Streetwise Professor

Two articles from Eurasia Daily Monitor on Turkmenistan provide some good news. The first is on China’s efforts to secure Turkmen gas. The second reports that Russia’s efforts to lock up Turkmenistan’s gas supplies and box out potential competitors–China, the West, and recently, the Indians–are running into difficulties:

In recent months Turkmenistan and Kazakhstan have been targeted by coordinated and escalated pressures from the United States, European Union, and Great Britain in favor of the sub-sea Trans-Caspian gas pipeline, the state-run RIA-Novosti news agency commented on October 19, adding that, since earlier this year, nearly 20 U.S. delegations have traveled to Turkmenistan. Maneuverings by potential gas consumers allow Russian neighbors to use the issue of alternative pipelines to prop-up their bargaining position in discussions on gas prices, the agency commented.

In the meantime, Ashgabat has other arguments to boost its bargaining position. On October 25, Berdimukhamedov announced that construction of a Turkmenistan-China gas pipeline would be an important factor in regional stability and development. He said bilateral cooperation, including energy, would top the agenda during Chinese Prime Minister Wen Jiabao’s upcoming visit to Turkmenistan (Xinhua, October 26).

It seems that the US and Europe are finally getting their acts together. The report of 20 US delegations to Turkmenistan is of particular interest.

As I’ve written often, it is in Turkmenistan’s interest to play the field and free itself from Russia’s–that is to say, Gazprom’s–grip on its gas supplies. And as I’ve also written many times, such a prospect is a dagger aimed at Gazprom’s–that is to say, Russia’s–heart. Given its declining production volumes, Gazprom desperately needs gas from Turkmenistan to meet its contractual commitments. And it needs the wide spread between the price at which it sells this gas to Europeans and the price at which it buys this gas from Turkmenistan in order to feed the many hogs at the Gazprom trough. To mix metaphors perhaps, Turkmenistan is the keystone of the Gazprom strategy, and if it crumbles (due to the construction of a Trans-Caspian pipeline, or a pipeline to China, or a pipeline to India via Afghanistan, or all three), the company will be in serious trouble.

There is a lot riding on this. And all directly involved know it–Putin et al most of all. I therefore expect the intensity of this set of the Great Game to ratchet up considerably in the coming months.

Via RIA Novosti (and JRL) I found additional details about the evaluation of Russia in the recent competitiveness rankings I blogged about yesterday:

“Despite the country’s large market size and improving macroeconomic management, Russia places 58th below other large European countries,” the World Economic Forum’s Global Competitiveness Index said. The country’s low position is mainly due to “weaknesses in its institutional environment and business standards, lack of government efficiency, lack of independence of the judiciary in meting out justice, and more general concerns about government favoritism in its dealings with
the private sector,” the report said.

The report also said the “environment for the protection of property rights is extremely poor and worsening” in Russia.

As I noted yesterday, the Competitiveness Index touts Russia’s potential (and the potential of other countries with large endowments of oil and other natural resources) because the stimulus from high commodities prices enhances macroeconomic stability and flows. But, in the case of Russia particularly, all of the negative factors listed above have become progressively worse as oil and metal prices have skyrocketed. This is not surprising, and indeed expected to anyone familiar with the corrosive effect of resource rents and the associated rent seeking on institutions, and hence on growth prospects.

Thus, the commodity boom has not been an unmixed blessing for Russia, and given the resource curse, it would be wrong to expect such a result. Hence my skepticism about the WEF’s conclusions, and its methodology, which apparently evaluates its various categories in isolation. It is a major oversight to fail to connect the resource boom with the concomitant institutional deterioration in Russia. As a result of this oversight, I think the WEF’s evaluations of the prospects of resource rich nations are fundamentally flawed.

A few quotes from a new paper by Art Durnev and Sergei Guriev are apposite in this context:

Recent literature [cites omitted] demonstrates that the resource curse is related to the deterioration of economic and political institutions. In particular, if resources are discovered in an economy with immature institutions, the resulting rent-seeking slows down or even reverses institutional development, which in turn, negatively affects growth. . . .

Our results therefore support the emerging consensus that slower growth in resource-rich economies may be explained by the negative impact of resource endowments on the development of economic and political institutions, which in turn suppresses economic growth.

Thus, though the WEF is to be complimented for its increased awareness of the important impact of institutional factors on competitiveness and growth, it still has some ways to go to understand the factors that strengthen institutions, or cause them to atrophy. Without a better understanding of these issues, its Index will present an incomplete–and arguably misleading–picture of the relative economic prospects of the world’s nations.

Yesterday I blogged about Chinese price controls on oil, and said that I wasn’t aware of any evidence of shortages/rationing, and hadn’t observed any lines, etc., on my trip to Beijing. Today’s WSJ provides that evidence:

Scarcities of diesel fuel are being reported in regions throughout China, forcing truckers to line up for supplies. The severity of the problem was further underscored by shortages in the capital of Beijing, which is traditionally kept well supplied. Several gas-station managers in the city’s suburbs said they had run out of some types of diesel and were rationing others.

Officials say the situation could worsen if not quickly resolved. A man was killed by another customer Tuesday morning after jumping a line to buy gasoline in the Henan Province city of Xinyang, local police said.

But, the article also notes that the Chinese government has heavily subsidized refiners: “China has given the country’s biggest refiner, China Petroleum & Chemical Corp., known as Sinopec, big subsidies at the end of the past two years to offset its losses.” The article also states: “Because of its special role in keeping China’s tanks full, Sinopec has been basically forced by the government to make up for any shortfalls. But some big players are suffering, too. Earlier in the week, Sinopec said it was under ‘tremendous’ pressure from the rising prices. ‘We will try the best to ensure a stable supply of fuel in the market, but it’s a big challenge for us,’ Sinopec’s chief financial officer, Dai Houliang, told reporters Monday.”

The article therefore suggests–though doesn’t make it completely clear–that there are price controls (which encourage consumption) but that through subsidies and compulsion (“Sinopec has been basically forced by the government to make up for any shortfalls”) Chinese refiners have supplied more fuel than they would like at the low controlled prices. They haven’t supplied quite enough to meet the entire demand at the artificially low prices, however, hence the lines/shortages.

Price controls, compulsion, and subsidies have different implications for the demand for crude. Depending on how China adjusts each of these policy instruments, the raising of the price ceilings could ease some pressure on the demand for oil.

The previous post quoted Vladimir Milov. This guy knows what he is talking about (from Kommersant via Johnson’s Russia List):

As to Russia’s participant of the discussion, Vladimir Milov, he recalled more than three-fold growth of government’s interest in private energy companies, which widened from 11.5 percent in 2004 to 38.9 percent today.

Asked to comment on results of the conference, Milov told Kommersant that there was no one to pursue common energy policy in Europe, as “this calls for the people with muscles.” “Today’s strategy of the Germans, Frenchmen, Italians and Austrians will make them bankrupt, if Gazprom has problems with supplies. As to the relations of the U.S. and Europe with Russia, they proved unprepared and overslept emergence of undemocratic regime in the RF,” Milov pointed out.

There’s really nothing to add.

This somewhat goofy article from Slate does contain something of interest:

China’s CPI rose 6.5 percent between August 2006 and August 2007, thanks in part to an 18.2 percent year-over-year increase in the price of food. Beijing has responded in part by telling government officials not to use the word inflation. But it is also taking action. The International Herald Tribune reported that China hasn’t permitted gasoline prices to rise since May 2006, when oil was about $70 per barrel. (Yesterday, oil closed at nearly $94 per barrel.) And in September, China froze prices on certain household staples.

The unanswered question here is how the price control is being managed. I didn’t notice any gas lines in Beijing when I visited there this summer, and haven’t read any stories about shortages. This suggests that refiners’ (e.g., Sinopec, CNPC) purchases of crude are being subsidized, or the refiners are being forced to produce sufficient gasoline to meet demand at the artificially low controlled price. If either is the case, there is some positive feedback going on here that is contributing to the higher world oil price. If either through subsidy or compulsion refiners are satisfying the excessive quantity of gasoline demanded (relative to the efficient quantity) at the artificially low price, the price control is contributing to an increase in the world demand for oil, thereby increasing the world oil price. That is, the price control on gasoline encourages consumption, bumping up world demand for oil, leading to higher prices.

Price controls on gasoline are not uncommon–I have read about such controls being in effect in Iran and Iraq, for instance, and would not be surprised if they were quite common. How these effect the world oil price depends on how the controls are implemented. If they reduce the incentive to refine crude into gasoline, because they are not offset by subsidies to refiners or forcing refiners to incur losses while supplying the excessive quantity demanded at the artificially low price, then these controls tend to reduce demand for crude and restrain prices. If, on the other hand, through subsidy or compulsion refiners are induced to meet the excessive quantity of gasoline demanded at the artificially low price, the price controls perversely increase the demand for crude, and thereby raise prices that consumers in non-price controlled countries pay.

I was quoted on a Marketplace story on the energy market regulation changes I blogged about yesterday. Nice to get the last word.

The CFTC is supporting Congressional efforts led by Sen. Levin of MI to pass legislation that would allow it to impose position limits and obtain position information on energy derivatives traded on ICE (and presumably other electronic OTC trading platforms) in order to prevent energy price manipulation:

The CFTC is seeking mandatory daily reporting to the agency of large ICE trades, limits on the number of ICE energy contracts a single trader could control and exchange rules to force a trader to unwind large contract positions.

To recycle a line I’ve used before, they want to reduce manipulation in the worst way–and they’ve found it. Position limits and position reporting are inefficient ways to reduce the frequency of manipulation, as compared to readily available alternatives. There are so many defects in these remedies, it’s hard to know where to begin.

For one thing, position limits must be set based using very crude information about the market conditions that will prevail when the position limits are in effect. Sometimes the limits will be too large to constrain much manipulative behavior. Other times, the limits will be smaller than necessary to combat manipulation, and will be so small that they constrain the legitimate activities of market participants.

This last effect is very important. It is economically efficient for some traders to accumulate large speculative positions. These speculators absorb risk from hedgers. Position limits constrain speculators’ ability to take on risk, meaning that hedgers will find it costlier to transfer risk to speculators. They will hedge less as a result. That’s a real cost.

I have just completed a paper that shows that even if position limits constrain manipulation, they reduce overall welfare because of they interfere with the efficient allocation of risk. In essence, position limits throw out the baby with the bath. Sure, they constrain the rent seeking, manipulative activities of speculators, but they also constrain speculators’ efficiency enhancing risk bearing function too. In the standard mean-variance/Anderson-Danthine hedging/speculation equilibrium model of my paper, the latter effect outweighs the former, and position limits reduce welfare. Thus, even if they are successful in reducing manipulation, that doesn’t mean that they’re good public policy.

This possibility has been totally ignored in the debate, such as it is, over position limits in energy. This reflects a general ignorance of the socially beneficial effects of speculation, and indeed, the hostility to speculation that has dominated the Congressional and regulatory intellect for decades (stretching back into the 19th century.) Risk transfer is a primary function of derivatives markets, and position limits interfere with this primary function. This is a real cost, but one that is too often ignored.

Position reporting wins no prizes for efficiency either. Presumably the theory is that the ability to monitor positions gives regulators the ability to identify incipient manipulations, and intervene before things get out of hand. Now let’s deal with the reality.

The first reality is that how big is big–i.e., how big a position must be before it poses a manipulative threat–depends on variable market conditions, and how the trader acts. Just seeing that somebody holds a big position tells you absolutely bupkus. As a result, regulators will start to scrutinize big positions only when price distortions become manifest in the marketplace. Well, by the time this happens, a lot of the damage is already done. Maybe the regulators can keep things from getting worse, but the idea of preventing manipulation before it affects prices is a pipe dream. Even when armed with position information, regulators only become engaged when price distortions become apparent.

And even when they intervene, there is no guarantee that they will succeed. They can jawbone, but sometimes regulators can be fooled, persuaded–or intimidated–into inaction by manipulators. Think that doesn’t happen? Want to buy a bridge?

Regulators can also be wrong, and it is important to remember that when attempting to intervene during an alleged manipulation regulators necessarily have worse information than is available after things play out. The manipulative “end game” (as I call it in my ’93 JOB piece on manipulation) often provides the most powerful information on whether a manipulation in fact occurred. For one thing, the price movements post-manipulation–the “burying the corpse” effect–often provide the strongest evidence that prices were distorted. (After a corner ends, the manipulated price collapses relative to other prices as the excess deliveries are dumped on the market. These deliveries are the “corpse” of the corner, and disposing of them is referred to in the biz as “burying the corpse.”) (And to reiterate, Bill, I didn’t make up that phrase. P. D. Armour did. Sorry for the inside humor, folks, but I couldn’t resist–although I did restrain myself from making a really cutting remark.) Also, the alleged manipulator’s behavior–whether he takes deliveries at prices that appear uneconomic–provides the strongest evidence on his motives and intent.

Errors are important. Regulators can intervene and force liquidations of large positions when there is really no manipulation, or they can fail to intervene when a manipulation is actually in progress. Both kinds of errors are costly. Given the lack of crucial information before things play out, for a given probability of one type of error, the other type of error is higher when regulators try to intervene before the fact than afterwards. As I’ll discuss momentarily, civil (or even criminal) sanctions imposed after the fact can utilize better information, reduce the frequency of one or both kinds of error, and reduce the frequency and severity more efficiently than early intervention.

Reporting is wasteful for other reasons too. It is costly to collect this information, most of which will never be needed to detect or prevent a manipulation.

Moreover, traders can avoid position limits and reporting by moving their activities into the non-electronic OTC market, using voice brokers or just bilateral deals with other traders. To the extent that it is more efficient to execute transactions electronically on a platform like ICE, this displacement of trading activity is inefficient (though it is a boon to voice brokers.)

So what is better? Dropping the hammer on manipulators after the fact, that’s what. Law and Economics scholars (notably Steve Shavell) have identified conditions under which deterrence through the imposition of sanctions ex post is more efficient than ex ante prevention. Most importantly, deterrence is efficient (relative to prevention) when the offense is detected with high probability, and malfeasors are not judgment proof.

Both conditions characterize manipulation in derivatives markets. As Judge Frank Easterbrook once wrote, an undetected manipulation is an unsuccessful manipulation. A successful manipulation distorts prices–and everybody in the market can observe it. Moreover, most manipulators are well heeled, and can pay legal judgments levied against them.

By waiting to act until after a putative manipulation runs its course, regulatory or judicial authorities–or private plaintiffs harmed by the manipulation–can rely on the best information available on the price impact of the manipulation–including the “burying the corpse” effect–and on the alleged manipulator’s actions. Thus, there should be fewer errors (incorrect convictions, or incorrect acquittals) after the fact than when regulators attempt to intervene during a suspected manipulation.

Litigation is expensive, to be sure. But the expenditures can be targeted, and only incurred when the harm occurs. Position information need only be collected via discovery when the evidence of a manipulation is manifest, and from the likely culprits (who can be identified pretty easily, as there is a lot of information about who is doing what is floating around the markets, and some manipulative behavior is hard to miss, e.g., who ends up owning all the deliverable supply.) This is cheaper than collecting information from everybody (virtually all of whom are completely innocent of anything) all the time (when usually nothing amiss is happening).

So, in a nutshell, deterrence rules, and position limits/reporting are for fools. And guess which way Congress and the CFTC are moving? Draw your own inferences, people; do I have to draw a map?

Ironically, the news about the Levin bill and the CFTC advocacy thereof comes almost simultaneously with the announcement that BP has agreed to pay $300 million(!) (subscription required) to settle civil charges that it manipulated the propane market in 2004, and that four BP traders are facing criminal charges (ditto) arising out of the same incident. I have mixed feelings about the criminal aspect of this case, but the imposition on a hefty fine on BP is the way to go as a way to deter this sort of conduct going forward. Three hundred large large is some major change–especially considering that the alleged (and I guess now admitted) BP corner attempt was apparently unprofitable because the company ended up with a much bigger corpse to bury than it had anticipated. Surely any trader contemplating cornering, squeezing, or hugging a market in the future will think once, twice, and a few more times, before squeezing the next time. It should also be noted that all this activity took place in the OTC market, and that it did not take place on ICE, or to my knowledge, any electronic trading platform. Nonetheless, the manipulation was identified, the culprit fingered, and the hammer brought down. No need for watching everybody all the time, most of said watching effort being completely unnecessary because much of the time manipulation isn’t a serious worry.

For those of you with way too much time on your hands, I have a much expanded analysis of the deterrence vs. prevention debate in my book The Economics, Law, and Public Policy of Market Power Manipulation. (Shameless plug! Now up to #1,302,119 on Amazon! Only 3 copies left! Order soon!) I also presented some rigorous numerical analysis of the power of detection ex post vs. ex ante in the working paper version of what eventually turned into my 2004 ALER article on the Ferruzzi squeeze. I think that version is still posted on my UH web page.

One last comment. I find the obsession with energy market manipulation to be somewhat curious. The US government has manipulation problems much closer to home–the US Treasury securities market. Manipulation problems in this market became so chronic in the early-2000s that two high ranking Treasury officials raised the subject in public speeches, and the FRBNY called bond market heavyweights to a Come-to-Jesus meeting, where the assembled congregation was sternly warned to go away and sin (that is, manipulate) no more. Despite the importance of the Treasury markets, and their size, Congressional interest in this problem seems de minimus as compared to the constant hyperventilating over energy market manipulation. Presumably this has to do with the fact that energy prices affect pretty much everybody, whereas the Treasury markets (especially the repo market) are pretty much inside baseball; Congress has to be seen Doing Something about energy prices even though there is little if any connection between persistently high energy prices and the kinds of manipulation that are allegedly the targets of legislation, and even though (as discussed above) the legislation is an inefficient way to reduce those kinds of manipulation.

I was thinking of inserting an apposite Mark Twain quote here (you probably know the one I’m thinking of), but won’t gild the lily. Like Mom says, if you can’t say anything nice . . . I know I’ve broken that rule a lot already in this post, but I’ll follow it just this once.

Correction. I wrote that to my knowledge, none of BP’s propane transactions were consummated on an electronic system. I took another look at the CFTC’s civil complaint against BP, and noticed that market participants utilized an electronic trading platform called Chalkboard to trade propane. I don’t know the breakdown of volume between voice brokers and Chalkboard.

Crain’s Chicago Business reports that several analysts are touting a potential CME-NYMEX merger. Crain’s cautions that it has no indications that talks are underway, and both exchanges declined comment. Nonetheless, it is clear that the compelling economics of the transaction, which I have been pointing out since early-2006, are becoming widely understood.

Interestingly, NYMEX’s stock price has been relatively flat in recent months, while CME’s has appreciated dramatically to all time highs–up $40/share since early August, and rallying over $80/share since late September after a sell-off earlier in the month. The CME’s warchest is therefore bulging, and CME is more than able to swallow NYMEX. Antitrust considerations would most likely stymie CME’s nemesis in the CBT merger–ICE–in its pursuit of NYMEX. Thus, CME’s most likely competition would be NYSE/Euronext, and Thain is desperate to get into derivatives, but I still give CME the leg up due to the fact that NYMEX contracts already trade on CME’s Globex.

The article also suggests that CME is looking abroad–to exchanges like Brazil’s BM&F. Given CME’s financial heft and management, in my opinion the exchange can do both. So, my guess is that in early ’08 we’ll see CME make a bid for NYMEX, and perhaps BM&F as well. NYMEX is the prize, though, and I expect the CME to focus there first.

Recently Condeleezza Rice met with Turkmenistan’s president Gurbanguly Berdymukhamedov. Energy was high on the agenda. In addition, I understand that a delegation of Turkmen energy personnel visited Houston to meet with US energy companies.

In earlier posts I bemoaned the lack of high level contacts between the US and Turkmenistan, so I am pleased that that the State Department is attempting to rectify this error. Hopefully it is not too late. There are some signs that Putin’s momentum in Central Asia–which looked so unstoppable after his extended state visits there in May–is slowing somewhat. Perhaps continued high level involvement by US and European governments can reverse it altogether. It is in both Turkmenistan’s and Europe’s interest to break Russia’s/Gazprom’s stranglehold on Turkmenistan’s gas reserves. So let’s keep on the pressure.

James Hamilton is a great econometrician, and has written importan tpapers on the relation between oil and the economy. He blogs periodically on the oil market. Yesterday he posted this piece on backwardation. Like my piece, he discusses Ann Davis’s WSJ piece. Overall, I think Hamilton’s take is reasonable, although he does engage in one of my pet peeves, by attributing the increase in storage to the contango in the market. As I noted yesterday, prices and inventories are both endogenous, and determined simultaneously. As the Welfare Theorems show, in a competitive market prices adjust to induce agents to take the first best actions. Therefore, saying that “storage increased because the market moved into contango” is an incomplete analysis. One must push the analysis back one step to understand what economic forces made it optimal to increase the amount of oil in inventory. When talking about forward curves, the key forces are market tightness today relative to expected future tightness.

Hamilton’s post reproduces the graph of oil forward curves (from last week and a year prior) that ran in the WSJ. The interesting thing about the graph is that when the market was in contango a year ago, distant dated forward prices were substantially lower than they are today when the market is backwardated. This illustrates an important point; it is not the level of market tightness per se that drives backwardation or contango. It is tightness today relative to what is expected in the future.