Streetwise Professor

The very informative RBN Energy blog notes “Look What You Made Me Do – Permian Crude Producers Waste No Time In Ramping Up Production“:

Crude oil supply news comes in from all angles these days, bombarding the market daily with fresh information on producers’ efforts to ramp their volumes back up now that the global economic recovery is cautiously under way. Crude demand is rising, storage hasn’t burst at the seams yet, and prices have come a long, long way in just a few weeks. Permian exploration and production companies, having avoided a fleeting, longshot chance that the state of Texas might regulate West Texas oil production, are responding to higher crude oil prices as free-market participants should. The taps are quickly being turned back on, unleashing pent-up crude and associated gas volumes that, you could say, were under a sort of quarantine of their own for a while. Today, we provide an update on the status of curtailments in the Permian Basin.

The story mentions “the taps.” US shale regions, Permian in particular, are as close to something that can be turned on and off like a tap as anything in the history of the oil business.

You will recall that Igor Sechin’s brain flash in responding to the Covid-caused demand crash was to spurn Saudi importuning to extend output cuts, which spurred the steamed Saudis to increase output, thereby turning a hard fall in prices into a bona fide crash. A crash that hurt Russian producers generally, and Rosneft specifically, extremely hard.

The reasoning for Sechin’s strategy was that US shale producers had been the main beneficiary of previous output cuts, and he wanted to drive them out of business. Predatory pricing, in other words.

But as the RBN post indicates, this strategy, like most predatory pricing strategies, doesn’t work if the target can rope-a-dope and recover when you attempt to raise prices. That’s exactly what’s happening.

Yes, some companies have gone bankrupt–but bankruptcy is different than destruction. (Igor might not know this. Seriously.) And yes, the industry is facing more stringent financing conditions–but if prices rise these will ease too, and drilling activity will resume.

In other words, Sechin failed to realize that not only is predatory pricing almost always a futile strategy, it is particularly futile when unconventional US oil production is concerned. The Saudis found this out in 2014-2015, but Igor either wasn’t paying attention, or didn’t learn the lesson.

Predation doesn’t pay. This is hardly a new insight, or one not demonstrated by repeated experiences–including experience involving Igor’s intended prey.

Sechin’s predatory endeavors work when they involve exploiting the Russian legal system. In the marketplace, not so much. But we all knew that Igor is basically a thug, and not all that bright.

The June 2020 WTI contract expired with a whimper rather than a bang yesterday, thereby not repeating the cluster of the May contract expiry. In contrast to the back-to-back 40 standard deviation moves in April, June prices exhibited little volatility Monday or Tuesday. Moreover, calendar spreads were in a modest contango–in contrast to the galactangos experienced in April, and prices never got within miles of negative territory.

Stronger fundamentals certainly played a role in this uneventful expiry. Glimmers of rebounding demand, and sharp supply reductions, both in the US and internationally, caused a substantial rally in flat prices and tightening of spreads in the first weeks of May. This alleviated fears about exhaustion of storage capacity. Indeed, the last EIA storage number for Cushing showed a draw, and today’s API number suggests an even bigger draw this week. (Though I must say I am skeptical about the forecast power of API numbers.). Also, the number of crude carriers chartered for storage has dropped. (H/T my daughter’s market commentary from yesterday). So the dire fundamental conditions that set the stage for that storm of negativity were not nearly so dire this week.

But remember that fundamentals only set the stage. As I pointed out in my posts in the immediate aftermath of the April chaos, technical factors related to the liquidation of the May contract, arguably manipulative in nature, the ultimate cause of the huge price drop on the penultimate trading day, and the almost equally large rebound on the expiry day.

The CFTC read the riot act in a letter to exchanges, clearinghouses, and FCMs last week. No doubt the CME, despite it’s Frank Drebin-like “move on, nothing to see here” response to the May expiry monitored the June expiration closely, and put a lot of pressure on those with open short positions to bid the market aggressively (e.g., bid at reasonable differentials to Brent futures and cash market prices). A combination of that pressure, plus the self-protective measures of market participants who didn’t want to get caught in another catastrophe, clearly led to earlier liquidations: open interest going into the last couple of days was well below the level at a comparable date in the May.

So fundamentals, plus everyone being on their best behavior, prevented a recurrence of the May fiasco.

It should be noted that as bad as April 20 was (and April 21, too), the carnage was not contained to those days, and the May contract alone. The negative price shock, and its potentially disastrous consequences for “fully collateralized” long-only funds, like the USO, led to a substantial early rolls of long positions in the June during the last days of April. Given the already thin liquidity in the market, these rolls caused big movements in calendar spreads–movements that have been completely reversed. On 27 April, the MN0 spread was -$14.45: it went off the board at a 54 cent backwardation. Yes, fundamentals were a major driver of that tightening, but the early roll in the US (and some other funds) triggered by the May expiration clearly exacerbated the contango. Collateral damage, as it were.

What is the takeaway from all this? Well, I think the major takeaway is not to overgeneralize from what happened on 20-21 April. The underlying fundamentals were truly exceptional (unprecedented, really)–and hopefully the likelihood of a repeat of those is vanishingly small. Moreover, the CME should be on alert for any future liquidation-related game playing, and market players will no doubt be more cautious in their approach to expiration. It would definitely be overlearning from the episode to draw expansive conclusions about the overall viability of the WTI contract, or its basic delivery mechanism.

That mechanism is supported by abundant physical supplies and connections to diverse production and consumption regions. Indeed, this was a situation where the problem was extremely abundant supply–which is an extreme rarity in physical commodity futures markets. Other contracts (Brent in particular) have chronic problems with inadequate and declining supply. As for WTI being “landlocked,” er, there are pipelines connecting Cushing to the Gulf, and WTI from Cushing has been exported around the world in recent years. With the marginal barrel going for export, seaborne crude prices drive WTI. With a better-monitored and managed liquidation process, especially in extraordinary circumstances, the WTI delivery mechanism is pretty good. And I say that as someone who has studied delivery mechanisms for around 30 years, and has designed or consulted on the design of these contracts.

The past few weeks have brought pleasant surprises from people whom I usually disagree with and/or dislike.

For one, Michael Moore, the executive producer of Planet of the Humans. Moore does not appear on camera: that falls to Jeff Gibbs and (producer) Ozzie Zehner. The main virtue of the film is its evisceration of “green energy,” including wind and solar. It notes repeatedly that the unreliability of these sources of power makes them dependent on fossil fuel generation, and in some cases results in the consumption of more fossil fuels than would be the case if the renewables did not exist at all. Further, it points out-vividly-the dirty processes involved with creating wind and solar, most notably mining. The issues of disposing of derelict wind and solar facilities are touched on too, though that could have been beefed up some.

If you know about wind and solar, these things are hardly news to you. But for environmentalists to acknowledge that reality, and criticize green icons for perpetrating frauds in promoting these wildly inefficient forms of energy, is news.

The most important part of the film is its brutal look at biomass. It makes two points. First, that although green power advocates usually talk about wind and solar, much of the actual “renewable” energy is produced by biomass, e.g., burning woodchips. In other words, it exposes the bait-and-switch huckersterism behind a lot of green energy promotion. You thought you were getting windmills? Sucker: you’re getting plants that burn down forests. You fucked up! You trusted us!

Second, that biomass is hardly renewable (hence the quote marks above), and results in huge environmental damage. Yes, trees can regrow, but not as fast as biomass plants burn them. Moreover, the destruction of forests is truly devastating to wildlife and to irreplaceable habitats, and to the ostensible purpose of renewables–reduction of CO2.

The film also points out the massive corporate involvement in green energy, and this represents its weakest point. Corporations, like bank robbers, go where the money is. But that begs the question: Why is there money in horribly inefficient renewables? Answer: Because of government subsidies.

Alas, the movie only touches briefly on this reality. Perhaps that is a bridge too far for socialists like Moore. But he (and Gibbs and Zehner) really want to stop what they rightly view as the environmental and economic folly of renewables, they have to turn off the money tap. That requires attacking the government-corporate-environmentalist iron triangle on all three sides, not just two.

I am not a believer in the underlying premise of the movie, viz., that there are too many people consuming too much stuff, and if we don’t reduce people and how much they consume, the planet will collapse. That’s a dubious neo-Malthusian mindset. But put that aside. It’s a great thing that even hard core environmentalists call bull on the monstrosity that is green/renewable energy, and point out the hypocrisy and fundamental dishonesty of those who hype it.

My second candidate is long-time target Elon Musk. He has come out as a vocal opponent to lockdowns, and a vocal advocate for liberty.

Now I know that Elon is talking his book. Especially with competitors starting up their plants in the Midwest, the lockdown in California that has idled Musk’s Fremont manufacturing facility is costing Tesla money. But whatever. The point is that he is forcefully pointing out the huge economic costs of lockdowns, and their immense detrimental impact on personal liberty earns him some newfound respect, strange or otherwise.

Lastly, Angela Merkel. She has taken a much more balanced approach to Covid-19 than most other national leaders. Perhaps most importantly, she has clearly been trying to navigate the tradeoff between health, economic well-being, and liberty. Rather than moving the goalposts when previous criteria for evaluating lockdowns had been met, when it became clear that the epidemic was not as severe in Germany as had been feared, and that the economic consequences were huge, and that children were neither potential sufferers or spreaders, she pivoted to reopening quickly and pretty rationally.

The same cannot be said in other major countries, including the UK and France as notable examples. She comes off well in comparison to Trump, although the comparison is not completely fair. Trump only has the bully pulpit to work with, for one thing: actual power is wielded by governors. But Trump’s use of the bully pulpit has been poor. Moreover, he has deferred far too much to execrable “experts,” most notably the slippery Dr. Fauci, who has been on the opposite sides of every policy decision (Masks? Yes! Masks? No! Crisis? Yes! Crisis? No!), is utterly incapable of and in fact disdainful of balancing health vs. economics and liberty, and who brings to the table a record of failure that Neil Ferguson could envy, for its duration if nothing else. The Peter Principle personified: he is clearly at the level of his incompetence, and due to the perversity of government, has remained at that level for decades.

Merkel’s performance is particulary outstanding when compared to those who wield the real power in the current crisis, American governors, especially those like Whittmer, Pritzker, Evers, Walz, Brown, Wolf, Cuomo, Murphy, Northam, and Newsom. These people are goalpost movers par excellence, and quite clearly find the unfettered exercise of power to be orgasmic.

It is embarrassing in the extreme to see the Germans–the Germans–be far more solicitous of freedom and choice than elected American officials, who seem to treat freedom–including the freedom to earn a livelihood–as an outrageous intrusion on their power and amour-propre.

Will this represent the new normal? Will SWP props for Moore, Merkel, and Musk become routine in the post- (hopefully) Covid era? I doubt it, but for today, I’m happy to give credit where credit is due.

Matt Levine wrote a typically amusing piece highlighting the role of Trade at Settle (TAS) contracts in the 4/20/20 oil futures debacle:

But actually a lot of oil changed hands at those negative prices. Not because a bunch of investors came to the market all at once looking to sell, and no one would buy from them at negative prices, but for a more technical reason. Some oil traders use “trade-at-settlement” contracts: Instead of buying (or selling) oil futures at the market price at the time of your trade, you agree in advance to buy (or sell) them at whatever the official 2:30 p.m. settlement price is that day. 1  This is a good trade, for you, if your job is to obtain the day’s settlement price: For instance, if you run an index fund or exchange-traded fund that is benchmarked to that price, using TAS futures guarantees you the benchmark price. If you invest in oil futures and your boss fires you if you miss the benchmark, you might use TAS futures, that sort of thing. If you are a savvy oil trader attuned to minute-by-minute changes in supply and demand and trying to capture as much value as possible from your skills, you’ll probably just trade the futures at their current prices, selling if the price is too high and buying if it’s too low. But a lot of oil traders are doing something else, something a bit more passive, and for them the ability to guarantee the settlement price is useful.

He goes on to ponder whether the TAS mechanism could be manipulated, and whether manipulation could have contributed to the settlement fire that Red Adair couldn’t have put out:

The basic pattern—agree in advance to buy (sell) stuff at the official settlement price at some fixed future time, and then sell (buy) a bunch of that stuff in the minutes leading up to the official settlement time with the effect of pushing down (up) the price at which you are buying (selling)—is incredibly common, and the gradation from “sensibly pre-hedging the exposure you will get at settlement” to “sloppily pre-hedging the exposure you will get at settlement” to “manipulating the market to push down the price you will get at settlement” is blurry. If you type in a chat room “lol I’m gonna pound out 500 contracts to push down the settlement price and make fortune on my TAS trades, I am really ripping those muppets’ faces off, hope I don’t go to prison bro, hashtag fraud hashtag crime hashtag manipulation,” you will get in trouble. But if you don’t type that, and you quietly sell the 500 contracts and the price goes down, then as far as anyone knows that was just pre-hedging.

So could somebody have popped CLK20 with a TASer last Monday?

Funny you should ask. I wrote a paper on TAS manipulation a while ago. My interest was sparked by the CFTC’s action against Dutch trading firm Optiver, which the agency accused of doing exactly the kind of thing Levine writes about in crude, gasoline, and heating oil futures back in March, 2008. You can read the complaint–and listen to some actual “ripping those muppets’ faces off” trader braggadocio.

How does manipulation work here? First, to make manipulation profitable, there has to be an asymmetric price response to purchases and sales. If the manipulator’s purchases impact prices the same as sales, just buying and selling a lot can’t move prices in a profitable direction. Indeed, the manipulator would have to pay transactions costs (crossing the spread, brokerage, etc.) and this would cause the trading to be unprofitable.

The model in the paper derives conditions under which purchases and sales of TAS have a smaller impact on prices than do trades in the underlying futures. The basic idea is that if information is short-lived, or if there is intense competition among informed traders, new information will be incorporated into prices very quickly. Under those circumstances, informed traders will not want to trade TAS: their information will already be incorporated into the price by the time settlement occurs. Thus, TAS is a mechanism that allows traders to signal that they are uninformed: many “muppets” choose to trade TAS, and the informed don’t. Thus, the price impact of TAS trades is smaller than the price impact of regular outright trades: trades move prices because of the possibility that they are motivated by private information, so trades that are unlikely to be privately informed move prices less than trades that are more likely to be so.

This creates the asymmetry that makes manipulation possible: the manipulator buys, say, the TAS and then sells in quantity immediately before and during the settlement period and profits as Levine describes.

This type of manipulation is particularly pernicious because manipulative trades have persistent price impacts because they cannot be distinguished from informed trades (or liquidity trades, for that matter). Note that in Optiver, prices did not reverse after the firm’s trades,

This strategy is likely to be particularly profitable when markets are relatively illiquid, as in an illiquid market outright trades have bigger price impacts. Liquidity (measured by the bid-ask spread, quantity at the top of the book, price impact coefficients, etc.) has plummeted for everything since the CovidCrisis began, and the decline in CL liquidity has been particularly pronounced. Moreover, contracts close to expiration are less liquid anyways. Add to this the extreme physical constraints (which mean that small shocks to fundamentals have big price impacts) and the raging uncertainty about the logistical situation at Cushing, and it is likely that small volumes at the settle could have big impacts on prices.

To this I would add that an unexpected shortfall in buy orders (due to shorts exercising market power) at the settle could have price impacts, and exacerbate the price impacts of sell orders by exacerbating order imbalances.

Thus, the potential for a big asymmetry in price impact was pronounced on that fatal Monday.

In sum, it is not implausible that the market did indeed get TASed. Or at the very least, a TASer jolt contributed to the collapse. (Sort of like in this video!)

A final remark on the economic benefits and costs of TAS trading. TAS is a form of “cream skimming”–i.e., the skimming off of uninformed order flow. This tends to make the order flow in the regular continuous market more toxic, which reduces liquidity in that market. For this reason, other cream skimming mechanisms used primarily in equity markets (payment for order flow, dark pools, block trades) are frequently criticized. (This is why some regulators, particular in Europe, have attempted to curb such activity and force more trading into “lit” venues.)

I showed in my Market Macrostructure paper that things aren’t so simple. If the regular market isn’t perfectly competitive, the increased competition from a cream skimming mechanism can improve welfare. Moreover, there are distributive effects here: the uninformed traders who can utilize the TAS mechanism (e.g., those who are hedging exposures tied to the settlement price) benefit, while uninformed traders who can’t lose. Informed traders can lose too. Moreover–and this is a point that is almost always overlooked–some informed trading is essentially rent seeking (e.g., trading on information that will be released shortly anyways, and accelerating its incorporation into prices has little effects on resource allocation decisions). Reducing rent seeking informed trading is a good thing.

All in all, the role of the TASer is yet another piece of the 4/20/20 WTI WTF puzzle. The forensic analysis of this entire episode will be fascinating.

Just another day at the Globex, folks. May WTI up a mere $49.88 on its last trading day at the time I write this paragraph, a while before the close. (Sorry, can’t calculate a percentage change . . . because the base number is negative!) That’s just sick. But at least it’s positive! ($12.25. No, $9.96. No . . .) (This reminds me of a story from Black Monday. My firm did a little index arb. We called the floor to get a price quote on the 19th. Our floor guy said “On this part of the pit it’s X. Over there it’s X+50. Over there it’s X-20. I have no fucking idea what the fucking price is.”)

But June has been crushed–down $7.35 (about 35 percent). Now the May-June spread is a mere $.83 contango. That makes as little sense as yesterday’s settling galactic contango (galactango!) of $57.06. (Note that June-July is trading at at $7.71 and July-August at $2.65.

I’m guessing that dynamic circuit breakers are impeding price movements, meaning that the prices we see are not necessarily market clearing prices at that instant.

A few follow-ons to yesterday’s post.

First, the modeling of the dynamics of a contract as it approaches expiration when the delivery supply/demand curve is inelastic, and some traders might have positions large enough to exploit those conditions to exercise market power, is extremely complicated. The only examples I am aware of are Cooper and Donaldson in the JFQA almost 30 years ago, and my paper in the Journal of Alternative Investments almost a decade ago.

Futures markets are (shockingly!) forward looking. Expectations and beliefs matter. There are coordination problems. If I believe everyone else on my side of the market is going to liquidate prior to expiration, I realize that the party on the other side of the contract will have no market power at expiration. So I should defer liquidating–which if everyone reasons the same way could lead to everyone getting caught in a long or sort manipulation at expiration. Or, if I believe everyone is going to stick it out to the end, I should get out earlier (which if everybody else does the same results in a stampede for the exits.)

In these situations, anything can happen, and the process of coordinating expectations and actions is likely to be chaotic. Cooper-Donaldson and Pirrong lay out some plausible stories (based on particular specifications of beliefs and the trading mechanism), but they are not the only stories. They mainly serve to highlight how game theoretic considerations can lead to very complex outcomes in situations with market power and inelasticity.

One thing that is sure is that these game theoretic considerations don’t matter much if the elasticities of delivery supply and demand are large. Then no individual can distort prices very much by delivering too much or taking delivery of too much. Then the coordination and expectations problems aren’t so relevant. However, when delivery supply or demand curves are very steep–as is the case in Cushing now due to the storage constraint–they become extremely relevant.

Perhaps one analogy is getting out of a theater. When there are many exits, there won’t be queues to get out and little chance of tragedy even if someone yells “fire.” If there is only one exit, however, hurried attempts of everyone to leave at once can lead to catastrophe. Moreover, perverse crowd dynamics occur in such situations. That’s where we were yesterday.

About 90 percent of open interest liquidated yesterday. That is why today is returning to some semblance of normality–the exit isn’t so crowded (because so many got trampled yesterday). But that begs the question of why the panicked rush yesterday? That’s where the game theoretic “anything could happen” answer is about the best we can do.

About that storage constraint. My post yesterday focused on someone with a large short futures position raising the specter of excessive deliveries by not liquidating that position, thereby triggering a cascade of descending offers until the short graciously accepted at a highly profitable price.

But there is another market power play possible here. A firm controlling storage could crash prices (and spreads) by withholding that capacity from the market. The most recent data from the EIA indicates about 55 mm bbl of oil storage at Cushing. That’s about 80 percent of nameplate capacity (also per EIA.). Due to operational constraints (e.g., need working space to move barrels in and out; can’t mix different grades in the same tank) that’s probably effectively full. Therefore, someone with ownership of a modest amount of space could withhold it drive up the spread. If that party had on a bull spread position . . .

Third, we are into Round Up the Usual Suspects mode:

And first in line is the US Oil ETF. There has been a lot of idiotic commentary about this. They were forced to take delivery! (Er, delivery notices aren’t possible before trading ends.) They were forced to dump huge numbers of contracts yesterday! (Er, they publish a regular roll schedule, and were out of the May a week before yesterday’s holocaust. They also report positions daily, and as of yesterday were 100 pct in the June.)

Not to say that USO can be implicated in hinky things going on in the June right now, but as for May–that dog don’t hunt.

Fourth–WTF, June WTI? Well, my best explanation is that the carnage in the May served to concentrate minds regarding June. No doubt risk managers, or risk systems, forced some longs out as the measured and perceived risk for June shot up yesterday. Others just decided that discretion was the better part of valor. The extremely unsettled positions no doubt impaired liquidity (i.e., just as some wanted to get out, others were constrained by risk limits formal or informal from getting in), leading to big price movements in response to these flows. If that’s a correct diagnosis, we should see something of a bounceback, but perhaps not too much given the perception (and reality) of an extremely asymmetric risk profile, with going into expiry short being a lot more dangerous than going into it long. (This is why expectations about future conditions at delivery can impact prices well before delivery.)

Fifth, on a personal note, in an illustration of the adage that the apple doesn’t fall far from the tree (and also of Merton’s Law of Multiples) my elder daughter Renee completely independently of me used “WTI WTF” in her daily market commentary yesterday. I’m so proud! She also raised the possibility of negative prices some time ago. Good call!

And I finish this just in time to bring you the final results. CLK goes off the board settling at $10.01, up a mere $47.64. CLM settles at $11.57, down -$8.86. The closing KM20 spread, $1.56.

Someday we’ll look back on this and . . . . Well, we’ll look back on it, anyways.

Today was one of the most epochal days in the history of oil trading, which is saying something. The front month May contract–which expires tomorrow (21 April, 2020)–(a) settled at a negative price of -$37.63, (b) declined $55.90 from the previous day’s settlement, and (c) exhibited a trading range of $58.17, which is about 3.5x Friday’s settlement price.

Even these eye-popping numbers don’t tell the full story. The last traded price was -$13.10. Note that the settlement price is based on the volume weighted average price during the last two minutes of trading, so an average price of $-37.63 in the last two minutes and a last traded price of -$13.10 means prices moved more that $25/bbl in these minutes.

And we’re not done yet! As I write at 1841 CDT, the price is up to -$5.00–an increase of $32.63.

That there’s what they call volatility, folks.

To put these numbers in perspective, the largest trading range on the any day of the last three trading days of CL contracts from 2000-2019 is $26.65, a day around the time of the financial crisis and the aftermath of Hurricane Ike (October 2008 contract): here’s what I wrote about that event. The median intra-day range on the last three days is $1.6, the mean is $1.5, and the standard deviation is $1.47. So we are around a 40 standard deviation event here.

The largest daily price change during the last 3 trading days is $16.37, with a median of $.73 and a standard deviation of $1.45.

The calendar spread is also extreme, settling at $58.06 between the June and the May. Meaning that if you had storage, you could get paid to take delivery, sell it forward, and lock in that $58.06 (net of what the storage costs you). I guess you could call that the megacontango.

All in all, a historically unprecedented day.

The proximate cause of these wild gyrations, and unprecedented negative prices is, of course, the collapse of demand and the looming exhaustion of storage space, including at the delivery point of Cushing, OK. But although this is a necessary condition for today’s events, it is not a full explanation.

The storage issue has been known for weeks, and discussed intensely. It had been priced in to a considerable degree: contango was already at a historically high level. What information about the availability of storage arrived between Friday and today? Unlikely to be anything that could cause such chaotic price movements.

The likely cause is the difficulty of liquidating about 100,000 open contracts (100 million barrels!) in such extreme technical conditions. It is plausible, and indeed likely, that strategic behavior–perhaps rising to the level of manipulation–is the major cause of how prices moved today against the background of conditions that were widely known on Friday.

Let me start out by noting that something similar, though not as extreme, occurred during the demand collapse and associated flooding of storage during the Financial Crisis. As I documented here, the expiries of the January, February, and March 2009 WTI contracts saw what were then historically unprecedented price collapses. So did other US grades of oil. Here’s a picture from the linked document:

The big downward spikes in the front month-back month spreads correspond with the days around expiry.

How does strategic behavior/market power/manipulation play into this? The model of short manipulation in my 1996 book (only $169 paperback–buy two!) and 1993 J. of Business article formalizes the argument, but the intuition is fairly straightforward. Manipulation exploits frictions and bottlenecks. (My article/book refer to “frictional manipulations.”). There is now a huge friction/bottleneck in Cushing–constrained storage. This bottleneck makes the demand curve for crude at Cushing extremely inelastic, and means that the movement of even small excess quantities of oil into that location will cause prices to decline dramatically.

In these conditions, a trader, or a group of traders with modest-sized short positions can exercise market power by delivering even a small amount of oil over and above the quantity that should flow to Cushing. This drives down the price and allows the trader or traders to cover his (their) position(s) at artificially low prices.

In this situation, the storage bottleneck is the gasoline, the exercise of the market power is the match. With 100,000,000 barrels of open long positions needing to liquidate, given the storage constraint, the resulting conflagration can be epic.

This is, at this stage, a hypothesis. It is a possible explanation of the beyond extreme movements observed today. Under the circumstances, it is a very plausible explanation, and one that deserves scrutiny. And given the amount of money that changed hands today (~$6 billion on a mark-to-market basis) I’m sure that it will get it.

The only parallel I can think of is the onion market in 1955, when the movement of a couple of superfluous carloads of onions into Chicago, and delivery thereof against futures, caused the price to crash below the cost of the bags that they had to be delivered in. There was no demand for the onions (being perishable, and people eat only so many hot dogs), so many of the excess plants ended up getting dumped into the Chicago River. (Which, in 1955, probably improved the water quality.) (Another irony being that Chicago means “stinky onions” in the Miami-Illinois Indian language.)

In 1955, demand was inelastic because onions are perishable (i.e., they can’t be stored). In a way, the lack of storage space makes oil perishable. Even if that analogy isn’t perfect, the economics are the same: an economic constraint (the non-storability of, or the lack of storage space) leads to extremely inelastic demand that makes short market power manipulation possible.

Tomorrow is the last trading day for CLK20. Strap it up! It’s going to be a wild ride.

A little more than a month ago, when the China virus was first wreaking havoc in the oil market, Vladimir Putin and Igor Sechin demurred when the Saudis requested an extension of OPEC+ oil cuts. Furious, the Saudis retaliated by promising to ramp up oil production by more than 1mbpd, and prices truly cratered.

No problem!, said Vladimir and Igor. This is part of our master plan to destroy US shale! (Never mind such “logic” is right out of Economics for Mouth Breathers.) Furthermore, Russia has ample financial reserves, and its government can ride out a long stretch of low prices. (The Russian people? Ha! Demonstrating the state-centric nature of Russian policymakers.) The ruble crashed. No worries! In fact this is GREAT for Russian oil producers, because their costs are in rubles and the weakening of the currency cushions the impact of a lower dollar oil price on revenues. (The Russian populace? Again Vova and Igor DGAS.)

But despite the bold talk (which in some ways reminded me of the old story about G. Gordon Liddy holding his palm over an open flame to prove how he could take pain without cracking), the magnitude of the collapse, and the possibility that it would endure, obviously caused considerable consternation in the Kremlin.

The first indication was when the Russians claimed that the Saudis had taken their action to harm US oil producers, a complete flip for Russia’s bragging that that’s why they were taking the hard line.

In the past few weeks, Trump cajoled the parties to the bargaining table, and yesterday–after overcoming a Mexican holdout–the parties agreed to a deal. And what a deal it is, involving Russia agreeing to cut production by 2.5mbpd–almost 23 percent–an amount 4 times what they refused to accept a little more than a month ago. (I also note that it flies in the face of repeated Russian statements over years saying that it was operationally impossible for them to cut more than trivial amounts.)

The Russians had insisted on formal commitments from the US to cut. Trump–who brokered this deal–said that US production would fall due to price declines. (True dat–I’ll try to provide some estimates tomorrow.). The Russians said that wasn’t good enough (apparently demonstrating an ignorance of the limited ability of the US government to force output reductions)–they wanted mandated cuts. But in the end, the deal was done, absent any formal US commitments.

In other words, Putin and Sechin cried uncle. Hell, they tapped out like an MMA fighter in a chokehold. This makes a mockery of their bold front of a month ago. I think it reveals that they were truly shocked by the Saudi reaction, and were desperate to find a way out, but they didn’t want to show it. They needed some sort of fig leaf, and Trump gave them one.

Now this is being spun as some sort of Putin master plan to curry favor with Trump to gain negotiating leverage on other issues.

All together now: Suuuurrrre it is, Vova. Suuurrrre. Trump don’t owe you–you owe him.

I oppose the deal, despite the fillip it will provide to the US oil industry. Artificially boosting oil prices will harm already devastated consumer economies (including the US). Further, this will potentially rejuvenate OPEC post-crisis. Again that would be good for the US oil industry, but not for the US.

I also wonder whether Putin (and the Saudis) will come back later with proposals to get the US government to take measures to reduce output in a coordinated fashion. Just how that would be done is rather mysterious. The only plausible measure that I could think of would be some sort of tax (either on production, or on exports). But this would require Congressional action–it’s not something Trump or any president could negotiate unilaterally–and I don’t see that happening.

But that’s for the future. In the present, Putin and Sechin reaped what they sowed. They thought they could force the Saudis into bearing the brunt of supporting oil prices, while they could continue to produce at capacity. The Saudis responded like it was 1986, and the resultant collapse in prices brought the brilliant schemes of the KGB masterminds crashing down. In the end, they had to capitulate. No matter how hard they try to spin it, it’s obvious that they did.

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

The collapse in oil prices is completely understandable. The co-movement in equity and bond yields is harder to fathom.

As I noted in a previous post, the initial sell-off in oil was driven by corona-related demand declines. One thing interesting at the time was that equities did not respond similarly, which suggested that the prevailing view was that the situation would be contained in China. The last few weeks, equities and bond yields caught up, presumably due to the spread of the virus outside of China (especially in Italy).

The main oil-related news was a big supply shock–the prospect for higher Saudi and Russian output. But this should be positive for the economy overall, and thus for equities. There does not seem to be any new virus-related news that would lead to predictions of a sharp reduction in incomes and output. So, by itself, the oil supply shock should not cause a large sell-off in equities and big buying of bonds. But that is what we are seeing.

One can imagine other channels, e.g., losses on oil positions causing liquidation of equity positions. But the oil markets likely aren’t large enough to trigger such a reaction, and this channel would require those who are long equities to be long oil too–and in a big way in both.

Focusing on the oil supply shock in particular, I wonder if Putin and the Russians expected the furious Saudi reaction. The ruble is down 5+ percent today. Amusingly, Russian cat’s paw Zerohedge is claiming that Putin is all copacetic with this, saying that Russia can survive $25/bbl oil prices for a decade.

This is putting a brave face on things. And those with long memories will recall similar statements during the 2008-2009 collapse–statements that proved laughably false.

It is also interesting to note that Russian expressions of confidence relate to the state budget. Maybe the fiscal frugality has indeed positioned the government to live lean. The populace, not so much. But that’s very revealing about the mindset of the Russian ruling class: it is all about the state, utterly state-centric, and largely dismissive of the citizenry. And it has been so, as long as there has been a Russia.

As a coda to the post on the bloodbath in oil. I remember how many Smart People claimed that Putin’s alliance with MbS’s Saudi Arabia was an act of strategic genius! Genius I say! The move of a 4 dimensional chess grandmaster. A move that went a long way to achieving Russian dominance in the Middle East, at the expense of the US.

Er, no. Like almost all of Putin’s moves, it was an act of short term opportunism, and one that was built on a foundation of sand (appropriate, given the locale). MbS was being equally opportunistic, and his and Putin’s short-term interests aligned. But cartels–and this was little more than a cartel with a little geopolitical gloss–are inherently unstable, and the interests of the colluders are inherently in conflict. Inevitably such condominiums collapse.

Inevitably.

And so has this one. It was merely a matter of time, and what the proximate cause of the collapse would be.

There was no enduring alignment of interests that would provide the basis for a strategic realignment. There was a momentary alignment of interests between oil ticks. A market shock (extremely unexpected, no doubt) smashed the delicate structure to pieces.

The furious Saudi reaction to the Russian move demonstrates how fleeting Putin’s gains were. MbS is well and truly pissed, and looking to take revenge.

The only question that remains is: who will drink whose milkshake?