Streetwise Professor

I’ve been asked for my take on the Senate report/hearings on the London Whale.  I’m responding more out of a sense of duty, rather than any actual enthusiasm for the subject.

There are two issues that need to be distinguished, IMO: the operational aspects of JPM’s CIO, and the economic substance of the transactions that cost the bank billions.

The operational aspect is indeed appalling.  The reliance on a spreadsheet with manual inputs to quantify the risks of the CIO is truly appalling.  Division, multiplication-whatever!   The failure to take into account market liquidity, and the ability to get out of a huge position in the event that circumstances changed.

The battle over marks-hardly surprising.  It has always been so, and will continue to be so long after we have all shuffled off this mortal coil.

With respect to the economic substance, I don’t have much to add beyond what I said last summer, or beyond what the wickedly sardonic Rhymes With Cars and Girls has written over the past days.  I encourage you to read Crimson Reach’s posts.

In a nutshell, Crimson ridicules the presumption that banks can invest in ways that are immune to the risk of loss, and mocks the Shocked! Shocked! response when losses are actually realized.  Relatedly, he eviscerates the attempts to distinguish between “hedges” and “speculative” trades.

These distinctions are indeed Talmudic.  Any investor-including banks-makes risk-return trade-offs.  With respect to banks particularly, they are in the business of taking credit risk.   There are myriad ways of taking on credit risk.  Making loans.  Buying or shorting corporate debt.  Buying or selling CDS .  What really matters is the risk of the overall portfolio.  There are many ways to achieve the same risk profile.  And since banks inevitably take on risk, there are many ways to lose money.  And believe me, banks have found them all.  Sovereign debt (remember the LatAm debt crisis, anyone?), mortgages, corporate debt, consumer lending.

What JPM described as a “hedge” was really a trading strategy was not a mechanical offset of an existing position.  It was designed to perform (relatively) well in a particular state of the world, i.e., another financial crisis.  In that sense, it was taking a view on the potential damage associated with that state of the world, and the likelihood of that state.  That state didn’t occur, and the position performed badly.

Like I said, there are myriad ways to invest or trade based on that view, and there’s virtually no way to prevent banks from investing or trading based on their views on risk.  That’s what banks do.  Deal with it.

These views will often be wrong.  Which is why banks frequently lose a lot of money.  When they share the same views, and hence trade/invest the same way, they will lose money at the same time: that’s when we have a systemic risk problem.  Again: LatAm sovereign debt in the ’80s; mortgages in the ’00s.  The blessing of the JPM case was that it was pretty much alone in its strategy.

Insofar as the atmospherics are concerned, I am sure that any forensic examination of any of these loss-making episodes would reveal the same kinds of behavior documented in the Senate report.  The same duplicity.  The same attempts to avoid blame.  The same attempts to defer recognition of losses.  The same arguments and backbiting.

The biggest problem with JPM was that, well, it was big.  If you look at many major financial debacles, a common feature is that big institutions make bets that are so big that they become price makers rather than price takers.  When the bets go wrong, and they want to get out, or to reduce exposure, size becomes a liability, rather than an advantage.  Size creates positive feedbacks, and in financial markets, positive feedbacks have very negative effects.  The holder of a big position suffers losses, and tries to reduce exposure: they are so big that these attempts move prices against them, thereby exacerbating the losses.

That’s what happened to LTCM.  That’s what happened to JPM’s CIO.  The difference was that JPM had the capital to survive: LTCM didn’t.  Another good thing.

Carl Levin is using the Whale Trade to dragoon the regulators into implementing the Volcker Rule, which is intended to prevent banks from “trading”, and to limit their activities to “lending” instead.  Again color me unimpressed.  Banks have proved since time immemorial that they can lose vast sums lending, thank you very much.  One of the virtues of trading is that the discipline of mark-to-market forces realization of losses sooner: it’s harder to conceal losses on the trading book than the banking book.  (I understand the complexities here.  Especially when banks are subject to capital requirements, realizing losses can force banks to shrink balance sheets in ways that generate fire sales and positive feedbacks.)  Yeah, the traders at CIO tried to finesse/manipulate the marks to defer recognition of the losses.  But they wouldn’t have even had to resort to chicanery had these losses been on the banking book: in a (perhaps perverse) way, the frantic attempts to jigger the marks demonstrate the ruthless disciplinary effects of marking to market.

In brief, drawing distinctions between “hedging” and “speculating” or between “trading” and “lending” or “investing” or “market making” is typically futile.  Banks can f*ck up-or make lots of money-doing any of these things. And have.  Rather than attempting to micromanage the activities of banks, it’s better to focus on making sure they have the incentives to take risks prudently, and have the capital to absorb the inevitable losses.

Which is why, as far as I am concerned, the would-be Ahab Carl Levin set out to kill a great whale, and brought home a minnow.

Just because I find the expropriation of Russian deposits in Cyprus wrong doesn’t mean that I’ve gone soft on Russia.  To the contrary, my criticism of Russia and my criticism of the Cypriot confiscation grow from the same roots: a belief in the rule of law, and a deep dislike for the natural state.

A couple of stories along those lines.  First, a Russian court permitted a Russian firm, Agroterminal, to walk away from an interest rate swap it had entered with the Italian bank Unicredit:

The court’s ruling was based on a clause in the swap documentation that says a party can unilaterally terminate if there are no outstanding obligations at that point. Agroterminal had made one of the swap’s quarterly payments to UniCredit Bank and terminated immediately afterwards, arguing that as the new quarterly payment had not been calculated, there was no outstanding obligation.

Put differently, per the Russian court’s interpretation, the party to a swap has the ability to walk away at any time between payment dates.  Yeah, the market will totally work under that interpretation.  It turns the swap into an option: each party has the choice to walk away when the swap is underwater immediately after each calculation date. Since the swap will be underwater to one of the parties, this means that the swap is a non-starter.  Not a forward starting swap: a non-starting swap.

The lawyers quoted in the Risk piece attribute the court’s decision to ignorance and naivete.  Actually, what is naive is that interpretation.  Maybe the court was playing dumb, but it is pretty clear that Agroterminal had the home court advantage-literally.  That is, the court was just favoring a Russian firm at the expense of a damn furrin’ bank.  The decision is transparently silly: if one would take it literally, any floating rate claim (e.g., a floating rate bond) would be unenforceable between payment dates.  The Russian court was looking for some fig leaf to justify stiffing the Italians, and it found it.  Go figure.

The second story: Putin’s judo buddy Arkady Rotenberg has made billions on contracts for the Sochi Olympics:

Those contracts, which number at least 21, include a share of an $8.3 billion transport link between Sochi and ski resorts in the neighboring Caucasus Mountains, a $2.1 billion highway along Sochi’s Black Sea coast, a $387 million media center, and a $133 million stretch of venue-linking tarmac that will double as Russia’s first Formula One track.

Wow.  I keep kicking myself  for not taking up judo (but wouldn’t kicking be Karate-related? Whatever).  Arkady is not just the best producer of steel pipe for gas pipelines, he’s also the best builder of transportation systems, highways, media centers, and Formula One tracks.  His personal connection with Putin is no doubt totally coincidental: can he help it if he  has such varied talents?

These two stories illustrate different aspects of the Russian natural state.  The elites get fed. Kormlenie lives.   Sometimes courts do the feeding.  Sometimes the government feeds its friends, through contracts or restrictions on competition.  But the natural state rewards the connected.

And this is Russia’s curse.  This is why it is on the hamster wheel from hell.

The clearing and reporting requirements of Frankendodd have barely gone into effect, and the unintended consequences are already beginning to pile up.  Who coulda seen that coming, eh?

Even I couldn’t have made up the bestest of them.  Namely, as a result of the SEC’s bizarre portfolio margining rule, ICE has said that it will not clear single-name CDS.  You know, the weapons of financial mass destruction that were supposed to be the reason for needing a clearing mandate in the first place.  So ICE won’t clear the poster children for the clearing mandate.  Like I say: you cannot make up this stuff.

From Risk:

Ice Clear Credit has shelved plans to clear single-name credit default swaps (CDSs) for clients of its member firms, as a result of a new Securities and Exchange Commission (SEC) policy on portfolio margining. Under the terms of that policy, circulated late on March 8 – the last working day before the start of mandatory clearing for CDX index trades in the US – clients would be able to benefit from risk offsets between cleared index and single-name contracts, but the vast majority would be charged twice the margin calculated by a central counterparty (CCP).

The move sparked a furious response from some buy-side firms and has now dissuaded Ice’s CDS clearing house from offering the service at all.

“Last Friday, the SEC issued a temporary approval requiring broker-dealer futures commission merchants (FCMs) to charge two times the initial margin requirement of the CCPs. This was unfortunate, so we made a decision, based upon that unexpected development – news of which we received very late in the day on Friday – and based upon input from many clients, that it would be better not to offer single-name clearing under those conditions than to make single names available,” Peter Barsoom, chief operating officer of Ice Clear Credit, told attendees at the Futures Industry Association (FIA) annual conference in Florida last week.

The SEC policy gives temporary approval for an FCM to allow cross-margining if it collects 150% of the margin required by a CCP, but only if the client has “virtually no credit risk”. For all other clients, 200% must be collected on positions held in the portfolio margin account, which participants say would apply to most buy-side firms.

Portfolio margining across asset classes is theoretically beneficial, but practically dicey due to the instability of correlations, which often result in positions being undermargined during conditions of market stress.  And yes, individual name CDS and indices can diverge, again particularly during periods of financial stress.  But a portfolio consisting of a position in an index and offsetting positions in single names (especially names in the index) is less risky than either leg on its own.  This means that it is possible to improve capital efficiency while holding risk level constant by giving margining offsets for portfolio benefits.  But noooooooooooo.  In its infinite wisdom, SEC has decided to punitively margin these portfolios.  This reduces substantially the benefits of clearing individual name CDS, so ICE says to hell with it.

Again, the irony is almost too much.  The risks of single-name CDS were constantly invoked to justify the clearing mandate.  Those arguments were largely bogus, but regardless, due to regulations adopted to implement the mandate, single-name CDS will not be cleared for the foreseeable future.  Yay!

This is yet another example of the perverse effects of regulatory setting of margin levels.  I’ve been saying this so much I’m blue in the face: you could call me the smurfwiseprofessor.   For the zillionth time: regulatory margin setting is a form of price control, risk price control specifically.  Price controls never work.  Worse than that, price controls always lead to distortions.  First with futurization and now with portfolio margining, we are seeing these distortions appearing, big time.  And they’ll likely only get worse, when margins on non-cleared swaps are finalized.

Regulators have neither the information or incentives to set these prices right.  They bewail regulatory arbitrage, but their attempts at price control are the destined to set off a regulatory arbitrage land rush.

Sheesh.

But it gets better!  Even the seemingly banal task of reporting swap trades is overwhelming the CFTC.  According to Scott O’Malia, they cannot find a London Whale in a phone booth:

Dodd-Frank Act derivatives rules are failing to give regulators a full picture of the swaps market and wouldn’t help them detect a loss similar to JPMorgan Chase & Co. (JPM)’s London Whale trades, according to Commodity Futures Trading Commission member Scott O’Malia.

Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.

The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.”

. . . .

Different swap dealers and trading counter-parties are using their own reporting formats because the government failed to specify standards, O’Malia said.

“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?”

The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said.

This should be no surprise.  The issues with CFTC computers particularly.  The GAO issued reports in the ’80s ripping the agency for its IT dysfunctions.

Frankendodd has barely come to life, and it is already wreaking havoc.  I am sure there are more good times to come!

And I am totally, totally sure that Obamacare will work just as well.  No prospect for unintended consequences there!

Sorry about the silence, folks.  I was in Geneva doing my annual teaching in the University of Geneva’s Masters program in International Trading, Commodity Finance, and Shipping.  It is a very unique program, and a joy to teach in.  I also spoke at the annual Trading Forum sponsored by the Geneva Trading and Shipping Association (which also sponsors the Masters program).  I spoke about Frankendodd, which is somewhat ironic given that Mary Shelley wrote Frankenstein on the shores of Lac Leman a few miles from Geneva.

Some quick catch up.

First, Bloomberg is threatening to sue the CFTC for discriminating in favor of futures and against swaps.  Bloomberg plans to launch a SEF, and (rightly) believes that the discrimination regarding the margin requirements will seriously impair the prospects for its success.

At the annual FIA gathering in Boca, Gary Gensler doubled down in his support for the discrimination (a Risk Magazine link, so a subscription is required):

“Under clearing rules finalised in 2011, swaps executed on a designated contract market or a Sef have the same margin requirement – one day for energy, metals and agriculture, which is where we as a market have been for years. Interest rate swaps have been cleared for nearly 10 years on LCH.Clearnet. They have used a practice for many years around five-day minimum margining,” Gensler told Risk, after his prepared remarks yesterday at the Futures Industry Association annual conference in Florida.

How’s that for an answer lacking any intellectual content or analysis?  LCH’s done it that way in interest rates for many years, so everybody should do that for everything going forward.

Got it.  Why think when you can merely defer to precedent, regardless of how relevant that precedent is?

Someone is thinking, and echoes my analysis of the inanity of treating economically equivalent instruments differently just because one is called a “future” (good!) and the other a “swap” (bad! bad! bad!):

“If there are two products that are equally standardised, that take the same time to liquidate, that have the same risk, volatility and liquidity characteristics, then both of them should be subject to the same margin requirement. Collateral should be determined on the characteristics of the product in question, not the wrapper,” said Sunil Hirani, chief executive of fledgling interest rate swap and futures exchange TrueEx, speaking on the sidelines of the conference.

“If a contract takes five days to liquidate then it should be subject to five-day value-at-risk, and a one-day liquidation product should be subject to one-day VAR. If a futures contract has worse risk, liquidity and time-to-liquidation characteristics than a swap, but then receives a more favourable margin treatment because it’s in a futures wrapper, that is an injustice,” he added.

My only quibble is that it’s not an injustice, it’s a recipe for regulatory arbitrage and potentially for systemic risk.

Speaking of SEFs, Scott O’Malia told Risk that progress on writing the SEF rules-which had been expected any day-is slow.  Tiresomely, this also bears the fingerprints of Gensler’s meddling hand:

Nonetheless, at a panel discussion on Sefs held earlier in the day, O’Malia recited the Dodd-Frank definition of a Sef and observed pointedly that “the word five does not appear anywhere in there” – an allusion to the controversial proposal that any request for quote (RFQ) via a Sef must go to a minimum of five dealers.

“[CFTC chairman] Gary Gensler’s original position was that he did not want Sefs to include RFQ capability at all,” says one chief executive of a trading platform that plans to register as a Sef. “His initial hope was to restrict all these new venues to a central limit order book model, but when it became clear that an order book would only work for the most liquid swap contracts, he conceded the need to permit RFQ as an execution method, but included the stipulation that quotes must be sought from a minimum of five market-makers.”

And some dealers claim this is now the major impasse, with Gensler said to be refusing to drop the so-called RFQ5 provision from the final language or bring it into line with corresponding Securities and Exchange Commission rules for securities-based Sefs, which state that an RFQ can be sent to a single dealer.

So again, Gensler wants to dictate market structure: every SEF has to have a CLOB foot.  One size fits all.  No appreciation whatsoever for the fact that there is a diversity of market participants and interests that may well be served by a diversity of execution mechanisms.  No appreciation for the fact that the supposed beneficiaries of Gensler’s would-be fiat might actually know their own interests better than he does.  No appreciation for the fact that the discovery process of competition can result in the creation of a set of SEFs that best matches the diverse needs of market users, and that this competition may spur innovation that would result in the creation of an as yet undreamed of trading mechanism that meets market users’ needs far better than a CLOB.

Keeping this Gary Knows Best attitude in mind, be afraid, be very afraid when you read this story of about the next potential target of CFTC inquiries: price setting mechanisms. Taking inspiration from the Li(e)bor issue, the Commission is now (informally) discussing the possibility of investigating other benchmarks, notably the London gold and silver fixes:

“The idea that pervasive manipulation, or attempted manipulation [of interest rates], is so widespread should make us all query the veracity of the other key marks,” said CFTC Commissioner Bart Chilton at a Feb. 26 roundtable in Washington on financial benchmarks. “What about energy, swaps, the gold and silver fixes in London and the whole litany of ‘bors’?” he said, referring to Libor, Euribor and other benchmarks.

What’s rather disturbing is the linking of the gold and silver fixes and “bors”.  These things are very different.  The main problem with Li(e)bor, etc., is that they are not set on the basis of transactions: on this I agree with Gensler, having been making this point in an interest rate and commodity context for going onto 20 years.  (In my 1992 book Grain Futures Markets: An Economic Appraisal, I criticized proposals for cash settled grain contracts due to the lack of cash transactions on which to base an index.)

In contrast, the LBMA fixes are centralized auction mechanisms (Note to Gar: nearly a CLOB!)  Indeed, they are textbook examples of a Walrasian auction.  An initial price is mooted, and the participants indicate the amount they want to purchase or sell at that price: the quantity announced by each participating bank includes customer bids and offers, so buying and selling interest reflects more than just the proprietary trades of the fixing banks.  If at the initial price there are more buys (sells) than sells (buys), the price is increased (decreased), and each fixing participant again indicates its trading interest at the new price.  The process continues until buys equal sells, i.e., until the market clears.

Crucially, participants in the auction who are buyers (sellers) at the clearing price take (make) delivery of metal in an amount equal to their bid (offer) quantity at that price.  That is, the clearing price results in actual trades.  This is miles different than Li(e)bor.

This is not to say that a Walrasian auction cannot be manipulated: for instance, a company with a large long derivatives position that has a payoff tied to the fixing price might want to put in large buy orders in the fix to drive up the clearing price in order to impact favorably the payoff of the derivative.  Here the relevant issue would be the impact of orders on the clearing price.  That’s a totally different issue than in Li(e)bor, but I’m quite concerned that CFTC views all benchmarks as indistinguishable pieces in a mass.

And Gensler’s analysis-free treatment of futurization and SEFs only fuels those concerns. Good policy needs to be predicated on good analysis, not the prejudices and suspicion of the policymaker.  Gary Says So ain’t good enough, even for government work.  But too often that’s what we are getting.  We’ve seen it with futurization and SEFs, which raises legitimate concerns that the same will occur with benchmarks.  The confabulation of LBMA fixes with ‘bors only heightens those concerns.

A side note (added later): The suggestion that the CFTC can examine the London fixes betrays incredible hubris.  How could the US CFTC possibly have any jurisdiction over a UK entity-the LBMA-or the conduct of banks, only one of which (HSBC USA) is a US entity?  Especially given that as far as I am aware there is no CFTC regulated derivatives contract tied to the London gold or silver fixes.  But Gensler is all about extraterritoriality, so don’t put it past him to try.  I hope he tries, actually.  The Brits will go totally ballistic if he does.  Perhaps that’s exactly what’s needed to constrain GiGi’s imperial ambitions.

One other thing.  I didn’t mention anything about clearing, but Gensler’s analysis-free approach has been particularly prominent there.  To say that his “analysis” of clearing over the past 4 years has epitomized a comic book approach to the issue is an insult to the intellectual rigor of comic books.

There has been considerable hue-and-cry over reports that the CFTC’s SEF rule will require market participants to solicit only two quotes instead of five when using a Request for Quote (RFQ) in a swaps trade.  This is being portrayed as a concession to the dealer banks that will permit them to perpetuate their alleged oligopoly.

I have always been harshly critical of the SEF mandate, and of regulations dictating how market participants execute transactions.  Indeed, I named the SEF mandate the Worst of Frankendodd.  And believe me, the competition is so intense, so hell to the victor.

There are diverse market participants trading diverse instruments, and there is no one-size-fits-all best execution mechanism: diverse execution mechanisms have evolved to accommodate diversity in products and transactors.

This is true of RFQ mandates too.  Indeed, it is passing strange that anyone believes that requiring end users to get more quotes is in their benefit.  If the goal of the execution mandates is to help end users by breaking the dealers’ alleged stranglehold on the market, why should you impose constraints/requirements on the end users?  Why can’t they determine what the right number of quotes to solicit is?  Don’t they know their own interests?  Can’t they trade off the alleged benefits of soliciting more quotes-namely, greater competition to take the other side of the trade-against potential costs-such as information leakage?  The regulation seems to be extremely paternalistic.  Like end users are children who need to be made to eat their Brussels Sprouts, because they don’t know what’s good for them.

But, in fact, end users-including extremely sophisticated buy side firms like Blackrock and Pimco and FMC-know quite well what works for them.  Indeed, ISDA and SIFMA just released the results of a poll showing that buy side firms-non-dealers, in other words-heartily oppose the 5 quote rule.  Actually, “heartily oppose” is a putting it mildly.  They hate it.  By wide margins they think it will reduce liquidity and raise their execution costs.  More than 80 percent of poll respondents expressed concerns about information leakage.

Ironically, 68 percent of the respondents said that they would try to trade instruments not subject to the SEF requirement.  In other words, a regulation intended to ensure that swaps were traded on open, transparent, exchange-like platforms will instead cause traders to attempt to avoid them.

Another example of “we’re from the government and here to help you” in action.

The histrionics over the “weakening” of execution mandates also betrays the intellectual incoherence of Frankendodd and it’s advocates.  The putative purpose of the law is to reduce systemic risk.  Its focus on derivatives is predicated on the belief that these instruments are inherently systemically risky, and that derivatives markets are too big and need to be cut down to size.

If that’s what you believe, then you should favor of the exercise of market power by dealers.  You should love-love!-a dealer oligopoly that raises the price of execution, because that reduces the size of derivative markets.  You believe that derivatives markets are too big, and should be taxed: and practically speaking, a dealer oligopoly that inflates execution costs serves as a tax.  It is equivalent in many ways to a transaction tax.  What’s more, the rents created by such supercompetitive prices are like a boost to the capital of dealer banks which reduces the likelihood that they will need a bailout.  That is, a dealer oligopoly reduces systemic risk, and increasing competition increases systemic risk.

In other words, if you believe derivatives markets are too big, you should *NOT* want to make execution more efficient.  You should love love love dealer market power, and strive to do anything to enhance it, rather than reduce it.  This is the theory of the second best in action.

But, sadly, intellectual coherence has never been the strong point of Frankendodd advocates. Which goes a long way to explaining what a mess it is, and what havoc it will wreak.

John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville–is going on about the “disconnect” between nearby and deferred Brent.  He blames-wait for it-hedge funds.  Natch.

The Brent market is currently in a steep backwardation.  I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.  Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky.  My 2011 book provides a robust model that predicts exactly this result.

The intuition is quite straightforward-as I’ve been teaching for about 20 years too.  Inventory is what connects spot and futures prices.  When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices.  In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low.  Hence the association between contango and high correlations.

Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.

Kemp does note that there is physical tightness that does explain the backwardation:

Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.

But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.

Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.”  Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months.  This should put downward pressure on nearby prices, if the speculators were really  in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.

Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements.  But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence.  Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out.  The level of the curve is largely driven by persistent, business-cycle type shocks.  This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison.  The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom.  This resulted in a rise in the price level and only a modest increase in backwardation.  That is completely different from current conditions-hence the different behavior.

Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable.  The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”.  Again, one would expect this to be associated with high spot-futures correlations.

Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations.  The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis.  These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.

At that time, macro volatility-as measured by the VIX-was high.   In early ’09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent.  Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.”  High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big.  The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities.  These are exactly the patterns observed in the past months.

That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds.  Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive.  At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production.  Overall BFOE production is only about 1mmbpd.  Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).

If you want to identify who might be doing that, look at who is taking the physical cargoes.  Those parties would be the squeezers.  If hedge funds are the culprits, they should be taking a lot of physical supply.  Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too.  Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.

Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes.  Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems.  But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes.  Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.

Squeeze-driven backwardation also tends to reduce spot-forward correlations.  The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals.  Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism.  As I show in another book (and many articles).

So Brent may indeed be broken, but hedge funds haven’t broken it.  It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply.  I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.

Fixing Brent requires enhancing deliverable supply.  Not an easy thing to do.

Again contrast Brent and WTI.  Brent boosters have constantly bashed the WTI disconnect.  But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed.  But building infrastructure is a helluva lot easier than building  a new Buzzard. Trust me on this.

So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.

I laughed out loud when I read this paragraph from a Risk Magazine article about futurisation in the energy markets:

Top CFTC officials [GiGi? Is that you?] as well as members of Congress who supported Dodd-Frank [that’s Frankendodd around here, buddy] have repeatedly said the law was not aimed at physical end users of derivatives.  But if the the flight towards futures causes liquidity elsewhere in the market to dry up, end-users might have no choice but to fall in line.

Look: Elvis Costello’s “My aim is true” is definitely not the theme song of regulators and legislators in the US, or anywhere for that matter.  A 16 year old, hopped up, Afghan jihadi sprayin’ and prayin’ with his AK on full auto is more discriminating in his targeting than most regulators, and regulations.  Unintended consequences-AKA collateral damage-are the rule, rather than the exception with regulations.  This goes N-fold for monstrosities like Frankendodd.

Frankendodd is just starting its rampage.  The energy derivatives markets-and end-users in them-are only the first victims.

So when a regulator or legislator says that a particular reg or law isn’t aimed at you, don’t take comfort: take cover; there will be incoming.   We’re not talking Sergeant York or Annie Oakley behind the trigger here. More like Blind Lemon Jefferson.

I am adding a new entry to my list of phrases that put me on guard that someone is trying to con me: “balanced approach.”  Obama is always blathering about balanced approaches to fiscal matters.  And in today’s WSJ, Dow Chemical CEO Andrew Liveris pleads for a “balanced approach to shale gas exports.”

To say that “balanced” is highly subjective is the understatement of the century.  In Obamaland, “balanced approaches” mean large tax increases now, and hazy promises of spending cuts in some distant future.  In Leveris’s oped, “balanced” means imposing restrictions on exports of natural gas to lower the cost of his most important input.  Funny, ain’t it, that things seem to tip the way of those advocating “balanced approaches”?  In other words, if it helps me, it’s fair and balanced!

Liveris couches this as a means of stimulating employment in US manufacturing and increasing GDP:

Moving manufacturing facilities back to the U.S. from abroad—the trend known as “reshoring”—could create up to five million American jobs over the next seven years, according to the Boston Consulting Group. This figure is so high partly because in the chemical industry jobs created by investing in domestic manufacturing are eight times more beneficial to gross domestic product than are simple gas exports, as documented by the American Chemistry Council.

To which I reply: Bull.  National income is maximized when goods are allowed to flow to their highest value use.  If domestic gas prices are $3/mmBTU and foreign prices (net of transportation, etc.) are $4, that means that at the margin 1 mmBTU of gas consumed in the US-including by Dow-generates $3 of value, and if consumed overseas it generates $4.  Letting that mmBTU go overseas therefore generates $1 of value-of income.  No BCG or American Chemical Council mumbo jumbo can change that simple fact.  And I’m sure that the ACC is totally objective.  Totally.

Leveris pleads that all he wants is a rule-based system:

The truth is that every firm in every sector benefits from exports and rules-based free trade. But what are the rules for exports of liquefied natural gas? Who sets them? Oil and gas companies, states, Japanese government agencies? Or are they part of rules-based free-trade agreements that the U.S. government has negotiated so as not to disadvantage domestic consumers, manufacturers and workers?

Here’s a balanced rule for you, Mr. Leveris: Producers can sell to whomever offers them the highest price.  Short. Simple. Easy to understand.  No bureaucrats required.  And to show what a broad minded guy I am, I propose that the rule be applied to Dow.

But Leveris wants to insert bureaucrats into the process:

The Department of Energy has already received applications for the export of half the gas consumed in the U.S. today. Under a 1938 law, the department must determine if those applications for exports are in the national interest (taking into account all segments of society).

Several manufacturers, including Dow, are calling for faithfulness to current law. We are concerned that hasty government action, coupled with growing domestic and international demands for natural gas, will trigger a severe supply pinch that will send the U.S. back to the days of higher and more volatile domestic natural-gas prices.

Ah.  “The national interest.”  That’s the ticket.

The 1938 law inserts a government bureaucracy that can distribute rents among rent seeking supplicants-such as firms like D0w-based on political calculations.  Resources are wasted in the influence process: e.g., chemical companies and energy companies engage in an influence arms race employing lobbyists and other resources to importune the bureaucrats.  More resources are wasted as this process inevitably leads to inefficient outcomes.  The uncertainty generated by the vagaries of this process also serves to damp investment.

So here is my balanced proposal: scrap the 1938 law.

Everywhere you look you see that energy is highly politicized.  Politicians and bureaucrats exert a huge influence over the allocation of energy resources.  Look at Keystone XL.  Look at cockamamie subsidies for solar and wind.  I could go on and on.  These interventions destroy huge amounts of value.

Balance is a relevant concept here, because politicians and bureaucrats balance competing political interests when choosing policies that divide up the pie.  But that “balanced” process destroys wealth.

We need less politicized energy market.  Allowing free export of US natural gas-and oil-should be a no brainer if your object is-as Mr. Leveris claims his is-to maximize national income.  But that’s not his real objective.  His real aim is to maximize Dow’s income, to redirect wealth from the shareholders of E&P firms to his shareholders.

Leveris’s piece is a gaseous plea for mercantilism, though of a rather apostate form since traditional mercantilism advocates the maximization of exports.  But the essence of mercantilism is government control and manipulation of trade.  And moreover, one staple of mercantilist thought is that domestic raw materials should only be used in domestic manufacture because manufactured goods are more valuable than raw materials.  Leveris repeats this long discredited fallacy in his oped.  Proving that few things live longer than bad arguments.

Sadly, it is likely that the chemical industry, and other energy consuming industries, will exert some influence and succeed in restricting the exports of natural gas.  That’s the way things work, alas.  But don’t buy the bilge that these restrictions are part of a “balanced approach” that advances (ill-defined) “national interest.”  Instead, they are inherently unbalanced and advance very specific economic interests.

And one last word of advice: when anyone says they are only advocating a “balanced approach”, grab your wallet and call bull.

Gensler and Chilton are taking up the cudgels again for position limits-this in spite of the spanking from Judge Wilkens last year.

Chilton, as usual, is most outspoken on this issue:

Today, energy costs for most families have risen more than 20 percent since 2001. This hurts not only American households, but also American business—like many of your businesses—that rely on energy. According to the Energy Information Administration (EIA), nearly nine percent of our economy or $1.4 trillion is spent on energy annually. Imagine if that figure dropped by just ten percent—$140 billion freed up for investment and economic growth.

So that’s why I continue to lead the charge for position limits—to help keep the markets working for you. The efforts to stop position limits will ultimately fail. Congress told us in no uncertain terms to get it done, and I intend to see that we do that, before more families and businesses go into the “red” column on their balance sheets.

First of all, 20 percent in 13 years is less than 2 percent per year-that is, less than the rate of inflation: the CPI is up almost 30 percent over those 20 years, meaning that the real price of energy has fallen.   I say again: the real price of energy-per Chilton’s own numbers-have fallen.

I also note Chilton’s continued focus on the rise in oil prices, and his complete refusal to acknowledge the collapse of natural gas prices precisely during the period in which his Massive Passive bogeymen have allegedly driven commodity prices generally, and energy prices particularly, far above what they “should” be.   If “speculation” by “massive passives” (or whoever) can cause prices to become completely unhinged from fundamentals, why has natural gas moved in the exact opposite direction from oil?

Chilton’s egregious errors of omission and commission must be caused either by a lack of intellectual capacity, or a lack of intellectual honesty.  I really see no other alternative.

A member of my vast, globe-straddling network of sources informs me that at this morning’s session of International Petroleum Week in London, John Kingston of Platts referred to my estimate of the economic surplus created by new pipeline investment.  That number is almost a year old, and Kingston’s mention prompts me to update that computation.

It is a basic welfare triangle calculation that depends on quantity-pipeline capacity-and price differences between LLS and WTI.  At present, the LLS-WTI spread is slightly north of $20/bbl.  The forward spread is above $7/bbl (and nearly $8/bbl) as far out as December 2015.  (These are based on settlement prices from CME Clearport.  There aren’t a lot of trades that far out, so those numbers have to be treated with some caution.  That they are in the ballpark of the forward Brent-WTI spread provides some confidence, but of course, CME might have used the Brent-WTI spread in calculating the settlement price for forward LLS-WTI spreads that didn’t trade.)

According to the EIA, there are 1.150 mm bpd of planned pipeline capacity additions from Cushing to the Gulf, and another 830 m bpd planned capacity additions from Permian to the Gulf (back in the day much Permian oil flowed into Cushing, so the Permian capacity additions are another way of easing the Cushing bottleneck)

Given the uncertainty about when that capacity will come on line, I will make a couple of calculations that will bound the value they create.

If all the capacity is expected to come online by December, 2015, the welfare gain is (.5)($20+$7)(1.98mm)-($2)(1.98mm)=$22.77mm/day.  (The $2 is an assumed marginal cost of transportation.)  Note that there is remaining value to adding even more capacity under these assumptions.  If Q additional bpd of capacity is required to drive the spread to marginal cost, the gain from adding this Q units of capacity is (.5)($7+$2)Q-($2)Q=$2.5Q.

If the capacity is expected to come on line sometime after December, 2015, and it is expected that the spread will go to marginal cost when it does, the value of the capacity is (.5)($20+2)(1.98mm)-($2)(1.98mm)=$17.82mm/day.

Big numbers.

It is possible to calculate a similar number for pipeline capacity going into the Midcontinent.  EIA reports that 1.19 mm bpd of capacity from Canada to Midcon is planned.   Western Canadian Select quotes are available via CME only through February, 2015, and are under -$20/bbl for the entire 2 year period: the nearby number is $-26/bbl.  I’ll make a WAG as to what the spread should be once the transport bottleneck is eliminated (because there are quality differences, and the distances are substantial, I don’t know off the top what that should be)-my WAG is $5/bbl.  That gives us (.5)($26+$5)(1.19mm)-($5)(1.19mm)=$12.5mm/day.  That number swings (.5)(1.19mm) for every dollar change in my WAG.