Streetwise Professor

According to this Interfax report, Vladimir Putin has provided assurances that investment in Russia’s energy sector is risk free!:

Investment in Russian oil, gas sector risk-free, Putin tells Shell CEO
Interfax

Moscow, 20 October: Russian Prime Minister Vladimir Putin has assured Shell chief executive Jeroen van der Veer that investment in the Russian oil and gas industry carries no risks.

“These concerns can be lifted,” Putin said, commenting on the Shell CEO’s view that Russia had to guarantee good payback terms when foreign companies developed Russian deposits.

“In Jackpot, you can win or lose, and more often than not you lose. But if we draw up a system in which we can fully repay the spending on exploration and not refuse to reimburse you for developing these deposits, then there will be no losses, and there’ll be an opportunity to win big,” Putin said, commenting on the Shell CEO’s remarks.

“We intend to continue to improve regulatory standards in the sphere of natural resources,” the prime minister said.

For his part, Russian First Deputy Prime Minister Igor Shuvalov explained the gist of the discussion between Putin and Van der Veer: “Jackpot carries high investment risks. Our head of government stressed that investment carries no risks.”

I feel so much better now!

I mean really, how is one to interpret to such Orwellian statements? Is it that Putin has an extremely sadistic sense of humor and he just wanted to torment Van der Veer, one his previous victims (Sakhalin II)? Or, perhaps, making such outlandish assertions and then standing back and to observe that nobody contradicts him validates his sense of absolute power. Or maybe, just maybe, he has stared into an (economic) void, and has come to the realization that the vision that the world was at his (and Russia’s feet) when oil was $140+/bbl was chimerical; that his previous cockiness was nothing but a case of the Cocaine Blues; and that Russia desperately needs the likes of Shell and other foreign investors.

Even if the last conjecture is right, hopefully Shell and BP and others will think “once burned, twice–no thrice–shy.” For if Vlad has turned on a dime once, he can do it again. And once somebody has put their money in assets–like oil wells–that cannot be picked up and moved out of Russia, he will have no compunction at expropriating yet again. And he will do so exactly at the moment when the investments are most valuable.

So, Mr. Van der Veer, and your fellow energy CEOs: Don’t be a sucker.

Two articles suggest that the Putinist “natural state” cartel is under strain, and that the informal agreement among competing interests among the elite held together by the glue of rents is fraying. First, Pavel Baev from Eurasia Daily Monitor:

Putin’s major political achievement was securing firm support from many different groups of the elite: from successful entrepreneurs to empowered bureaucrats, from pompous top brass to ambitious artists. This elite consensus was sustained through the uncertain period of power transfer and the establishment of the Putin-Medvedev duumvirate, but now it is being tested by the crisis, which for the most part was completely unexpected. The abrupt end of a petro-prosperity that had been taken for granted has revealed and exacerbated divergences and clashes of interests among various groups of loyalists, who suspect that their “social contracts” have been revised without their consent.

Baev also notes the opacity of the process for doling out money and support. Basic cartel theory (which is applicable in this context, because the model I have in mind for the Russian state is a repeated prisoner’s dilemma) states that lack of information about defections from agreements can induce a breakdown of tacit cooperation. The lack of transparency that characterizes the bailout process is conducive to suspicions of double dealing and violations of previous understandings; these mere suspicions can produce conflict, and an unraveling of the cooperative structure.

Paul Goble reports on an article by the Indem Foundation’s Gyorgy Saratov that argues that the popular quiescence with the government is also not assured. Saratov argues, as I did in a previous post, that the high expectations that Putin has inculcated in the populace is a double edged sword. The population will remain loyal and supportive (or apathetic, which is just fine with the government) as long as those expectations are met. Disappointment of these expectations, however, could engender a backlash.

The prospect of a merging of elite and popular discontent is a nightmare to Putin et al. It is now only a possibility, and Saratov’s argument seems a little hyperbolic and premature. But these articles make it clear that it is becoming more widely recognized that the stability of the Putinist system is vulnerable to an economic slowdown. Given that Russia’s economic prospects and the flow of rents that glues the system together are highly dependent on the price of oil and the support of external capital flows, this stability is largely out of control of the government, as the course of the world financial crisis, and its consequent effects on the demand for energy and the availability of capital, are clearly well beyond its control.

That’s the price of Urals-Med today. The $70 barrier has definitely been breeched. Now, it should be noted that Urals sells at about a $2 discount to Brent, and the Brent forward curve is pretty steeply upward sloping, so the Urals forward price should be above $70 for most of 2009. Nonetheless, the Russian budgetary cushion is getting thinner by the day.

Just a couple of comments re the still continuing debate between DR and Michel.

First, re OPEC–cartels are inherently unstable. The level of the equilibrium competitive price of oil isn’t really that germane to the ability of the cartel to peg the price above that level. The cartel must restrict output in able to do that. Every individual member has an incentive to cheat on its quota. In OPEC, as in most cartels, that cheating has been rife. In essence, Saudi Arabia has been the swing producer, and it almost unilaterally is the only force that reliably affects prices by reducing output. And Saudi wants a price of around $80. And at times (e.g., 1986), Saudi Arabia gets tired of bearing the entire burden of supporting prices. If it has to restrict output too much in order to prop up prices, it may repeat its 1986 performance and open the spigots to punish all the cheaters.

As an aside, perhaps some of Russia’s recent output stagnation/decline reflects its effort to act as a swing producer, though it may also reflect the inefficiencies associated with greater state control.

Second, re the great consumption debate. I don’t think that there is any doubt that Russian private domestic consumption has risen quite steadily over the past decade. In large part that reflects the low starting base and the resulting catch-up, the more efficient allocation of resources in the post-Soviet period, and the dramatic reallocation from heavy industrial production towards consumer goods. Moreover, per DR, it also reflects a favorable tax climate, with a low, flat tax rate. (One thing about Russia that I’d like to imitate in these parts.)

However, in some respects the consumption growth is a bug, not a feature, because of its flip side–the very low rate of domestic Russian savings. As a result, Russia is highly dependent on external capital, and current events are demonstrating the pitfalls of this reliance with a vengeance.

Relatedly, domestic investment rates in Russia are very low compared to other countries that have achieved and sustained high growth rates. Russian domestic investment is 18-20 pct. of GDP, as compared to the 30+ percent of high growth success stories.

But in the end, my long horizon skepticism about Russian economic prospects (should I say bearishness?) is not primarily rooted in traditional macroeconomic considerations. Instead, my skepticism is traceable to the weakness of property rights, the vulnerability of profitable businesses large and small to the predations of the state (of which corruption and “raiding” are two symptoms), and the brittle political/natural state institutions. As I said in an earlier post, Putin has created a sort of economic purgatory, better than the economic hell that proceeded it, but hardly ideal. And the political economy of the natural state system makes it very, very difficult to exit purgatory for something better. Moreover, although it may not be a highly probable outcome, rent-based politico-economic systems like Russia’s are vulnerable to instability and collapse. In a parallel to the girl with the curl (when she’s good she’s very very good but when she’s not she’s horrid): When they are orderly, they are very, very orderly, but when they’re not, they’re chaotic.

To me, it’s not necessarily the budgetary implications of a low oil price that creates substantial downside risks for Russia, though that’s not irrelevant. Instead, the major risk is that the system is predicated on distributing rents to keep the various clans happy. While the rents are big enough, and the clan members think the game will continue for awhile, the system can operate relatively well. When the rents erode, or economic shocks affect the distribution of rents to the substantial relative disadvantage of some, however, that stability can disappear almost overnight. Given the extreme weakness of formal institutions in Russia–and I don’ think any objective observer can dispute that formal institutions like property rights, courts, etc., are deficient there–the dissolution of the informal, relational bonds that hold things together can lead to substantial disruption.

The world is currently experiencing a major shock. (Duh.) This first major effect of this is to reduce the prices of natural resources, and the associated rents, that have been the basis for Russian politico-economic stability. Moreover, due to Russia’s dependence on foreign capital; its own self-inflicted wounds (Georgia, Mechel, BP-TNK, etc.); and its increased integration with the world economy, the world/US shock has had a disproportionate impact on Russian equity markets. Moreover, it is evident that the shock has had big distributive effects within Russia. All of these factors eat at the informal bonds that mitigate conflicts between competing factions.

Finally, the economic shock has created an environment favorable to the enhancement of the powers of the state (through acquisition of heretofore private companies at cheap prices). Even if the current structure survives the present stresses–probably the most likely outcome, even though the risk of a major blowup is higher now–this will have adverse consequences for Russian growth in the future, and public enterprises are inherently less efficient.

The Economist has two articles that cleave very closely to various SWP posts that predate their publication.

This one discusses the “collateral damage” of the SEC short-sale ban on the convertible bond market, and particularly its effect on banks. The 9 October article says that the effect on convertibles was “a typical example of the unintended consequences of meddling with the markets in response to populist pressures.” Gee, but that seems very, very similar to what I wrote on 27 September in “Unintended–But Totally Predictable–Consequences.” Specific use of the term “Collateral damage”? Check. Specific use of the term “Unintended consequences”? Check. Analysis of the damaging effect on convertibles market and on banks? Check. Criticism of stupid pandering policy? Check. Very pronounced similarities here, undoubtedly.

This one makes several arguments regarding commodity speculation that I have flogged repeatedly on SWP and in my Congressional testimony and WSJ piece. Here, the similarities aren’t quite as close, but the focus on looking for distortions in stocks and the lack of a direct channel by which fund money can affect physical commodity prices reprises two themes that I have emphasized repeatedly.

But, then again, maybe both things are so obvious that it’s no surprise that the Economist advanced the same arguments. But, especially with the short sale ban post, the similarities in argument and language make me lean towards rejecting the null hypothesis of “coincidence.”

Any thoughts, readers?

I have often written that Russia is a natural state, a cartel of violence specialists that is held together by economic rents, primarily generated by natural resources. As I have noted, such states/cartels are fragile, and subject to collapse. Collapse occurs when (a) the rents dissipate, or (b) the time horizons of the colluding parties shorten. Natural states look strong pendant les bon temps roulez, but have a tendency to implode once the music stops.

The crash–crashes plural, actually–of the Russian stock market, the gridlock in the money/banking markets, and the decline in oil prices, are dissipating rents, and arguably convincing the various clans that the game will soon be up. Moreover, the financial crisis has weakened some players (Deripaska is a well-publicized example), which could tempt others to exploit this weakness and grab what they have left. This could induce a breakdown in the uneasy peace between competing factions of violence specialists.

What is occurring now is just the sort of crisis that threatens the natural state with collapse. The facade of order and control can quickly dissolve into chaos and conflict. Like glass, natural states are strong but brittle, and shatter when the stress becomes too acute.

It has been reported that numerous big state firms–most notably, Gazprom and Rosneft–are importuning the state for financial support. It is well known that these two firms are at the centers of two contending clans. They will be competing to get at the same money. Both are tightly connected to heavyweights in the Russian government and security services (to the extent there is a difference between the two.) A battle between the two would shake Russia to its foundations. If each–or either–senses that its future is in question, tacit cooperation is no longer an optimal strategy, and out will come the knives.

Everyone’s attention is turning to the stability fund. In virtually all of the commentary written since the beginning of the meltdown in August, the phrase “the $570 billion dollar stability fund” has been repeated like a mantra, an incantation that will ward off a return to 1998. As commentor Michel points out, however, the government has already committed a substantial fraction of this sum in various market and bank support schemes, none of which have stemmed the bleeding. Hence, the line of mendicants begging for a piece of the fund is getting longer, and more insistent. Kudrin, who has played Horatius at the Gate defending the fund against those who desire to divert it to their purposes, is under pressure. You think it was a coincidence that Storchak was just indicted? I don’t. Moreover, those now pleading for the money–Gazprom, Rosneft, the three amigos from BP-TNK–are really heavy hitters. I doubt that Kudrin, or Medvedev, or even Putin, can resist their pressures.

The market apparently has its doubts too. Credit default swaps (EEEEEEEK! CDSs! Run for the hills!) on Russian government debt rose 52 basis points to 352 bp, as compared to 36 bp in May ’07. If the stability fund makes Russia immune from default, why the bulge in CDS prices? (Part of that is due to an increase in the market price of risk in these unsettled times, but certainly part reflects a perceived increase in the probability and severity of a default.)

I think Michel has put his finger on the matter. He conjectures that “[m]any have been lusting after those billions for years, and the crisis was the perfect cover to launder piles of money from the reserves to the offshore accounts of friends of the regime.” That makes perfect sense, and today’s Moscow Times provides evidence for it: “Four major energy companies have asked the government to lend state money on market terms to help refinance foreign debt and buy new assets abroad as they become cheaper, a top oil executive said on Tuesday.” Cheaper. Riiigghht. That’s the ticket. No, I think the key word in the sentence is “abroad.” Like Michel, I read this to mean: “Give us money in the stability fund so that we can take it out of the country while the taking is good.”

In brief, although the existence of the fund makes survival of the current system in Russia more likely than it would be in its absence, it is not a talisman. If the crisis–in the US, in Europe, and in Russia too–shows anything, it shows that $570 billion can evaporate in a trice. That is especially true in a country like Russia, where the formal institutional safeguards are so weak. In a highly personalized natural state, rife with corruption, where the state is essentially the cash cow for aggressive and amoral individuals who are comfortable with the use of violence, when the deluge begins, no property is safe. So, to those who repeat “the $570 billion dollar stabilization fund” to lull themselves to sleep, I say–there are monsters under the bed. And it is at times like these that they come out and play.

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.

Sheesh, how many fans are there out there, anyways? (If you get this, and the connection to the title, you’re a Warren Zevon aficionado. If not, google “zevon lyrics laywers guns money.”)

I am referring specifically to today’s events in the NYMEX crude market. From Bloomberg:

Sept. 22 (Bloomberg) — Crude oil climbed more than $25 a barrel, the biggest gain ever, as the dollar weakened the most against the euro since January 2001, boosting the appeal of commodities as a hedge.

The October contract, which expires today, rose almost $12 more than the contract for November delivery, as traders rushed to close positions. Oil, gold, corn and other commodities climbed as the dollar dropped on concern that a U.S. proposal to buy $700 billion of troubled assets from financial firms will deepen the budget deficit.

“This looks like a squeeze play,” said Phil Flynn, senior trader at Alaron Trading Corp. in Chicago. “All of the contracts are up, but nothing like October. This is the last day of trading and someone is scrambling to guarantee supply.”

Crude oil for October delivery rose $18.05, or 17 percent, to $122.60 a barrel at the 2:30 p.m. close of floor trading on the New York Mercantile Exchange. Futures climbed as much as $25.45 to $130 a barrel, the highest since July 22. The more- active November contract rose $6.11, or 6 percent, to $108.86 a barrel.

It sure does look like a squeeze, Phil. During a squeeze the nearby price (October, in this instance) increases relative to the deferred prices (November, and later months.) On Friday, October settled $1.80 over November. At some point today, October traded at least $19.55 over November. Based on settlement prices, October gained $9.45 on November. That last number is a huge move, given the normal volatility in calendar spreads, but the $17.75 move is mind-blowing.

A squeeze would work by somebody holding a large long position refusing to liquidate that entire position. On the last trading day, refusing to liquidate is equivalent to demanding delivery. If the shorts perceive that deliverable supplies are inadequate to meet the long’s implied demand for deliveries, they are willing to bid up the price in order to offset their positions and avoid the prospect of making inefficient deliveries.

I would therefore like to see how many contracts liquidated. WSJ data report open interest of 23,130 contracts–or 23 million barrels of oil. I am pretty sure that this figure is yesterday’s open interest. That’s substantially more than the likely delivery capacity in Cushing, OK over the coming month. If one long, or a couple, held the bulk of these positions, or a large futures long also has a big long position in deliverable crude, they would possess the market power to squeeze the shorts. To the extent that the large long was also long in OTC instruments settled against the last NYMEX settlement price, they could profit even more from the price spike.

In some respects, this is a stunning development. Anybody even remotely familiar with these markets is aware of the intense scrutiny they are currently subject to. Any large long has to know that subpoenas are incoming. Knowing that the world–the regulators, the Justice Department, Congress–is watching, you would think that large longs would go out of their way to avoid doing anything even remotely manipulative. The most plausible explanation of today’s move, however, is that somebody squeezed October crude. Dunno about the guns, but money and lawyers will certainly be in play very, very soon.

Update: Another piece of information consistent with the squeeze interpretation.   October Heating oil and RBOB gasoline were up less than 5 percent on the day.   OCT and NOV HO were about by about the same amount, and OCT RBOB actually rose less than NOV.   The sharp rise in the price of nearby crude relative to products (i.e., the sharp decline in the crack spread), and the lack of steepening backwardation in products are what you would expect to observe in a squeeze of the CLV.

Last week I was invited to testify about energy speculation in front of a Senate subcommittee on energy.   I had to decline due to the uncertainty surrounding Ike, but another academic who has also expressed skepticism about the Master’s view of the financial universe accepted–only to be uninvited the day before the hearing.

Draw your own conclusions.

About a year ago, in “Cocaine [Oil] Blues,” I wrote:

The thing about cocaine is that what goes up, comes down with crash. After that shot, you feel invincible, but the comedown is brutal and depressing. That’s what happened to Willy Lee, and what’s likely to happen to Putin-or his successor, if there is one-when oil prices come down, as they inevitably will.

That day may have arrived. Even though oil prices are still higher than they were at the time I wrote that piece, they are well off their historical highs. Moreover, developments in the world financial markets have combined with the decline in the oil price (and exacerbated the decline) to shake the Russian financial system to its foundations. The equity market is in freefall–indeed, trading was halted today in a typically shortsighted attempt to kill the messenger. But the equity market, and the capital market more generally, is not the cornerstone of the Russian financial system. Russian finance is bank-centric. Those banks have always been shaky, and they are showing signs of acute strain in the midst of capital outflows and a flight to liquidity. Major Russian corporations are also highly leveraged, and tap external markets for credit. The credit crisis will constrain their ability to continue to finance their operations.

Sitting here in the US one can hardly crow about the state of the banking system, but as bad as things are here in the US, they are marginally worse in Europe, and substantially worse in Russia.

As oil prices skyrocketed, and billions flowed into Kremlin coffers, and the economy recovered from its 1990s disasters, Putin et all–and the Russian public–wildly exaggerated the nation’s economic strength and economic independence from the rest of the world. Like Willie Lee after his shot of cocaine, Putin (and Russians generally) felt invincible.

But the strength was extremely dependent on a factor largely beyond Kremlin control–the world price of oil. And that factor was–and is–extremely dependent on world economic activity. What’s more, Russia is dependent on external capital flows. The credit crisis strikes at both sources of dependence. Hence, when New York or London feels a chill, Russia gets pneumonia.

This dependence has been, as I have written, exacerbated by self-inflicted wounds–Mechel, BP-TNK, and, most importantly, Georgia. Russia therefore faces a perfect storm of internal and external factors that will seriously challenge Putin’s grandiose ambitions.

The question becomes–Can Putinism withstand the strain?

Recall that the Putinist economy is a “natural state” that uses resource-based rents to buy peace (or, perhaps, merely peaceful coexistence) among rival factions of siloviki. The sustainability of this system is questionable if these rents decline substantially. Moreover, using the cartel analogy I have advanced in the past, systemic crises can raise the discount rates of the rival clans, which can also undermine their incentives to maintain the uneasy cooperative equilibrium, and instead grab while the grabbing is good. Thus, at the level of the “elites” (a polite expression that in this context refers to Chekists who exercise control over the state’s coercive powers), the financial crisis corrodes the monetary glue that binds rival gangs in an uneasy peace. The crisis therefore dramatically increases the odds of an outbreak of conflict among rival clans.

But the problem is not limited to the prospect of interclan warfare alone. One of Putin’s accomplishments has been to reverse the despond of the 90s, and replace it with extremely high social and popular expectations of a prosperous future. In part, this is due to the fact that by comparison to the 90s, anything looks great. In part, it is due to the fact that the economy has without a doubt improved–in large part due to external factors for which Putin et al have been more than willing to claim credit. In part, it is due to the drumbeat of propaganda emanating from the government and its media lackeys. But whatever their source, these very expectations pose a great threat to Putin. If they are disappointed–and the credit crisis and the knock-on effects on Russia’s banking and capital markets dramatically raises the risks of disappointment–Putin’s (and Medvedev’s) popular support is at risk. Bank failures, or difficulties in obtaining credit on now accustomed terms, or a spike in inflation resulting from (a) a decline in the ruble, and (b) massive injections of liquidity in an attempt to prop up the banking sector, could all bring back memories of the 90s, thereby striking at the very rationale for Putinism.

Thus, economic weakening poses both elite and popular challenges to Putinism. Internal and external events over the last months have increased substantially the likelihood of such a weakening.

It may be premature to posit that Russia’s “Black Tuesday” and associated events represent an existential crisis for Putinism. But maybe not. Putin has essentially entered into a Hobbesian bargain with the Russian people. In exchange for a restoration of public order, and ending a war of all-against-all (as many people view the 90s), Putin demanded unchallenged authority and the perquisites of power. A struggle among the elites to protect their own shares of a shrinking pie would give the lie to the image of order that is essential to the maintenance of the system. Indeed, it could well spark a return to actual violence, either among the clans, or directed at any manifestation of popular unrest, that would call into question the viability of the Hobbesian bargain.

As I have written before, the Putinist system is extremely brittle. If it breaks, it will shatter. In a largely non-idealogical system held together by rents and a promise of order and improved living standards, financial shocks are the primary thing that can cause the structure to collapse.

What might transpire in the coming days and months? There is a distinct risk of greater instability. I definitely expect a pronounced ramping up of anti-Western, and anti-American, vitriol–as hard as that is to imagine given the rhetoric already emanating from Russia. But Putin et al have clearly made attacks against the West a major part of their political defense at home. I also anticipate an intensification of domestic oppression, and a clampdown on the few remaining independent outlets for public opinion–including especially the internet. Atomizing the domestic opposition and uniting the country against a common enemy are tried-and-true tools of control in Putin’s Russia.

There is also an air of unreality, and denial, surrounding the Russian leadership today. Medvedev gives anodyne “there’s nothing to worry about” pronouncements; Putin announces large increases in defense spending (at the same time the resources to fund such increases are declining and are likely to decline further.)

Even if Russia muddles through the current situation, there are still reasons to doubt the benefits of Putinism. For those whose horizons are defined by the Soviet period or the 1990s, Russian economic accomplishments of the Putin era do indeed seem nearly miraculous. Those, however, are very low standards indeed. What Putin has essentially created is an economic and social purgatory–certainly an improvement on hell, but hardly the best outcome that can be envisioned, and one that it is difficult to escape for something better. The prospects for moving beyond the purgatory of the natural state to something more dynamic, modern, and self-sustaining are poor.

To use a financial metaphor (which seems appropriate under the circumstances), to me Russia is like a short options position. Limited upside. Large–and potentially unlimited–downside. As North et al point out, the natural state is self-limiting; it must be so to survive, as it cannot withstand the uncontrolled development of competing sources of power and wealth. But, at the same time, it is vulnerable to collapse in the face of increased uncertainty or declines in the rents that hold the system together. We may stand at the cusp of the latter outcome.

AP has an interesting article that complements my earlier analysis:

A debilitating dispute at Anglo-Russian joint venture TNK-BP, in large part resolved, has also stoked concerns. The company reassigned 148 technical specialists from the country earlier this year amid visa difficulties and litigation.

In July, chief operating officer Tim Summers said the Russian shareholders’ desire to cut capital expenditure by $900 million in 2008 could wipe up to 1 million tons to 5 million tons from the company’s output over the next 12 months.

Further evidence that the Russian partners in BP-TNK are highly desirous of getting cash out now.

The article also points out that the nearly confiscatory tax regime also depresses the incentive to invest.