Streetwise Professor

I’ve written about the hard-to-explain behavior of oil prices and stocks.  But oil isn’t the only commodity around, so I thought it would be worthwhile to look at some others to see whether their behavior may shed light on which version of the “green shoots” theory their behavior supports–the green shoots of a recovery in output, or the money-is-green version that the price rises are a harbinger of inflation.

The best data on prices and especially stocks for industrial commodities is available for non-ferrous metals.  Here are the comparisons (all data from the LME):

• Copper 3/2/09.  Cash: $3329, 3 Months: $3355, Stocks: 530,875 MT.
• Copper 5/13/09.  Cash: $4507, 3 Months: $4530, Stocks: 373,750 MT.
• Lead 3/2/09.  Cash: $1160, 3 Months: $1166, Stocks: 60,750 MT.
• Lead 5/13/09.  Cash: $1450, 3 Months: $1440, Stocks: 73,500 MT.  
• Nickel 3/2/09.  Cash: $9602, 3 Months: $9607, Stocks: 99,378 MT.
• Nickel 5/13/09.  Cash:  $12450, 3 Months: $12545,  Stocks: 111,648 MT.
• Primary Aluminum 3/2/09.  Cash: $1270, 3 Months: $1310, Stocks: 3,243,900 MT.
• Primary Aluminum 5/13/09.  Cash: $1428, 3 Months: $1521, Stocks 3,880,325 MT.
• Tin 3/2/09.  Cash: $11,047, 3 Months: $10702, Stocks: 9,140 MT.
• Tin 5/13/09.  Cash: $13,890, 3 Months: $13,615, Stocks: 13,405 MT.
• Zinc 3/2/09.  Cash: $1078, 3 Months: $1104, Stocks: 355,500 MT.
• Zinc 5/13/09.  Cash: $1430, 3 Months: $1475, Stocks: 322,025.

Note that the prices of each commodity have risen.  Depending on the metal, the rises have been between about 15 percent and 40 percent.  For some of the metals, spreads have narrowed.  For instance, the contango in copper has decreased, as has that of lead (which has gone from contango to backwardation).  For aluminum, however, the spread has widened, as it has for zinc (though not in percentage of the spot price).  

Interestingly, lead, nickel, tin, and especially aluminum stocks have increased; stocks for copper and zinc have decreased, especially the former.  Aluminum is of special interest, as this is a major industrial commodity, and is highly sensitive to industrial uses (e.g., in autos).  

Overall, the story is quite mixed.  Copper suggests bullish fundamentals: a sharp rise in price and a pretty steep fall in stocks.  But, overall, the stocks data give no evidence of a near term strengthening in demand that would explain the price rises across all metals.  Note the rise in aluminum price and the contemporaneous nearly 20 percent increase in stocks.  Hardly a signal of a rebound in industrial demand.

There are two interpretations consistent with the data: (1) spot demand remains low, but demand is expected to pick up in the future, and (2) real spot demand remains low, future real demand is expected to remain in the doldrums, but prices are being buoyed by expectations of a possible inflationary burst (i.e., the money is green version of green shoots).  

Even the copper data, and perhaps data from the oil market, are potentially consistent with (2).  It is widely reported that China is stockpiling copper and oil.  Indeed, some of the copper stocks decline may be a mirage as copper is merely being transferred from LME warehouses to Chinese strategic stockpiles that are invisible to the market, rather than being consumed.  This could reflect a Chinese substitution of dollars/dollar denominated assets into real assets such as copper (and perhaps oil) due to their fears about the US dollar and inflationary pressures in the US.  That would be consistent with the inflationary expectations story, and indeed, a channel by which these expectations influence current prices.

If I had to choose between (1) and (2)–between an anticipated increase in future real demand and an anticipated increase in nominal demand due to inflationary pressures–I guess I would choose (2).  Suffice it to say that although I’m not metaphysically certain as to which explanation is right, the data do not contradict the inflationary expectations story.  Moreover, the future demand/spot demand story is not that convincing.  Anticipation of future demand should lead to an increase in current demand, but that is not being reflected in stocks.  

With stocks largely signaling weak real demand (especially when one considers that the copper stock drawdown may not reflect an actual increase in copper consumption), but prices rising, there is a very good chance that metals prices are in fact a harbinger of inflation.  In his speech at the Atlanta Fed conference on Tuesday, John Taylor suggested that the Fed may not have much time before it has to decide whether to switch gears and fight inflation.  The metals data support that suggestion.  Indeed, if China’s actions in the copper market reflect a substitution of real stuff like the red metal for dollar denominated nominal claims, rather than a real need for the commodity, the time for choosing may be coming much more quickly than is conventionally believed.

Just sayin’.  Or, perhaps I should rephrase that: Just the metals market sayin’.  Listen up, Chairman Bernanke.

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

Other than the price, that is.  The excellent Izabella Kaminska continues her fascinating coverage of the relation between oil prices and fundamentals at FTAlphaville. Izabella provides additional data on the continuing accumulation of oil and product inventories in the face of rising prices, and links to a Goldman Sachs analysis thereof.  

A positive co-movement between inventories and prices is an anomaly in the standard theory of storage model.  In that model, an negative demand shock (or a positive supply shock) leads to (a) a decline in price, and (b) an increase in inventories.  

I have devised a model (the ideas for which I first explored on SWP) in which you can get a positive covariation between prices and inventories due to stochastic fundamental volatility.  The basic idea is that when fundamental uncertainty goes up, people increase precautionary inventory holdings.  The only way to do this is to bid up price in order to reduce consumption and increase production.  

Although I think that this model can explain some market behavior (such as in the post-hurricane period 2005-2006), it doesn’t seem to fit the current episode.  If anything, fundamental uncertainty is declining of late.  Stock prices have been rallying.  The volatility indices (e.g., the VIX) have been declining.  

Here’s an alternative explanation.  Traditional models posit Markovian processes for (net) demand shocks.  This means that current demand shocks imply a distribution of future demand.  Moreover, the models are typically stationary, meaning that a given current demand shock leads to a smaller change (in the same direction) in expected future demand.  In these models, the distribution of future demand changes only if current demand changes.  

An alternative model (which is hard to implement formally) incorporates “future” shocks that are distinct from current shocks.  (A Fama-French JF paper on metals prices from 1988–if I recall the year–explores this idea.)  That is, information may arrive today that has no implications for current demand or supply, but does has implications for future demand or supply.  So, for example, if new information arrives that suggests the economy will be better in 6 months than than had been previously anticipated, a rational economic response is to add more to inventory in anticipation of higher future demand.  Expected future prices rise due to the bullish future information, and in conditions of full inventory, the cost-of-carry relationship causes current prices to rise too.  (Indeed, holding current demand constant, the higher price induces lower consumption and higher production, which allows the accumulation of additional inventory.)  

This is pretty close to the Goldman-Sachs story.  Goldman also argues that if oil storage facilities fill up, the connection between future prices and spot prices will break down.  In the context of the model, if the marginal cost of storage becomes very steep, the increase in future demand leads to a rise in the future price, but a much smaller rise in the spot price; it is too costly to accommodate the future demand shock by adding even more to inventory due to the very high and rapidly rising cost of storage.  Thus, current inventory (and hence current consumption) do not respond to the future demand shock; since consumption doesn’t respond, spot prices don’t change either.  

Note that the nature of the “future shock” (to steal the name of an old book) is not specified here.  It could be a real shock or a nominal one.  That is, it could be that information arrives that suggests that real demand will increase in the future, or that only nominal (money) demand will increase.  That is, inflation is expected to increase.  This could lead to increases in nominal spot and futures prices, even in the face of stagnant or declining real demand.  

One piece of evidence that could bolster this interpretation is that nominal Treasury yields are beginning to rise.  The 30 year auction yesterday was something of a disaster, and 10 and 30 year yields are rising. Indeed, over the past week when oil prices have been rising, the breakeven rate (the difference between 10 year nominal T-note rates and the corresponding TIPS yield) has increased from about 1.41 percent to 1.58 percent.  Not a big deal, but the direction is interesting.  

So, the oil market could be a “green shoot” signaling an impending recovery of demand.  One not quite here yet, but on the horizon.  Or, it could be a “green” shoot in the sense that (a) money is green, and (b) per Milton Friedman, inflation is always and everywhere a monetary phenomenon.

The IMF World Economic Outlook makes extremely dispiriting reading.  Especially for Russia.  The IMF completes the trifecta of major international organizations (after the World Bank and OECD) to revise sharply downwards its prognostication for Russian economic growth.  (SWP paging Bob!  SWP paging Bob!)  Indeed, Russia is the champ, according to IMF.  That is, the IMF reduced its estimate of growth for every country, but the reduction in Russia’s GDP growth forecast was the largest, at -5.3 percent.  Indeed, the IMF’s forecast of Russian growth is lower than its forecast for any country other than Japan for 2009: IMF estimates that Russian GDP will drop 6 percent, compared to Japan’s decline of 6.2 percent.

Russia is also the champ when one compares 2007 or 2008 growth rates to forecast 2009 growth rates.  Whereas Japan’s growth rate in 2009 is forecast to be 5.6 percentage points below its 2008 growth rate, Russia’s 2009 rate is forecast to be 11.6 percent below.  Comparing 2007 and 2009 growth rates implies a difference of 8.6 percentage points for Japan, and a whopping 14.1 percentage points for Russia.  Say that slowly.  Fourteen point one percentage points.  That’s huge.

An article in the Moscow Times should only deepen the sense of gloom.  The article notes that Russian inflation was 5.8 percent in the first quarter.  This is consistent with another SWP prediction that Russia is mired in a deep stagflation.  The acceleration of inflation at the same time the economy is plunging is deeply troubling, and reflects the forces that I mentioned in some earlier posts, namely, the quite reasonable decision by people to exchange rubles for goods.  I doubt the ruble can maintain its rally under such circumstances.  Unbelievably, though, the government is sticking with its forecast of 13 percent inflation for 2009.  Dudes.  You’re like 45 percent of the way there after 25 percent of the year.  Expecting a dramatic slowdown of inflation is very unrealistic, especially given the seemingly entrenched inflationary expectations among the Russian people.

The head of the Kremlin’s anti-crisis task force, Vladimir Mai channels the SWP theme that Russian policy options are extremely limited, especially given the sharp inflation:

“Inflation limits the tools of our anti-crisis policy. Many measures used in the United States and Europe are not available for us. We cannot carry out quantitative easing, we cannot use budget stimulus and we need to maintain high interest rates,” he said.

Mau fears that renewed growth in commodity prices could stall the modernization drive and bring the government back into a complacency mode that characterized the last years of Vladimir Putin’s presidency.

“During an economic boom, it is impossible to carry out a modernization policy,” he said. “If prices for oil and gas are high, there will be no diversification.”

Translation: “We’re screwed.”

The last paragraph is of particular interest.  The political will for modernization and diversification is lacking in times of economic crisis because the government is in survival mode then.  The political will for modernization and diversification is lacking when the economy is strong due to high oil and gas prices because under such circumstances, who needs modernization?  Laissez les bon temps roullez!  Especially for the kleptocrats.    Where’s the Goldilocks spot?  You know, the one that’s just right to facilitate modernization and diversification?  Uhm, somebody will have to get back to you on that one.

For the foreseeable future, if anybody (now who could that be?) uses the words “nano” and “Russia” in the same sentence, my immediate reaction will be to think of the order of magnitude of the probability that Russia will achieve the economic ambitions that harbored a mere six months ago, let alone achieve the fantasy set out in the Russia 2020 pipe dream.

In this environment, Putin’s statements about the economy are delusional.  Beyond delusional.  As are the pursuit of “prestige” projects like Sochi, billion dollar bridges to Godforsaken islands, and large expenditures on new weaponry.

Kudrin may be overly pessimistic in saying that this crisis has set the country back 50 years, but maybe not.   The crisis has derailed for the foreseeable future measures necessary to cope with Russia’s serious long term problems, such as demography and health, and infrastructure.  I hope to write soon on a couple of articles on Russia’s demographic situation, but given that economic growth of the first decade of this millenium led to only a modest decline in Russia’s downward demographic trajectory, there is a serious prospect that the current crisis will eliminate that faint progress, and lead to the return of the apocalyptic trends of the 90s.  Similarly, the prospects for addressing Russia’s serious infrastructure problems are fading fast.  The resulting deterioration in human and physical capital undermines the prospects for long term growth.  Upon consideration, maybe the “stressed” Mr. Kudrin is an optimist.

Oil was down almost 10 percent today, following the decline in equities.  But that’s not what I find intriguing.  What I find intriguing is that the price of oil was able to rise above $50/bbl, and stay there for awhile, despite extremely weak fundamentals.

These two FT Alphaville blog posts set out the story in detail.  They document continuing increases in inventories.  Specifically, both crude inventories and refined product inventories have been continuing their increase even as prices have inched upwards.  The increase in US refined plus crude stocks is a 4 standard deviation move–bigger than observed in almost 30 years.  Tanker rates are falling even as firms are chartering both clean and dirty tankers to store products and crude.  Refinery capacity utilization is at very low levels.

In a conventional theory-of-storage model, the increase in inventories would reflect a decline in demand/increase in supply that would also result in lower prices; the accumulation of inventories would slow, but not stop, the decline in prices.  Given that supply has actually dropped (due to OPEC output cuts), this would mean that demand has continued its precipitous drop.  

In the past I’ve argued that inventories and prices can move in the same direction when fundamental uncertainty increases.  An increase in fundamental volatility leads to increases in precautionary inventory holding.  The only way to accommodate this demand for higher inventories is to raise prices.

But that doesn’t seem to be a plausible explanation of what’s been happening in the last couple of months.  Some indicators of fundamental uncertainty, such as the VIX equity volatility index and credit spreads have actually eased in past months while the oil price was rising.  

So that leads me to another explanation, similar to the one advanced by the Diapason Commodities guy quoted in one of the FT pieces: Inflationary expectations.    

So what was behind the recent strength in crude prices? According to Corrigan most likely the same thing that was behind the equity rally – people investing in commodities and ‘real assets’ as an inflation hedge. As he explains:

This inflationary policy is already beginning to push people towards increasing their exposure to real assets — hence the rise in commodities and stocks   – a phenomenon very similar   to that which took place after the American devaluation of 1933, well ahead of the recovery in real output.  

Given the dismal news about the real economy, that’s the only thing that makes sense to me (in both the equities and commodities markets).  (Though Chinese strategic inventory accumulation is probably playing a role too.  That could be seen as inflation related too, however, as it involves the Chinese exchanging nominal claims, US dollar denominated securities, for real commodities.  That is a reasonable response to inflationary expectations; tends to reduce the demand for dollars; and cause an appreciation in the dollar prices of real commodities.  It is a Chinese contribution to quantitative easing.)  

You might say: “But the CPI and PPI actually dropped last month.  Inflation is the least of our worries: deflation is a more pressing concern.”  I would argue that these price measures are backwards looking; asset and commodity markets are forward looking.  And looking forward, there are many signs pointing to a potential spike in inflation.  It is not a probability one event, but the huge monetary overhang poses acute challenges to the Fed, and other central banks that have engaged in quantitative easing.  If they do not walk a very fine line, inflation could very well flare up.  And the line will be very hard to walk, because of the politicization of the Fed and other central banks, and the inherent credibility problem in anti-inflation policies as economies pull out of recession/depression/banana (a reference to Alfred Kahn’s quip in the 70s).  Therefore, it is not surprising to me that the dollar value of equities and commodities has strengthened somewhat recently.  

I will be keeping an eye on the connection between commodity prices and measures of fundamentals, especially inventories and capacity utilization.  Bearish fundamentals plus firming prices are a strong signal of potential stagflation.

A brief comment about today’s equity selloff.  I was actually surprised at the rally in stocks in recent weeks on bank earnings news.  I was surprised because I thought these earnings announcements said nothing about the main issue involving banks–the values of the assets in their portfolios.  Making money trading in an illiquid environment with wide bid ask spreads (because many competitors have exited the market), and intermediating in a market with a relatively steep term structure, is no surprise.  But what inquiring minds want to know is whether the banks are really solvent or not, and the answer to that question depends on the performance of all the bad assets.  It appears that today’s decline was related directly to inferences about the continued, and perhaps increasing, severity of this problem.  Inferences derived from reading between the lines in various bank earnings statements.  

For my part, I am paying little attention to bank earnings.  I am looking for clues about solvency.  And today suggests that the market is adopting a similar approach.

Today’s WSJ reports that Russian Finance Minister Alexei Kudrin is publicly acknowledging that Russia’s economic straits are far more dire than the government has been willing to admit heretofore:

Russia’s rapid economic decline may force the country to return to international debt markets next year to fund its budget deficit and pave the way for corporate borrowing, Finance Minister Alexei Kudrin said Tuesday.

Such a move would be Russia’s first foreign borrowing after a decade marked by buoyant growth. But a recent, rapid reversal into recession — which was fueled by a plunge in oil prices — and the deterioration of the global economy is putting pressure on the state coffers and leaving companies struggling to refinance foreign debts.

“It will take us several years to get out of this crisis,” Mr. Kudrin said during a finance ministry board meeting.

“We need to look at the possibility of entering the external market already in 2010, and this year to hold a roadshow…which will allow international investors to get better acquainted with our aims and plans,” Mr. Kudrin told the meeting, according to Reuters.

He added that the government’s forecast for a 2.2% contraction in gross domestic product this year already seems “optimistic.”

I agree that the 2.2 percent contraction forecast is indeed optimistic, and have been expressing that opinion for several months now, thereby eliciting the scorn of some commentors (the scorniest of whom has apparently vamoosed.  I wonder why?)  

Kudrin does not say so specifically, at least he is not reported to have said so by the WSJ, but the oft-revised government budget is predicated on that 2.2 percent decline in GDP.  Moreover, if that forecast is no longer operative, neither is the 7.5 percent-8 percent of GDP deficit number; a figure that Kudrin has said was a red line.  This puts further stress on Russian policymakers, who have fewer tools at their disposal than their counterparts in the US or Japan or the EU.  

Given these circumstances, Kudrin’s position is not an enviable one.  The administration is apparently concerned about the deficit:

The issue of public debt remains sensitive for the Kremlin.

On Tuesday, President Dmitry Medvedev’s top economic adviser, Arkady Dvorkovich, started a debate over the 2010 budget by saying the forecast of a 5% deficit is dangerous for macroeconomic stability.

“It [the deficit] should be lower,” Mr. Dvorkovich said, urging the Finance Ministry to work on cutting it.

An 8 percent of GDP deficit (predicated on the current forecast) seems unachievable if the economy indeed contracts by more than 2.2 percent as Kudrin deems likely, so a 5 percent deficit would require deep spending cuts–cuts that would conflict with Putin’s plan for a fiscal stimulus totaling $90 billion (3 trillion rubles.)  How Kudrin can square that circle is beyond me.  (This also suggests the potential for a very testy interaction between Medvedev and Putin.  If his chief economic advisor is calling for a 5 percent deficit, and that means that Medvedev is of the same mind, there would be a clear potential for conflict between Putin and Medvedev.)  

The WSJ article contains one odd statement about the purpose of Russian government borrowing:

Russia might tap the markets next year, issuing as much as $5 billion in Eurobonds, with maturities of three to five years, Konstantin Vyshkovsky, the head of the finance ministry’s debt department, told reporters.

“What is important is not so much the ability to receive funds to cover the budget deficit as it is to pave the road for corporate borrowers,” Mr. Vyshkovsky said.

What “pav[ing] the road for corporate borrowers” means, I have no idea.  If anything, increased government foreign borrowing would tend to crowd out private  foreign  borrowing.  Foreign lenders take some comfort in the fact that Russian reserves are sufficient–barely, for now–to cover private foreign borrowing. Government borrowing will represent a priority claim on those reserves, making foreign lenders less confident in the ability of Russian corporations to service foreign currency borrowing.  Perhaps Vyshkovsky is intimating that some of the government borrowing will be used to pay down private corporate debt, but this would contradict other recent policy pronouncements.

I cannot leave this subject without quoting Putin’s latest rant on the subject (from the Bloomberg article linked above):

“We managed to avoid the worst scenario,” Putin said. “At the same time, 2009 will be very hard for us.”

The government abandoned the three-year budget it approved last year and has delayed passing the 2009 spending bill as it debates ways to minimize the first economic contraction in a decade. The government and central bank have already spent or pledged more than $150 billion in emergency funding since September to cope with the country’s worst financial crisis since the debt default and ruble devaluation of 1998.

“Could Russia have avoided the crisis or completely escaped its negative effects?” Putin said in the State Duma. “Of course not, it’s impossible, an illusion. The problems didn’t arise here and they weren’t our fault.”

That’s funny.  Putin now asserts that escaping the negative effects of a world crisis was “impossible, an illusion.”  Of course, some people (ahem) were saying that in September, and October, and November, when Putin was actively promoting an illusion–the illusion of Russia as an island of stability in stormy world economic seas.  

Even more funny, in a sick sort of way, is the continued whinging about “problems didn’t arise here and they weren’t our fault.”  To some extent that’s true, but it’s not completely true.  The policy choices made–or not made–when Russia was “on top of the world, Ma” and oil prices were climbing steadily made Russia acutely vulnerable to a world contraction.  That is, by its fundamental nature Russia is a high beta country due to its resource dependence, but  Putin fostered policies that reinforced that feature.  Moreover, his undermining of property rights and the rule of law made the financial system in particular more brittle, and encouraged capital flight when things turned bad.  

So, Putin misdiagnosed Russia’s vulnerability to “things arising” outside of Russia, and implemented policies that increased that vulnerability.  Moreover, his apparently genuine belief in things that he now acknowledges to be “illusions” interfered with the creation of a more constructive policy when the collapse came.    

Just why, objectively, should he continue to be so popular in Russia?

Commentor lisa castigates me for illogic/inconsistency in my analysis of Russian oil export policy, and what I claim is its serial dishonesty with OPEC.  You’re wrong, lisa, and I have the data to prove it.

In a nutshell, my analysis was: (a) that Russia was not choosing its oil export duty to discourage exports as part of a cooperative strategy with OPEC to raise world oil prices, (b) that to the contrary, Russia was choosing its oil export duty to maximize revenues, and take advantage of OPEC’s output cuts by selling as much oil as possible at the higher price produced by OPEC output cuts, and hence (c) Russia’s professions of solidarity with OPEC are deeply dishonest.  

From today’s Bloomberg:

OPEC agreed at three meetings last year to cut output by 4.2 million barrels a day, a 14 percent reduction to 24.845 million, as prices fell from a record $147.27 on July 11. The group reduced pumping by 1.2 percent in March, according to a Bloomberg News survey of oil companies, producers and analysts. The 11 members with quotas produced 25.06 million barrels.

As shipments declined, deliveries from exporters that aren’t in OPEC rose by 670,000 barrels a day in January. Russian overall exports climbed 6.3 percent in February and 2.2 percent in March, according to the Energy Ministry. Brazilian total exports more than doubled in both February and March, according to Brazil’s Trade Ministry.

The IEA has similar data for the period over which OPEC was cutting.  According to the IEA March report (the April report is subscription only), in December, Crude seaborne exports from the former Soviet Union (FSU) rose 410m bbl/d over November (ex BTC pipeline, which is mainly Azeri exports).  Total exports ex BTC rose 640m bbl/d (this includes some Kazahk exports via the Druzhba pipeline) in December vs. November.  Transneft exports rose 590m bbl/d.  In January, total seaborne exports ex BTC rose 150m bbl/d relative to December, and total exports ex BTC rose 170m bbl/d.  Transneft exports fell slightly.  

Russian product exports also rose.  Total exports of refined products from the FSU rose 150m bbl/d Nov-Dec, and another 150M bbl/d Dec-Jan.  Russian exports increased more than this, because, as IEA states, Ukraine and Belarus banned fuel oil exports during the Gas War.  

IEA also states that Russia oil production increased in January.  At the same time Russian oil output was nudging upwards, domestic consumption was falling dramatically due to the dramatically weakening Russian economy (a pronounced weakening that the IEA report remarks about several times):

Given the worsening economic outlook for Russia coupled with dismal oil demand readings for January, we have sharply revised down our oil demand prognosis for 2009.  Total oil product demand contracted 7.2 percent year-on-year in January, according to preliminary data, with all product categories bar gasoline posting sharp losses.  In particular, LPG, gasoil, naptha, and residual fuel oil–barometers of industrial production and power demand–shrank by 21.2%, 7.3%, 5.1%, and 4.0% year-on-year, respectively.  Moreover, a product associated with both consumer confidence and air freight–jet fuel/kerosene–fell by 10.4%.  [Note that since these are year-on-year figures, and consumption had increased from last January into the 3rd quarter, the falls in domestic consumption since 3Q08 are even larger than these figures.]

If Russia had been choosing its export duty to reduce exports as part of a coordinated strategy with OPEC to support oil prices, basic economics implies that: (a) exports would fall, (b) output would fall, and (c) domestic consumption should rise, or at least fall by a smaller amount than output (as setting taxes to reduce exports should divert output into the domestic market).*  In fact, (a) exports rose, (b) output rose slightly, and (c) domestic consumption plummeted. This pattern is consistent with my earlier analysis of the level of the Russian oil export duty. In essence, Russia set the export duty to divert supplies from the domestic market to the world market, exactly the opposite of what it would have done if it were acting in concert with OPEC to raise world prices.

In contrast, it is interesting to note that February 2009 OPEC output was approximately 8 percent lower than in the fourth quarter of 2008, and almost 10 percent lower than in the third quarter. Declines in Saudi output have been even more dramatic, falling 16.5 percent from their third quarter levels, 11 percent from the 4th quarter, and 5 percent from December.

In brief, it is abundantly clear that Russia set its export duty to take advantage of OPEC output cuts, encouraging exports, encouraging output, and stifling domestic consumption, rather than discouraging exports and production and encouraging domestic consumption, as would have been the case that it was attempting to reinforce OPEC actions.

And OPEC has noticed. From the Bloomberg piece:

Algerian Oil Minister  Chakib Khelil, who held the group’s rotating presidency in 2008, said March 17 that he was disappointed Russia hadn’t cut production to support prices. Suppliers need prices in a $60-to-$75 range to support production of higher-cost resources, Saudi Arabian Oil Minister  Ali al-Naimi  said on March 16 in Geneva.

Russia also lowered export duties this month to $15 a barrel from $15.70 in March to boost exports, the IEA said in the April 10 report. Brazilian production will rise 7.2 percent in 2009 to 2.54 million barrels a day, the IEA said.

And from the WSJ:

Mr. Sechin claimed Russia cut production and exports in recent months but most OPEC officials weren’t buying it. Exasperated, they say independent data show Russia boosted exports by almost 700,000 barrels a day the past six months, even as OPEC members shaved their own production.

As I’ve said before, this is actually one Russian policy that I endorse.  Undercutting the OPEC cartel is just dandy with me.  

That said, the whole episode demonstrates that Russia’s public statements about its policy goals are completely unreliable.  You need to look at what they do, not what they say.  And the oil case is an excellent example of how their actions give the lie to their words.

Combine this with Turkmenistan’s fury over the gas explosion (and the drastic cut of purchases that apparently caused it), the ongoing rancor between Ukraine and Russia (for which Ukraine also bears substantial culpability), the frictions over energy with Poland, Lithuania, and Belarus, and you get the picture.  The Russian Dale Carnegies: Putin, Sechin, and Lavrov, winning friends and influencing people through energy policy.

* Holding demand constant, a change in export duty intended to reduce exports to help support the world price would lead to a rise in domestic consumption.  Both world demand and domestic demand were likely falling, certainly in November-December, and domestic demand into 1Q09.  With falling for Russian oil, if Russia had chosen its export duty in coordination with OPEC output cuts in order to support world prices, exports should have fallen.  Exports can decline due to  a reduction in output and a smaller fall (or rise) in domestic consumption.  To help support the world price, declining export and domestic demand should have resulted in a decline in output, and a smaller decline in domestic consumption.  As noted above, however, Russian output increased slightly, and domestic demand plummeted.

It seems to me that two stories reported largely separately last week are related: the Turkmenistan gas pipeline explosion, and Gazprom’s threat to fine Ukraine for not taking contracted quantities of gas.  Here’s the scenario that makes sense.  Ukraine fails to perform on its take or pay obligations to Gazprom–or to whomever is the real counterparty to the most recent gas deal.  Much of the gas supplied under these contracts purportedly originates in Turkmenistan.  Importantly, though, Turkmenistan doesn’t sell directly to Ukraine.  Instead, Gazprom and/or intermediaries take title to the gas in transit, and likely under take-or-pay type contracts with Turkmenistan at prices that are now well above what the gas can be sold for in Europe.  So, when Ukraine reneges, Gazprom and/or intermediaries are on the hook to pay Turkmenistan for the (high priced) gas but aren’t getting money from Ukraine.  So, they cut off gas shipments from Turkmenistan, causing the explosion.

Today, a Bloomberg article suggests a connection, but does not make it explicitly:

 OAO Gazprom  may seek as much as $530 million in fines from Ukraine for failing to import contracted volumes of natural gas in March,Kommersant-Ukraine  reported, citing an unidentified Gazprom official.

Russia’s gas export monopoly notified NAK Naftogaz Ukrainy that it intended to levy fines at the end of last week, Kommersant said. In March, Naftogaz bought 0.95 billion cubic meters of the fuel compared with 2 billion cubic meters envisaged by a January contract, according to Kommersant.

Gazprom has “insured itself” in the event that Turkmenistan manages to restore full gas flows via Russia after a pipeline explosion, the newspaper said. State-run Gazprom had cut supplies from the Central Asian country by as much as 90 percent before the blast, Kommersant said.

Turkmenistan plans to complete repairs to the pipeline today, though Gazprom hasn’t said when it intends to end limitations on pumping gas from the country, Kommersant said. Ukraine is the main consumer of Turkmen gas, according to Kommersant.

The report also casts doubt on Russian Foreign Minister Lavrov’s–claims that the explosion was not the result of a slashing of gas imports:  “This accident is purely technical,” Lavrov said late Friday, according to Russian news agency RIA-Novosti. “I am counting on the fact that this will all be quickly settled.”  (Although with Lavrov, the meaning of the phrase “purely technical” could encompass almost anything.)  Gazprom has studiously avoided making any comment, so the Kommersant statement that Gazprom had not said when it intended to restore gas shipments could be one of those “when did you stop beating your wife?” type of statements, i.e., it presumes what has not been admitted.  But, Gazprom’s silence is quite damning.  And just how Gazprom “insured itself” is rather hard to figure out from the Bloomberg story.  

Now, if Ukraine did indeed renege on take-or-pay obligations, its counterparty should be able to enforce those obligations.   But, any Ukrainian malfeasance does not provide Gazprom with a legitimate basis to renege on its contractual obligation to Turkmenistan.  Gazprom and/or any intermediary that bought Turkmen gas for sale to Ukraine assumes Ukrainian performance risk.  It cannot just pass that risk on to Turkmenistan.  And doing so through a unilateral, arbitrary action that inflicts substantial damage on the transportation network, not to mention potentially threatens lives, is clearly unacceptable.  

It is a delicious irony, though, that Gazprom was so anxious to lock up Turkmen gas that it now can’t sell.  That is, Gazprom is hoist on its own petard.  It–and the Russian government–has adamantly stood in the way of any direct dealing between Turkmenistan and the consumers of its gas.  To prevent such deals, it inserted itself as the intermediary in all Turkmen gas transiting Russian territory.  In so doing, it accepted both price and performance risks, both of which are now hitting it very hard.  

In other words: Be careful what you ask for, you might get it.

Gazprom is evidently desperate to get out from under this unforeseen, and now onerous, obligation, that it is willing to use any means fair or foul to do so.  Expect mainly foul.

Great News!  All is not well between Russia and Turkmenistan.  Although happy talk emanated from Moscow in the aftermath of  Turkmenistan President Gurbanguly Berdymukhammedov’s state visit to the Rusisian capital, developments in the weeks following the visit are definitely not to Putin’s and Medvedev’s liking:

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.

Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia  before the Ukraine dispute in January.

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.    Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on      pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia      before the Ukraine dispute in January.

She said the consideration of new routes “fits into the discussions that the Turkmen authorities have been having with Austria’s OMV and Germany’s RWE on a Caspian Energy Corp.”

The Caspian Energy Corp.’s stated aim is to assess prospects for development of a trans-Caspian gas pipeline. This would then be able to hook into the existing South Caucasus Pipeline from Azerbaijan to Turkey, enabling it to connect up with the planned Eur7.9 billion ($10.6 billion) Nabucco pipeline project, in which both companies are also involved.

The EU-backed Nabucco pipeline is intended to carry Caspian gas on strictly commercial terms all the way to the Austrian hub at Baumgarten, with European Union officials specifically arguing that Nabucco should be seen as a way of attracting large volumes of gas — eventually as much as 60-120 Bcm/year — from Turkmenistan, as well as Azerbaijan, to Europe.

During Berdymukhammedov’s Moscow visit, an aide to Russian President Dimitry Medvedev said March 25 that the two presidents would sign during one of their future meetings an agreement on developing a major internal pipeline intended to connect the giant South Yoloten field with coastal producing  regions near the Caspian port of Turkmenbashi.

But on March 30, the Turkmen authorities announced that Berdymukhammedov had instructed the “Turkmengaz” state concern to announce an international tender for design and construction of the 30 million mt/year East-West gas  pipeline with a length of 800-1,000 km.

Such a pipeline would play a vital role in ensuring that any  trans-Caspian pipeline system to Europe would be able to access the giant South Yoloten field, which the UK’s Gaffney Cline declared last September contained a minimum of 4 trillion cubic meters of gas-in-place.

Russian accounts had said the aim of the east-west line was to provide a feeder for the planned Caspian Coastal pipeline, intended to run from the Turkmenbashi area to Russia.

The April 4 statement stressed the importance of a planned conference in Ashgabat over April 23-24 at which Turkmenistan hopes to gain further global support for its proposals to enhance “reliable and stable transit of energy to international markets under the aegis of the UN.” The conference is also expected to serve as a sounding board for companies seeking to take part in the East-West pipeline tender.

To summarize: Turkmenistan has taken a very brash, public, and outspoken position in direct opposition to virtually every Russian/Gazprom position on major gas policy issues, namely control of transportation, pricing, intermediaries, and a “Gas OPEC.”  Russia wants to control the transportation of gas, and ensure that Turkmen gas transits Russia on its way to European markets; Turkmenistan wants direct access to Europe.  Russia wants to control the marketing of gas, via shady intermediaries; Turkmenistan wants to deal with the consumers of its gas directly.  (Side note: another illustration of Russia’s/Gazprom’s peg-the-needle hypocrisy, given its constant demands to have direct access to downstream customers in Europe, and now in the US.)  Turkmenistan is worried that the Russians won’t pay what they’ve agreed.  Russia is seriously shopping the idea of a “supranational” cartel of gas exporters; Turkmenistan flatly opposes this idea so near and dear to Putin’s heart.

They must be fuming in the Kremlin and the White House on the Moskva, especially after

Medvedev said that Moscow and Ashgabat will soon sign new agreements on natural gas production and transportation, RIA Novosti reported. “We studied in detail cooperation in the fuel and energy sector, including progress in the implementation of very important accords, such as the intergovernmental agreement on the Caspian pipeline, and other projects,” Medvedev said after talks in Moscow with Berdymukhammedov.

. . . .

Russian presidential aide  Sergei Prikhodko  told journalists that Energy Minister  Sergei Shmatko  would soon head for Ashgabat to fine tune an agreement on the East-West gas pipeline, to link northeastern Turkmen deposits with the Caspian gas pipeline. He said the Russian and Turkmen leaders would soon meet again to sign the deal.

Given Turkmenistan’s defiance on every major issue, and its recent blunt statements regarding the pipeline explosion (arising from Russia refusing to accept contracted deliveries of gas, according to Turkmenistan), somehow I think that Medvedev can put his pen away.

This raises the question: What accounts for Turkmenistan’s sudden obstreperousness?  Things are so opaque in that part of the world, it’s very hard to say.  My guess is that Gazprom’s/Russia’s acute financial difficulties, and its desperation to get out of contracts to buy gas at high prices, have demonstrated clearly to the Turkmens that they cannot be dependent on Russia, as Russia will screw them at every turn. Moreover, they may sense that Russia/Gazprom are in a weak position right now due to the financial crisis, and so there is now a glittering opportunity to slip out of Moscow’s suffocating grip.  Maybe too the European move in Ukraine gave the Turkmens some indication that the game may be changing.  And, certainly, there must be all sorts of byzantine diplomatic maneuverings going on involving the US, the EU, and China, as well as Russia.

Whatever the reason, Ashgabat’s newfound spunk is very welcome.  I say again: let us hope that Foggy Bottom and Brussels will seize this opportunity, although, I share R’s doubts that they will.

Turkmenistan’s foreign ministry issued an exceedingly blunt statement blaming Gazprom for an explosion in a Turkmen gas pipeline.  The explosion allegedly followed an unexpected curtailment of Russian imports of Turkmen gas:

Turkmenistan, however, in a burst of undiplomatic language, blamed Russia for the pipeline disruption, saying Russia’s gas export monopoly Gazprom (GAZP.MM) had “irresponsibly” cut imports of gas and caused the accident.

The undiplomatic diplomatic response:

Turkmenistan’s foreign ministry said in a statement Gazprom cut gas imports on April 8 without warning its government in the capital of Ashgabat.

“Such actions by Gazprom Export are ill considered and irresponsible because it created a real threat to peoples’ lives and health and can lead to unpredictable ecological consequences,” the ministry said.

“Such an approach (low gas imports) is a unilateral, rude violation of the terms of the take-or-pay gas supply contract,” the ministry said in an unusually harsh statement. Gazprom is a state controlled firm and Turkmenistan has repeatedly called Moscow one of its most important strategic partners.

Now, let’s take our minds back to the dark, distant past; like, say, March, 2009.  Can anybody remember the bleating from Putin and Gazprom about how unacceptable it was for Ukraine and Europe to take unilateral actions in gas transportation without consulting with, or considering the interests of, the supplier of the gas?  I knew you could.  If Ashgabat is to be even partly believed, Russian took unilateral action  that caused a serious accident  without consulting the supplier of gas.  Kremlin/White House whinges about respecting their rights/interests would be less nauseating if they kept their hypocrisy somewhat in check, rather than giving it full, neurotic, narcissistic play at every opportunity.   (I acknowledge that anything coming from the Ex-Sov space needs to be taken with a dose of skepticism, but since Gazprom/Putin are among the world’s most brazen liars, Turkmenistan wins my vote on the relative credibility scale here.)  

So why would the Russians cut imports of Turkmen gas?  One hypothesis is that it is payback for Turkmenistan’s audacity in issuing an international tender for a new gas export pipeline–a pipeline that Gazprom had assumed it would build:

Russia began a “gas war” with Turkmenistan after the Central Asian nation called an international tender last week to build a pipeline, hurting relations as  OAO Gazprom  expected the contract, Kommersant said.

The tender for the East-West link from the biggest gas field in the Commonwealth of Independent States came as a surprise for Russia, the Moscow-based newspaper said.

Turkmenistan accused Gazprom of causing an explosion on a pipeline to Russia via Uzbekistan yesterday by reducing supply “sharply.” The country had exported 70 million to 80 million cubic meters of gas a day via the link before the blast cut shipments completely, Kommersant said.

I have another hypothesis.  Gazprom is sucking wind, and badly.  To mix medical metaphors, it is hemorrhaging cash, and those problems will only get worse in the coming quarters as the lagged adjustment in gas export prices will drastically cut the price Gazprom gets for its sales to Europe, and as volumes decline as well due to seasonal factors and the severe economic downturn in Europe.  

And here’s the major point.  The company also outsmarted itself by buying large quantities of Turkmen gas at  fixed prices that seemed like a good idea at the time, but which retrospectively turned out to be far above the current market price, and likely prices going forward.  (It’s a bitch being long flat price and short floating price in a bearish environment.  But schadenfreude is so sweet when Gazprom is involved!)  Note the Turkmenistan foreign ministry statement explicitly mentions “take-or-pay” contracts–this means that Gazprom was contractually obligated to take the full volume at the above market price, even if it had no market for the gas.  

So, one reasonable hypothesis is that a cash-strapped Gazprom probably tried to get Turkmenistan to give it a break on the take-or-pay obligations; Turkmenistan told Gazprom to pound sand; and Gazprom/Russia decided to welsh on the contract, unilaterally cutting its acceptance of deliveries.  Any pique over the Turkmenistan’s temerity at acting as an independent nation rather than a satrapy of Gazprom/Russia just provided another motive for Gazprom to stiff/punish the Turkmen.

Keep this episode in mind the next time Gazprom/Putin/Medvedev/Russia mention anything having the remotest connection with commercial morality or professionalism.  

The best thing about this is that it suggests that Turkmenistan is actually showing backbone and standing up–in a very public, in-your-face sort of way–to Gazprom and Russia.  There is an opportunity here.  I just wonder if anybody in DC (Foggy Bottom in particular) or Brussels is smart enough to take advantage of it.

The second best thing is that it provides evidence that Gazprom is under intense financial pressure.  And if Gazprom is under intense financial pressure, so are Putin and the rest of the coterie of parasitic capos that feast off it.