Streetwise Professor

In “Care to Dance the Contango?” I analyzed in some detail the movement of the oil into contango–where prices for future delivery are above nearby “spot” prices. Consistent with the theory of storage, the move to contango coincided with massive increases in the amount of oil in storage.

Now, the market for oil has moved into backwardation–the typical state of the market since the birth of crude futures trading in the early-1980s. And, surprise, surprise, inventories of oil have fallen. The theory of storage strikes again.

This movement in oil inventories and prices was discussed in a recent WSJ article (subscription only). There are glimpses of economic sense in the article, but there is a lot of nonsense too. I doubt that the lay reader could make heads or tails on why inventories have fallen. One problem is that prices and quantities are determined simultaneously, but author Ann Davis makes statements about price structures causing inventory levels. Most importantly, the article Rounds Up the Usual Suspects–speculators–and attributes the movements between contango and backwardation to their whims.

Speculators participate in the market, and big financial firms such as Morgan Stanley have staked out big positions in the physical oil business. But speculators are responding to fundamental economic conditions, not dictating prices to move contrary to levels and structures justified by fundamentals.

As I noted in “Care to Dance,” the move to contango was a rational response to fundamental market conditions. The oil forward curve goes into contango when the current supply is abundant relative to expected future supply (or, put differently, when the current supply/demand balance is less tight than anticipated supply/demand balance.) Given the widespread anticipation in late-2005 of repeated hurricane-caused supply interruptions in the Gulf of Mexico; geopolitical unrest in the Middle East, Nigeria, and Venezuela in 2005-2006; and expectations of robust world growth in the future, as tight as supply conditions were in fall 2005, it was reasonable to believe that supply conditions would become even tighter in the future. Under these conditions, holding higher precautionary inventories was economically efficient; inventories rose accordingly; and the market moved into contango.

In recent months, the most acute fears of future supply disruptions due to hurricanes, political unrest, etc., have dissipated, and the subprime crisis has reduced expectations for future economic growth. Under these conditions, precautionary stocks needn’t be as large. Hence, we’ve seen the drawdown in stocks and the concomitant move of the forward curve into backwardation.

Speculators are an important part of this process. It is their job to assess market conditions and take positions accordingly. They are essentially conveyor belts that transform diffuse information about current and future supply and demand fundamentals into real economic decisions that affect prices and quantities. They are not always right of course, when viewed retrospectively, but that’s because the world is an unpredictable place and the best information today only imperfectly forecasts the future. But speculators are responding to market conditions, and the market is a harsh taskmaster. There are rich rewards to being right, and harsh punishments for being wrong. So, rather than lazily attributing any movement in prices and quantities to the deus ex machina of speculators, it would be far better if journalists and other analysts would think a little more thoroughly about the fundamental economic forces that really drive markets–and speculators.

Putin’s recent announcement about his intention to become prime minister has touched off a good deal of speculation that he will retain his existing dominance over Russian politics but merely change the chair in which he sits. Color me skeptical.

The presidentialism of the Russian political system, established under Yeltsin and solidified under Putin, places all the formal levers of power in the hands of the president. In this system, the prime minister is combination sock puppet and scapegoat–there to dutifully echo the President, and to take the blame when things go wrong. Today, the President controls the two most important sources of power in Russia–the special services and the state media. Although Putin has no doubt placed cronies throughout both, and throughout the other administrative sources of power in Russia, the loyalty of these people is inherently suspect. Particularly in a system like Russia’s, what loyalty there is attaches to the person in power who can reward and punish; transfer those powers from one person to another, and the loyalty transfers with it. In Russia, it is the president that wields these powers, and Putin’s current personal popularity will not change this fact.

Perhaps Putin is so taken by his current popular standing that he believes that the power he wields will adhere to his person, regardless of the office he holds. I doubt this. I think that he knows that he must remain President, and that if he does not, his successor will neuter him–or worse.

Hence, I am putting my money on some scenario likethis one laid out in Eurasia Daily Monitor in an article by Charles Gunn. That is, Putin will utilize some sort of political conjuring trick to adhere to the letter of the constitution, but remain as president for years to come.

Which brings us to another curious development–the public revelation of a “clan war” between rival security services, the FSB and the Russian narcotics police, Gosnarkokontrol. The rivalries between factions within the Kremlin have been widely rumored, but have remained largely below the surface, especially to Western Eyes (apologies to Joseph Conrad.) The fact of the conflict is not surprising–after all, turf wars among mobsters are to be expected. The publicity is something of a surprise . . . but maybe not, when one considers it in the context of succession.

Internecine warfare among Kremlin clans could provide a reason, a pretext, and maybe even part of a plan, for Putin to remain in power. Even if Putin had nothing to do with fomenting, or even publicizing, the conflict, it should make him and others around him acutely aware of the chaos that could await if he is unable to maintain an iron grip upon leaving the Presidency. A weak successor, although attractive to Putin from some perspectives, would be less able to stamp out such infighting, which could quickly spin out of control, thereby endangering the power, the fortunes–and the lives–of the siloviki, Putin included. This is good reason–and at least a good pretext–for Putin to engage in some maneuver to retain power. Moreover, such a move would attract widespread support from many of the siloviki fearing for their lives, fortunes and (choke) sacred honor.

Perhaps Putin had nothing to do with the outbreak of hostilities between FSB and Gosnarkokontrol, and will simply find this a compelling reason to do what is necessary to retain Presidential powers. Perhaps he had nothing to do with the hostilities, but opportunistically encouraged their rather shocking airing in order to build a case, a pretext, for retaining these powers. Or perhaps he actually fomented this incident as a Machiavellian maneuver. I discount, though not completely, this last alternative, but believe that Putin will use this incident and its publicity as part of his campaign to retain power.

A riddle, a mystery, an enigma, indeed.

Examining Figure 2 from this article on the Russian energy economy by Gaddy reminds me of the old Johnny Cash song “Cocaine Blues”:

Early one mornin’ while makin’ the rounds
I took a shot of cocaine and I shot my woman down
I went right home and I went to bed
I stuck that lovin’ .44 beneath my head

Got up next mornin’ and I grabbed that gun
Took a shot of cocaine and away I run
Made a good run but I ran too slow
They overtook me down in Juarez, Mexico

The graph depicts Gaddy’s estimates of the energy rents accruing to the Soviet–and Russian–economy. Each of the two spikes in the graph corresponds to a period of Soviet/Russian adventurism. The first shot of oil/cocaine during the 1970s oil shock fueled Soviet aggressiveness around the world. The second oil/cocaine shot–the post-2003 runup in oil prices–is powering Putin’s recent revanchism.

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

This WSJ article (subscription required) warns about Russia’s creation of an oil exchange that will “shift energy business away from existing global financial centers.” St. Petersburg’s historic Greek Revival Bourse building is being restored to house it. Author Judy Shelton says that this is just one effort among many by Putin to challenge America’s (and to a lesser degree Europe’s) global financial primacy.

My fearless prediction: within months of its opening, you will hear crickets chirping on the trading floor. I base my prediction on two factors, one common to all attempts to start new exchanges, one specific to Russia and other nations that do not respect property rights and which are dominated by lawless governments.

The universal problem is liquidity. It is notoriously difficult to start a new market, or to launch a new contract, especially in competition with existing markets. This is due to the difficulty of attracting liquidity. As a result of the Catch-22 nature of liquidity, nobody wants to enter a market where no one else is trading. Potential traders are like Alphonse and Gaston, each waiting for the other to go first.

There is an excellent example of this right now in the very oil market that Russia hopes to enter. The world’s oil supply is increasingly sour and heavy, but both major pricing benchmarks—Brent and WTI—are sweet and light. Thus, oil traders, producers, consumers, and marketers have been seeking a viable sour/heavy price benchmark and hedging vehicle. Both ICE and the Dubai Commodity Exchange (“DCE”) launched Middle East crude contracts (tied to Omani crude) that would meet these needs. After the typical initial flurry of activity, volume in both contracts has declined dramatically, and ICE has pulled its contract. These problems follow the pattern of earlier failed attempts to launch a heavy/sour contract (NYMEX tried back in the 1990s.)

Both ICE and DCE are excellent exchanges operating under secure legal and contractual regimes. Both have spent a lot of money designing, developing, and marketing their contracts. Despite these efforts, both contracts have withered, and I have little faith that this trend will be reversed.

The specifically Russian problem? That should be problems, plural. Futures and commodity markets are markets for promises. If there is even a modicum of doubt that contractual promises will be honored, a futures market cannot develop. Russia’s lack of a rule of law, and its recent flouting of laws and contracts, creates a something well beyond a modicum of doubt regarding the sanctity of contractual commitments.

One can easily imagine scenarios in which contracts are abrogated or undermined. Let’s say that a politically connected individual or firm (a member of the siloviki, for instance, or Rosneft or Gazprom) takes a big position that loses a lot of money. The loser raises a hue and cry that the market has been manipulated, and a sympathetic government (which may include people with a direct financial interest in the losing company, or who can be “persuaded” with a well-placed gratuity) brings its investigative and police powers to bear. It finds manipulation, and either explicitly abrogates the contracts, or exerts pressure that leads to a “negotiated” settlement that makes the loser whole—and maybe even more than whole. This outcome is particularly likely if the party on the right side of the market happens to be a foreigner.

If you think this is far-fetched, you obviously haven’t been paying attention to the way that Putinworld works, cf. Yukos, Rusoil, Ukrainian gas, Sakhalin II, BP/TNK, maybe Sakhalin I, etc.

And speaking of manipulation, let’s turn the example on its head. A playah—a Rosneft or a Gazprom—has incredible leverage through its control of physical assets to manipulate prices. Consider this very real possibility: Remember that pipeline that is the source of deliveries against the futures contract? Well, it just sprung a leak, and darn it, we really don’t know how long it will take to fix. So deliverable supply has just gone to zero. And wouldn’t you know it, we just happen to be long. Sorry about that, suckers . . . we mean shorts. Better luck next time. Or a connected a firm can just run the tried-and-true squeeze play.

In either instance, is there any reason to believe—any at all—that the Russian authorities would intervene, or impose penalties on the connected malefactor?

As a quick example, I read some months ago how Gazprom was using its market power to hammer the Russian electricity behemoth EES. (I also read another article that specifically discussed a gas auction which resulted in EES paying much higher prices. There were allegations that Gazprom withheld output from the auction. It’s in my clip files–I’ll try to dig it out.) Were there consequences? Surely you jest.

Moreover, although the Russian government is no doubt happy now that oil markets are establishing high prices, but will it be so happy if (and I should actually say “when”) the worm turns, and prices move lower? The government’s temptation to interfere with the market, or to shut it down, will be very great. Shooting the messenger is not unknown in Russia (and unfortunately, the shooting is arguably not just metaphorical.) The government may like the market’s message now, but will not like it nearly so much in the event of a price decline, and in my view it is highly likely to act aggressively in that event. This is another major political risk that will impede the development of an open oil trading market in Russia.

Vertical integration is another obstacle to a successful Russian energy futures market. Vertical integration impedes the development of a viable futures market. There are fewer arms-length transactions that need to be priced and hedged in a highly integrated chain, as opposed to a dis-integrated one. Energy trading is all about identifying and pricing transformations in space, time, and product. These transformations are internalized in an integrated structure, and hence there are fewer trading opportunities.

The Russian energy infrastructure is already highly integrated, and becoming even more so as the result of conscious political decisions, rather than economic forces. The “power vertical” in the energy industry means that vertical integration is the dominant form of organization in Russian energy. Indeed, Russia is trying to integrate extensively into marketing, distribution, transportation, and refining outside of Russia. This integration will impede the development of a Russian energy exchange.

Information asymmetry is another impediment to the development of a liquid market. The notorious lack of transparency in Russia aggravates information asymmetries. And there is incredible opacity obscuring the kinds of information that are particularly important in Russia—such as political information and operational information relating to the Russian energy infrastructure. Energy has been identified as a primary pillar of Russian state security, and the aggressive use of state secrecy and espionage laws that has characterized Russia in recent years strongly suggests that these laws could readily be directed against those attempting to ferret out price-relevant information in the energy market. Indeed, since information advantages would tend to redound to the politically connected in Russia, there is a direct economic incentive to use the state’s powers to preserve those information advantages.

In sum, launching a new exchange is hard enough in a country subject to the rule of law, with independent enforcers and a tort system available to crack down on manipulators, a culture of transparency, and a relatively unintegrated market structure. The fundamental defects of Russia’s political, regulatory, and economic structure make the prospects for an energy exchange dim indeed. Inside a cave at midnight dim. And this is true in spades for Iran, another country that has made noises about starting an oil bourse to undermine American economic hegemony.

So, it’s nice and all that a historic building with ties to Russia’s financial past is being refurbished. It is a nice symbol of the demise of communism, and of the fact that Russia is at least paying lip service to markets. But don’t expect much of consequence beyond the architectural preservation/revitalization. A la the military posing I analyzed in an earlier post, this seems just another Potemkin moment. Viable markets need the appropriate institutional and legal infrastructure, and those are woefully underdeveloped in modern Russia–when, indeed, they are not actively undermined by the actions of the state and politically connected companies.

Recently it was disclosed that Gazprom and Rosneft were given permission to form their own armed security forces. Does this mean that the companies believe that the state is unable to protect them from security threats? Or is it perhaps that they are most worried about threats from within the state? In a country where the state is the biggest threat to property rights, and many disputes are settled with violence or threats of violence, vertical integration into security (and the potential for violence) is individually rational. That is, for a company like Gazprom it makes sense to provide its own “roof.”

Although this is rational for a company in Russia, this decentralization of violence potential is symptomatic of an unhealthy state. In a state where the capacity for violence is subject to the rule of law, and those who control this capacity are constrained from using it for economic or political advantage, large and profitable companies have no need for their own paramilitaries. Such forces are much more valuable when those conditions are not met. The creation of Gazprom and Rosneft militias speaks volumes about the security of property rights and the reliability/trustworthiness of state security forces in Russia.

Recent weeks have seen the continuation of the methodical march of Putinism and Russian resource nationalism. BP surrenders Kovytka. Gazprom and the Russian government (is there a difference?) begin making noises about elbowing their way into ExxonMobil’s Sakhalin I project (heretofore largely thought immune to predation). And in today’s Eurasian Daily Monitor, Vlad Socor reports that Transneft–Russia’s oil pipeline monopoly–is squeezing the Caspian Pipeline Consortium through demands for renegotiation of existing deals and demands for new capital, with demands backed up by the old standby–outrageous bills for back taxes.

The craven behavior of BP and Shell in the face of Putin’s predations at their expense has undoubtedly emboldened the Russians to take additional steps. Similarly, the sotto voce responses of the Eurowimps are also music to Putin’s ears. When will Europe awaken to the tightening grip of the Russian python?

The losers here are not just the shareholders of integrated oil majors, or American or European consumers of gasoline and natural gas. Though they may not realize it now, it will soon become apparent to the Russian people that they will be the biggest losers. I have been reading every political economy book that discusses the role of a nation’s resource endowment on its political structure that I can get my hands on. This research emphasizes a theme that I have explored before on SWP, namely that rent intensive economies (notably those with outsized endowments of natural resources) are prone to authoritarianism and dictatorship, and that increasing economic inequality and the suppression of commercial and political activity go hand in hand with growing state control over the natural resource sector. Thus, though the energy boom (and the nickel boom and the copper boom and the aluminum boom and the gold boom) will enrich the “elite” (though referring in that way to the thuggish siloviki who rule Russia sounds discordant) with access to the rents, it will condemn most Russians to a penurious economic future and a deprivation of their civil and political liberties.

To follow Putinism is to watch these theories in action. They describe Russian political developments post-2000 to a “T.” The most depressing thing is that inasmuch as these models characterize stable equilibria as a function of underlying endowments, it is unlikely that Russia will leave this trajectory. Revolution and violence are possible, but the likely results of such an explosion would mainly be (a) much death and destruction, and (b) a replacement of the old set of rent parasites with a new set. So, it is well to wish the destruction of Putinism, it is far harder even to imagine how that can be accomplished.

This is particularly true because Putin is doing the basic blocking and tackling needed to secure an authoritarian regime. The moves to revise the history textbooks provided to Russian primary and secondary students and Putin’s historical revisionism (e.g., his assertions that Russia and the USSR have a pristine record as compared to those blood-stained Americans) represent classical authoritarian moves to control the future by controlling the past. Presenting a unifying historical narrative congenial to the regime and suppressing the voicing of any alternative, more discordant, narrative reduces the costs of maintaining control. Similarly, the harassment and sometimes suppression of any non-state organization that could serve as a focal point for collective action directed against the regime is a traditional means of retaining and strengthening control. The atomization of Russian society, and the replacement of myriad spontaneous and organic links of individuals and groups across society with managed vertical relations intermediated by the state and its creatures (a wheel and spoke vs. a network model of society) cripple the formation of alternative sources of power and influence that can challenge the regime.

Not a happy vision, indeed. But Western nations need to develop a Russian policy based on a sober assessment of current realities, and likely future developments. Happy talk in Kennebunkport, or pitiful plaints about the desire for normal relations with Russia, or craven energy executives opening their wallets just after Putin took their watches, are all manifestations of denial. A denial of the reality of “modern” Russia (which is oh-so-much like not-so-modern Russia, and pre-modern Russia). Until the scales drop from European and American eyes, and they devise policies that deal with realities rather than deny them, Putin will march from triumph to triumph. It is unlikely that Putinsim–which is just a latter-day Russian version of natural resource sustained authoritarianism–can be quashed completely, and Russia transformed into a liberal (in the classical sense) modern state and civil society. However, unified resistance can mitigate its more deleterious consequences (at least for non-Russians.) As long as short sighted, commercial interests drive European policy in particular, however, such resistance is unlikely to arise.

Collective action is needed, but collective action is always difficult due to free riding and rent seeking. The entire justification for a European Union is its purported ability to facilitate collective action on matters of common interest and concern. Insofar as Russia policy is concerned, it has failed miserably in this task. The “interests” of individual states, and more shockingly, individual companies within these states (most notably German and Italian), have precluded any robust collective response to Putin’s march. Until that changes, Putin wins, and Russians (and myriad others) lose.

I write this on the plane (Business First is the way to go!) returning from a 2 week stay in Beijing, where I taught a course in energy risk management to executives from the two largest Chinese oil companies, Sinopec and PetroChina. My involvement with these two national oil companies (NOCs) sparked some thinking about NOCs in general, and the future role of the private integrated oil majors (IOMs).

It is well known that NOCs are playing an increasingly important role in the world oil and gas markets. Indeed, they increasingly control the reserves, and the access thereto. It is also well known that the NOCs lack the technical expertise of the IOMs, especially when it comes to exploring, developing and operating more challenging fields (e.g., deep water offshore) which will be the source of an increasing fraction of the world’s growing energy needs. Absent access to the technical expertise of IOMs, NOCs will be unable to produce as much oil, with predictable—and unpleasant—implications for oil prices.

Can NOCs obtain the requisite technical expertise under contracts that do not provide an equity share to output? (This is what Russia is trying to do, as with its recent announcement of the deal with Total to develop the Shtokman field.) They can obtain some technical expertise in this way, no doubt, but there are compelling reasons to believe that vertical integration is efficient in oil exploration, development and production. As a result, there will be a substantial efficiency loss when NOCs produce and own output, and acquire technical support via contracts with IOMs that do not extend equity rights to the latter.

Integration is efficient due to the nature of the process of exploring for and developing oil reserves. Especially with regards to technically challenging projects, such as deepwater fields, oil exploration and development are informationally intensive. Moreover, a good deal of this process involves identifying and exploiting real options. As information is produced during the process of exploration and development, it is used to make decisions about how to proceed going forward. The IOM has a substantial advantage not only in generating the information, but in knowing how to utilize that information to make better decisions about the exercise of real options.

There is no way in hell to write a contract that provides the owner of the technical expertise (e.g., an IOM) with the incentive to utilize this information optimally. This is true for a variety of reasons. First, the contingencies are too numerous and too difficult to specify ex ante, hence any contract will be incomplete. Moreover, even if the parties were to attempt to specify such contingencies, due to the technical complexities, they would be nigh impossible for third parties to verify. It is well known that the inability to verify also contributes to incompleteness.

Integration greatly mitigates this problem. The owner of the knowledge captures the value of using it efficiently because it also owns the output—the oil and gas. It internalizes the benefits of better decisions.

It should also be noted that there are arguably far more imposing barriers to transferring information across firm boundaries than within firms (although transfer within firms is not free either.) Again, issues of verifiability and completeness confound addressing information transfer by contract.

Thus, we are confronted with a dispiriting state of affairs. Those who own the reserves are loath to provide equity rights therein to those with the information and expertise. Maximizing the value of those reserves requires allowing those with the information and expertise to utilize that information to exercise the myriad real options in an oil or gas project efficiently. Equity ownership of production—integration—is an efficient way of providing incentives to those with the information and expertise to use it effectively. The incentives are inherently much weaker when the reserve owning NOCs merely contract for services from the IOMs with the information and knowledge. This translates into lower output and higher prices.

Not that equity ownership is a panacea when opportunism is unchecked. Equity rights have never been secure, and they are less so now (witness the expropriations in Russia and Venezuela.)

Is integration gone forever? Probably not. The deadweight losses that will arise as NOCs attempt to acquire IOM expertise without giving equity rights will provide an incentive for a major rethink. For instance, Mexico’s autarkic energy policy is leading the country’s oil industry to a precipice with dire financial consequences for the government. Resource nationalism may feel good, but it don’t pay the bills. Even when this realization dawns on even the most reflexive nationalist demagogue, and reserve owners permit some form of equity participation by those with the know-how, we won’t be in Nirvana due to the tenuous nature of these equity rights when expropriation is a threat.

This all has interesting implications for another subject of interest—energy policy as a response to purported anthropogenic climate change. Proposals for taxation of hydrocarbons (or direct controls on consumption through cap-and-trade or CAFÉ-type policies) are premised on the assumption that it is necessary to raise the costs of oil consumption to offset the effects of environmental/climate externalities. But hydrocarbons are already heavily taxed. Moreover, the foregoing argument implies that the insecurity of property rights in energy production and the inefficiencies of acquiring exploration and development expertise through contract are reducing oil output, and will reduce it even more in the future. These inefficiencies in property rights and organization are effectively implicit taxes on hydrocarbon production. It may well be the case that even when one takes environmental impacts into account, oil and gas output is too low today because the explicit and implicit taxes are bigger than the efficient tax. Certainly, arguing for higher hydrocarbon taxes based on a tacit assumption that environmental externalities are the only distortion in energy production and consumption (which seems to be the case, as existing explicit and implicit taxes are almost never mentioned in this debate) is bad economics.

The distortions arising from insecure and inefficient property rights in oil exploration, development, and production are real, and likely to become larger in the future. These costs should be accounted for in any policy decisions on carbon taxes. So far, I have seen no evidence that this subject has even been mooted, let alone considered seriously. This bodes ill for effective energy policy in an age of climate change hysteria.

It’s a bummer (grew up in the 70s? who? me?) to have to read about the approval of the CBT-CME merger from distant China, where I am teaching until mid-July. But it’s good news nonetheless. Things played out pretty well as I forecast, with CME bumping its bid at the last minute, and ICE folding because it just couldn’t afford to overcome the CME’s efficiency advantages. Congratulations to the managements of both exchanges, and to their owner-members.

Although this brings down the curtain on the longest running act in the derivatives business (at least as an independent venture) it is a smart move. Due to mis-steps in the 90s (born out of a futile hope that they could stave off the electronic era by failing to create a viable electronic system and building a huge new trading floor–sorry guys, but Econ 1o1 says sunk costs are sunk), the CBT has been living on borrowed time for years. It never owned its clearing operation, and due to its failure to create and own its own technology, it was inevitable that it would be snapped up post-demutualization by somebody who owned both. And who better than the CME, with a first class clearing operation and arguably the best trading system in the business. The CBT-CME combination was clearly the most efficient way to go.

As I noted in an earlier post, things will develop quickly, and the remaining independent exchanges will soon cease to be such. NYMEX and ICE will soon be the next to go–and for quite handsome prices, thank you. The FT surmises that NYSE-EuroNext will try to snap up NYMEX to break up the CME-NYMEX strategic partnership. I doubt it. That partnership has worked very well, so why should NYMEX migrate to a new platform only months after moving to Globex? Moreover, the clearing efficiencies would be large. As I have said for well over a year, I expect NYMEX to end up in the CME Group ASAP. The natural thing is for NYSE-EuroNext to buy ICE.

That pretty much leaves CBOE, and various small fry, at least in the US. (LSE is another matter altogether). One could see a rationale for CBOE combining with CME, but I think that (a) the CME’s reluctance to suffer any more SEC oversight than it has to, and (b) the lingering rancor over the CBT-CBOE trading rights will make that a difficult deal to do. (Although a marriage might be one way of dealing with that troublesome issue.) So I see CBOE going with NYSE too, although that’s going to have to wait resolution of the trading rights issue.

But those are tomorrow’s stories. Now it is appropriate to reflect on the glorious and colorful–though often contentious–history of the Chicago Board of Trade. Truly a pioneer, the derivatives business as we know it would not exist if it hadn’t blazed the trail for almost a century and a half. In some respects, however, that very historical legacy–the traditions and habits and interests that grow like barnacles on venerable institutions–impaired its ability to lead the industry in the 21st century. Its management made the wise choice of partnering with a younger, more dynamic, and lately more innovative exchange. I fully expect that this partnership will blaze yet more trails, and thereby enhance the efficiency of the financial markets in the 21st century and beyond.

The Independent carries an article discussing the future of foreign energy investment in Russia. Overall, it is about as sympathetic a piece as you will read, outside of the rantings of Russian energy nationalists or their Russophilic Western fellow travelers.

There is one part of the article that deserves comment:

In fact, there are many in the international energy industry who, if asked, admit to seeing Gazprom’s takeover of Sakhalin-2 in a slightly different light. They have some sympathy for Russia’s view that Shell’s original deal was almost extraordinarily advantageous, if not actual theft, and reflected the special conditions of the Nineties. Russia was almost bankrupt; its leadership was weak, its energy industry was in disarray, and the international price of oil was $10 a barrel. It was a deal, they say, that could not last. That Gazprom is buying out Shell and shareholders will be compensated is, they argue, proof that times have changed. It is at least better than confiscation.

This is actually the woe-is-me conventional wisdom about Russian oil deals of the time, but it must be taken with a grain of salt–not to say a Siberian salt mine. Sure, Russia was in sad shape when the Sakhalin-2 deal was negotiated–but the world oil industry was in a pretty bad way overall. The quote above mentions $10/bbl oil almost in passing, but that is the salient fact that cannot be forgotten. Oil majors like Shell were facing lean times indeed with low oil prices, and no prospect for an improvement any time soon. They were sharply cutting exploration expenditures. They were also cutting headcount ruthlessly. Seasoned people left the business in droves, and they were not being replaced; this is reflected in the odd demographics of oil firms, which are laden with people on the brink of retirement and many new hires, but with a “missing generation” in the middle.

In this environment, oil majors were not swimming in cash to sink in Siberian wastes. Nor did they have a huge appetite for risk. And Sakhalin-2 presented substantial risks–both technological and political. Hence, no PSA–no dice. Russia was not in a great bargaining position, but Shell (or any other major for that matter) was not in a negotiating mood anyways. They weren’t looking for the upside in speculative ventures–they were only willing to commit capital under terms that strongly limited their downside risk. Russia didn’t have the cash to invest, and given the economic environment and shareholder pressure prevailing at the time, the majors were only going to put up the cash under terms like those in PSAs.

Put differently, it is highly unlikely that Russia would have had anything to expropriate but for the PSA. Shell invested at a time when the economics of big investments in oil were very shaky. The world changed in a big way, and now Russia wants to take the upside. Russia, and sympathetic ears like the Independent, and perhaps “many in the international oil industry” not too proud to smooch a little Kremlin keister to get on Vlad’s good side, emphasize only one part of the history of the time in order to
insinuate that any 90s deal bordered on theft–all in order to excuse a real theft.

I have written before that Shell did itself no favors with the cost overruns, and its failure to keep the Russians apprised thereof. Moreover, PSAs–which are effectively cost plus and option contracts–don’t provide the best incentives to control costs. But it is doubtful that anyone would have invested in Russia in the 90s when oil prices were at rock bottom without such a contractual guarantee that costs would be covered.

Furthermore, I might have more sympathy for the Russians if they had pursued their grievance against Shell in a more legally or commercially respectable way. Instead, they engaged in a shakedown that would have made any extortion racket proud. These illegitimate means–so redolent of the mafia style that pervaded (and pervades) so much of Russian political and economic dealings (read David Satter’s Darkness at Dawn if you doubt the veracity of this statement)–cast serious doubts on the legitimacy of the grievance.

So I’m not buying the revisionist line the Independent–and the Kremlin–are peddling.

RIA Novosti reports on a speech given by Assistant Deputy Secretary of State Matthew Bryza on Central Asian energy. According to Novosti, Bryza said:

Pipelines in the Caspian region bypassing Russia do not spell confrontation with the country’s energy giant Gazprom, a senior United States official said Wednesday.

Speaking at an oil conference in Azerbaijan’s capital, Deputy Assistant Secretary of State for European Affairs Matthew Bryza said the U.S. welcomed supplies to Europe via the well-developed pipeline network run by Gazprom, but that U.S.-Russia energy relations would only gain from robust competition.

I find it hard to believe that Bryza really believes this tripe. Pipelines bypassing Russia are all about confrontation with Gazprom. Moreover, “robust competition” will not improve US-Russia relations on any dimension. A serious effort to wrest some Central Asian gas from Russia/Gazprom strikes at the very heart of the entire Russian strategy. It will compromise its ability to meet its supply commitments to Europe. It will sharply reduce the fat margins that are the lifeblood of Gazprom and the Russian state. Given these realities, Russia will fight tooth and nail to protect its hammerlock on the Caspian. A serious battle will not put them in a good mood. And all the better for that.

So what’s the point of making such risible statements? Does he really think that such anodyne remarks will actually put the Russians at ease? If anything, such statements are likely to inflame the paranoia that characterizes so much of the Russian leadership. It’s all just diplospeak, you might say. Diplomacy is often built on polite fictions, but these fictions have to be at least slightly plausible. Bryza’s statements are anything but. In my view, a much more honest and straightforward approach would be desirable–and would more be more likely to get some respect from the Russians, as opposed to the derisive snorts that no doubt greeted Bryza’s remarks in the Kremlin.

This also illustrates a point that I made in an earlier post. Specifically, whereas Russia plays its A team in this game–with Putin spending an entire week in the region to seal deals–we have Deputy Assistant secretaries carrying the ball. And he’s speaking from Azerbaijan while Putin does business in Turkmenistan and Kazakhstan. And the Europeans are MIA altogether.

I guess it could be worse. We could have Deputy Assistant Undersecretaries leading the charge. But until folks at substantially higher pay grades are regularly engaged in the task of dealing with Caspian energy issues, Putin will continue to leave us in the dust.