Streetwise Professor

Mikhail Khodorkovsky and his colleague Platon Lebedev are the subject of new charges in Russia. These charges involve money laundering, supposedly involving sham sales of oil.

As yet, the charges have not been circulated publicly, and the evidence is unlikely to be. All indications are that the trial will be tightly controlled, and the result a foregone conclusion. The holding of the trial (illegally, as I understand it) in a prison complex in the isolated Siberian backwater of Chita rather than Moscow; the Kafkaesque procedural machinations; the intimidating security presence in Chita (complete with squads of Spetsnaz commandos in black balaclavas toting automatic weapons on the streets); and the ongoing intimidation of the defendants’ attorneys all make it abundantly clear that this is not about finding facts and dispensing justice, but is instead all about power. Indeed, as is common in authoritarian and totalitarian states, the blatant and unapologetic mockery of justice and due process is intended to send a message to anyone who dares challenge the authority of Putin and the siloviki.

The more outrageous the charges, and the more sinister the procedure, the more effective the signal. A fair and regular procedure with reasonable charges would be a far less effective method pour encourager les autres. Arbitrary and absurd charges are so much more . . . persuasive. They demonstrate that the law is not a constraint on the state, but its tool. It says “The state can do anything it wants. It can convict you on absurd charges if you challenge it. So be smart—don’t challenge.”

I do not know that Khodorkovsky and Lebedev did not break any Russian laws. However, a just government and legal system convinced of the truth of its charges and the strength of the evidence to back them would not hesitate to risk an open and fair trial operating under internationally recognized standards of due process. The Kremlin’s actions betray no such confidence, and provoke considerable skepticism about the truth of the allegations.

The single-minded intensity with which the Kremlin going after anyone connected to Yukos, which brings to mind Ahab pursuing the White Whale to the ends of the earth, or Inspector Javert hounding Jean Valjean, is truly creepy. The hatred is palpable. This is clearly very personal, which lends credence to the view that the true motive is deeply political, and that Khodorkovsky in particular is a mortal threat to Putin and his coterie.

In some respect, this fear is surprising, because Khodorkovsky is such a polarizing figure that there is reason to doubt his political viability. Like many of those who became unbelievably wealthy in the chaotic 1990s, he is widely resented in Russia, and his fate apparently attracts little public sympathy outside of the increasingly beleaguered liberal community. His supporters point to his corporate governance reforms; his critics claim that these were a newfound religion, and that his allegiance to clean governance was honored more in the breach than the promise during his rise to control of Yukos.

One accusation that seems difficult to credit is that Yukos is just a Russian Enron. The evidence that I have seen suggests just the opposite. Accounts from respectable independent sources state that under Khodorkovsky’s leadership, Yukos’s production and efficiency rose smartly—and that under Rosneft management, the same assets have become markedly less productive. That is, Yukos was a real company with real assets, and managed these assets well.

If it were not, why would the Russian government move heaven and earth to get control of it and its assets? If the US government had seized Enron, what would it have found? A shell of a company with far fewer assets and far more liabilities than it claimed. A knowledgeable government would have never tried to expropriate Enron (knowing that there was little to expropriate); a knowledgeable Kremlin’s expropriation of Yukos gives the lie to the Enron analogy.

What’s more, in a country where the rule of law is a nullity, and the government and its minions are willing to use any foul means to seize assets or cash flows that catch their eyes, it is understandable that corporate managers will engage in creative means to protect their companies’ assets. Again, I have no basis to determine with any certainty that the transactions at issue in the most recent Khodorkovsky allegations did not represent “tunneling” of Yukos assets for the personal enrichment of the firm’s management. I only mean to emphasize there are reasonable alternative hypotheses that could justify the use of complicated financial transactions by a firm rationally paranoid (which, as the Transplants song says, is “way past concerned”) about the predatory intentions of the government.

I obviously have no direct knowledge of which hypothesis is correct. I can observe, however, that the Russian government is bound and determined to avoid an open, transparent, and equitable process by which the evidence for each hypothesis can be presented and weighed by an impartial finder of fact to reach an appropriate verdict. And that speaks volumes.

In an earlier post I mentioned Robert Service’s history of Russia post-1991. Reading it in the context of recent developments in Russia reminds me yet again of Fate’s twisted, ironic, sense of humor. When there was a serious commitment to reform under Yeltsin, rock bottom oil prices undermined the fiscal foundations of the Russian state, making the success of this reform all but impossible. Now, when the commitment to reform has vanished, and has been replaced by an obsession to restore the power of the Russian state to its past imperial grandeur, high energy prices are fueling an aggressive foreign policy. Seventy dollar oil (or even forty dollar oil) in 1995 would have gone far to cushion the impact of shock therapy and would have reduced the dependence of a penurious Russian state on the oligarchs; fifteen dollar oil in 2006-7 would starve the current Russian government of all of the geopolitical leverage that it is so zealously exercising. Timing is indeed 90 percent of life.

Russia’s most recent energy contretemps, this time with hapless Belarus, raises some interesting issues and questions.

The first relates to the European response to Russian energy muscling tactics. I have read that this is “a wake up call for Europe.” It sure should be, but Europe responds to these alarms in much the same way as does my college daughter while on break—by hitting the snooze button and pulling the covers overhead. The EU now offers its citizens the worst combination of government characteristics; it is united, intrusive, pushy, nosy, aggressive, and dirigiste when dealing with the most routine domestic matters, or with enforcing politically correct speech and behavior, while at the same time it is pusillanimous and divided when confronted with a determined and aggressive opponent with contrary interests (cf. not just the responses to Russia, but to Muslim extremists as well.)

The second matter of interest is the speed with which Putin acts, and his apparent unconcern for external criticism, especially European criticism. This can in part be explained by a well-merited disdain for Europe’s ability to match words with deeds (see above), but there is something more to it. Putin is clearly a man in a very big hurry with very little concern for the reputational impact of his actions. Why?

Like many things, this one is likely over-determined; many factors plausibly impel such determined haste.

Part of it is personal makeup. In his “Russia: Experiment with a People,” Robert Service portrays Putin as a “man of action” of “relentless menace” who was always wanting to advance quickly. For instance, Service notes his attempt to join the KGB at age 15.

But I think there are other fundamental, non-personality related factors at work too. Here are a few:

• Energy prices are high, which gives the Kremlin leverage over divided and somewhat panicky consumer nations. Moreover, despite the Kremlin’s confident rhetoric, the current dip in prices shows that this may not last forever. Hence, the urge to strike while the iron is hot and grab as much as possible as quickly as possible before the energy “correlation of forces” (in the old Soviet military argot) becomes less favorable, or altogether unfavorable.
• The unsettled succession situation and the behind the scenes battle for position in the succession struggle (which may account for some of the growing body count) truncates time horizons. Planning beyond 2008 is a dangerous thing to do. Again, better to get while the getting is good. Even though current strong-arming will undermine Russia’s reputation as a reliable supplier and place to invest, that bill will only come due in the years ahead, and who knows who will be in power to pay it? The future is now.
• As I have written before, Russia’s long term prospects are dim. It is living a demographic and public health nightmare. Such an environment is not conducive to long time horizons. When you perceive that you have no future, you obviously discount future costs heavily, and emphasize short run benefits.

It is difficult to identify factors that might offset these considerations. The unsettled political environment, the brutal means of settling scores, and the bleak long term prospects all tend to focus the mind on the here and now. Let the future take care of itself, and the devil take the hindmost.

I think that most Europeans, and those few Americans who seem to pay much attention to these issues, are nonplussed by Putin’s audacity in large part because they are projecting their attitudes onto him. They cannot envision why someone would engage in such seemingly short sighted actions. As a recent Newsweek story puts it, they wonder why Putin is risking severe “blowback.” However, their attitudes have evolved and developed in a completely different institutional, economic, and political environment than Russia’s. The Euro-American environment is much more conducive to taking the longer view that the unsettled (and unsettling) environment that characterizes Russia today. So, the Europeans—and Americans—should be ready for more “surprises” from Putin—which shouldn’t be surprises at all.

I flew over Sakhalin Island on my way back to the US from Beijing this summer. During the trip I thought about the Soviet shootdown of KAL 007 over Sakhalin in 1983.

Sakhalin is back in the news for a completely different reason today. Under intense pressure from the Russian government, Shell has agreed to give a controlling stake in a gas production and liquified natural gas processing venture located in Sakhalin to Gazprom. The Financial Times’ coverage of the issue is outstanding; in addition to the linked article, there are several others. Robert Amsterdam has released a critical assessment of the deal.

Shell did itself no favors with the $10 billion cost overrun. This would have upset any residual claimaint–and under the terms of the original contract, the Russian government was a residual claimant, receiving payment only after the project’s revenues were sufficient to cover the original investment outlay. This does not mean that handing control to Gazprom is the best way for Shell to compensate the Russian Federation for any mis-management that contributed to the overrun. Gazprom has no expertise in such large and technically complex offshore projects. It can contribute nothing in terms of management or technical expertise. It can barely manage its sprawling–and somewhat decrepit and declining–existing collection of upstream and midstream assets. It has already announced that it would develop the Shtokman field in the Barents Sea–another project which it probably has no business doing by itself. If the economics of the Sakhalin project were already dicey (as the FT article suggests), Gazprom’s “contribution” will be to make them even dicier.

Some adjustment of the contract, such as requiring Shell and its Japanese partners to eat some of the overrun, would have been a more efficient way to handle the situation. But that wouldn’t have suited Putin and Gazprom. That would have resulted in money received down the road. They want control–now.

Moreover, the means by which the RF and Gazprom muscled their way into control is predictably shameful. Trumped up environmental problems–which again should have been dealt with and compensated for in other, more efficient ways–were the knout that Putin/Medvedev wielded this time to bludgeon Shell into submission. One day it’s taxes, the next day it’s environmental laws. As Roseanne Roseannadana used to say, it’s always something–and something always results in Gazprom walking away with the marbles.

This rent seeking makes some people wealthy, and some governments more powerful, but in the end is wealth destroying. It discourages investment, especially in “strategic sectors” that are most likely to be the next target of Putin’s predation. Moreover, it will result in the inefficient exploitation of Russia’s natural resources. Gazprom’s involvement can only cock up the already cocked-up operation of Sakhalin even more. And it is highly unlikely that Gazprom’s magic touch will enhance Shtokman’s productivity (sarcasm alert!). Russia’s taxation through expropriation creates enormous deadweight losses, but advances the interests of state power and the interests of the connected, who care more about the distribution of rents than the maximization of value.

I am keeping an open mind on Robert Gates. Score one in his favor today: he emphasized Europe’s vulnerability to energy blackmail, and noted that (ahem) Reagan had warned the Europeans about relying on Russian gas oh so many years ago (a point I made in my July World Energy piece on Gazprom.) Pace one of my earlier Russia posts, he averred that the Russians (I would say the Russian government) were humiliated by the loss of their empire, and are thirsting to matter as a world power again. Like I said before, with all of Russia’s other pressing problems, this is so sad.

A few thoughts regarding the Amaranth matter.

First, the good. A large hedge fund blows up, losing $6 billion in a matter of days, and the market just chugs along with no problems. Quite a contrast to the tumult that accompanied the demise of LTCM 8 years (to the month) earlier.

Now, that said, we shouldn’t get too complacent about this. For one thing, although the dollar value of Amaranth’s loss dwarfs that of LTCM (which lost about $2 billion in equity), the market is just much bigger today. It remains to be seen whether a fund with the same relative size as LTCM could implode without wider fallout. For another, LTCM’s problems occurred during a time of—indeed were caused by—a general financial crisis sparked by a de facto Russian default. This caused a rush for liquidity, and since LTCM was long illiquid instruments and short liquid ones, it was devastated. Its losses, combined with the fact that it was counterparty to most major financial institutions, threatened to make a bad situation worse. In contrast, Amaranth’s travails occurred during relatively quiescent times in the broader financial markets—although natural gas markets were indeed highly volatile and unsettled. It still remains to be seen whether a major hedge fund collapse in the midst of a financial crisis could touch off an acute systemic problem.

Second, the bad. The Amaranth episode proves again, as if further proof was needed, the danger of the “superstar trader” complex. Gas trader Brian Hunter reportedly made Amaranth $800 million in 2005. Whereas historically the fund had kept a close watch on its traders, requiring them to operate out of its Greenwich, CT offices, Amaranth let Hunter set up his own little empire in Calgary. Moreover, it is plausible that Hunter’s past success made the fund’s management loath to question his judgment in putting on the massive spread trade that apparently brought down the house. For you slow learners out there: big winners need more supervision and oversight, not less.

Third, the ugly. Not that we should be surprised, but the usual suspects in DC immediately leapt into action to use the Amaranth situation to justify yet again (yet again . . . ) their tiresome claim that the OTC energy markets are a threat, and that additional regulation is required. One failproof way to identify quackery is if the doctor always prescribes the same “cure” (nostrum is more like it) regardless of the patient’s symptoms. If anything even remotely untoward happens in the OTC energy markets, Drs. Feinstein, Levin, and Coleman (see, it’s not a purely partisan game) always prescribe greater oversight of electronic OTC trading platforms (read ICE) and the mandatory reporting of large OTC energy derivative positions. Possible manipulation—position reporting. Large investor loss—position reporting. Energy prices go up—position reporting. Energy prices go down—position reporting.

What, pray tell, would the CFTC have done with additional information in the Amaranth case? Since Amaranth’s positions posed no plausible manipulative threat in the immediate term (as they were 2007 gas positions) the CFTC could not have used the information to facilitate a manipulation investigation. Nor was fraud a remotely likely problem. Furthermore, CFTC is not in business to keep adults from losing money by speculating the wrong way. Perhaps the agency might have directed inquiries to Amaranth’s FCMs to determine whether the positions posed a threat to the financial viability of these firms and their other customers. Since there have been no reports that any FCM was seriously injured by Amaranth’s difficulties, however, it is unlikely that such inquiries would have led to any CFTC action that would have had the slightest effect on developments.

Even with regard to matters clearly within the CFTC’s ambit—notably, the prevention of manipulation and fraud—it is highly unlikely that position reporting is all that helpful. Position reporting might—and I emphasize might—facilitate early intervention to prevent a manipulation. As I’ve written in the past, notably in my book on manipulation (now #1,565,885 on Amazon after reaching the low-500,000s in late-August!), however, prevention is inefficient as compared to ex post deterrence. As Judge Easterbrook put it, an undetected manipulation is an unsuccessful manipulation. Highly anomalous price movements are the hallmark of manipulation. Transparent exchange prices, and prices on transparent electronic OTC platforms like ICE, provide the most reliable information regarding manipulation. Anomalous price movements—and the complaints of traders harmed by them—can trigger further inquiry to determine whether a manipulation has plausibly occurred, or is in process. Position information can be requested and obtained at that time. Why incur the cost of routinely collecting and analyzing masses of information about positions, most of which is almost completely irrelevant to detecting, deterring, or preventing manipulation? Put differently, a large position may be a necessary condition for manipulation, but it is clearly not a sufficient one. It is more efficient to utilize scarce enforcement resources to examine circumstances in which the primary indicia of manipulation—anomalous prices—are present, than to scrutinize big positions even when price distortions are not evident.

Ironically, raising the cost of doing business on transparent electronic platforms would likely force business into less transparent ways of transacting. This would reduce the availability of reliable price data that is of essence in any manipulation case.

To those who might say: “well, by the time that prices become distorted it’s too late—we need to catch these things ahead of time” I reply: just how, exactly? All manipulations are associated with big positions, but many big positions are not associated with manipulation in any way. One needs to worry about both type I and type II errors, false positives and false negatives. Raising the costs of accumulating large positions may reduce the frequency of manipulation—but it can also constrain the accumulation of large positions for legitimate business purposes. This is costly. A rifle shot approach directed at particular markets where the signs of manipulation are manifest is more efficient than a shotgun approach like that advocated by Sens. Feinstein, et al.

So I venture a daring prediction: the next time the energy market catches a cold, the flu, colitis, or any other ailment known to man or beast, the Capitol Hill Medicine Show will prescribe its Sure-Fire Senatorial Position Reporting Cure.