper the presumptuous arrogance that has characterized the administration’s financial regulation initiatives, and its other efforts to remake virtually every other part of the American economy from energy to healthcare.

But I doubt that it will.  And as a result, I would imagine that Mr. Geithner and his colleagues will provide numerous opportunities to exercise my talents in the lowest form of wit.

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.

One of my new favorite blogs, Zero Hedge, echoes my serious reservations about the reliability of bullish statistics releases from China.  The basic point is that (a) China had a heavily export oriented economy; (b) recent turbocharged Chinese growth was driven by exports; (c) world trade is in the dumper, and every other trade-dominated economy (e.g., Germany, Japan, S. Korea) is doing worse than other, less trade-dominated ones; and (d) it is very difficult to engender a major structural shift in an economy away from one driven by trade to one driven by domestic consumption.  The turnaround is attributed to a near immediate, miraculous reaction to a huge Chinese fiscal stimulus.  Maybe . . . but the evidence on the stimulative effects from other countries would suggest that such an outcome is highly unlikely.

Given that any optimism about world economic prospects is predicated on rosy views of the Chinese economic picture, if this data in fact exaggerates Chinese economic conditions, the implications for the strength and timing of any recovery in the West and Japan are not good.

There are some reasons to doubt Chinese data.  First, China is still an authoritarian state that exerts tremendous control over information.  Second, it quite anxious about domestic unrest–as recent riots make quite clear.  This could make it reluctant to disclose bad economic news.  Third, it does things like cut off releases of electricity data that might give the lie to other statistics.  (Of course, why not just lie about the electricity numbers if they are lying about something else?)

So, maybe the bullish news is true, maybe not.  I think that Zero Hedge’s skepticism is quite warranted however.  For if the data out of Beijing are correct, that would be the real Chinese miracle.

Almost exactly a year ago, I testified before the House Ag Committee and wrote an oped for the WSJ on the effect–or lack thereof–of speculation on oil prices.  The issue was high on the political agenda at the time, as oil prices hit $147/bbl, and gas prices were above $4/gal.  The collapse in prices during the financial crisis put the issue on the backburner, but it is back with a vengeance.  To loud Congressional hosannahs, the CFTC has announced its intent to impose a far reaching regime of position limits on energy and other commodities “in finite supply“–pray tell, what traded commodities are in infinite supply?

So, I guess I have to roll that rock up the hill, yet again.  (I have posts on the subject of “excess speculation” and position limits from 2006, 2007, 2008, and 2009.)  

At the risk of becoming even more of a repetitive bore than usual, I’ll restate my objections to the intellectual basis to these policy initiatives, and the policy initiatives themselves.  Before doing so, it is worthwhile to define “excessive speculation,” something those that hurl around the phrase with abandon almost never do.  I define “excessive” speculation as that which drives prices away from the competitive price consistent with available information.  That is, excessive speculation distorts prices.  Now, my objections:

• The mechanism by which speculators allegedly distort prices is almost never specified, and when it is, it makes no sense.  Advocates of the “excessive speculation” hypothesis routinely say that speculators inject artificial demand into the market.  Given that most speculators almost never actually take delivery, and thus offset their positions as they become prompt, they are not influencing either supply or demand for the physical commodity.  This is a point that has been recognized since at least 1902 in a report authored by the US Industrial Commission, which included several Congressmen and Senators.  Which I guess goes to show that Congressional IQ exhibits an inverse Flynn Effect.  
• This is especially the case for commodity index traders, who almost all trade cash settled instruments, and hence can in no way influence supply or demand.
• That is, none of the boatloads of money allegedly flowing into commodity funds actually goes into, you know, actual commodities.  Some of the money in commodity-linked investments is purely notional (e.g., in commodity swaps, or index swaps).  Some goes into T-bills (in the form of margin, or in fully collateralized commodity trades).  
• The evidence of a distorting speculative effect is laughable.  Distortions in prices should lead to distortions in quantities, e.g., in commodity stocks.  No reliable evidence of such an effect exists.  Indeed, I have looked at one commodity–copper–in close detail as part of a chapter of my upcoming book on commodity price modeling.  People were screaming about a speculative bubble in copper last year at the same time as the (louder) screams about a speculative bubble in oil.  But copper stocks (and the stocks of other industrial metals) were drawn down sharply at the same time prices were spiking: this is exactly what one would expect to observe with a positive demand shock.  Indeed, I am working on calibrating a rational expectations theory of storage model to copper data, and this model can explain the twists and turns of prices and stocks during the extreme events of the last several years.  That is, speculative irrationality is not required to explain the movements in copper prices AND inventories over the 1997-2009 period.  (I’ll post more on this when I finish a couple more parts of the analysis next week, hopefully.)
• Some of the “evidence,” logically ungrounded as it is, doesn’t even support the assertion of a speculative effect.  For instance, a common piece of “evidence” is that prices rose right along with measures of long speculative interest in the oil markets.  (This was a Michael Masters favorite).  Set aside the correlation-causation post hoc/propter hoc problems, and the potential for spurious regression problems whenever one examines the relation between two highly autocorrelated series.  Just look at the graph in this WSJ story:

Sure, prices and long non-commercial positions were both trending up in 2005-2008 (not that that means a damn thing).  But look at what happens in late-08 and early-09.  Prices and long spec positions are mirror images: prices were plunging when long interest was rising, and then, just as long spec interest peaked and began to fall, prices ceased their fall and moved strongly upwards.  How can you possibly explain this if the market dances to the speculators’ tune?  The speculative Pied Piper story says that these measures should move up and down together, not in opposite directions.  Now, this Masters style analysis is B.S., but those who used it to rationalize their assertions of a speculative effect are hoist on their own petard: they vouched for the validity of non-commercial long open interest as a measure of the “excess” demand for oil caused by speculation, but the most recent experience is decidedly inconsistent with that story.  Not that that they have even paused for thought, but continue to flog the same story.  

• Not to mention that numerous analyses, relying primarily on Granger causality, have failed to find any reliable connection between changes in speculative positions and price changes.  Or the analysis (by the CFTC!) showing that commercial traders tend to be market leaders and speculators are followers.

The calls for government regulation have gone international, and gone beyond calls for mere position limits.  Gordon Brown and Nicholas Sarkozy penned a WSJ editorial advocating widespread governmental “supervision” (Euphemism alert!) of the energy markets (including cooperation with OPEC):

For two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics. First it rose by more than $80 a barrel, then fell rapidly by more than $100 before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply.

The oil market is complex, but such erratic price movement is cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.

Where does one even begin the ridicule (beyond noting the point that whenever French and British politicians agree, it must be a really bad idea)?  Regarding volatility.  Uhm, the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar.  In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities.  Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard.  That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s.  Look at every measure of uncertainty, notably such things as the VIX volatility index.  These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007).  What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.  

Regarding “serious interruption of supply.”  Uhm, Gordo, Nicky–there’s this concept called “demand.”  Believe it or not, it’s one of the “accepted rules of economics.”  Don’t take my word for it.  It’s in all the textbooks.  Price evolution in the recent period is clearly demand driven, not supply driven.  Prices spiked when demand spiked.  Prices plummeted when demand cratered.  

And there have been supply shocks.  Nigeria is an ongoing source of supply shocks, and during the price spike last summer losses of sweet Nigerian crudes in the face of very high demand for distillates (driven in part by European regulations regarding clean diesel) led to big spreads between benchmark sweet crudes like WTI and Brent and sourer crudes.  What’s more, OPEC output cuts (especially by Saudi Arabia) played a key role in the firming of prices following the price collapse in October-January.

I should also note that recent research by Lutz Kilian (nicely summarized in his JEL piece) shows that movements in oil prices hew more closely to movements in proxies for demand than measures of supply.  James Hamilton disputes Kilian’s contention that supply shocks are unimportant, but Kilian does demonstrate that demand is clearly an important price driver.  (I also have some reservations about some of Kilian’s analysis, most importantly his conclusion that changes in demand for precautionary inventories is also an important driver of prices.  I don’t disagree with the logic, having written several posts and an academic paper–which will also be another chapter in the book–showing rigorously how that can work in practice.  My problem is that Kilian does not measure factors that could affect precautionary inventories directly, but instead attributes oil price movements not explained by supply or demand measures to an “oil market specific” factor which he asserts is related to the precautionary inventory effect.  I am currently working on developing some more direct measures that would influence precautionary inventory holdings.  I have a good handle on measuring demand side risks that could influence such holdings, but measuring supply side risks is far more difficult.)

In recent months, the oil market and world equity markets have exhibited unprecedented positive correlation (something I called attention to in October-November).  Oil and equities swooned together; they rallied together March-June; and have been selling off together in the last couple of weeks.  This reflects the dominant role of demand in commodity prices at present.  Both equities and commodities are responding to rapidly evolving views in a highly uncertain situation about the likelihood and strength of economic recovery.  They are also responding to government policies, notably aggressive quantitative easing strategies that raise the specter of inflation.  

Now, you could argue that this is speculative.  And indeed it is.  Both equity market and commodity market participants are speculating on the future course of the world economy.  But is it destablizing speculation?  

What’s more, to the extent that energy prices (and commodity prices) are reflecting information/perceptions/sentiment about the future course of economic recovery, and are reflecting the same information/perceptions/sentiment as equity markets and bond markets, why would anyone think that position limits on commodity derivatives would break this linkage?  Once embedded in equity prices, information/perceptions/sentiment about future economic growth become public information that will be embedded in prices even if speculators are forced to trade less.  

The arguments against position limits as a policy are well known.  Speculators absorb risk from hedgers, and supply liquidity.  They therefore impair ability of the markets to serve their essential risk shifting function.  They therefore increase the costs of managing risk, and impose harm on hedgers.

This makes a mockery of the distinction that politicians and regulators draw between the “good hedgers” with price exposures inherent in their businesses that need to be managed, and “bad speculators” who have no underlying exposure to manage, but are taking on risk like gamblers in a casino.  But there is a symbiotic relationship between hedging and speculation.  To whom do hedgers transfer the risk if not to speculators?  And if there are no speculators, how is it possible to hedge risks?; after all, hedging doesn’t make risk magically disappear, it just transfers it to somebody willing to hold it–a speculator.  Thus, politicians and regulators who invariably say that they just want to protect “legitimate” commercial participants from the predations of evil speculators are more full of it than usual.

That said, there is an apparent puzzle: many of the most ardent critics of speculation are physical market participants.  But it’s not necessarily a puzzle, for the same reason that nobody should be amazed that Walmart supports Obama’s health care plan: many firms benefit from regulations that make markets less efficient.

In the commodities case, here are a couple of examples.

It is well known that some commercial market participants are informed traders who make money on the basis of their information.  A Cargill, for instance, has an extensive information network that allows it to trade profitably.  (I sat at the trading desk of Continental Grain some years back, and observed that the traders had access to information around the world about weather conditions and grain flows due to their physical presence in numerous markets.  This gave them an information edge.)  Such firms don’t hedge mechanically.  They trade futures and other derivatives strategically to optimize a risk-return trade-off.  Their information advantage allows them to time the placement and unwinding of their hedges so as to make money.  

Competition from informed speculators tends to erode the competitive/information advantage that informed commercial firms have.  Hamstringing such competition could provide a greater benefit to such firms than would result from the loss of liquidity from speculators.  

As another example, a reduction in market liquidity resulting from speculative position limits almost certainly has disparate impacts on commercial firms.  Some firms, due to capital structure, operational leverage, real options, or other reasons, get more benefit out of hedging than other firms in the same industry.  A regulation that reduces market liquidity raises everybody’s costs, but the first type of firm’s costs go up more than the second type of firm’s.  Thus, the second type of firm may actually support regulations that make hedging costlier or less effective because it raises their rivals costs more than its own costs go up.  

So, the support of some commercial firms for restrictions on speculation is not necessarily a puzzle.  In my view, it more likely reflects an opportunistic use of the regulatory process to distort competition in a way that profits some firms.  This is a ubiquitous phenomenon, observed in many industries and many regulations: why should derivatives trading be any different?  

Well, that’s all I have to say for now, though I doubt this will be last word on the subject, hardy perennial that it is.  Like Sisyphus, I am resigned to the unending task of rolling the rock of enlightened reason up the slope of benighted ignorance, only to see it slip back down again:)

A trader at British oil brokerage PVM Oil Associates has been identified as a rogue trader who entered buy orders for 9mm barrels of Brent crude futures on ICE Futures in London during the illiquid early morning hours, causing a spike in the price of oil–and costing PVM $10 million.  To me, the most interesting aspect of this is the potential for can’t-change-their-mind-won’t-change-the-subject fanaticism of American legislators railing against the “London loophole”:

Unauthorised trading in oil futures in London and the corridors of power in the US Congress may not seem to have much in common.

But London’s markets have become easy targets for US lawmakers eager to show that loose practices on foreign energy markets are hurting US consumers.

Traders, so the theory goes, are carrying out nearly half the world’s global crude oil futures trades on ICE Futures Europe under the eyes of the Financial Services Authority.

The  PVM case  could re-ignite such concerns, just as US politicians are again railing against “excessive speculation” in energy and commodity markets.

This week Bart Chilton, a commissioner at the US futures watchdog, the Commodity Futures Trading Commission, said it was looking for signs of excessive speculation in commodity markets, with specific attention on oil prices.

Last month senator Carl Levin, a Michigan Democrat who has long campaigned for  tighter regulation of energy markets, said the US futures markets regulator needed to enforce strict position limits to curb speculation that last year caused record  wheat prices  that could not be explained by the dynamics of supply and demand.

A year ago, Mr Levin became convinced that improper trading of oil futures was taking place in the UK’s financial centre without sufficiently tight supervision by regulators.

A version of the West Texas Intermediate crude oil contract is traded in London on ICE Futures Europe, and regulated by the FSA. It is similar to the WTI contract traded on the New York Mercantile Exchange, regulated by the US futures watchdog, the CFTC.

Dubbing this the “London Loophole”, Mr Levin forced the CFTC to forge closer ties with the FSA, including a system by which the FSA would report irregular market activity much more quickly to the US.

Yet it does not seem to have worked as intended in the PVM case. CFTC officials claimed they were kept in the dark for several hours in spite of last year’s agreement for closer co-operation.

The FSA said on Friday: “We work very closely with the CFTC to ensure fair and orderly markets. The way we oversee the commodity markets is adequate for the UK regime.”

If there was any delay, regulatory experts say that could easily have been due to the time it took for FSA officials to get a clear picture of what had taken place at PVM, not a break-down in communications with the CFTC.

“The last thing they want to do is start rumours if they don’t know all the facts,” said one.

For the record: rogue trading is an international problem. A few choice examples: Singapore’s China Aviation Oil (2004, $550 million); France/Germany, SocGen’s Jerome Kervial, (2007-2008, $6.5 billion) (yes, with a “b”); Japan/Singapore, MItsui Oil Asia (2006, $81 million).  

Oh, and the United States.  We don’t know whether the 22 September, 2008 spike in the oil price–which dwarfed the recent spike apparently caused by the PVM trader–was due to a rogue trader, but it is highly suspect nonetheless.

And who can forget the MF Global trader in Memphis who lost $141.5 million in a day on Minneapolis wheat?  

I could go on.  

Where does rogue trading occur?  Well, where trading occurs.  There is a lot of trading in London, so it is inevitable that some rogue trading will occur there.  When assessing the adequacy, or not, of regulatory oversight in a market, it would be worthwhile to control for the magnitude of trading activity.  On that score, Singapore looks like a more dodgy place (with the infamous Nick Leeson/Barings episode in addition to the two cases listed above).  So, actions relating to the London Loophole (a vastly overrated financial bogey man in any event) are unlikely to have any effect on the frequency of rogue trading.  

It is primarily a problem of internal controls, but there is no system of controls that is capable of eliminating rogue trading altogether.  (Moreover, as with anything, there is a trade off, and it would be inefficient to invest in controls sufficient to eliminate such trading.)   And the US is hardly immune to the problem.  So although regulatory jingoism may feel good, it can happen here.  And it does.

The European Commission has just released a Commission Staff Working Paper  on “Ensuring efficient, safe, and sound derivatives markets.”  Not surprisingly, it comes out in favor of extending central clearing, especially to credit default swaps.  It must be said that the EC’s paper is far superior to the product of the US Treasury Department (a low bar, to be sure).  That said, I believe that many of the arguments and conclusions are fundamentally wrong.  The paper does the best job I have seen in making the case for extending clearing, but in so doing has unintentionally pointed out the flaws in that case.  Indeed, the basis for many of the paper’s conclusions actually supports the exact opposite of what the paper recommends.

At a high level, the failings of the paper are: (1) it identifies alleged benefits of central clearing, virtually all of which are private benefits, but completely begs the question “if these (private) benefits are as large as the EC says, why haven’t private parties adopted central counterparties (CCPs) more widely?”; (2) relatedly, it does not provide any explanation of why the market share of products purportedly traded on inefficient market structures has increased in recent years; (3) it fails to take into account the endogeneity of market structure, or explain how these structures arose and why–or why not–they are inefficient; and (4) although it clearly identifies the unique risks associated with CDS, it draws the exact wrong conclusion about how default risks from CDS should be borne–bilaterally or through a CCP.

The paper’s main case for CCP clearing (set out in section 2.4.2 and 2.4.2.2) focuses on netting, and the benefits associated therewith including “more efficient use of collateral” and “operational efficiencies.”  But these are benefits captured by the members of a CCP, and provide no rationale for mandating the adoption of clearing.  There’s no externality related to these issues that needs internalizing.  Relatedly, the paper asserts that a CCP is “considered a zero risk counterparty” and hence frees regulatory capital.  Really?  Clearinghouses can fail.  Cf. Hong Kong, 1987, and the near failures in Chicago at the same time, and the near failure on COMEX on “Silver Tuesday” 1981.  If regulators really treat it this way, a CCP would be a source of regulatory arbitrage, again meaning that market participants would have a strong–too strong, in fact–incentive to adopt it.  

With respect to risk sharing and collateral, the paper mistakenly claims that all collateral can be used to cover the costs of a default.  This is obviously wrong–as the box on SwapClear default management process in section 3.2.5.1 shows.  

The paper fails to mention that netting is not necessarily a social benefit, and can facilitate redistribution from one group of firms to another.  This redistribution can also give excessive incentive to form a clearinghouse.  

The paper also fails to recognize that more rigid collateral mechanisms can reduce the utility of a market as a hedging mechanism, and forcing adoption of these mechanisms can actually increase risks some firms face by precluding otherwise mutually beneficial hedging trades.

The paper touts that a CCP “an institution whose sole focus is risk  reduction.” But the world involves trade-offs, and an organization with a “sole focus” is not able to make such trade-offs. If the CCP prices risk appropriately, and therefore charges the right amount of collateral, then other market participants will make the appropriate decisions. But as I’ve argued extensively here, in my Regulation Magazine piece, and in working papers and presentations, for many transactions the clearinghouse is at an informational disadvantage relative to dealers in appraising risk–in which case it is less likely to price risk appropriately.

Moreover, the paper does not consider the incentives that the CCP faces. Yes, it has one job, but how strong are its incentives to do that job? A CCP is typically subject to low-powered incentives (e.g., non-profit form), which is understandable since it is an agent, and an agent of multiple principals; whereas a dealer bears many of the costs of poor counterparty risk management, as an agent the CCP does not. Moreover, although the CCP is touted as a solution to systemic risk, if systemic risk gives rise to externalities that affect those beyond its membership, this benefit is overstated: the CCP does not internalize all relevant externalities and therefore takes too few measures to address systemic risk.

The clear logical implication of the EC paper is: “If clearing is so great, somebody should have done it by now.”  Like virtually all advocates of the idea, the EC paper does not raise, let alone answer, that objection.  To do so, the EC must identify the market failure, and show how its proposed solution would ameliorate it. It has not done so.  It has not even recognized the necessity of doing so.  

The paper also asserts that clearing can “solve[] disruptive information problems” by improving information on positions.  But this can be achieved without the mutualization of risk that clearing entails.  

The paper sets out in great detail the dramatic growth in OTC trading, and the limited penetration of clearing, even in relatively standardized sectors.  Again, given the asserted benefits of clearing and other changes to OTC market structure, this calls for an explanation that is completely absent from the paper.  There must be something else going on here sufficient to overcome the supposed advantages of a CCP.

The paper does provide a very nice description of the variations in structure across different OTC products.  Note that these structures arise endogenously.  This raises the questions: (1) why do different products (e.g., interest rate swaps and CDS) have different structures? and (2) are these structures inefficient?  The endogenous variation suggests that there are fundamental differences across products and participants, and that different structures have evolved to accommodate these differences.  The paper sets out no serious argument or evidence that these variations are accidental, or inefficient.  As a result, it provides no basis for recommendations on how to change market structure via regulation.  

This failure to grapple with endogeneity–the causes of variations in market structure across products–leads to silly inferences, such as: “CCPs have proven to be resilient even under stressed market conditions . . . and showed their ability to ensure normal market function in the case of failure of a major market player” (2.4.2.1).  Yes . . . but this does not imply that similar results would obtain if all products were cleared.  The products that are cleared, and which worked successfully, have attributes that differ from the attributes of products that are not cleared–a point that the paper makes very forcefully.  Therefore one cannot conclude that requiring clearing of other products would work as well.  It could also be stated that other non-cleared products, e.g., CDS, also worked successfully in the face of the failure of a major dealer.

This issue of the differences across products is essential, and one that the paper raises repeatedly before drawing the wrong conclusion.  For instance, in the Executive Summary, and elsewhere, the paper says that CDS are different because of their “binary and discontinuous pay-out structure, concentrated dealer market structure, difficulty in valuing the rights and obligations contained in the contract, especially for the less liquid single name part of the market, lack of solid risk management measures and disproportionate dimension of the derivatives market with respect to the underlying market.”  I agree, completely.  

But I disagree with the conclusion drawn from these differences: “CDS have particular risks . . . all of which are difficult to mitigate . . . . For all these reasons, CCP clearing is desirable.”  But all of these features pose major informational challenges to clearing, and in my view, make it sensible to share risks bilaterally; the conclusion therefore does not follow from the stated premise.   Similarly, the paper points out the valuation difficulties involved in setting collateral from some products, due to the difficulties of valuation.  Again, agreed.  But the relevant question is who can do this better, bilateral parties or a CCP.  For some products, a CCP can do just fine, but for other products, it is quite likely that dealers can do a better job.  

These very considerations are why many operators of clearinghouses–who at first blush would seem to have an interest in a clearing mandate–have come out almost universally against such a requirement.  Note, this is not allegedly self-interested dealers talking: it is the clearing operators.  They recognize the unique risks of clearing some products, notably CDS, and believe that these risks make some products inappropriate for clearing.  That’s been the gravamen of my argument all along, but the paper completely overlooks this point–even though the clearing operators expressed their reservations very publicly weeks before the paper was released.  

Relatedly, in section 2.4.1.4 the paper identifies as a “Potential weakness of bilateral clearing” to be the fact that it relies on “each party’s internal ‘risk engine’ . . . . These risk engines are essential parts of a bank’s comparative advantage and while the broad contours may be similar each bank has a slightly different approach to risk assessment.  Overall, the crisis has highlighted the difficulty of designing models that adequately measure market risk.”  True, again.  But the relevant–unasked–question is: in this imperfect world, who can design the better model?  (Not perfect, but better.)  Due to the very “comparative advantage” aspect the paper identifies, dealers and other big traders have stronger incentives and better information to build better models than a CCP.  (A point I first made back in the 1990s.)  Moreover, an argument can be made that diversification in models is beneficial as a way of reducing the market’s exposure to model risk, whereas a clearinghouse chooses one model, and exposes the market in a big way to its (inevitable) limitations.  

In sum, in my view the paper presents a very thorough and accurate overview of the various OTC markets and products, and the unique characteristics of these products.  It then either ignores the implications of these differences altogether when making its recommendations, or makes recommendations that do not follow from its factual analysis.  Indeed, its recommendations are often the opposite of what a thorough consideration of the implications of these differences would imply.  

That is, the paper is very effective at pointing out the wide variation in the informational and risk characteristics of the various products traded in the OTC market.  It also effectively characterizes the wide variation in trading structures.  But it fails altogether at connecting these two inherently interconnected things.  Moreover, it focuses on the private benefits of its favored “solution” (clearing), even though this cannot be the appropriate basis for its policy recommendation.  There must be some sort of externality or other market failure that results in the adoption of inefficient institutional arrangements, but the paper fails altogether to identify what this externality or other market failure.

In brief, whereas the Treasury Department earns an F+ (and I am a generous grader), the EC merits a gentleman’s C.  It at least provides a factual basis for a considered analysis of the trade-offs entailed with different market structures.  I disagree with the conclusions it draws from its facts, but it’s a start, and a big improvement over Treasury’s arguendo ad AIG.