Streetwise Professor

During the aftermath of Hurricane Katrina, General Russel Honore castigated a reporter for being “stuck on stupid.”

For some reason, that phrase has come to mind repeatedly in the past hours. Perhaps it is due to the fact that I am sitting on the 9th floor of the Hilton in College Station, Texas, watching the rains and winds of Hurricane Ike. But more likely, it is that I am passing the time reading several of the latest “studies” purporting to lay the blame for the runup of commodity prices (especially energy prices) in 2007-2008 at the feet of speculators, and more particularly, commodity index traders.

The most widely disseminated of these is the Masters-White “Accidental Hunt Brothers” piece. Another is “The Commodities Market Bubble: Money Manager Capitalism and the Financialization of Commodity Markets” by University of Missouri-KC professor L. Randall Wray.

In a nutshell–same old, same old BS.

I could go on and on deconstructing this bilge, but even though the opportunity cost of my time is only slightly above zero, being marooned as I am, it is still positive. So I will limit myself to hitting the low-lights.

The most fundamental problem with these papers is their failure to identify any channel whereby side-bets on commodity price outcomes affect the supply and demand for physical commodities. Masters and White are particularly slippery in this regard, equating in a conclusory way the purchase of physical oil by China to the purchase of forward and futures contracts in similar notional quantities by index funds, and then asserting that the side bets contribute just as much to demand as the Chinese purchases of physical oil, and hence are just as responsible for any price increases. Similarly, Masters-White state that index traders are holding “stockpiles” of oil. Uhm, no, they don’t. They hold contractual claims on oil that they liquidate without converting them into actual, bona fide stockpiles of physical oil. The Masters-White argument is akin to saying that the bettors at race tracks own the outcomes of horse races. No, they own betting tickets–contingent claims that have payoffs that depend on the outcome of a horse race. Absent some other mechanism (e.g., bribing the jockeys), these contingent claims don’t influence the outcome of the race.

Put differently, moneys invested in indices don’t actually flow into the market for the physical commodities. Nobody uses these dollars to buy oil or corn. Instead, these funds are used to place collateralized bets on future movements in prices. The actual money invested in these strategies (if the index investor follows a fully collateralized strategy) is used to buy T-bills in dollar amounts equal to the notional value of the commodity index. The actual moolah doesn’t flow into the commodity markets, the way that it does when Sinopec or PetroChina buys a supertanker of Arabian crude.

Masters-White and Wray also fail to address the fact that index investors liquidate their positions before they become claims on physical commodities, and hence they are typically sellers at the time that spot prices are determined.

In terms of “evidence” these authors merely point to the fact that index fund investments have risen at the same time that commodity prices have risen. They do not appear to separate out the effect of increases in the amount of commodity index fund assets that was caused by the effect of rising prices on the value of existing positions from the increases attributable to the flows of new moneys into the funds. There is no effort to carry out rigorous statistical tests (e.g., cointegration tests, Granger Causality tests) to establish causation or an equilibrium relation. (It is possible that the visual relationship between two strongly trending series like an oil price and the size of index positions could be a spurious one. The authors of these studies make no attempt to explore this possibility.)

Masters-White make a big deal of the fact that all commodities in the various indices have gone up, and say that this would be extremely unlikely unless the index investment was driving all of them. But commodities not in funds, such as MGE wheat, iron ore, minor metals, have been skyrocketing in price too.

This line of reasoning does suggest one potentially rigorous test of the hypothesis. Namely, if the increasing importance of index money is injecting a common element into prices of all index commodities, overwhelming individual commodity-specific fundamentals, one should observe increasing correlations across commodities in indices, and stable or declining correlations between indexed and non-indexed commodities. This effect should be especially pronounced in high frequency data (daily, or intra-day) because the index investments are by construction made simultaneously or nearly simultaneously across commodities in the indices. Of course, Masters-White-Wray don’t even come close to identifying, let alone testing, such a refutable hypothesis.

In terms of “theory,” Masters-White and Wray put great stock in the cost-of-carry relationship between spot prices and futures prices, asserting that by buying futures, index investors drive up futures prices, which equal spot prices plus carrying costs, thereby forcing spot prices up too. But, for instance, in copper and oil, the price rises in 2007-2008 occurred simultaneously with movements from contango into backwardation.

Masters-White assert that order flow moves prices, so the predominately long order flow of index funds therefore must move prices up. There are two fundamental problems with this “reasoning.” First, when index funds roll, their order flow is on the sell side–so why don’t they move nearby prices down when they roll?

Second, and more importantly, they are very confused on the relationship between order flow and price discovery. Although Masters-White are correct that orders in futures markets are anonymous, they draw the wrong conclusion from this. The impact of any particular individual, anonymous order on prices depends on the average information content across orders. Holding the intensity of informed trading constant, increasing the intensity of index trading reduces the average informativeness of order flow. Thus, more orders are entered, but their individual impact is smaller, leading to little or no net impact on prices. (Index trades are likely to be deemed uninformative on average for reasons identified by current colleague Praveen Kumar and fellow Chicago GSB PhD classmate Duane Seppi. It is unlikely that a particular trader has private information on all components of an index, and if he has private index on any individual components, it is more effective to trade on that information in the markets for the individual components. This is why markets for index products, e.g., SP500 futures, are typically much more liquid than the markets for the individual components.) Moreover, informed traders adjust the intensity of their trading in response to changes in uninformed order flow, and generally trade to offset the effect of uninformed orders on prices. Thus, even if “dumb money” moves prices away from where they “should be,” this is an opportunity for smart money to trade against that, thereby forcing prices back towards the level justified by fundamentals.

Masters-White also make a big deal out of the fact that many market participants quote spot prices basis a futures to conclude that futures prices are driving spot prices, and hence noise injected into futures prices by index trading must therefore contaminate spot prices. In other words, futures prices are the dog, spot prices are the tail.

This is to confuse mechanics with substance. The key point is still that when it comes to determining futures prices as the market moves to expiry, participants recognize that if they hold positions to term they must make or take delivery of physical product. Thus, futures prices at expiration reflect supply and demand fundamentals in the physical market. I will not take delivery of something at a price if I do not believe that I can sell it at that price or better. I cannot sell it at that price or better unless there is physical demand for the product at that price. Thus, even though it is common to price some physical trades basis a futures price, that basis is determined in the market. Moreover, it adjusts to reflect physical supply and demand fundamentals, just as the delivery mechanism connects fundamentals to futures prices.

Put differently, basis pricing does not mean that spot prices do not reflect physical market realities. The best illustration of this (discussed in a SWP post over the summer) is the heavy/sour crude basis, which widened dramatically over the summer. This reflected the high demand for low sulfur diesel, the low yield of such fuel from heavy crude, and disruptions in the markets for sweet crude (driven primarily by problems in Nigeria.) (All of these are nuances that Masters et al, and Michael Greenberger, miss completely–even though they are salient factors in understanding the summer’s market dynamics.) Physical crude traders did not mindlessly pass on increases in WTI prices to the prices of heavy crudes. Differentials adjusted to reflect physical market supply and demand realities.

This gets back to the fundamental problem with all these analyses, one that is highlighted by Masters’ and White’s choice of a title for their opus–“Accidental Hunt Brothers.” I have said it a zillion times, but maybe the zillionth-and-first repetition will make it sink into heretofore impervious skulls: PRICES SERVE TO ALLOCATE REAL RESOURCES. IF PRICES ARE SUBSTANTIALLY DISTORTED, THAT MUST MANIFEST ITSELF IN PRONOUNCED DISTORTIONS IN THE ALLOCATION OF REAL RESOURCES. In the case of the real Hunt brothers, to keep prices high, they had to accumulate huge quantities of physical silver–real physical inventories, not phantom paper inventories. When the government propped up the price of wheat and milk, it had to buy and hold (or destroy) huge quantities of physical wheat and milk. As another example, when a manipulation takes place, the manipulation causes manifest distortions in commodity flows. For instance, in 1910 famous (or infamous) speculator James A. Patten (benefactor of the Patten Gymnasium at Northwestern University as well as the Chicago Art Institute) cornered the New York cotton market. Prices became so distorted that English spinners shipped cotton back to the US to take advantage of the price distortions–the economic equivalent of water flowing up hill.

If speculators are distorting prices, that necessarily causes distortions in stocks or flows of physical commodities. If index investors, or other speculators, were Hunt brothers, accidental or otherwise, they would necessarily find themselves in the same circumstances–paying for, holding, and financing large positions in physical commodities. Positions so large–if the price distortions are as large as asserted–that could not escape notice. Neither Masters-White, Wray, nor any of the other critics of index investment have provided any evidence of such distortions. Indeed, they haven’t even tried to do so.

To his (mild) credit, Wray recognizes the problem, anyways. He notes that Krugman has argued that speculative distortion should lead to accumulations of large and growing inventories in the hands of speculators. He attempts to avoid confronting this implication by stating that Krugman’s argument presumes perfect competition, and that commodity markets are not perfectly competitive, therefore Krugman’s argument doesn’t hold.

It is Wray’s argument that doesn’t hold. Perfect competition is not the essential linchpin of the analysis. Even if there is some market power on the producer side of the market, sellers will respond to higher prices by increasing output. Similarly, consumers will respond by reducing consumption. If somebody–a speculator–injects additional demand for the real commodity into the market, and drives prices up, producers will increase output and consumers will reduce consumption. This is sustainable only if the speculators willing to pay the (putatively) artificially high price put their money where their mouths are, and hold inventories of the commodity. (Wray tries to finesse the analysis by stating that maybe large oil producers are keeping oil in the ground rather than producing it. Maybe. But that is something that cannot be laid at the feet of the speculators. Moreover, it is hard to reconcile with the movement of the market into backwardation.)

Wray makes some other basic economic errors. For instance, he notes: “Americans have responded to rising gasoline prices in the manner economists expect, with consumption falling sufficiently to offset China’s increased use of crude oil—yet crude prices barely responded.” Catch the freshman mistake? If the reduction of consumption is an equilibrium response to higher prices, you wouldn’t expect the drop in consumption to cause a fall in prices. The reduction in consumption is a movement along a demand curve, and absent any shift of the demand curve, holding all else equal, the price should not fall. Wray’s is essentially a yo yo theory of prices. Rising prices cause falling consumption cause falling prices cause rising consumption cause rising prices . . . Maybe Wray should get rich by inventing a perpetual motion machine.

In brief, there is nothing new here. Indeed, these papers–trumpeted to the skies by Senators Lieberman, Cantwell, and others–are just a repetition of the same blarney that’s been flying about for months now. Can we please get unstuck from stupid, and start having an intelligent debate on these issues, one that reflects at least a modicum of comprehension of basic economics? Alas, I seriously doubt it.

I have noted before that when making the investment case for Russia, Putin, Medvedev and their pilot fish (or remoras) from the financial community claim that Russia is driven by its own strong fundamentals and is essentially decoupled from the American and European stock markets, but when anything goes bad in the Russian market, it’s the Americans’ fault (e.g., credit crisis). With the Russian market currently in near meltdown mode, the latter claims have become even more shrill. To wit, Putin’s and Medvedev’s recent penetrating diagnoses of the precipitous drops in the RTS and MICEX:

Vladimir Putin yesterday admitted that foreign capital inflows could fall by up to 45 per cent this year, but rejected suggestions that turmoil in Russia’s financial markets was caused by the conflict in Georgia.

The Russian prime minister said that the country was simply suffering from the same credit crisis affecting the rest of the world, but he acknowledged that foreign inflows might fall this year from $80bn in 2007 to $45bn or $50bn (€35.7bn, £28.5bn).

Mr Putin blamed Russia’s outflow of capital on “speculative” moves by western institutions withdrawing funds because of the “mortgage crisis” in the US and Europe.

But, speaking to western journalists in the resort of Sochi, he denied there was a liquidity crisis and rejected the view that the turmoil had “anything to do” with the Georgian conflict.

The US market has been moving largely sideways during a period when the Russian market has moved down approximately 45 percent. The recent precipitous drops in the Russian indices have not been matched by similar declines in the Dow or S&P, or any of the European indices. Indeed, for Putin’s story to make sense, one would have expected the Russian market to outperform (e.g., lose less) than the US market. The reverse has happened.

The far more plausible explanations for the Russian market implosion are (a) the Mechel episode and its aftermath, (b) the Russo-Georgian War, and (c) the sharp (approximately 40 percent) drop in oil prices post-July. For Putin (and Medvedev) to deny the obvious connections between their actions and the market’s reaction is a testament to either denial or chutzpah. It is particularly difficult to reconcile the sharp drop of the ruble relative to the Euro and the dollar with Putin’s United States-centric explanation. If US financial turmoil was the driving factor, the ruble should have been rising (as investors flee the dollar), instead of falling like a stone as it has.

During this interview, Putin dishes out more than usual dollops of his famous charm:

Mr Putin devoted much time to defending Russia’s intervention in Georgia, saying Moscow had had no choice but to respond to Tbilisi’s aggression in South Ossetia. “Should we have wiped the bloody snot off and bowed our heads again this time? What did you expect us to do, defend ourselves with catapults?”

In the three-hour meeting, Mr Putin appeared in complete command, giving the impression that he had ceded little, if any, authority to Dmitry Medvedev, his successor as president.

Asked whether he saw prospects of improvement in ties with the UK, the Russian prime minister offered little hope.

“Why do you use the territory of Great Britain to be used as a launching pad to fight Russia,” he asked, referring to the asylum granted to various Kremlin opponents including Boris Berezovsky.

“That’s why it’s not possible to have normal relations with the UK. If we had given safe haven to the militants of the IRA with weapons in their hands, what would you have done?”

This vulgarity is of a piece with Ivanov’s carpet f-bombing British Foreign Minister Miliband. It is especially pitiful when the elfin Medvedev feels compelled to talk like a capo to fit in with the overall mien of the siloviki dominated government.

I predict that the shrieks from Casablanca on the Moskva and the Kremlin to become even more shrill in coming days. Such shrillness is common when there is a yawning gap between reality, and what the speaker wants the audience to believe. (Hence, I also predict an increasing shrillness in the anti-Palin hysteria.)

An article on the McClatchy wire states that the Russian oil industry is facing a dire future due to “the practice of reaping quick profits and ignoring long-term interests.” This is no big surprise to those who understand the effects of insecure property rights on the incentives to (a) invest in specific assets, and (b) take as much as you can grab today because it may not be yours tomorrow. There are few assets more specific than an oil well. If you invest wisely today to maximize the present value of the well’s future output, that does you no good if you’re not around to claim those future flows (because, for instance, you’re rotting in a jail in Chita.) So, to hell with the future–maximize what you can produce today, even though that impairs the well’s long run value.

This is somewhat ironic because in the early days of the oil boom, the property rights regime in the US favored accelerated depletion of wells due to its failure to address the common pool problem, whereas Tsarist Russia encouraged a longer view. This was reflected, in part, by the far larger number of wells drilled in the US to produce a given amount of oil. In the US, competing producers (including wildcatters) drilled wells to get the oil from a given pool before somebody else did. This wasteful competition was attenuated in Russia.

Short-termism is clearly an important–and arguably the dominant–source of friction between BP and its Russian partners in BP-TNK. The Russians want to maximize current cash flows, BP wants to take a longer view. This short-termism is also likely an important cause of the relatively low rate of fixed investment in Russia. And this short-termism is a direct result of the insecurity of property in Russia. The constant threats of state expropriation and corporate raiding a la Russe will continue to impede Russian economic growth.

The contrast with China is of some interest. Formal property rights are absent in China too, but China’s rulers act more like “stationary bandits” (in Mancur Olson’s felicitous phrase) with an “encompassing” interest in the long run health of the nation’s economy. They apparently figure they have a high probability of being around for awhile, and therefore temper their short term exactions in order to enhance their future take. Thus, property rights are informally protected and relatively secure (by comparison to the Chinese past and Russia, but not to the US.)

Russia’s rulers, by contrast, act like Olson’s “roving bandits.” Apparently insecure in their future prospects, they lean towards taking today and letting the future take care of itself. The Putinists probably have a longer view than the pirates of the 90s, but they clearly have shorter time horizons than their Chinese counterparts. In an environment where competing clans vie for control, this is probably a rational view. My clan may control asset X today, but who is to say that the competing clan may not seize it tomorrow? So rather than enhance X’s future potential, grab as much as I can from it today.

In one of my earliest SWP posts, Whither NYMEX?, I pondered the future of NYMEX. Somewhat later (and in an interview on CNBC) I predicted that NYMEX would wind up in the hands of the CME. That prediction has come to pass with yesterday’s vote by the NYMEX membership to accept the CME’s merger offer. The weeks leading up to the vote saw the chest-puffing bluffing that one can expect from canny experienced traders trying to extract the most from a trade as possible, but the CME management did not budge after raising its offer to the holders of trading rights, and in the end the trading rights members meekly accepted the CME bid.

This outcome was almost inevitable given the lack of any competing bid for NYMEX. This distinguished the NYMEX bid from the CME’s bid for the CBT, where ICE made the Chicago Boys sweat. The lack of a competing bid was in no way surprising, given (a) the contract between CME and NYMEX to trade the latter’s contracts on GLOBEX, and (b) the clearly superior synergies between CME and NYMEX as compared to NYMEX and anybody else. ICE was not a player in this game because of antitrust obstacles that would have been acute particularly in the hothouse environment surrounding energy prices and the criticism that the USDOJ has faced. NYSE-Euronext wasn’t a good fit at all, and wouldn’t have offered nearly the same economies in clearing. NYMEX was also not viable as a standalone in the long run, especially given its weak technological position, doubts about its management, and Byzantine internal politics (factors discussed in Whither NYMEX.) So, when push came to shove, the members had no better option than to accept the CME’s bid.

So, now the question becomes: Whither CME? The decline in the company’s stock price has been pretty stunning, but its fundamentals are still strong. It has, however, effectively completed one phase of its strategy–and of the industry’s evolution: the consolidation of the US futures trading industry on a first rate execution and clearing platform. It can expect continued growth in revenues from growing trading volumes, especially when the credit crisis runs its course. But that organic development is not going to be sufficient to generate the profit growth capitalized even in the company’s currently lower stock price. CME will need to develop a whole new product line. The most likely candidate is OTC clearing. The acquisition of NYMEX is a step in that direction given the New York exchange’s nice OTC energy clearing business. But the big prize is clearing of OTC financial derivatives, notably credit derivatives. That is an immense market, and cracking it faces numerous challenges.

Clearing works best with homogeneous products traded in transparent markets with accurate and reliable pricing. (I have a working paper that argues that traditional impediments to risk shifting–moral hazard and adverse selection–are most acute when products are customized and heterogeneous, require specialized valuation expertise, and when there is not reliable pricing information.) These conditions are not yet met in OTC credit derivatives.

Moreover, CME will face competition in this business. The big banks are not willing to give up this lucrative business without a fight, and even if the CDS market moves to centralized clearing, the big banks have already established a clearing entity in combination with The Clearing House Formerly Known as BOTCC to vie for this business.

CME’s management will spend some time on the integration of its new acquisition, but this should be a relatively straightforward process given that NYMEX contracts already trade on GLOBEX and that there is considerable overlap between clearing memberships on the two exchanges. Once that task is complete, Donahue’s and Duffy’s real work begins–to revolutionize the management of derivatives performance risk by integrating OTC and exchange clearing.

Well, that didn’t take long. In my first post on the Russo-Georgian War I opined that the next move would be in Abkhazia to force the Georgians from the Kodori Gorge. That move has apparently begun:

Earlier, Georgia said Russia had brought an additional 10,000 troops across Georgia’s frontiers – 6,000 by land into South Ossetia and 4,000 by sea into Abkhazia.

The head of the pro-Russian separatist authorities in Abkhazia also said he had sent 1,000 troops to the Tbilisi-controlled Kodori gorge and announced the “full mobilisation” of reservists.

“We are ready to act independently,” Sergei Bagapsh said. “We are ready to enforce order and go further if there is resistance from the Georgian side.”

A Georgian interior ministry official later told the BBC that Russia had launched what he called “all-out military aggression” against Georgia, including attacking areas outside the conflict zone in South Ossetia.

He said Russian planes were now bombing the western town of Zugdidi and Georgian-controlled territory inside Abkhazia. The claims could not be independently verified.

The UN’s Assistant Secretary-General for Peacekeeping, Edmond Mulet, said on Saturday that he feared the Abkhaz separatists were preparing to launch an offensive.

“At this point we are particularly concerned that the conflict appears to be spreading beyond South Ossetia into Abkhazia,” he said.

The Russian Black Sea Fleet is also apparently massing off the Georgian coast, and threatening an amphibious assault and potentially a blockade of Georgian ports:

Russia appeared to be opening a second front in Abkhazia, to the west of South Ossetia, and to be aiming to drive Georgian troops from the Kodori Gorge, a small mountainous area in Abkhazia that Georgia reclaimed by force in 2006. Georgian officials said 12 Russian jets were bombing the area, shortly after a Western official said United Nations peacekeepers had withdrawn from the area at the request of Abkhazia’s de facto government.

Russia also notified Western governments that it was moving ships of its Black Sea fleet to Ochamchire, a port on the Abkhaz coast. Georgian officials said they expected Russian troops to land there.

Regarding the blockade, Die Welt writes:

Warships from Russia’s Black Sea fleet by Sunday morning had clamped down a naval blockade on Georgia’s coastline, turning back “several civilian ships,” said Aleksander Lomaia, Georgia’s National Security Council Chief, in a statement.

Among freighters halted with warning shots was a Moldovan-flagged vessel carrying wheat to the port Poti, threatening Georgia’s food supplies, Lomaia claimed.

Georgian intelligence gave the elements of the Russian squadron as three amphibious assault vessels, two anti-submarine warfare vessels, a reconnaissance ship, two minesweepers, two missile boats, and a missile cruiser.

This situation is rapidly spiraling towards disaster, with historic foes Turkey and Russia facing off:

In the Black Sea area, Russia is accusing Turkey of aiding Georgia. “Russian Izvestya newspapers has claimed that Turkey was among the countries that supported Georgia in the recent strife in South Ossetia, by supplying the country with weapons, CNNTurk reported on Sunday. The Russian newspaper cited a Russian Defense Ministry report published three months prior that claims over the past four years Turkey has supplied Georgia with $45 million in weapons and ammunition, as well as training Georgian army officers. Interfax Agency also reported that Turkish naval ship has entered in to Georgian territorial waters off the coast near the city of Batumi.” Moscow is feeling its oats and not shy about warning Turkey off.

And Ukraine is threatening to become involved as well, by barring the return of the Russian Black Sea Fleet to Sevastopol:

Ukraine warned Russia on Sunday it could bar Russian navy ships from returning to their base in the Crimea because of their deployment to Georgia’s coast.

The statement could affect Russian-Ukrainian relations, already strained by energy disputes and Ukraine’s plans to join NATO.

Ukraine’s Foreign Ministry said the Russian naval deployment to Georgia’s Black Sea coast has the potential to draw Ukraine into the Russian-Georgian conflict over the separatist province of South Ossetia. Georgia launched an offensive Friday to regain control over the inland province, and Russia responded by sending in tanks and troops and bombing Georgian territory.

In the meantime, Russia has deployed a naval squadron off the coast of another of Georgia’s separatist regions, Abkhazia. The ships are part of Russia’s Black Sea Fleet, based in the port in Sevastopol, which Russia leases from Ukraine under a 1997 agreement.

“In order to prevent the circumstances in which Ukraine could be drawn into a military conflict … Ukraine reserves the right to bar ships which may take part in these actions from returning to the Ukrainian territory until the conflict is solved,” said the Ukrainian statement, posted on the ministry’s Web site.

The statement reflected strong support for Georgia. Both Ukraine and Georgia have sought to free themselves of Russia’s influence, and to integrate into the West and join NATO.

Russia’s deputy chief of General Staff, Col.-Gen. Anatoly Nogovitsyn, said the statement had been unexpected and was being analyzed by the Russian government.

“It makes a third party involved, and it’s quite unexpected,” Nogovitsyn said at a news conference.

He said the ships had not taken any action against Georgia.

Russia’s Deputy Foreign Minister Grigory Karasin said the ships had been sent toward Abkhazia as a deterrent, to prevent hostilities from erupting there.

“The deployment is quite natural. We don’t want a repeat of what happened in South Ossetia,” he said at a news conference.

The 1997 agreement lets Russia’s Black Sea Fleet remain in Sevastopol through 2017, but Ukrainian officials have said they want it out after that.

The issue adds to emotions over Crimea, which was part of the Russian Federation but ceded to Ukraine during the Soviet era and became part of the independent Ukraine when the Soviet Union collapsed in 1991.

Ukraine and Russia are already at loggerheads over arranging Russian departure from Sevastopol. The Ukrainians say that the agreement requires the Russians to leave by 2017. The Russians say that’s when the talks over arranging the departure should begin in earnest, with the actual departure date to be somewhere in the hazy future beyond 2017. To say the least, this episode will only exacerbate that conflict, which is already at a high emotional pitch with Russian nationalists vowing never to give up Sevastopol.

[And, as an aside, if Col.-Gen. Nogovitsyn, the Russian General Staff, and the Russian government were really surprised that Ukraine would react with alarm at a Russian move into Georgia, one may seriously doubt their comprehension of the effects of their actions. Any nation that escaped the USSR–the Baltics, Ukraine, Moldova–watches what is happening in Georgia and immediately thinks–“well, I’m next.” Ukraine may well be acting under Eisenhower’s old dictum–if a problem seems intractable, enlarge it. The near abroad nations realize that their only salvation is American and European intervention, and that given the current circumstances, this will be forthcoming only if the situation threatens to metastasize.]

And in the meantime, Europe seems too engaged in its August vacation to do anything remotely serious. Sort of reminds me of the French leaving thousands of elderly people to die during the 2003 heat wave rather than disrupt their vacations.

During his testimony before the House Ag Committee on 9 July, 2008, Rep. Bart Stupak (D-MI) asserted that current speculation in the oil markets is just like the Hunts in silver in 1980. The next day, a Republican representative (Bob Goodlatte, R-VA of Virginia, if memory serves) asked me whether the analogy was correct. (Unfortunately, hearing transcripts are not yet available.)

I responded no, they were not, and that indeed the contrast between the Hunt episode and the current oil market provides an excellent illustration of (a) why there is no evidence that speculation is distortion the energy markets, and (b) what kind of evidence you would see when such distortion occurs.

In stark contrast to oil speculators today, the Hunts accumulated huge–and I mean huge–quantities of physical silver. In September, 1979 the Hunts owned about 40mm ounces of silver in deliverable stocks, and COMEX and CBT deliverable stocks were approximately 105mm ounces. By March the Hunts owned approximately 100mm ounces of deliverable stocks, and total COMEX stocks had risen to about 130mm ounces. In addition, I have read that the Hunts also owned about 90mm ounces in Switzerland. In a nutshell, during their silver escapades, as prices were rising dramatically, the Hunts held large and rising amounts of physical silver, and deliverable silver stocks rose substantially (approximately 20 percent).

Moreover, there were manifest signs of distortions in the physical market. Massive amounts of silver coins were melted into bullion. So many coins were melted that the capacity to convert them was strained. As a result, the differential between the price of bullion and the price of coins swelled to unprecedented levels. (This differential represents the shadow price, and the marginal cost, of the conversion. The marginal cost increases with the amount of coins converted.) Large amounts of silver flowed out of India–and into the hands of the Hunts.

The prices of silver were clearly distorted in 1979-1980. These price distortions were reflected in (a) the flow of large stocks of silver into the Hunts’ hands, and (b) distortions in the physical market. This illustrates that if speculators drive up prices–if they are willing to pay more than anybody else for the commodity–they must end up holding the commodity, and that distortions in prices inevitably lead to distortions in the physical market.

None of these signs are present in today’s energy market, or other commodity markets, for that matter. Prices are indeed high, but speculators are not sitting atop large and growing stocks of the physical commodity. If they were, one could say, with Rep. Stupak, that we are seeing the second coming of the Hunts. Since they aren’t, we can’t. Indeed, as I testified in Congress, the differences between silver 1979-1980, and energy in 2007-2008 are very revealing. And what they reveal is that today one should look for other causes of high energy/commodity prices than excessive speculation.

The recent assault against commodity speculation could use a little historical perspective. In particular, history can provide some lessons regarding what happened during previous attempts to restrict–or ban–futures trading.

Example 1. Gold futures during the Civil War. Union fortunes were ebbing during the spring of 1864. In early-June, Grant had suffered a punishing defeat at Cold Harbor, suffering 7000 casualties in a period of an hour. In mid-June, he made a brilliant descent on Petersburg (a major transport hub south of Richmond), but his assaults on 15-17 June made only limited headway. In Georgia, Sherman was making only slow progress against Joseph Johnston, and was mired in the piney forests around Dallas and New Hope Church in late-May. West of the Mississippi, Banks’ Red River Campaign had ended in disaster in late-May, with the US Navy’s Riverine fleet barely escaping capture only through the ingenious efforts of Army engineer Joseph Baily.

Union military failure was reflected in a skyrocketing price of gold in greenbacks (i.e., a collapse of the paper dollar.) Data from The International Center for Finance shows that from the time of Grant’s crossing of the Rapidan on 4 May until 16 June, the value of the Greenback fell from $.557 gold to $.507 gold–a 9 percent drop.

Congress soon found a culprit–gold speculators. Congressmen lashed out at speculators on the New York Gold Exchange, and soon matched their words with deeds. On 17 June, 1864, Congress passed the Anti-Gold Futures Act of 1864. The Act prohibited the trading of gold futures, and for good measure, banned the trading of foreign currency contracts with more than 10 days to maturity. The Act also made it a crime to transact in gold bullion anywhere but the ordinary place of business of the buyer or seller, effectively putting the Gold Exchange out of business.

The exchange closed, but speculation didn’t. Instead, trading activity in spot gold moved to the offices of brokers. And the price of gold continued to plummet. From 17 June to 30 June, the price of greenbacks fell to $.4082–a 21 percent drop. Congress soon recognized the folly of its anti-speculation legislation, and in a commendable example of legislative humility, repealed the Anti-Gold Futures Act on 2 July, 1864.

What had driven down the price of greenbacks during the Act’s short life? In a word: Fundamentals. Bad news continued to flow from the war fronts, indicating a long war–and a continued need to run the printing press to finance it. Grant was definitively stopped in front of Petersburg, and suffered some punishing defeats at the Battle of the Weldon Railroad. Sherman suffered a bloody repulse at Kennesaw Mountain. A large Confederate force under Jubal Early was on its way north through the Shenandoah Valley, with nothing in its way to stop it.

The moral of the story: constraining speculation is easier said than done, and such constraints are too weak to overcome the effects of powerful fundamentals.

Example 2: The German Exchange Act of 1896. This bill implemented many restrictions intended to constrain speculation in agricultural commodities and stocks. The Act gave German state governments the authority to ban futures trading. In addition, in an interesting parallel to one feature of the Stop Excessive Energy Speculation Act, the German legislation empowered the state to appoint a board consisting of agriculturalists and grain processors to oversee the operation of grain exchanges. The Act also eliminated futures trading in the stocks of industrial and mining companies.

The attempt of the Prussian state government to appoint a board to oversee the exchange, with its implied threat of eliminating futures trading on the exchange altogether, led the members of the Berlin Exchange to decamp from their facilities to a theater across the street–evocatively named “The Fairy Palace”–where they continued to carry out their business, but without calling themselves an exchange. The outraged Agrarians railed against this attempted evasion, and pressured the Prussian authorities to announce to the Fairy Palace crowd that if they did not disperse, the police would be called to break up the gatherings of traders there.

According to contemporary accounts, such as an article by Henry Emery in the Political Science Quarterly, and by Ernst Loeb in the QJE the Acts did not have the desired results, and actually had detrimental effects. Although neither author presents any empirical evidence, according to their accounts, speculation did not decline, but shifted into securities not covered or into cash transactions. Market liquidity declined, and prices became more volatile. Transactions costs increased. In foodstuffs, the absence of a central location for price discovery led to more negotiations and haggling between buyers and sellers. In stocks, trade was driven from exchanges into the hands of big banks who internalized orders. Some trading activity was diverted to foreign markets. According to Emery, the passage of the Act and the reduction of trading activity on the exchange was accompanied by a dramatic increase in the commissions that banks earned (and this presumably does not include the effect of the profits that the banks made on the internalized order flow in the absence of competition from a liquid and transparent exchange.) According to Carl Parker, “Governmental Regulation of Speculation” (Annals of the American Academy of Political and Social Science, 1913), the elimination of futures, and the resulting increase in difficulties of short selling, led to more pronounced rallies followed by more pronounced crashes as prices returned to levels dictated by fundamentals.

In time, even the German government recognized that the law was ineffective at best, and pernicious at worst. A 1907 government report stated “[t]he dangers of speculation have increased, the power of the market to resist one-sided movements has weakened, and the possibilities of misusing inside information have enlarged.” The report further stated that the law “has proved injurious to the public, without accomplishing its original purpose.”As a result, in 1908 Germany repealed many of the features of the law. The continued outrage of agricultural interests led to the continuation of the ban on agricultural futures, which lasted until almost 100 years after its passage. Ag futures trading was allowed only in 1998. (Personal aside: after the repeal of the law, I worked on a feasibility study and contract design work for the first German ag futures exchange, the Warenterminborse, or WTB. The exchange continues to operate under the name Risk Management Exchange, or RMX.)

So, the bottom line is that previous efforts to ban futures trading, or sharply constrain it, have failed in their object. They have reduced market quality, increased transactions costs, and impaired competition–without actually reducing speculation or affecting prices in the way that the sponsors of the anti-speculation laws intended.

Will Congress take these lessons into account? Somehow I doubt that a consideration of the facts will overcome the temptation to engage in political pandering and demagoguery.

It looks like the energy markets have dodged a bullet; the Stop Excessive Energy Speculation Act (S. 3268) has failed a cloture vote, and is in limbo despite an earlier 94-0 vote in favor of cloture on the motion to proceed. This sparked a Harry Reid hissy fit (always music to my ears.)

And a good thing too. Although not including some of the most damaging proposals that have been mooted, such as draconian increases in margin or the outright banning of large financial institutions from the energy derivatives markets, it was plenty bad enough.

Some of the bill’s greatest misses include:

• Designating some market participants as “nonlegitimate hedge traders” and limiting the designation of “legitimate hedge traders” to those entities that actually produce or consume physical petroleum or natural gas.
• Establishing an advisory committee consisting of legitimate hedge traders only to make recommendations to the CFTC on position limits applicable to nonlegitimate hedgers and speculators.
• Extending position limits to OTC markets.
• Giving the CFTC the authority to intervene in the OTC market in the event of “a major market disturbance.”

All of these measures are pernicious. The would do nothing to reduce manipulation or improve the efficiency of the energy markets or reduce prices, but would reduce the effectiveness of these markets as risk transfer and price discovery mechanisms and raise compliance costs.

The creation of a separate caste of hedgers–“nonlegitimate”–makes no sense economically. Financial institutions that use the energy markets as part of a portfolio management strategy are as legitimate hedgers as an oil company or an airline. Even the very language “nonlegitimate” is tendentious and offensive.

Moreover, it is a dangerous precedent to give one group of market users a say over what other market users can do. The favored group is likely to use its power to benefit its own members to the detriment of the unfavored ones. Note that many firms that could fit in the “legitimate hedger” category speculate too, and could exploit the powers vested in the advisory committee to favor themselves at the expense of other competitors in the supply of risk bearing services. Similarly, long hedgers (airlines, as an example) would benefit if long speculation, or long portfolio hedging, is constrained. (Long speculators offset the effect of short hedging pressure, and thereby cause the futures price to rise relative to the expected spot price. Long hedgers benefit from a fall in the futures price relative to the expected spot price, and hence would benefit from constrianing other longs in the market.) These entities could also use their position on the advisory committee to advance their interests at the expense of short hedgers and long speculators.

Since speculative limits designed to make speculation more costly are detrimental to the efficient operation of the market (by constraining the ability of the markets to shift risk), extension of these limits to the OTC market will impair the effectiveness of the markets as risk management tools. Moreover, the CFTC (and its fox-in-the-henhouse “legitimate hedger” advisory board) are charged with the responsibility of setting position limits to eliminate “excessive” speculation. Good luck with that. These limits will just become another political and regulatory football over which competing interests will squabble.

The extension of emergency authority to the OTC market is a particularly scary expansion of regulatory authority. Here’s the language in full:

GENERAL.—In the case of a major market disturbance, as determined by the Commission, the Commission may require any trader subject to the reporting requirements described in paragraph (3) to take such action as the Commission considers to be necessary to maintain or restore orderly trading in any contract listed for trading on a registered entity, including—
”(i) the liquidation of any over-the counter transaction; and
”(ii) the fixing of any limit that may apply to a market position involving any over-the-counter transaction acquired in good faith before the date of the determination of the Commission.

The definition of “major market disturbance” is extremely broad and vague:

• `(C) MAJOR MARKET DISTURBANCE- The term `major market disturbance’ means any disturbance in a commodity market that disrupts the liquidity and price discovery function of that market from accurately reflecting the forces of supply and demand for a commodity, including–
• `(i) a threatened or actual market manipulation or corner;
• `(ii) excessive speculation;
• `(iii) nonlegitimate hedge trading; and
• `(iv) any action of the United States or a foreign government that affects a commodity.

In other words, not only does this provision permit the CFTC to intervene in the event of a corner–a real manipulation–it gives the Commission the authority to interfere directly in the market whenever in its infinite wisdom it deems that “excessive speculation” (where excessive is evidently in the eye of the beholder, and is not defined and is not capable of being defined) or “nonlegitimate hedging” is distorting prices. This in effect gives the Commission the authority to second guess the market. Moreover, since regulators are subject to pressure from organized interests who may benefit from an intervention, this opens the door to all sorts of influence activities and will undermine the certainty of contract in the energy markets. Think of it; somebody makes a bad trade, begins to howl about excessive speculation distorting the markets, and just might succeed in buffaloing the CFTC into forcing liquidation of the offending contracts. Great. Read my 1995 JLE piece on self-regulation of commodity markets for a few examples of how these powers can be used to make mischief.

In all honesty I doubt that the CFTC would use these powers. But they are there, and an activist Commission or one subject to intense lobbying or Congressional pressure could well use them, and wreak tremendous havoc in the markets. This is a really bad idea.

I would oppose this provision even if its application was limited to “(i) a threatened or actual market manipulation or corner.” As I have argued for well over a decade in my academic research, it is best to address corners and real manipulations ex post. The likelihood of a wrongful intervention is much greater (due to the lack of good information and the difficult of making decisions under time pressure) when a regulator attempts to intervene while a corner is in progress. Moreover, the regulator is likely to intervene only when the price distortions resulting from the exercise of market power are large, so early intervention is unlikely to mitigate price distortions all that much. Manipulation is perfectly suited for deterrence through harm-based sanctions, like those imposed on BP in the aftermath of its propane adventure. It is inefficient to rely on emergency authority, and its extension to the OTC markets is a bad idea.

Advocates of this type of regulation make ominous allusions to the dangers of “dark markets” not subject to constant government observation and meddling. Like small children, paranoics, and control freaks, they appear to be phobic about things that consenting adults might do out of their sight.

I, for one, am not scared of the dark, or most of the things that go on in the “dark” OTC markets. One thing is for sure; if a real manipulation takes place, it will come to the light in short order. As Frank Easterbrook has written, an undetected manipulation is an unsuccessful manipulation. If somebody corners the market, it will not remain a secret, its perpetrators will be known to other market participants–and to the authorities shortly thereafter. That is the time to bring the legal guns to bear. Until that time, let adults do in the dark what they will.

The BP propane episode is a perfect example of this. It is hard to conceive of a darker, more obscure corner of the energy market than propane. It is traded almost exclusively OTC, and trading activity in that commodity is dwarfed by that for other energy commodities. BP’s actions soon sparked the outcry from affected market participants, and soon parallel civil and criminal investigations were commenced. One trader plead guilty to a felony, and sometime thereafter the company entered into a deferred prosecution agreement with the government and agreed to pay a large civil fine and criminal penalty. We’re talking 9 figures.

It is far better to devote scarce enforcement resources to investigate instances of real potential harm that occur relatively infrequently, rather than spend resources to monitor all market activity on an ongoing basis, since most of that activity is benign at worst, and beneficial at best, and hence most of the resources devoted to oversight are wasted.

In sum, Harry Reid’s pet energy speculation bill is a disastrous piece of legislation. It is built on a foundation of anti-speculation animus that has no basis in economic theory or empirical evidence. It mandates a tremendous expansion of regulatory authority that cannot be used for good, but which has the potential to be used to distort markets, to intervene when intervention is unjustified, and compromise the surety of contract. Hopefully the bill is dead. But just to make sure, let’s drive a stake through its heart and shoot it with a silver bullet and repeatedly drive an M-1 Abrams over it repeatedly.

The battle royale between BP and the AAR Group over BP-TNK is reaching a climax with Robert Dudley’s decision to leave Russia and attempt to run the country from an undisclosed location (shades of Dick Cheney, circa 2001). Like many things that happen in Russia, the events are somewhat inscrutable. This London Times article seems to offer the most sensible interpretation: namely, the Russians want their money out of Russia.

It explains many of the details that have emerged from the murk. For instance, one bone of contention between the parties is allegedly that BP wants to manage the BP-TNK properties for the long term, investing substantial amounts in new technology and using more conservative production techniques, whereas the AAR gang has been looking to maximize output even though this compromises the long term productivity of the company’s wells. Relatedly, BP technical staff has been a particular focus of official harassment. Furthermore, another argument has raged over investment outside of Russia. BP wants to focus on inside Russia, the AAR oligarchs are pressing to invest outside of the country. A last clue is that one proposal floated by the Russian side to end the stalemate–an exchange of TNK shares for BP shares.

All of this is consistent with a desire by the Russian partners to maximize short term cash flow and/or get their money out–and out of the country. If that doesn’t speak volumes about the rule of law and the security of property in Russia, I don’t know what does.

The game being played by the Kremlin/White House (theirs, not ours) is more difficult to fathom. One hypothesis, advanced in Steve LeVine’s excellent blog is that AAR believes/believed that BP is trying to sell them out by doing a deal with Gazprom. I think that most likely that the government isn’t taking one side or the other, but is setting the two against one another like scorpions in a bottle. Once the battle is over, the government/Gazprom/Rosneft or some combination thereof will swoop in to claim the spoils. Or perhaps the relatively standoffish approach of officialdom reflects a stalemate in a battle between contending clans.

One thing for certain is that in the end, BP will emerge bloodied, and perhaps, as LeVine posits, a takeover target. Another is that the end of legal nihilism is far, far into the future.

The Russian equity market is in freefall in the aftermath of Vlad the Expropriator’s most recent outburst–this one directed at steel and coal giant Mechel, whose COO (chief oligarchic officer) had the temerity to decline the honor of attending an audience with His Eminence. For this dis , Putin sicced prosecutors on the company to investigate allegations of . . . who cares? The specific allegations are meaningless. The new oprichniki will find something, and Igor Zyuzin and his company will soon sample the delights of “the dictatorship of law.” And this in the same week in which BP’s Robert Dudley decided that discretion was the better part of valor, fleeing Russia rather than try another spin at Russian Legal Roulette.

Western investors were Shocked! Shocked! upon hearing the news:

Investors said Thursday’s events underlined the risk borne by Russia that, until now, had largely been masked by record-high prices for the commodities and oil that Russia produces in abundance.

“The place looks rotten to the core. It always did, but it was masked by high commodity prices,” said one fund manager who asked for his name not to be used.

WRONG! Russia’s rottenness was never masked by anything, let alone high commodity prices. It was there for anyone with eyes to see. Those that didn’t see it, didn’t want to see it. Salivating at the prospect of getting a seat on the Russian Rent Express, these investors, investment bankers, and fund managers ignored the stench of corruption that one can smell clearly here in the heart of the US. Like the classic mark in any con, they let their greed overcome their common sense.

Indeed, this fund manager’s diagnosis is 180 degrees from the truth. High commodity prices did not mask the rottenness–they fed it! The stream of rents flowing from Russia’s oil and gas empowered a corrupt elite to do anything it willed; these rents freed the siloviki from the constraints of domestic politics and permitted them to undermine totally Russia’s already weak legal safeguards for person and property. And the enabling behavior of fools like the wisely-anonymous “fund manager” only moved the process along.

Another anonymous codependent, a “sales trader at a major Western bank,” offered this pearl of wisdom: “The Russian government doesn’t care about foreign investors. It cares about its national security and, if foreign investment gets stomped on, then so be it.”

WRONG AGAIN! National security hasn’t a goddam thing to do with it. It’s all about one thing, and one thing only–the wealth and the power of Putin and the clans. It’s about their personal security, their personal wealth and power, the country be damned. All this yammering about making Russia strong, about restoring Russian greatness, is a joke. It is the Russian equivalent of boob-bait, intended to exploit the prejudices of the Russian populace and distract their attention from the accumulation of power and wealth by the ruling clique.

I have no sympathy whatsoever for any investor in Russia who, post-Yukos, post-Sakhalin II, post-Hermitage, post-corporate raiding, tried to get rich in Russia on the hope that the crocodile wouldn’t eat them. In one of my earliest posts, A Fool and His Money, I wrote:

[W]estern banks insistence that “their participation means that the deal will meet their exacting standards” won’t amount to squat if Putin decides to flex his muscle.

This raises the question-what are the incentives to expropriate, and what incentives cut the other way? If Putin were interested in building a reputation for avoiding expropriation in order to attract western capital, he might abstain from aggressive action. However, if anything, Putin seems fixed on-indeed, almost obsessed with-using control of Russian energy assets to exert geopolitical influence. He seems far more interested in control than attracting foreign capital. Moreover, revenues from $70 oil and expensive gas are filling Kremlin and Russian oil company coffers, limiting their need for external capital. Given these circumstances, the lure of increasing Kremlin control over Russian energy production and distribution, likely through its chosen vehicle Gazprom, seems irresistable-especially if it also allows the fleecing of foreigners to the tune of tens of billions of dollars. Even though commodities/energy are hot now and likely to get hotter, all in all, I’d rather take my chances on three card monte.

Sadly, I predict that soon enough those pigeons who avoided being the crocodile’s lunch this time around will be back, cash in hand, and that soon enough I will be able to write another told-you-so post.