Streetwise Professor

In an apparent attempt to make Michael Masters look good, Rice University’s Baker Institute has released a report on oil speculation, that concludes that increasing volumes of speculation have caused oil prices to be higher than they would otherwise be, and in a novel twist, have caused a higher correlation between the dollar and the price of oil.  It also lays blame on everybody’s favorite whipping boy, the Commodity Futures Modernization Act of 2000.

In a nutshell, this report is bilge.  It relies on no rigorous economic analysis to support its contentions.  Moreover, it is unscientific, eschewing any serious statistical analysis.

The report first sets out its evidence that speculation has increased, and that this increase is due to the CFMA.  It attempts to argue that speculation increased 15-fold, while commercial trading only doubled, by adding non-commercial outright futures, options, and spread positions, as measured by the CFTC Commitment of Traders Reports.  The vast bulk of the increase in speculation is attributable to spread positions.

But it is odd indeed to argue that a massive increase in speculation caused higher oil prices when the bulk of this increase in speculation occurred in spread positions.  Such positions, which involve the purchase and sale of oil for different delivery dates, are speculations on the shape of the oil forward curve, not on the absolute price level.  Indeed, it is very difficult to imagine how such spread positions would cause prices to rise since they involve purchases and sales in equal magnitude.  Certainly the authors of the Baker study provide no rigorous justification for any such connection.  For that matter, they don’t provide any non-rigorous justification either.

Tying the massive increase in speculation as they measure it to CFMA is particularly bizarre.  As they note, the main provisions of the CFMA eased restrictions on trading on the OTC market, and in non-US markets.  As a result, if anything, the CFMA favored these other markets over NYMEX.  But all of the data in the “study” pertain to NYMEX futures markets.  How can you attribute a rise in trading on NYMEX, and a change in the composition of that trading, to regulatory changes that would tend to shift trading to venues not covered by the data?  (You could make an argument that the increase in off-exchange activity lifted NYMEX volumes due to arbitrage, or to the use of futures to hedge OTC positions.  But the Baker boy and girl don’t do that.  And if some non-commercial NYMEX positions are actually hedges of OTC positions, you can’t conclude the futures positions are speculative without knowing about the related OTC positions).

In other words, report authors Ken Medlock and Amy Jaffee play the drunk looking for a wallet under the lamppost.  The COT data is the only data relating to speculation that they can get their hands on, and they use it even though it is peripherally related to what they want to demonstrate, namely, that a set of regulatory changes that mainly benefitted non-NYMEX markets led to a dramatic increase in speculation.

This is the crudest post hoc, propter hoc reasoning.  CFMA happened in 2000.  Speculative futures positions increased, especially post-2003.  Therefore, the former caused the latter.  (Why the big lag?  Don’t bother looking for answers in the report.  You won’t get one.)  This is about as weak as it gets.

When they get to analyzing the effects of speculation on prices, the spreaders are out the window, and Medlock and Jaffee focus on net non-commercial positions.  (This could be viewed as a tacit admission that there is no basis to believe that spreaders could have an effect on price levels.)

Do the study authors utilize statistical techniques, like Granger Causality or the like, to document such a connection?  Surely you jest.

They use a much more sophisticated diagnostic instrument.  Their eyeballs.

Seriously.

They present a graph of net non-commercial positions overlaid on prices, and say:

Generally, movements in price over the last few years have coincided with trends in open interest by noncommercial traders.  We can see that during periods where [sic] speculators have been net short, prices typically declined, even if only slightly.  When speculators are net long, the general shift in the market has been upwards, in some cases to a dramatic extend.  Some exceptions have occurred when speculators were generally in a net long position, but were moving to liquidate positions.  In this case, such as the late spring/early summer 2008, prices responded by moving sharply lower.

Well, when I look at their Figure 5 with my eyeballs, I note numerous instances when the changes in net non-commercial positions were of a similar magnitude to what occurred in spring-summer 2008, and the price movements were nowhere as large as in the late-summer/fall of 2008.  I see other periods (fall, 2008) when net long positions spiked, but prices fell.

I just wonder: think the financial crisis might have had something to do with the collapse in prices?  What financial crisis you might ask, after reading the report: if this was the only information you had, you’d never know there was a financial crisis.

Also, why the asymmetry?  Why do net shorts often result in “slight declines” while net longs can lead to big spikes?  It is not obvious a prior that this should be the case, and Medlock and Jaffee certainly provide no explanation.

There is no way in hell that such a casual, visual analysis of that Figure can provide a basis for their grandiose conclusions.  To say that this is unscientific is far too kind.  It would be too kind to call it junk science.  It’s just junk.

Medlock and Jaffe also interpret the data, uhm, flexibly, in order to make their case.  On the one hand, they claim, prior to 2006 “the open interest of noncommercial players” was a “lagging indicator” of prices.  (If it lags, how can it cause?)  But then, in a “striking” development, it becomes a “leading indicator of price around January 2006.”

Do they present a rigorous test of this assertion?  No.

Do they provide a coherent explanation as to why it would go from a lagger to a leader?  They provide an explanation, but it is not coherent.  It is in effect the story of a perpetual motion machine.  Speculators buy so prices go up so people think prices will go up and so they buy and force up prices more yadda yadda.  This is, at best, ex post rationalization, fitting their story to the data rather than coming up with a rigorous hypothesis without peeking at the data and then testing it.

How do they address the problem that if COT data is really a leader, and leads by months (according to their eyeballs, anyways), why did all of these greedy speculators leave money on the table?  As soon as they recognized that COT data lead oil prices, they would trade on the COT data, and voila!, the relationship would disappear.

Again, the more obvious answer: there is no causal relationship between COT numbers and prices.

A more reasonable explanation is there is no connection between movements in net noncommercial positions and prices.  Sometimes positions lead price, then sometimes the reverse is true, but there is no causal connection, just chance in action.  This makes Jaffee and Medlock look like fools for randomness.

The asserted connection between oil and the dollar resulting from increased speculation is bizarre.  For starters, I contest their statistical results, such as they are.  They report a correlation between the dollar and the price of oil of -.82.  I can reproduce that number by calculating the correlation between the levels of the dollar index and the price of oil.  However, since both time series have unit roots, such high correlations are extremely suspect: highly persistent time series can be highly correlated even if, in fact, there is no economic relation between them.  This is the spurious regression problem.

A more reasonable method is to look at correlations between percentage price changes.  This number is much smaller (in absolute value) for 2001-2009: only -.22.  It is bigger than observed in 1986-2000, but so what?  What’s more, that -.22 isn’t nearly as eye-popping as -.8, is it?

And what theory do these people advance to explain why an increase in speculation would increase the correlation?  They tell a story–and it’s no more than that–about speculation causing high oil prices causing higher trade deficits causing a lower dollar.  There is no evidence supporting any one of these alleged causal connections.  And considering the trade deficit–like, have these two heard of China?  Or any other factor that might have influenced the trade deficit?  This is more post hoc, propter hoc mumbo jumbo, with myriad omitted variables.  A serious study would (a) estimate the relation between the trade deficit and the dollar index, controlling for other factors that could affect the dollar; (b) estimate the effect of the price of oil on the deficit, and combine this with (a) to get an effect of the oil price movements on movements in the dollar, and (c) estimate the effect of speculation on the price of oil, and combine with (a) and (b) to get an estimate of the contribution of speculation to changes in the value of the dollar.  Or include oil speculation as an explanatory variable in a model of the dollar that also includes other relevant explanatory variables.

But that would be, as I say, a serious study.  This one is a joke.

There’s also a serious issue regarding the direction of causality.  Why should it go from oil prices to the dollar?  A decline in the dollar represents a fall in its value relative to other currencies.  The factors that lead to such a fall (e.g., a US monetary policy that is looser than the monetary policies of other nations) also plausibly lead to a decline its value relative to goods, including oil.  A decline in the purchasing power of a dollar means that the prices of goods, including oil, rise in nominal terms.

Here’s a final, telling example of the level of rigor in the report: “While correlation does not imply causation [really?], the trends evident in the open interest data are impossible to ignore.”

Is that so?  Just watch me.

Blogmeister James at Robert Amerstdam was nice enough to link to нет дениг, нет проблем and say some nice things about it:

Craig Pirrong has a stinging piece [stinging? moi?] over at  Seeking Alpha on all the upcoming nastiness he expects out of the economic crisis in Russia, beginning with the Sayano-Shushenskaya dam explosion to Gazprom’s disappointing first quarter results.   It’s good article (especially the sharp rebuke against bullish analysts predicting a Gazprom rally)

But there’s a but (isn’t there always?):

but I think the eagerness to hold a parade over the collapse of the gas giant will only guarantee its next wave of revanchist corporate foreign policy strategy.   Gazprom has a lot of ways to still make money, and the full bore weight of the Kremlin helping it out.

I agree completely, James.  In fact, that was the thrust of my objections to Biden’s dismissing of Russia due to its economic and demographic weaknesses: namely, that these problems, and the desperation that goes with them, will make Russia more aggressive, not less.

When it comes to gas and Gazprom, that means that anyone touching Russian gas, or in a position to damage Gazprom’s interests better jock it up and get ready for battle.  It means that companies like ExxonMobil that have gas in Russia, and rights to sell it into potentially lucrative markets will face  intense pressure.  It means than even independent Russian companies can expect some smashmouth.  It means that a country like Turkmenistan that sells gas to Gazprom and prices that seemed like a good idea at the time, but no longer, should get ready for economic and even political aggression.  It means that Ukraine–and Europe–should look out come January.

Get ready to rumble, folks.

Although there are fleeting, ambiguous signs of recovery in the US, Germany, and France, conditions are far more bleak in Japan–and Russia.  Russian retail sales continued their steep fall:

Russian  retail sales dropped the most in almost ten yeas in July, sliding for a sixth consecutive month, as households cut back spending after incomes dropped and consumer borrowing declined.

Sales slid 8.2 percent from a year earlier after declining 6.5 percent in June, theFederal Statistics Service said in an e-mailed statement from Moscow today. That was more than the median  forecast of 16 economists surveyed by Bloomberg for a 7.1 percent drop.

. . . .

Retail sales began slipping in February for the first time since September 1999 as the weaker ruble, wage cuts and rising unemployment forced Russians to curb spending. The central bank’s five interest-rate cuts since April 24 have failed to spur lending as banks hold back on concern borrowers can’t repay loans. Lending to consumers dropped 1.1 percent in June for the fifth consecutive monthly decline, according to Bank Rossii.

Gross domestic product contracted a record 10.9 percent in the second quarter after shrinking 9.8 percent in the first three months, ending 10 years of expansion that averaged almost 7 percent. Average wages rose six-fold in the past decade as the economy recovered from the debt default and ruble devaluation of 1998.

. . . .

The average monthly wage fell an annual 5.8 percent in July, while real disposable incomes decreased 5.4 percent.

Capital investment tumbled 18.9 percent as industrial output declined an annual 10.8 percent in July.

Given all this gloomy news–which is far more gloomy than from developed markets (even Japan, which showed growth last quarter), and far, far more gloomy than from any emerging market–this bit is extremely anomalous: “Russia’s  unemployment rate remained unchanged at 8.3 percent in July.”  This calls into question the government statistics.  Or, if the government statistics are in fact correct, it means that there is considerable hidden unemployment; that firms (most likely due to government pressure) are not laying off people, but are keeping them on and paying them (mostly) even though they are not productive.  This eases social pressures in the short run, but eats into the already shaky financial foundations of Russian firms, and thus further undermines Russia’s dodgy banking system.  This will delay and weaken any recovery.

Russia faces extreme difficulties.  Its political brittleness, and the rigidity of its labor market (due in large part to the monocities, the legal and institutional nihilism and state capitalism that stifle small business and encourage large, cumbersome enterprise, and other Soviet inheritances) make it very difficult to adjust to large economic shocks; in this system, large enterprises serve as welfare agencies.  But this threatens to turn them into zombies–and take the rest of the Russian economy with it.

“Cash for clunkers” is apparently predicated on two of the three most common lies:

• “The check is in the mail.”
• “I’m from the government, and I’m here to help you.”

Heaven help us.

The Treasury Department has released its draft OTC derivatives regulation bill, “The Improvements to Regulation of Over-the-Counter Derivatives Act.”  The actual language of the 115 page proposal follows quite closely what Geithner has been floating for several months–a clearing mandate for standardized derivatives, attempts to force OTC derivatives trading onto execution facilities, differential margin and capital requirements for cleared and non-cleared products.

My initial reactions:

First, there’s a whole lot of delegatin’ goin’ on.  A good part of the bill sets out the haziest general objectives, and then directs the CFTC, SEC, and “the Prudential Regulator” (either the Fed, the Office of the Comptroller of the Currency, or the FDIC, depending on a bank’s charter status) to come up with specific rules on what constitutes a standardized derivative, capital and margin requirements, position limits and so on.  There is an aggressive timeline for most of these rules–180 days.  Given the depth and breadth of the issues, and their contentious nature, and the needs to coordinate among disparate agencies, this will be very difficult to do at all, and extremely difficult to do well.

Second, the Treasury has finessed the jurisdictional issues by giving multiple regulators authority over OTC derivatives markets, with the injunction that everybody share and play well together.  Many of the provisions require that the CFTC and SEC issue rules jointly, with the proviso that if they cannot, the Treasury will prescribe them.

Given the delegation-heavy aspect of the proposal, there are few specifics to analyze.  But there are some aspects of the proposed bill that are spelled out with sufficient detail that deserve comment.

I’ve beaten the clearing mandate horse repeatedly before, so I won’t do more than repeat my previous conclusion that the mandate approach is wrongheaded, and ignores crucial economic issues.  The proposal does not require clearing when “one of the counterparties to the swap— (i) is not a swap dealer or major swap participant; and  (ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”  This would seem to permit an end user (e.g., a gas producer) to enter into a swap with a dealer without triggering the clearing mandate.

This is a desirable feature, and would permit end-users to enter into swaps without having to clear them; this could be especially important for end users concerned about the cash flow and liquidity risks associated with daily mark-to-market.  However, there are some peculiarities as to what constitutes a swap dealer or major swap participant that confuse me, and create ambiguity in the application of this exemption from the clearing requirement.  For instance:

The term ‘swap dealer’ means any person engaged in  the business of buying and selling swaps for such person’s own account, through a  broker or otherwise.

“(B) EXCEPTION.—The term ‘swap dealer’ does not include a person that  buys or sells swaps for such person’s own account, either individually or in a  fiduciary capacity, but not as a part of a regular business.”

“As part of a regular business”?  As opposed to what?  An irregular business?  A hobby?  I think most involved in this industry have a pretty good idea of what a swap dealer is, but would have a hard time recognizing one from the language just quoted.  A dealer is a firm that stands willing to quote prices at which it is willing to buy and sell products–a market maker.   The dealers/market makers usually enter into large numbers of off-setting positions.  Those features are totally absent from the bill’s definition of dealer.

Here’s the definition of a “major swap participant”:

The term ‘major swap participant’ means any  person who is not a swap dealer and who maintains a substantial net position in  outstanding swaps, other than to create and maintain an effective hedge under generally  accepted accounting principles, as the Commission and the Securities and Exchange  Commission may further jointly define by rule or regulation.

It seems the key phrases here are “substantial net position” for a purpose “other than to create and maintain an effective hedge.”  So, they’re not hedgers, and they have a substantial net position.  The addition of the “net position” language would seem to mean that swap dealers often don’t have net positions, which is true.

So, it would seem that what Treasury is trying to say is that a major swap participant is not a dealer and not a hedger, so that would suggest speculator.  But what about a hedge fund that is basis trading, or spreading between some cash instrument or commodity and a derivative?  A lot of speculators do just that.  Are they hedgers?  You could argue that the derivative is hedging the cash position, and under that interpretation any deal involving a hedge fund engaging in this strategy would be exempt from the clearing mandate.  I doubt that’s what Treasury means, but their drafting leaves a lot to be desired.  This imprecision will become a litigation magnet if it makes its way into law.

This is true not just because the clearing mandate turns on the classification of the counterparties, but because the execution facility mandate does so as well:

Except as provided in paragraph (8), a swap that is  standardized shall be traded on a board of trade designated as a contract market under  section 5 or on an alternative swap execution facility registered under section 5h.

“(8) EXCEPTIONS.—The requirements of subsection (j)(1) and (7) do not apply to  a swap if—  “(A) no derivatives clearing organization registered under this Act will  accept the swap for clearing; or

“(B) one of the counterparties to the swap—

“(i) is not a swap dealer or major swap participant; and

“(ii) does not meet the eligibility requirements of any derivatives  clearing organization that clears the swap.”.

So, if our hypothetical hedge fund doing a basis trade is deemed a hedger, any trade it does needn’t be executed on an alternative swap execution system (e.g., an electronic trading platform) that is subject to various requirements and obligations similar to those imposed on exchanges.

This whole regulatory schema is based on creating distinct classes of market participants, with different rights and obligations.  Given that the mandates in the proposal turn on the classifications of both parties to a trade, and that there is notable ambiguity in the definitions of the classifications, this will likely lead to some legal disputes.

The proposal also addresses the “standardization” issue, but again in an unsatisfactory way.  This is also crucial because the clearing and trading mandates also turn on standardization.  Most of the specifics are punted to CFTC and SEC, but the proposal does set out some criteria that the agencies should take into consideration when determining whether something is standardized.  These criteria include whether trade terms (including prices) are distributed, or relied on in determining the prices of other deals, and the volume of trade.  Unfortunately, however, most of the other criteria refer to the “terms” of the swap as the criteria by which CFTC and SEC assess standardization.  Are the terms of swap A like those of swap B that is cleared?  Are the differences in terms economically significant?

But it’s not just the terms that matter in determining suitability for clearing.  The risk characteristics of the instrument, and the availability of pricing information are also relevant.  Two deals with very similar terms may differ along these economic dimensions in ways that make one efficient to clear, and the other not.  (The volume of trading requirement is a crude way of assessing the price information availability issue.)  Moreover, these economically relevant factors may vary over time.  Is a CFTC/SEC determination permanent?  This would be problematic.  It should also be noted that due to economic differences, and variations of these economic conditions over time, that clearinghouses may not price risks appropriately, and that as a result the mandate could discourage mutually beneficial trades that parties would be willing to enter bilaterally because it is cheaper to do that than to clear.

The proposal also sets out rules for capital requirements and margins on non-cleared deals, but these aren’t that helpful:

BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—In setting  capital requirements under this subsection, the Prudential Regulators shall  impose:

“(i) a capital requirement that is greater than zero for swaps that  are cleared by a derivatives clearing organization; and

“(ii) to offset the greater risk to the swap dealer or major swap  participant and to the financial system arising from the use of swaps that  are not centrally cleared, higher capital requirements for swaps that are not  cleared by a registered derivatives clearing organization than for swaps  that are centrally cleared.

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Capital  requirements set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than the capital  requirements set by the Prudential Regulators under this subsection.

So, capital requirements on cleared deals are positive, and requirements on cleared deals are higher than that.  That’s a huge help, guys.  This will touch off huge efforts to influence the determination of these requirements, and regulators will quite honestly not have the knowledge or information to set them efficiently.  I foresee reliance on crude proxies for risk, such as . . . wait for it . . . credit ratings.  Heaven help us.

Margin requirements are similarly fuzzy:

Prudential Regulators shall impose both initial and variation margin requirements  under this subsection on all swaps that are not cleared by a registered derivatives  clearing organization, except that the Prudential Regulators may, but are not  required to, impose margin requirements with respect to swaps in which one of  the counterparties is—

“(i) neither a swap dealer, major swap participant, security-based  swap dealer nor a major security-based swap participant;

“(ii) using the swap as part of an effective hedge under generally  accepted accounting principles; and

“(iii) predominantly engaged in activities that are not financial in  nature, as defined in section 4(k) of the Bank Holding Company Act of  1956 (12 U.S.C. 1843(k)).

“(B) NON–BANK SWAP DEALERS AND MAJOR SWAP PARTICIPANTS.—Margin  requirements for swaps set by the Commission and the Securities and Exchange  Commission under this subsection shall be as strict as or stricter than margin  requirements for swaps set by the Prudential Regulators.

So, again: virtually no guidance on the principles regulators shall use to set margins, the counterparty classification issue, and the need to get numerous regulators to play nicely.

The proposal also opens the way for the vast expansion of position limits.  Swap execution facilities are required to set accountability or position limits, which means that the reach of these limits is extended to the swap market.  Moreover, Section 723 states:

The Commission may, by rule or regulation,  establish limits (including related hedge exemption provisions) on the aggregate number  or amount of positions in contracts based upon the same underlying commodity (as  defined by the Commission) that may be held by any person, including any group or class  of traders, for each month across—

“(A) contracts listed by designated contract markets;

“(B) contracts traded on a foreign board of trade that provides members or  other participants located in the United States with direct access to its electronic  trading and order matching system; and

“(C) swap contracts that perform or affect a significant price discovery  function with respect to regulated markets.

The definition of “significant price discovery function” is very broad:

SIGNIFICANT PRICE DISCOVERY FUNCTION.—In making a determination  whether a swap performs or affects a significant price discovery function with respect to  regulated markets, the Commission shall consider, as appropriate:

“(A) PRICE LINKAGE.—The extent to which the swap uses or otherwise  relies on a daily or final settlement price, or other major price parameter, of  another contract traded on a regulated market based upon the same underlying  commodity, to value a position, transfer or convert a position, financially settle a  position, or close out a position;

“(B) ARBITRAGE.—The extent to which the price for the swap is  sufficiently related to the price of another contract traded on a regulated market  based upon the same underlying commodity so as to permit market participants to  effectively arbitrage between the markets by simultaneously maintaining positions  or executing trades in the swaps on a frequent and recurring basis;

“(C) MATERIAL PRICE REFERENCE.—The extent to which, on a frequent  and recurring basis, bids, offers, or transactions in a contract traded on a regulated  market are directly based on, or are determined by referencing, the price  generated by the swap;

“(D) MATERIAL LIQUIDITY.—The extent to which the volume of swaps  being traded in the commodity is sufficient to have a material effect on another  contract traded on a regulated market;

These criteria would apply to most important, heavily traded OTC products.  Thus, the bill would give the CFTC tremendous power to impose position limits on combined OTC and exchange-traded positions.  Given the contentiousness of the position limit issue in energy alone, one can only imagine the difficulties that await when the CFTC’s powers to set limits extend to everything.

Overall, I think that it is a travesty to call this the “Improvements to regulation” act.  All of the substantive elements–the clearing mandate, the trading mandate, the setting of capital and margin requirements by relatively uninformed regulators subject to influence and pressure, the position limits–have no solid economic justification.  Indeed, the stronger justifications cut the other way in virtually every case.  Moreover, the ambiguities in the definition of key terms that determine the reach of the mandates are a recipe for trouble later on.  The delegation of virtually all implementation details to regulators, the rapid time frame for the formulation of specific rules, the need for coordination across regulators, and the lack of anything more than the haziest guidance will create immense implementation problems and lead to enormous influence activities.

All in all, therefore, this would be better titled “The (further) Bollixing of the Regulation of Over-the-Counter Derivatives Act.”

Check this out if you want to see examples of the myriad deformities in Russian energy policy in one brief article.   Wasteful use of gas due to domestic price controls–waste that contributes to the release of greenhouse gases, by the way.  The use of state regulatory agencies to exert pressure on a foreign investor;  in this case, the mineral rights regulator  RosNedra threatening to revoke Hungarian firm MOL’s license unless it captures gas production associated with the output of oil.  A threat that would be unnecessary if state firm Rosneft had followed Yukos’s practice of  purchasing of the gas.  The involvement of  Surgut Neftegaz–sometimes called Rosneft chairman’s Igor Sechin’s favorite “private” oil company–attempting to take control of MOL.  The simultaneous adversarial actions of RosNedra, Rosneft, and Surgut Neftegaz towards MOL suggests that they are playing a triangle offense, with the Hungarians caught in the middle.

In a more economically efficient system, the price of gas would adjust to ensure its efficient use, and eliminate wasteful flaring.  This would alleviate Russia’s looming gas shortage.  It would also make it unnecessary for the regulator to coerce firms into doing this–and therefore would also deprive it of the cover to use its powers at the behest of state owned firms, and the private allies of state owned firms.

But this is not possible in a natural state like Russia.  Prices cannot be allowed to allocate resources efficiently, because it would damage important domestic political constituencies, including individual consumers, but more importantly, industrial consumers and power producers dependent on below-market gas prices.  And protections of foreign investors constrain the ability of the state to shift rents around in order to placate other constituencies, so they cannot be countenanced.

The pressures being exerted on ExxonMobil represent another example of how the political imperative to allocate rents in the natural state precludes reliance on market mechanisms to allocate resources; the necessities of subsidizing restive Siberian consumers and feeding Gazprom’s voracious appetites means that something has to give, and that something is a foreign investor.

This is why this attempt to interpret Russia’s adamant unwillingness to sign onto the foreign investor protections in the Energy Charter solely as a response to the Yukos expropriation are simplistic, and wide of the  mark:

But everything was outweighed, judging by everything, by just one sole argument. The Energy Charter is the legal foundation for a claim by former shareholders of the YUKOS company against the Russian state. Investors who have suffered from the artificial bankruptcy of the former company of Khodorkovsky are demanding of the government of Russia to pay them back for their losses. In its time, the market had appraised the YUKOS company in the tens of billions of dollars. Correspondingly, the sum of the shareholders’ claims is comparable is size as well.

. . . .

It is possible that the powers would do well to be more consistent. It looks somewhat strange that the development of international relations and questions of economic strategy are subordinate to the logic not of benefit for the country or of society, but lie in the stream of resolution of superannuated conflicts. But, probably, it is not at all the «YUKOS affair » that should be determining the policy of the country, or else it turns out that the tail is wagging the dog, although it should be the other way around.

Yes, Yukos is important, and yes, the prospect of having to compensate the expropriated is one reason why Russia cannot join the Energy Charter.  But it could not join even if Yukos had never existed.  The energy charter would force an element of market discipline and economic rationality that the natural state that is Russia cannot abide.   The Charter’s provisions on investment protection, transit, and transparency limit the Russian government’s flexibility to manipulate markets in order to allocate rents to maintain a political equilibrium.  Khodorkovsky and Yukos threatened that equilibrium, but there are other threats.   As a result, Yukos or no, Putin and the Russian elite are perfectly willing to forgo some of the efficiency benefits of more secure property rights and the uses of prices to allocate resources, in order to ensure the distributive and political benefits that government control of resource allocation confers.

That’s the way the natural state works.

In the immediate aftermath of the Russo-Georgian War, I wrote that a major objective of US policy should be to revitalize the relationship with Turkey:

Rebuild the Relationship With Turkey. Turkey is another frontline state, and a largely overlooked one in commentary and analysis on the Russo-Georgian War. Turkey has a strong interest in keeping Georgia independent of Russia. The Turks have ambitions to be an energy hub, a bridge from the Caspian to Europe. Georgia is essential to realizing those ambitions. The Turks also have an ethnic affinity with Turkic peoples in Azerbaijan and the ‘Stans that would be more firmly in Moscow’s thrall if Russia controls the Georgian cork to the Caspian bottle. Turkey is also a historical enemy of Russia, with Russia’s 18th and 19th century expansion having come largely at Turkey’s (or, more precisely, the Ottoman Turks’) expense.

. . . .

American relations with Turkey have been rocky, especially since the Iraq war (with Turkey’s refusal to permit the 4th ID to attack from Turkey into northern Iraq), due to the impact of Iraq on the Kurdish issue, and the increasing Islamicization of the Turkish government. These fractures were perhaps inevitable in the absence of the perception of a common threat and a common interest that made the US and Turkey close allies during the Cold War. Russian revanchism in general, especially as manifested in the Georgian campaign, could bring these two somewhat estranged nations back together. It should certainly be a major objective of US policy to achieve this.

Sad to say, there has been little visible progress on this front, although the Europeans did secure something of a victory by getting Turkey to agree to proceed with the Nabucco project; although it must be said that there are still many potential obstacles, and Turkey’s future cooperation is not guaranteed.  They relented on some of their demands (e.g., 15 percent of the gas for domestic use, linkage of Nabucco to EU accession), but they could un-relent in the future.

Putin and Russia, though, clearly have identified Turkey as a linchpin in their energy strategy, and hence in their broader foreign policy.  (The two are so inextricably linked it’s impossible to say where one ends and the other begins, just as it is hard sometimes to determine whether Putin is prime minister of Russia, or of Gazprom.)  Almost immediately after the signing of the EU-Turkey accord over Nabucco, Putin jetted to Ankara, where he and the Turks inked their own deals, and discussed other ventures.  Notably, routing the South Stream project through Turkish waters, the creation of a South Stream 2 project that would ship gas through Turkey to the Mediterranean, and construction of a nuclear power plant.

One the one hand, this is worrisome, as it suggests that Turkey is more than willing to deal with Russia and engage in deals that will cement Russian gas dominance, at Europe’s (and Ukraine’s) expense.  It could be viewed as somewhat encouraging, though, because it also suggests a certain desperation on Putin’s part.  No sooner do the Europeans leave with Turkish agreement on Nabucco than Putin feels compelled to follow in their wake, offering all sorts of goodies.

There is, as always with these grandiose Russian gas projects, an element of unreality about them, not to say fantasy.  Medvedev and Putin are always slagging on Nabucco by questioning where the gas to fill it is going to come from.  But, pray tell, where is the gas going to come to fill South Stream (63 billion cubic meters/year) and South Stream 2 (16 billion cubic meters/year)?  South Stream in particular has growed like Topsy, with announced capacity more than doubling in a year’s time.

All this at a time when Russia is facing decline of its existing fields, delays in bringing new fields on line, cutting capex for exploration and development, not to mention a financial crunch that makes it highly doubtful that South Stream could be funded, even if there were the gas to fill it.  Also, Russia is facing a domestic supply crunch aggravated by the political necessity to keep domestic prices artificially low.  Russia has for years plugged its supply gap with gas from Central Asia, but the prospects for continuing to rely on that are bleak, thanks in no small part to Gazprom’s short-sighted cutting off contracted imports from Turkmenistan in response to its cash crunch.  Hence, there are even more doubts about the availability of gas for new pipeline projects.

Turkey is probably smart to exploit Russia’s willingness to deal, figuring that it might get something out of Russia and Europe.  Indeed, the smartest move would be for Turkey to continue to support Nabucco and to continue to negotiate with Russia.  Given Russia’s proven track record of ruthless opportunism (contract?  what contract?) if Turkey were locked into Russia with no Nabucco alternative it would be extremely vulnerable to holdup down the line.  Conversely, with Nabucco, it would have some leverage over Russia.  And Nabucco with no Russia would be preferable to Russia with no Nabucco, because the Europeans are more reliable contracting parties, and are far less likely to engage in holdups than the Russians would be.  And it is very possible that if Nabucco were dead, South Stream would soon follow it into the grave, leaving Turkey with zip.

All that said, a more proactive US policy towards Turkey would be welcomed, if only to force Putin to raise the bid further.  And the Europeans should not let this Russian-Turkish deal undermine their determination to proceed with Nabucco.  That prospect is no doubt a major reason for Putin’s Turkish sales job, and there’s no reason to hand him an easy victory.

The Federal Trade Commission issued its final rule on market manipulation, as authorized by Congress under the Energy Independence and Security Act of 2007:

The  final Rule prohibits any person, directly or indirectly, in connection with the purchase or sale of crude oil, gasoline, or petroleum distillates at wholesale, from (a) knowingly engaging in any act, practice, or course of business – including the making of any untrue statement of material fact – that operates or would operate as a fraud or deceit upon any person, or (b) intentionally failing to state a material fact that under the circumstances renders a statement made by such person misleading, provided that such omission distorts or is likely to distort market conditions for any such product.

The rule, and the enabling legislation, are patterned on the anti-manipulation provisions of the securities laws, rather than the commodity laws.  And therein lies a problem, and renders the rule another monument to Congressional cluelessness on commodity market manipulation.

The emphasis on “fraud and deceit” makes some sense in securities markets.  Securities values are information-driven, and hence manipulative schemes in such markets frequently rely on fraud and deceit to distort investors’ information sets, and thereby distort securities values.

Things are quite different in commodity markets.  Although some manipulative schemes do rely on making untrue statements (e.g., false price reporting), by far the most important type of manipulation in commodity markets–including oil markets–involves the exercise of market power.  It is nigh on to impossible to wrench the concept of “fraud and deceit” to cover genuinely manipulative exercises of market power in the oil markets.  So, one of two things will happen.  Either the rule will prove completely useless, because it does not touch the most troublesome form of conduct in commodity markets; or the FTC will play legal Twister to try to interpret a rule written to attack information-based manipulations in order to take action against market power manipulations.

I would bet that the latter alternative is the more likely outcome, for a several reasons.  First, it is in the nature of regulator agencies to extend their power as far as possible, and stretch the rules to the breaking point to do that.  Second, the FTC will be under pressure from Congress to act in the event somebody does try to execute a market power manipulation.

I spoke with a group of FTC staffers while the rule was being drafted.  It was discouraging in the extreme to hear, that when I told them that the rule did not touch the most important form of manipulative conduct in commodity markets, that they were completely unaware that there was such a thing as market power manipulation.  I participated in a workshop on the rule that the Commission held in November, and hammered home the issues of market power manipulation.  But to no avail.  As stated in the final rule:

Some commenters argued that the final Rule should extend to conduct such as speculative activity or the unilateral exercise of market power, because in their view such conduct is inherently manipulative.   See, e.g., CFA at 8 (arguing that the Commission “could have considered the exercise of market power and excessive speculation as manipulation” because they “have no economic justification”); Greenberger at 1 (opining that the proposed Rule could offer a tough enforcement mechanism against speculative activity); Senator Cantwell at 2-3 (asserting that Congress intended for the FTC’s rule to reach a broad range of conduct, including the withholding of supply); Pirrong, NPRM, at 2 (arguing that the proposed Rule should not focus on fraud or deceit, but rather on the exercise of market power).   However, the rulemaking record does not support extending the final Rule to cover such conduct, except to the extent that the practices used are part of a course of conduct that otherwise violates the final Rule.

Whatever that means.  Translation: we had already released a Notice of Proposed Rulemaking that was totally silent on the issue of market power manipulation, so the train had already left the station and we weren’t about to look like fools and start over.

Actually, the FTC doesn’t bear the primary culpability.  Congress is the one that put the train on the wrong track.  It wrote the “fraud and deceit language” in the statute.  It was the one that had no clue about what manipulation in a commodity market really involves.

Sadly, it’s not the first time that Congress made the same mistake.  The law giving FERC anti-manipulation powers does as well, and as a result, FERC’s rule is also fundamentally flawed.

The Congressional cluelessness on all things derivative does not stop with manipulation.  It is pervasive.  It is on display daily in the myriad efforts to completely reshape derivatives regulation.  The ACES (Waxman-Markey) climate change bill contains several sections that would take derivatives regulation back to the days of rumble seats and the Charleston.  Other regulatory proposals bouncing around Capitol Hill would do the same.

What’s their motto?  “Today we screw up the energy markets! Tomorrow, the world!”?  It would fit.

A couple of interesting articles questioning the reality of Chinese growth.  One, from Forbes, homes in on something I’ve been saying: there is an extreme disconnect between China’s official growth statistics and another independent measure of economic activity, electricity generation:

China watchers have been dubious about the quality of Chinese economic data for some time. And a recent spate of seemingly conflicting data has fuelled that criticism.

One particular quibble involves the relationship between electricity usage and industrial value added — another measure of output. The worry is that failings in the way official data are compiled may be generating results that are giving investors misconceptions about the health of  China’s economy.

During the first half of this year, industrial value-added rose a robust 7 percent, while total electricity usage fell 2.24 percent. This seemingly implies that output is growing and contracting simultaneously. The divergence has attracted attention, not least because industry is half of the economy and electricity usage is one of those bits of data that is hard to massage. Even Chinese Premier Wen Jiabao has openly said that electricity usage is the data that he trusts most.

. . . .

China’s National Bureau of Statistics has posted a few articles on its website trying to reconcile the two sets of data. But their explanation — that China’s industries have become less energy dependent during the thick of the financial crisis — just does not stack up. [It sure don’t!]

The article focuses on the fact that Chinese government statistics are biased towards large, and particularly state-owned firms, and overlook small firms that have been major contributors to recent Chinese growth.  Here’s one example:

In a similar vein, the state-compiled Purchasing Manager Index consistently looks more bullish than a similar index compiled by brokerage firm CLSA this year. The two diverged sharply in March, when the official number was 52.4, indicting expansion; while the CLSA figure was only 44.8, which indicates contraction. The official index tracks mainly large state-owned firms while the CLSA index is more weighted towards small, private firms.

A relative in-depth analysis from the American Enterprise Institute reinforces these points, and adds considerable detail:

Make no mistake: China’s 8 percent growth target for 2009 will be achieved, almost by definition. Whether or not that is a healthy outcome depends upon how you look at it and upon understanding just how China’s economy functions and what China’s growth “accomplishment” means. Chinese economic data are constructed very differently from the roughly comparable U.S. statistics, so that looking at Chinese data through a lens conditioned by U.S. data-building and reporting conventions can be misleading.

. . . .

China’s 8 percent output growth target will be met because China’s economic statistics are based on recorded production activity, rather than being a measure of expenditure growth–defined as the sum of consumption, investment, government spending, and net exports–as U.S. data are. The U.S. stimulus package, for example, attempts to boost GDP by undertaking measures that will boost consumption, investment, and government spending. China, however, decrees measures that will generate recorded increases in production spending. Part of the Chinese stimulus package involves large transfers of funds from the central-government planners directly to state-owned enterprises and to fixed-asset investment projects that are aimed at public works spending largely under its control.

Once China had announced its 8 percent growth target, it began to disburse funds directed at a sharp increase in public works spending. It is important to understand that the disbursal of funds is recorded as GDP growth. So the government can easily control the pace of growth by the pace at which it releases funds that have already been allocated in the stimulus package to the creation of higher production or growth numbers. Funds disbursed for fixed-asset investment by state-owned enterprises or provincial governments are counted as having been spent when they are disbursed. In fact, the funds go out to the state-owned enterprises and provincial governments and may be held until actual projects are identified and undertaken.

The same convention, counting production and shipments as de facto outlays by end-users, is employed with respect to retail sales data in China. Shipments to retailers are counted as retail sales on the apparent assumption that ultimately all goods shipped will be sold at some point in the future. China’s nominal retail sales have been rising at a rate of about 15 percent year-over-year during the first half of 2009 because that is the rate at which shipments to retailers have been occurring. There is very little direct data available to measure actual sales by recipients of the retail shipments to ultimate consumers.

In other words, there is some stuff being produced, but no reliable evidence on whether it’s being consumed.  Moreover, some stuff is being counted as produced merely because the money to pay for it has been shoved out the door.  Hardly what one would consider high quality growth.  Or maybe not even growth at all.

John Makin’s AEI piece recommends looking at credit creation for an indication of how the economy is really doing.  In his view, the more credit the government is pumping into the economy, the more pessimistic they are about its true prospects and performance:

It is possible, however, to make inferences about the pace of demand growth relative to production or supply growth in the Chinese economy by watching the behavior of the central bank and its control over the growth of money and credit. If policymakers observe that demand growth and progress on infrastructure projects is lagging behind announced production-side GDP data, they can attempt to boost demand growth by increasing the growth of money and credit. Such growth has accelerated sharply during the second quarter in China, indicating that while the measured pace of China’s increase in production is rising, the public works projects and actual spending already recorded are falling behind schedule.

. . . .

It is the intensification of efforts to use rapid money expansion that serves as evidence that private consumption and private investment have remained weak even though they are difficult to measure since little data are available on such demand-side components of GDP. Meanwhile, as already noted, China’s export growth remains weak, with exports dropping at a year-over-year rate around 20 percent during the first half of 2009, after growth rates of 17 percent in 2008 and 25 percent in 2007. Having announced a stimulus package that will boost domestic demand in order to compensate for the loss of export growth on overall economic growth, China’s planners are not about to risk any cessation of the intense monetary stimulus currently underway. That said, there are signs that problems are emerging from China’s growth policies that amount to assuming that supply creates its own demand with the help of adequate monetary stimulus.

Those problems that Makin mentions in the last sentence include surging bubbles in real estate and stock prices.  These bubbles are being fed not just by domestic credit creation, but by substantial flows of hot foreign money into the Chinese market.  Makin notes that since February–a mere 6 months ago–housing prices in 13 Chinese cities have risen 13 percent, a 26+ percent annual rate.  This is a very rapid pace, even by the standards of the dizzying rates of appreciation in overheated US real estate markets in the mid-noughties.  The stock market has also risen by more than 70 percent.  Looks bubblier than champagne to me.

My takeaways?

First, reported Chinese growth is a chimera. Chinese government statistics appear no more reliable than Soviet figures. The disconnect between electricity generation changes and reported growth is highly suspicious, especially for a manufacturing-intensive economy noted for its energy-intensity as well. The focus on big state firms that don’t produce what people want, and the slighting of small firms that do, in the collection and reporting of statistics also raises red flags (and not of the Red Flag of Revolution! variety).

Second, Chinese growth reporting is eerily like 90s-style earnings management. There’s a target, and the numbers WILL be massaged in whatever way necessary to hit the target. Indeed, some of the tactics bring sordid episodes like Enron and WorldCom to mind.

Third, it seems that the Chinese are betting on a recovery in the West, and hence a concomitant recovery in exports, and are determined to keep up the earnings management and the credit stimulus until that happens. That is a highly risky strategy. If the desired recovery doesn’t happen before the bubbles collapse, China will face both a domestic demand and a foreign demand crunch. Moreover, even if “successful” in the sense that a recovery in exports allows the government to ease up on the stimulus, it will have contributed to a substantial misallocation of capital and created the risk of substantial inflation.

In brief, in my view, like governments around the world, China is taking an extremely short-sighted perspective. It is greatly increasing the risks of large future dislocations in order to palliate current problems. It may work, but the risks of things spinning out of control are appreciable.

I was interviewed by Kim Parlee on Canada’s Business News Network. I talked about commodity prices and China. I had written a post on the subject last week; Kim/BNN picked up on it and thought it worth discussing on air.  Commodities are a big deal in Canada, of course, and the commodity rally has translated into a pretty big currency and stock market rally in Canada.

Thanks to Kim and BNN.  I enjoyed it.