Streetwise Professor

In this week’s edition of Energy Metro Desk, John Sodergreen wrote: “Normally, Pirrong is a ‘take no prisoners’
sort of economist.”  He was referring to my apparently serene response to the Singleton paper on energy speculation.

Rest assured, all, that I am not mellowing in my old age.  My response to Singleton qua Singleton was serene primarily because the results are capable of many interpretations, many of which are quite compatible to my views.  Further rest assured that I am my scathing self when it comes to the efforts to misinterpret and overinterpret Singleton’s results.  It is being waved about as the smoking gun proving that speculation distorts prices.  This is completely wrong, and reflects either the ignorance or agenda–or more likely, both–of anyone making the claim.

Remember what Puddin’ Head Wilson said: “We should be careful to get out of an experience only the wisdom that is in it — and stop there.”  People are getting far too much “wisdom” out of Singleton than there is in it. Singleton’s results are perfectly consistent with a favorable or benign effect of speculation.

But there is nothing more likely to get me to break out the black flag than an epistle from Bart Chilton, and yesterday he did not disappoint.  The NY Times’ Dealbook had this gem from our ol’ buddy Bart:

It’s a familiar cry from Wall Street executives and Congressional Republicans: New regulations will dampen profits and crimp an already-feeble job market.

But some federal regulators, now charged with writing dozens of new rules for Wall Street, beg to differ. Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, argues that a regulatory shake-up would actually spawn a wave of hiring on Wall Street and in Washington.

“The possibilities for economic growth and competition here are mind-boggling,” Mr. Chilton said on Friday during a speech at the University of Maryland.

The debate centers on the controversial Dodd-Frank Act, which overhauled financial regulations after Wall Street nearly collapsed during the financial crisis. The law, among other things, transformed the $600 trillion derivatives markets, a lightly regulated industry at the center of the mess.

. . . .

“I have no doubt that these new regulations, instituting new types of clearing, trading and reporting platforms, will foster a landslide of hiring in the financial sector,” Mr. Chilton said.

In particular, Mr. Chilton forecast growing demand for technology experts. “All of this new trading activity, with new regulatory oversight requirements, will mean the development of new technologies, both in the private and public sectors,” he said.

The mind boggles.  Chilton, like all too many regulators and legislators, confuses costs and benefits.  This is the broken window fallacy on crack.  Said regulators and legislators should be required to have Bastiat’s discussion of the seen and the unseen flashed before their eyes repeatedly, Clockwork Orange-like, until the idea sinks in.  Short of that, I am at a loss at how to educate them on this profound–yet simple–concept.

Yes, we can see all the accountants and lawyers beavering away on Sarbanes-Oxley-related work.  But what about all the other–and actually productive–things those people could be doing if Congress in its infinite wisdom and overweening arrogance hadn’t seen fit to create an artificial demand for their services, that distracted them from doing something that is actually socially productive?  What about the companies that are smaller, and the companies that don’t exist, because of the burdens of this and other counterproductive regulation?

Frank-n-Dodd is Sarbanes-Oxley raised to a power far greater than one.  Yes, there will be lawyers and compliance people working in their tens of thousands to ensure adherence to its mind-numbing dictates.  Yes, the idiotic SEF requirement will result in a splurge in spending on technology, and there will be much rejoicing among programmers and IT people.  To the bean counting regulator or legislator this is good.  To the more perceptive, it is a crime.

Riddle me this, Bart: If this technology were actually valuable, why do you and your ilk have to force its creation?  You, in particular have been critical of the dizzying pace of technological development in the trading space.  So you know this is obviously a technologically dynamic industry where there is intense competition to create new products and services and methods of delivering them, not some tradition-bound backwater.  If the kind of technology Frank-n-Dodd is going to bring into existence were actually delivering value to market participants, you can be damned sure that somebody would have figured that out.  Many somebodies, in fact, who would be competing like hell to bring it to market faster and better than anyone else.

And further: please tell me what actually beneficial inventions will not be created, or will be delayed, because their would-be inventors are instead (rationally) responding to some inane government mandate?  You can’t, and I can’t.  But they exist.  Just because you can’t see them, doesn’t mean they aren’t there

And please: tell me how you distinguish a cost from a benefit.

Sadly, the inability to tell cost from benefit is rife in the 202 area code.  The disease is probably most acute at EPA, which blessed us with this gem of economic analysis:

In fact, the EPA has even suggested that new regulations can have a positive impact on job growth. “In periods of high unemployment, an increase in labor demand due to regulation may have a stimulative effect that results in a net increase in overall employment,” the agency wrote in February.

This is the kind of moronism we are dealing with, people.  And the rot is spreading.  Including to the CFTC, apparently.

When you read or hear this or that macroeconomic theory about why the recovery–such as it is–has been so weak, and why the economy totters on the brink of another recession, put it in its proper perspective.  Yes, macro factors are important.  But so too is the massive regulatory millstone hanging around our collective necks.  People who think costs are benefits are running amok.  And sad to say, they are just getting warmed up.

We need to fight these people.

* The Degüello was a bugle call dating from the Moorish Wars of the Reconquista in Spain. Literally, it means “throat slashing” and was played to signal “no quarter–take no prisoners.” Santa Ana’s army played it before the final charge at the Alamo.

I consider the entire $500 million plus squandered on solar panel manufacturer Solyndra by Obama the Beneficent to be an appalling combination of green (as in money)-worshipping crony capitalism and green unicorn-worshipping foolishness.  That said, I am deeply uneasy over the Masky Raid that was unleashed on the company soon after its bankruptcy.  Like R, I find it all too redolent of Russia (pace BP’s and Prokhorov’s recent tortures).

Perhaps there is a crime here, but given the increasingly pronounced predilection of prosecutors and law enforcement to engage in what appears to be more headline seeking than serious attempts to deal with true wrongdoing, I have my doubts as to whether the company engaged in serious malfeasance.

Either alternative explanation of recent events is disturbing.  Under one explanation, Solyndra was not a criminal enterprise, but just not an economically viable one that the government pumped nearly half-a-billion into.  In that case, there is no justification for a raid.  Under another explanation, Solyndra’s management was engaged in criminal acts–but the Department of Energy (which participated in today’s raid) couldn’t figure that out when it gave the company $585 billion in March 2009, or when the company restructured mere months ago.

In other words.  Case 1: an economically unsustainable but legally clean company is harassed by Big Brother.  Case 2: Big Brother is so incompetent that it couldn’t figure out that it was shoveling hundreds of millions of dollars into a criminal enterprise, and didn’t engage in proper oversight of such a huge debtor, and hence financed the operation of a criminal enterprise.   Hard to see another alternative.

The incompetence alternative gets a boost from Nobel Prize winning Secretary of Energy Chu.  DOE’s Inspector General participated in the raid, but Chu apparently thinks that Solyndra is a success.  Yes.  You read that right.  A success:

Mr. Chu’s spokesman argued that “the project that we supported succeeded. The facility was producing the product it said it would produce, and consumers were buying the product.”

Then I guess every firm filing through bankruptcy court is really a success.  Chu is obviously a brilliant physicist and an economic numbskull.  Which wouldn’t be the first time that’s happened.

Seeing what has transpired with the spawn of the first stimulus, by all means, let’s “pass the bill” so we can watch Son of Stimulus.  By Chu’s standards, it’s guaranteed to be a smashing success.

Gillian Tett has apparently discovered (via JP Morgan) that commodity production costs are a fundamental.  Who knew?

This article by George Priest about the incoherence of the USDOJ Antitrust Division’s attack on the ATT-TMobile merger is worth a read.

The key fact that Priest focuses on is the response of Sprint’s stock price to the announcement of the Division’s attempt to block the merger.  If the merger really would reduce competition, Sprint’s stock price should have fallen.  The fact that Sprint’s price in fact rose is strong evidence that the merger would have increased competition in the wireless market.

The key analytical point in the article is this:

Much of the Justice Department’s failing on this issue derives from its failure to understand that network industries must be evaluated differently from more traditional, manufacturing industries. The market share guidelines upon which the Justice Department relies to oppose this acquisition may make sense in the context of manufacturing industries. But they make no sense in the context of networks in which there are great benefits from large networks with large market shares.

This was the mistake the Justice Department made in the Microsoft case almost a decade ago. It wanted to break up Microsoft, supposedly to create greater competition among Web browsers. The courts prevented the effort, and to good effect.

The rise of Google, Facebook and the competition from smartphones that resemble computers have shown that the focus then on browser competition misunderstood the rapidly changing nature of network competition. The Obama administration is making the same mistake with its opposition to AT&T’s acquisition of T-Mobile.

This is exactly right.  And it helps explain the intellectual confusion at DOJ and in the European Commission on all matters relating to financial exchanges and financial markets.  Financial trading is a network industry, and the same failure to understand the implications of network economics for market structure that has muddled antitrust enforcement in telecomms and software is leading to a similar muddle in antitrust analysis of financial markets.

Back in June, at a nice lunch with several LCH.Clearnet executives in The City, I was asked my opinion on the company’s future.  Recent news, notably the offers for the company by Markit and LSE, have brought that conversation to mind.

My answer was that I thought that the trend towards vertical integration by exchanges was inexorable, and that there were good economic reasons for this (which I have discussed for years here on SWP).  As a result, I didn’t/don’t consider the model of an independent firm clearing for multiple execution venues/exchanges to be viable.  Especially with Frank-n-Dodd and Emir, but likely even without that impetus, there definitely will be increasing opportunities for clearing OTC derivatives.  (Although I cautioned that if the ambitions of regulators and legislators to make OTC trading exchange-like were successful, the same kind of dynamic now playing out in listed derivatives could occur in swaps.)  So SwapClear is clearly a viable business (similarly, RepoClear).  But major dealer firms would demand considerable influence over, and perhaps control over, the clearing entity.  Any such entity would either be, or closely resemble, a member cooperative.

My prediction was that (a) the exchange clearing business of LCH.Clearnet would either go away, or be absorbed into an exchange or exchanges, and (b) the swap clearing business would be largely in the orbit of the big dealer banks, although how that would be achieved organizationally remains to be seen.

The LSE offer is clearly intended to obtain the in-house clearing capability that LSE has lacked for decades (in part due to its own missteps in the 1970s and 1980s).  But LSE has no comparative advantage in operating the OTC clearing business, and the dealer banks have no interest in having LSE control it.

In contrast, the OTC derivatives business is a much closer fit with Markit, given the overlap between the membership of OTCDerivNet (which governs SwapClear) and the ownership of Markit, and the synergy between Markit’s OTC valuation, processing, and data business and OTC clearing.  But Markit really has no need for LCH.Clearnet’s listed clearing business.

So the sensible outcome would be to split the baby, with LSE taking over its own clearing by acquiring part of LCH.Clearnet, and Markit taking the OTC-related business.  That end state seems much more sensible than either LSE or Markit swallowing all of the big London-Paris clearer.  How that end state is reached–how the baby actually gets split–will be quite interesting to watch.  I am sure there will be much drama in the coming months.

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.

I read Mark Thoma’s Economist’s View blog to get a view on the views of people who think quite differently than I.  It is particularly useful in that regard because although Thoma writes quite a few posts, he is more of a linker than a writer, so EV is an efficient way to get exposed to the views emanating from the Keynesian-left of the blog world.

Which means that whereas I think “aggregate demand” has something to do with the cement market, Thoma is definitely of the what-we-have-here-is-a-failure-to-demand-enough-in-aggregate kind of guy.  Which further means that he is frequently looking to rebut alternative explanations for poor economic performance.  Him being him and me being me, I usually find his efforts implausible, but this one particular effort of his is particularly lacking, and is sufficiently close to my bailiwick to warrant a rebuttal.

“Of his” might be a little strong, for the post in question primarily endorses the analysis of another blog, but he doesn’t even quibble, so attributing ownership is fair.  In any event, the alternative theory at issue is “regime uncertainty”; the view (originally developed by Robert Higgs) that uncertainty about government policy (and the economic environment at large) discourages hiring and investment.  Higgs originally applied the idea to the Great Depression: he argued that the frenetic regulatory activity of the Roosevelt administration created investment-killing uncertainty that prevented a normal rebound.  The similarities between what happened in the 1930s and what is happening today has led to an application of this view to current circumstances, just as it has led to a revival of old school Keynesianism which was born during the Great Depression.

Thoma links to a Gary Burtless piece that purports to debunk regime uncertainty as a cause of the current lack of growth in hiring and investment:

A couple of hours after talking to an ABC correspondent about the woeful job numbers and what might be done to improve them, I was in the Bloomberg TV studios debating a guy from Heritage. He went on for several minutes about the damage being done by high taxes, excess regulation, business “uncertainty” about future tax hikes and regulatory burdens.  I asked Bloomberg’s host whether he was aware that corporate profits relative to national income had just hit a 60-year peak?  He had heard rumors to that effect.  Was he aware that taxes on corporate earnings were at a 60-year low?  The Heritage guy had heard that might be the case.

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment and hiring right now?  If managers thought taxes or regulatory costs might go up in the future, wouldn’t it make sense to take advantage of today’s low taxes and lower burdens to invest and hire today?  According to the “uncertainty” argument, businesses are fearful they might face high taxes and extra health costs in 2016 or 2018.  Shouldn’t they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

The “tax uncertainty” and “regulatory uncertainty” arguments would make more sense if, say, taxes were already high and might be going higher or regulatory burdens were heavy and might be getting heavier. But when taxes are at a 60-year low and the regulations are pretty much the same as they were in the 1990s boom, the argument makes no sense at all.  As we used to say down on the farm, you should “make hay while the sun shines.” In other words, if you think it’s going to rain later in the week, it strengthens the case for cutting and baling right now.

This is utterly confused, and a complete mischaracterization of the regime uncertainty view.  It focuses on expected costs associated with policies like Obamacare (and, I might add, like Frank-n-Dodd and the EPA and the NLRB and on and on); the argument is essentially that if costs are expected to be higher in the future, why not hire more today?

But this focus on expectation (itself flawed–more below) is to misstate completely the essence of the regime uncertainty argument, which, believe it or not, is about uncertainty–variation around the expectation.   It can be conceived best as a real options argument.  Hiring is like an investment: there is a cost of hiring–and firing–workers.  This cost is not immaterial.  This cost is like the strike price of an option on the right to hire a worker and receive a stream of benefits from employing her.

This stream of benefits is uncertain.  Moreover, policy uncertainty is a major driver of the variability of this stream of benefits.  Nobody knows how Obamacare is going to play out.  Nobody knows what the actual costs of compliance are going to be.  If the burden turns out to be very high, the stream of benefits from hiring a worker (or investing in a new machine or a new product) could be quite low, and even negative.  If the burden turns out to be low, the stream will be commensurately higher.

Options pricing theory basically implies that in the face of such uncertainty, it is often optimal to defer paying a sunk cost (the strike price) until the uncertainty is resolved.  This is why it is usually better to defer the exercise of an option as long as possible, unless there is a stream of benefits (e.g., dividends, interest on the strike price) that can be obtained only after the option is exercised.  When to exercise the option–including exercising the option to hire somebody–depends on a trade-off between getting some benefits immediately, and waiting for the resolution of uncertainty about the value of those benefits in the future.

An immediate implication of this is that the greater the uncertainty about the future, the costlier it is to exercise an option early.  In the present context, higher uncertainty about the future means that firms will hire less today, all else equal.  Hiring a worker today (or investing in a machine or product) generates a stream of benefits for the employer in the short term, but if there is considerable uncertainty about the future value of that stream, it is often wise for potential employers to defer incurring the strike price (the cost of hiring) until some of that uncertainty is resolved.

In the investment literature, the option value of waiting for the resolution of uncertainty drives a wedge between the rate at which firms discount risky expected cash flows and the discount rate implied by something like the CAPM.  It helps explain why firms frequently use very high hurdle rates in capital budgeting decisions–and high hurdle rates tend to discourage investment, relative to those that would be undertaken using CAPM.  In other words, real optionality tends to reduce investment.

The same effect is at work here.   The Burtless argument endorsed by Thoma focuses on expected future benefits.  But since these future benefits are risky, and a cost must be sunk to achieve these benefits, there is a cost wedge–the option value of waiting–that is attributable to uncertainty.  The more the uncertainty, the greater the wedge.

In other words, the Burtless-Thoma “rebuttal” of the regime uncertainty analysis is nothing of the sort, because it completely misses the basic insight of that analysis.  When hiring is viewed as a real option–which is a fair analogy–uncertainty matters.  It is variation around the expected value that matters, but Burtless-Thoma focus on the expected value.

In other words: swing and a miss.  (Burtless’s argument is also strange even on its own terms because it presumes that firms don’t take future costs into account when making hiring decisions today.  Even absent uncertainty, higher future costs will deter hiring today if there is a fixed cost to hiring.)

There is no doubt that uncertainty is abounding today.  Just look at Europe for one example.  But even closer to (my) home, the uncertainty is immense.  One small example: the Obama administration’s request that the EPA defer action on ozone rules.  The key word here is defer.  It hasn’t been killed with certainty.  Its return depends on future political and economic developments: Obama loses, it is likely dead forever; Obama wins, it is likely to be revived, especially if the economy is doing somewhat better.  These future developments are fraught with uncertainty.  Moreover, the costs of the rule itself are highly uncertain, ranging from the EPA’s (typically risible) estimate of around $100 billion to more than ten times that.  Which means that although the suspension of the rule should reduce the expected cost of compliance which should in turn lead to greater economic activity, the suspension also creates a significant increase in uncertainty that will offset this effect.

One could repeat this exercise over and over and over.  Just focusing on one agency–the CFTC–would provide numerous examples.  And if you think that particular policy uncertainty would just affect, say, banks, you would be so wrong.

It is foolish in the extreme to disregard the economic drag that such policy uncertainty can create.   Most economic decisions–hiring and investment notable among them–are effectively real options.  The decisions to exercise real options depend on the amount of uncertainty.  Uncertainty has first-order effects on these decisions.  Thoma (and Burtless) may believe they have discredited regime uncertainty as an explanation for our current malaise, but they have done nothing of the kind.  Indeed, they completely miss the point and thrash a straw man.  Regime uncertainty is still a very viable and plausible explanation of the reluctance of firms to hire and investment.

A couple of wonderful stories today about contractual fidelity, Chinese style.

First, in 2008, when dry bulk shipping prices skyrocketed, Chinese national champion shipping company Cosco chartered large numbers of ships under long term deals at sky-high prices.  Today, prices are far lower, and Cosco has reneged on numerous contracts–thereby setting up ugly legal battles.  Fortunately, the shipowners believe they have a very strong case, and are threatening to take Cosco to court.  Cosco is counting that the prospect of the loss of future business will lead the shipowners to swallow their pride and cut the charter rates.  But who wants to do business with someone who views a forward contract as a free option?

At the same time, there is a risk that Cosco’s reputation, built up over 40 years, could suffer serious damage. Shipowners are unlikely to feel the same eagerness in future to let Cosco charter their ships to Australia.

Funny thing, reputation.  40 years to make.  40 seconds to break.

And here’s a doozy.  Back in 2009 I predicted that no sooner would the Russia-China oil pipeline get built, than there would be a contractual battle.

Sho’ nuff.

According to the 2009 Russian-Chinese intergovernmental agreement, oil deliveries to China through the Eastern Siberia-Pacific Ocean pipeline are made under contracts among Russian oil company Rosneft, Russian state-owned pipeline monopoly Transneft, and the China National Petroleum Corporation (CNPC) for 15 million tons a year over two decades. In exchange for guarantees of long-term oil deliveries China provided Transneft and Rosneft with loans of $10 billion and $15 billion respectively.

But at the beginning of 2011 the CNPC started underpaying for Russian oil, as China demanded a revision of the price formula. It currently includes the price of transporting oil along ESPO’s entire route to the port terminal in Kozmino. But as the branch to China begins at the point of Skovorodino, 1,271 miles from Kozmino, China is insisting that the pricing formula must be revised and that the cost of transportation from Skovorodino to Kozmino must be subtracted from it, with Beijing originally estimating the difference at $12 a barrel, underpaying accordingly.

Accordingly, China’s debt as calculated by Moscow is now approximately $85 million. In a telling comment on the validity of both Russia and China’s court systems, Rosneft and Transneft have begun consulting with lawyers about the possibility of initiating a lawsuit against the CNPC at the London Court of Arbitration. Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.

Switching gears, China is upping the stakes to begin discussions at the governmental level to resolve the impasse. Chinese negotiators have invited Russian Energy Minister Sergei Shmatko to participate in the next round of talks, which is to take place in Beijing starting at the end of August, when it was originally assumed that only Rosneft and Transneft representatives would be participating in the discussions.

Konstantin Simonov, general director of the National Energy Security Foundation, is convinced that China is indulging in a bit of good old fashioned “provokatsiia,” to use a Soviet word, telling reporters, “The statement by the Chinese customs is of a provocative nature: The Chinese are endeavoring to show that Russia is not fulfilling its contract obligations and is casting doubt on the development of energy relations with China as a whole.”

Two-sided opportunism, writ large.

The original pricing in the deal was very opaque (and still is), but given Russia’s palpable desperation in early-2009, my surmise was–and is–that the pricing terms were very generous to the Chinese.  I figured that Russia would try to find any pretext to break the deal, so this doesn’t surprise me: “Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.” But the Chinese are feeling their oats too, and no doubt they are trying to squeeze even more out of a specific asset.

Thus, given the two parties involved, no doubt each is attempting to hold-up the other.  So the Arbitrage Court should have loads of fun dealing with this one. Is “a pox on both” an allowable verdict in an arbitration?

Keep these kinds of things in mind whenever anybody talks about “capitalist” China.  Only fools would have any such illusions about Russia, and it is just as foolish to harbor such thoughts about China.  It is capitalist/rule of law when capitalism suits it, and statist/above the law when it doesn’t.  The country still has many miles to go before it is a truly reliable and law-based trading and contracting party.  When the stakes are big enough–as is apparently the case with Cosco and the ESPO pipeline–it will treat contracts like toilet paper.  (Which they need in a lot of places in China.)

In other words: seller (and investor) beware.

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

Three companies are at various stages of planning new capacity to ship oil from the Midcontinent to the Gulf.  A fourth is looking to redirect flows from Cushing to Houston.  The addition to capacity would total 1.4 mm bbl/day if all were completed.  Since that’s more capacity than is needed, not all the projects will go to completion.  But regardless, over the medium term it is likely that new pipelines will break the bottleneck and crush the differentials between WTI and LLS, MARS, and Brent.

The main obstacles that the WTI contracts face are enviros and Coasean challenges.  Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas.  The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts.  The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time.  So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s.  Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns.  Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract.  The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago.  Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode.  In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials.  For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk.  In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades.  This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users.  (Cash settlement based on a variety of crude streams would produce a similar outcome.)  In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically.  (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.)  Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing.  Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests.  The case of Chicago grains is illustrative.  As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design.  The committee had representatives from virtually every affected party.  Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem.  Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons).  This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months.  The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts.  (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows.  The representatives from ADM and Cargill took him outside to cool down.  I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later.  Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

Vladimir Putin weighed in on the ouster of S&P’s CEO:

Russian Prime Minister Vladimir Putin on Wednesday appeared to link the resignation of Standard & Poor’s chief executive to the agency’s downgrade of the U.S.’s sovereign rating earlier this month.“We all know what goes on in the financial world. Here you have the S&P ratings agency lowering the U.S. sovereign debt rating. And now they fired the agency’s head, and started an investigation regarding the agency itself,” Mr. Putin told a meeting of Russian academics, Interfax news agency reported.

“There is much that’s unclear about the situation, many things which are, let’s say, superficial,” Mr. Putin said.

To quote Joe Biden (always dangerous, I know), Putin’s suspicions are completely understandable.  That would be the obvious inference regarding a similar situation in Russia.

The more interesting question is whether Putin is merely projecting/mirror-imaging, or is instead correct in his conclusions.

Developments in recent years, most notably from 2008 on, and especially post-January, 2009, increase the odds that Putin has in fact nailed it.  There has always been an element of gangsterism in American government (as in any government), but those tendencies have become more overt and numerous in recent years.  So, as a Bayesian, I would say that my estimate of the likelihood that Putin is right is far higher now, than it would have been several years ago.

There is an ironic sort of convergence in this story.  One of the reasons my interest in Russia was rekindled several years ago after decades of slumber is that it struck me as a classical liberal (libertarian, if you must) dystopian novel come to life.  It illustrated all of the dysfunctions that arise in the absence of a rule of law and particularly property rights, the atomization of civil society, the dominance of a government operating with few real institutional checks, and the intersection between private economic interests and said unchecked government.

A crucial function of a dystopian novel, of course, is to point out through extension and exaggeration what will happen if existing repressive tendencies and features in society grow.  If the leading figure in a real world dystopia has, in fact, correctly diagnosed the reason why Deven Sharma was ousted from S&P, it would indicate that the US is itself slouching towards dystopia.

I have little respect for the rating agencies, and recognize that they are in many respects government creations and benefit from various government protections and mandates.  That said, N wrongs don’t make a right.  Better to eliminate privileges as a matter of principle, than to strongarm a company for having the temerity to question Leviathan’s solvency.

So I hope Putin is merely projecting, but I would also lay non-trivial odds on his prescience, at least in this matter.