Streetwise Professor

April 18, 2018

CEFC: The Rise and Fall of a Financial House of Cards

Filed under: China,Commodities,Economics,Russia — The Professor @ 12:34 am

This 1 March article from Caixin–which has since disappeared down the memory hole in China–is a stunning exposé about the ostensible purchaser of a 14.1 percent stake in Rosneft.  It portrays the company as a financial shell game that basically kited trade finance credit to grow like Topsy, and accumulate a collection of assets around the world–many of which it is now unloading.   The company also utilized shadow finance to raise funds via a securities affiliate.  It needed to grow rapidly to generate the financial churn that it used to finance itself. Now it is unraveling because the powers that be in China have, for some reason, decided this will happen–presumably because a forced unwind executed in a highly opaque manner is far preferable to an uncontrolled collapse that was impending.

That Glencore, Qatar, Intessa, Rosneft, and Russian and Chinese banks would agree to sell to such an entity, and/or to lend it money to permit it to purchase the Rosneft stake indicates either a shocking lack of due diligence, or more likely, a desperation to exit the deal and the lack of a more reputable buyer.  Given CEFC’s implosion, and the even more fraught circumstances of government-linked Russian companies, I’d be hard pressed to identify any company that can or will step into CEFC’s shoes.

An even more important issue here is why the Chinese authorities have yanked the reins on CEFC, and hard.  This follows the seizure of Anbang Insurance, and the regulatory pressure on HNA.

My suspicion is that the government realized that CEFC was a house of cards, and the financial strains of the Rosneft acquisition would bring the house tumbling down.  Indeed, it seems that the company was having real difficulties securing the funding, and if it had failed that would have been a major embarrassment to China. But this only raises more important questions, such as, what inferences should be drawn from the government’s intervention?  In particular, what inferences should be drawn about the state of the Chinese financial system?

One possible inference is that the CEFCs and Anbangs are the exceptions, and the government will intervene before they threaten the broader system.  That’s the comforting inference.  The more disturbing inference is that there are many houses of cards in China waiting to fall, and that the government can neither crack down on them all or let any fall, so it intervenes on a just-in-time basis.  This kicks the can down the road, and buys time to attempt to get the leverage in the system somewhat under control.

I say attempt, because this strategy is fraught with moral hazard.  A controlled wind-down cushions the blow for creditors, and the expectation that the government will do this in the future provides little disincentive to cut back on the extension of credit today.  Protecting creditors from the consequences of lending to the likes of CEFC ensures that they will continue to lend to similar companies in the future.  But letting companies fail in a way that imposes big losses on creditors threatens a crisis in the financial system.

I paid attention to CEFC initially because of the Rosneft angle.  But I think a far more important angle is what CEFC’s rise and fall say about the Chinese financial system, and the ability of firms to grow rapidly and to a huge size on the basis of the most dodgy financing mechanisms.  If CEFC is at all representative, the implications for the Chinese financial system are dire.  Which could explain the haste with which the government consigned the story to the memory hole.

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April 10, 2018

What SDN Hath Wrought: How Trump Rocked Not Just Rusal, But Most of Russia

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 8:42 pm

I clearly underestimated the impact that the sanctions imposed on Deripaska, Rusal, and others would have.  The initial reaction Monday by many was to puke everything Russian.  Everything.  The ruble. The overall Russian stock market.  Russian debt.  Every major Russian company.  They all crashed. The carnage was widespread and indiscriminate and extended far beyond those directly targeted.

Rusal was the biggest loser, and extended its losses today.  Overall, its stock price is down almost 55 percent.  Ivan Glasenberg resigned from the board, and just now two Russian non-executive directors also resigned.  The company is clearly toxic/radioactive.  I don’t see it surviving without massive state support, and perhaps nationalization.   But even then . . . who outside of Russia and China will buy its aluminum?  (Note China is already suffering an overcapacity problem in the metal, which US trade restrictions would only make worse.)

I thought I might have misjudged seriously that Potanin would gain at Deripaska’s expense: on Monday Norilsk Nickel was down almost 20 percent, and Potanin was the biggest absolute loser.  Norilsk has since bounced back, and recovered much of its loss: it is now down about 7.5 percent from Friday.  But the “shootout” auction will still be between two gunmen who have been grievously wounded by fire from an unexpected direction.

Many other Russian companies that were pounded yesterday have also bounced back.  Severstal is actually trading above the pre-sanctions-news price.  Rosneft and Novatek have also recovered most of their losses.

Sberbank remains down–down more than 16 percent.  The bank disingenuously stated that the selloff was overdone because its exposure to sanctioned companies represented only 2.5 percent of its assets.  Well, since it is leveraged about 12-to-1, that represents 30 percent of its shareholder equity, which would justify a pretty big selloff.

The ruble remains down.  Indeed, it extended its loss today, and actually experienced a greater percentage decline today (almost 5 percent) than it did Monday (around 3 percent).  Perhaps this reflects the central bank’s statement that it would not intervene in support.  But it does indicate that this is perceived as a Russia-wide shock, and not one limited to a few billionaires and their companies.

The broader selloff, somewhat overdone as it was (as reflected by today’s recovery in many names) suggests a widespread estimation that other shoes will drop, and that billionaires that escaped the first round are still at risk for the Oleg treatment.

This raises the question of how the targets were chosen. Leonid Bershidsky argues that Deripaska and Rusal were targeted because taking Rusal’s aluminum off the market (as is happening, with the LME saying it will not warrant Rusal metal not already in warehouses) would be a much more effective way of supporting the US aluminum industry than selective tariffs.  This does have a certain logic, but if that is the logic, it would speak very poorly of the the US government, for it would imply the masking of a protectionist measure behind an allegedly principled reaction to Russian turpitude. It also doesn’t explain the other targets.

Nor does it explain the non-targets.  Novatek and Timchenko are much more tightly connected to Putin than Deripaska and Rusal. And Novatek LNG competes with US LNG, so there would be a protectionist rationale for hitting it.  Yet Novatek was not subject to SDN treatment, and as noted earlier its stock price has largely rebounded.  Perhaps a journalist friend in Moscow is right that Total’s big investment in it and its Yamal project has given it some immunity.

Similarly, Rosneft and Sechin are much more in the inner sanctum than Deripaska/Rusal.  Yet it too has escaped SDN.  Perhaps the risk of creating an oil shock is too great.

The “perhapses” indicate, however, that the rhyme and reason of the administration’s actions is not obvious.  And perhaps (there’s that word again) that’s what really has the market–and many rich Russians–spooked.  Given the capriciousness of the list, everyone is at risk.

Russia’s official reaction was of course negative, but one voice has been missing: Putin’s.  It’s not quite akin to Stalin, 22 June-3 July, 1941 (when he remained out of sight after the shock of Barbarossa), but it does suggest uncertainty as to how to respond.  Not a B’rer Rabbit reaction, at least not yet.

This uncertainty is no doubt fed by the realization of the vulnerability of the Russian economy to US policy.  I’ve written before that the US could crush Russia like an overripe grape by, for instance, cutting it off from SWIFT or the dollar system altogether.  This shows that it can wreak havoc with far more limited measures.

It’s also interesting that Xi made rather conciliatory remarks yesterday.  A coincidence? Perhaps (again). But Friday’s sanction action shows that Trump can act unpredictably and punishingly.  That likely concentrates minds in Beijing as well as in Moscow.

Whatever the logic of Friday’s thunderbolt, it should put paid to the Trump-is-Putin’s-pawn and Putin-has-something-on-Trump theories.  Indeed, a desire to terminate with prejudice those narratives is as good an explanation for the administration’s action as anything.  Not that reality will interfere with the conspiratorial ravings of those in the Democratic Party and the media and the neocon NeverTrumpers.  They are just too invested and obsessed, and nothing short of a preemptive nuclear strike on Moscow is likely to change that–and even then . . . . And with Trump threatening to attack Syria despite Russian warnings against it, maybe we’ll soon put that theory to the test as well.

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April 8, 2018

Caught in the Crossfire: Oleg Deripaska and Ivan Glasenberg

Filed under: Commodities,Politics,Russia — The Professor @ 7:15 pm

On Friday, the US Treasury Department sanctioned several Russian billionaires, commonly but misleadingly referred to as oligarchs. Topping the list was Rusal’s/EN+’s Oleg Deripaska.  Also included were Suleiman Kerimov , Alexey Miller of Gazprom, and Viktor Vekselberg of Renova (which holds a substantial stake in Rusal).

Presumably the intent behind choosing these specific targets, and the sanctions law which led to their selection, is to somehow punish Putin, and to cause him to change his behavior.  The sanctions will probably fail in achieving these objectives, and could actually be a net benefit for Putin.

When it comes to Russian billionaires, there are distinct classes.

There are Putin’s favored billionaires–his buddies like Timchenko and the Rotenbergs (who share St. Petersburg roots with Putin).  To a large extent these figures are billionaires because of Putin–they are beneficiaries of his largesse.  As further evidence of their privileged position, he compensated them through favoritism to offset their losses when they were targeted for sanctions early on.

There are the billionaires Putin hates (or hated).  These are the 90s oligarchs proper, men like Khodorkovsky, Berezovsky, and Gusinsky, who are in exile or dead.

Then there are those billionaires he tolerates, because they steer clear of politics and pony up to pay for Putin pet projects (e.g., the Sochi Olympics).  Deripaska, Vekselberg, and Kerimov are in this category.

Deripaska in particular is hardly a Putin favorite, and at times Oleg has tested Putin’s tolerance–as evidenced by the pen throwing incident at Pikalevo in 2009, where Putin chastised Deripaska publicly, likening him to a cockroach who ran at Putin’s approach.

Punishing this group is unlikely to cause Putin any loss of sleep. And indeed, he may reap some benefits.  The sanctions make these men and their firms more dependent on him and Russian state support–and he can extract a price for this support.  Furthermore, it pays into his narrative of Russia being unfairly targeted by a hostile West (and the US in particular).  Indeed, the peripheral political role of those sanctioned allows Putin to make the colorable claim that the US harbors an animus against Russia and Russians generally: he will therefore be able to claim that this is just another example of American Russophobia.

Perhaps most importantly, Putin has been attempting rather pathetically to get wealthy Russians to repatriate their fortunes: truth be told, the US government is making a more persuasive case for that than anything Putin has done or even could do.  Putin is therefore somewhat in the position of B’rer Rabbit, and the US in the position of B’rer Fox.

All of these factors strongly suggest that the US action is at best symbolic, and perhaps counterproductive.  They certainly are insufficient to induce Putin to ratchet down his confrontation with the US, and may indeed play into his justification for such a confrontation.

Putting motivations and incentives aside, the sanctions will not have much impact–if any–on Russian capabilities to implement Putin’s confrontational strategy.

So again, a flamboyantly symbolic act, with little practical benefit accruing to the US.

This is not to say that the individual targets will not suffer–they will.  It’s just that Putin won’t feel their pain, or will use it to advance his own purposes.

Deripaska’s case is particularly striking.  The sanctions were clearly a surprise: Rusal stock fell 20 percent on the news, which would not have happened had it been anticipated.  [Update: as of Monday morning Central Time, Rusal is down 50 percent, and the company has asked customers to stop payment while it tries to right the business.] Moreover, Rusal/EN+/Deripaska were subjected to the most harsh form of sanctions–Special Designated Nationals (SDN) sanctions.  These are more punishing than those imposed on Rosneft, for instance.  Under SDN, any US person (including corporations) is forbidden to transact with the sanctioned individual or entity.  Moreover, secondary sanctions can be imposed on non-US entities that deal with an SDN target.  US firms can be precluded from dealing with foreign firms subject to secondary sanctions.  This makes it far more risky for non-US firms to cushion the blow against (say) Rusal: such firms may have to make the choice between transacting with US firms (especially banks and other financial institutions) and transacting with Rusal.  Many will likely say: “Lots of luck, Oleg! Been nice doin’ business with ya!”

Topping the list of firms facing this grim choice is Glencore, which has a marketing deal with Rusal through 2018.  This deal was expected to be renewed, except on a smaller scale for 2019 forward.  (On a smaller scale because Rusal has been moving away from selling primary aluminum which Glencore markets to selling value added wire rods, billets, and slabs directly to industrial customers.)  Glencore also owns 8.75 percent of Rusal, which it had announced it will convert into EN+ shares.

Of course one of Glencore’s strategies has always been to go where other companies daren’t.  Its appetite for political risk is clearly much larger than its peers in mining, and even its Swiss commodity trading peers.  But tempting fate with Uncle Sam on sanctions is a different matter, and thus I would consider a renewal of the marketing deal to be unlikely, and Glencore may also be looking to unload its Rusal/EN+ shares, although to whom and at what price are rather difficult questions to answer.  Probably to Russian entities (or a buyback financed by Russian state banks), and perhaps the Chinese, and for a song.

Glencore shares fell modestly on Friday, so the blow is not perceived as being too heavy.  But the company is likely the biggest loser other than Oleg himself.

The grievous blow directed at Deripaska also raises an issue that has not attracted much attention in the US or Europe–the fate of Norilsk Nickel.  Nornickel has been subject of a long running battle for control between Deripaska and Vladamir Potanin.  Roman Abramovich had indicated his intent to sell a block of shares that he had purchased as part of a peace deal between Deripaska and Potanin, and this raised the possibility of a “shootout” auction for the block between the two.

Well, methinks Oleg is plumb out of bullets right now, and so Potanin will prevail.  Which means that even a Russian billionaire can benefit from US sanctions on Russian billionaires.

(Curiously, although Potanin was on the “Forbes List of Potential Sanction Targets” announced earlier this year–as was Deripaska–he was not hammered the way Oleg was.  I have no idea why.)

All in all, there are loser and winners from Friday’s sanctions.  The losers are clearly Deripaska and to a lesser degree a non-Russian (despite the first name!), Ivan Glasenberg. One like winner is a Russian billionaire, and other winners are likely Chinese.

One person who is clearly not a loser, and may even be a winner, is the ostensible target–Vladimir Putin.

So other than throwing a few Russians to the US hounds baying for Russian blood, it’s really hard to see the point of this exercise.  It doesn’t advance American interests in any meaningful way.  Anyone looking for any change in Russian behavior–in Putin’s behavior–in the coming months will almost certainly be disappointed.  This is more another act in the ongoing American political melodrama than a serious policy move.

To alter a saying which Putin is fond of  quoting: the hounds will bay but the caravan–Putin’s caravan–will move on.

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March 27, 2018

CEFC: Everything Must Go! Does that Include Rosneft?

Filed under: China,Energy,Politics,Russia — The Professor @ 4:11 pm

The bizarre saga of CEFC just keeps getting more bizarre.  Today Bloomberg reports that the company is selling off all its real estate.  All of it: Everything must go!

CEFC China Energy Co., the sprawling conglomerate that’s come under increasing government scrutiny, plans to sell its entire global property portfolio with a book value of more than 20 billion yuan ($3.2 billion), according to people with knowledge of the matter.

Almost 100 properties are up for sale, including its headquarters in an upscale Shanghai neighborhood, four floors of the Hong Kong Convention & Exhibition Centre and a condominium at the Trump World Tower in Manhattan, as well as hotels, residential apartments and industrial facilities, said the people, asking not to be identified because the deliberations haven’t been publicly disclosed. The properties, mostly located in big Chinese cities, include a smattering of developments overseas, the people said.

Where this leaves the deal to buy the 14.1 percent stake in Rosneft from Glencore and the QIA is anybody’s guess.  But it probably doesn’t leave it in a good place.

Rosneft’s guess is probably as good as yours or mine.  They made inquiries, and learned nothing:

Rosneft representatives have since traveled to China but failed to get any update from CEFC on the stake acquisition deal, according to the sources.

“The other party (CEFC) has just vanished,” one source said.

“Just vanished” is not a phrase you normally hear uttered when referring to the purchaser of $9.1 billion in equity!  And definitely not one you want to hear!

(The Reuters piece is horribly and confusingly written, by the way.)

CEFC had apparently already paid out some money on the deal, but it has not closed.  Glencore optimistically asserted that the deal would close in the first half of 2018–which is already half over.  Given all of this uncertainty about CEFC, this looks incredibly unrealistic, but Glencore has not provided any more guidance. Go figure!

The price  CEFC agreed to was never disclosed in full, but was allegedly enough to allow Glencore (and the Russian banks backing it) and Intessa Saopaolo to emerge whole.   Glencore did let on that the price was at a 16 percent premium to the 30 day volume weighted average of the Rosneft price, presumably meaning the 30 day period (business days? Calendar days?) prior on 8 September, 2017.  In August-early September, 2017, Rosneft traded in the $5-$5.25 range, which puts the price in the $5.80-$6.00 ballpark.  That comports with a $9 billion total price for 14.16 percent of Rosneft’s 10,598,177,817 shares, which works out to about $6/share.  The price yesterday was $5.41, so it is clear that CEFC’s position is well under water.   This readily explains why the two Chinese government entities that have taken stakes in CEFC are allegedly reluctant to takeover the company altogether and proceed with the deal: it has already incurred a 10 percent loss.

To make things even more dicey, in January VTB announced it was “ready to” loan CEFC the money to finance the deal.  Presumably some of this money flowed, and is the source of the funds that have already been paid out.

So CEFC is selling off all its property.  Will it try to unload the Rosneft stake too? Or will the deal just collapse, leaving the original parties holding the bag? The deal was touted as a great example of Sino-Russian cooperation.  Will this compel the parties to save face by proceeding, or substituting some other Chinese firm?  Presumably this will require a price adjustment.  Who will eat that?

From day one almost 17 months ago the most bountiful product of the Rosneft privatization was questions.  And they just keep on coming.


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March 23, 2018

Will Chinese Oil Futures Transform the Oil Market? Highly Unlikely, and Like All Things China, They Will Be Hostage to Government Policy Whims

Filed under: China,Derivatives,Economics,Energy,Exchanges,Regulation,Russia — The Professor @ 11:08 am

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

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March 15, 2018

The Netherworld of the Russian Security State, Where Angels Fear to Tread

Filed under: Politics,Russia — The Professor @ 7:14 pm

Relations between Russia and the West–most particularly the UK, but the US, France, and Germany as well–are being roiled by the poisoning (using a nerve agent) of a former Russian double agent,Sergei Skripal, who had been exchanged for Russian spies in 2010.

So whodunnit?

I have no idea. And anyone who claims they know is full of it.  We have a very limited set of facts that can fit any number of competing–and indeed mutually exclusive–hypotheses.

Occam’s Razor says that an individual or individuals with connections to the Russian security services is responsible: who else would have access to a particularly nasty nerve agent developed under great secrecy and produced in large quantity in the USSR?*

Vladimir Putin certainly qualifies as an individual with connections to the Russian security services, and the reflexive reaction by many in the West has been to blame him personally.  However, although Putin is a member of the set of individuals with connections to the Russian security services, the set is not a singleton: there are thousands, and perhaps tens of thousands, of other members.  Some of these may not even be in the security services (e.g., mafia elements or an oligarch whom Skripal double crossed).

Like many in his profession, Skripal was a fundamentally dishonest man who could play both sides.  Men like that make many enemies.  His attempted murder could be very similar to Murder on the Orient Express, where the problem is not the lack of suspects, but a surfeit thereof.

My suspicion is that Skripal was far too minor a player, and one too far beyond his sell-by date, to warrant Putin’s personal attention.  But this cannot be ruled out.  Given the seismic consequences of such an act, the implications of Putin’s personal involvement would be ominous indeed.  He would be risking a superpower confrontation over a has-been: and for what? To gain a momentary burst of popularity to secure an electoral victory that was inevitable in any event?  A sort of burning of the boats, to bind Russians to him in opposition to the West?  To provoke a confrontation?

These are not inconceivable possibilities, but they seem so extreme–which is why that I am skeptical that Putin was involved directly.

The “Putin did it” claim that is so widely repeated is largely a reflection of the cartoon image of a Russia in which Putin is all knowing, all seeing, and all powerful, and where nothing in Russia, not even the fall of a sparrow, occurs but at his direction.

An alternative explanation is actually more plausible–and more frightening.  That there are elements with connections to the Russian security services who can carry out such an act without Putin’s permission.  The prospect of rogue elements operating in such a reckless way is truly sobering, especially since one predictable consequence is to create a confrontation between superpowers.

I have no doubt there are elements in Russia who want to provoke such a confrontation. Which is a reason to remember that however bad Putin is, his potential successor could be far worse.

The fundamental problem here is that Russia is so opaque, and there are so many scary types operating in the shadows, that it will be impossible to fix responsibility with any precision. We know Putin’s address, and his previous acts–real and imagined–make it emotionally satisfying to many to give him a knock. But we cannot know with any certainty–and we run the risk that even more ominous figures are counting on such a reaction in order to bring on a confrontational crisis.

The most likely outcome is an even greater estrangement between Russia and the West, and the potential return of a Cold War with a temperature approximating that in the 1950s.  Unless the perpetrators were mouth-breathing idiots similar to the criminals in Fargo, they would have known that this would be the result.  Tragically, the list of those who might have such an agenda is long indeed, and for all the hyperventilating, I don’t put Putin on the top of it.  It would actually be better if it was as simple as that.

Fools rush in where angels fear to tread.  And angels surely fear to tread in the netherworld of the Russian security services.

*It pains me to acknowledge that the credibility of Western security services, including notably MI6 and the CIA, has been so compromised as of late that the credibility of the claim that Skripal and his daughter were poisoned by Новичок is less than absolute.

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March 12, 2018

Into the Rosneft Black Hole–And No, I Don’t Mean an Oil Well

Filed under: China,Energy,Russia — The Professor @ 9:36 am

If you didn’t think the Rosneft-Glencore-QIA-Intessa-CEFC deal could get more bizarre–WRONG! Today Reuters reports that during the period of time that Chinese Firm of International Mystery CEFC agreed to buy a 14.6 percent share in Rosneft from whom it was parked initially–Glencore and QIA, funded by Intessa Saopaolo and ???–it was paying loan-shark rates to secure short term financing:

But from at least the second half of last year CEFC was approaching shadow bankers – non-traditional lenders – for costly short-term loans, said six sources with direct knowledge, in a sign of the strained liquidity the company was facing.

In early January, CEFC borrowed 1 billion yuan ($158.00 million) from the Shanghai-based Bida Holding Group, also known as U.Trust Holding Group, for a 15-day loan with a daily interest rate of 0.1 percent, equivalent to an annual interest rate of 36 percent, said one person with direct knowledge of the matter.

And, of course, it was recently revealed that the head of the CFIM–Ye Jianming–is under investigation for “economic crimes.” And an arm of the government of Shanghai has taken control of CEFC Energy–the part of the convoluted group that actually agreed to buy the Rosneft shares. Given the news relating to CEFC’s desperate need for funds in the shadow banking market, this now is quite clearly a shadow bailout.

More puzzles: at the time the deal was announced CEFC made a “huge” initial payment. To whom? Where is the money now? Glencore states that it anticipates the deal will close in the first half of 2018–meaning that they haven’t been paid.  Intessa says “no problema! The deal will-a get-a done!” Meaning it hasn’t been done and they are still on the hook.  The Qataris of course say nothing.

So where’s the money? Show me the money!

Some great due diligence by all involved, no? Sell out to a virtually unknown company with the creditworthiness of a busted racetrack punter. No doubt everyone was too anxious to get out to look too closely at the buyer, and perhaps they took it for granted, or on faith, or something, that CEFC was really a stalking horse for the Chinese government, and so no worries!

The Rosneft “privatization” has been opaque since day one.  And no surprise, as it involves a convergence of the most opaque entities on the planet: Russia, China–specifically a virtually unknown Chinese conglomerate with apparent ties to the Chinese security apparatus–Middle East investors, and a Swiss commodities firm.  Have them walk into a bar, and you have the beginnings of a great joke. Put all these together, and you get a black hole from which no light can possibly emerge.

And I say again: the one entity that should be shedding light because it is a listed public company in the UK–Glencore–provides little more information than the other conspirators involved in this drama.  The FCA should be all over Glencore like flies on cow pies. But it isn’t–although the recent Beaufort Securities scandal suggests its lassitude should be no surprise.

So what happens next? I have no idea. But whatever happens, there’s no guarantee that the world at large will know what actually happens, given this lot of opaque–and unaccountable–participants.


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March 1, 2018

Teetotaler Putin Channels the Bourbons–And I Don’t Mean Old Granddad or Maker’s Mark

Filed under: History,Military,Politics,Russia — The Professor @ 5:35 pm

Talleyrand famously said of the Bourbons: “They had learned nothing, and forgotten nothing.” That thought came to mind in reading more about Putin’s speech.  He has obviously not forgotten a single slight, perceived or real, from the west, ever.  But he obviously learned nothing from the demise of the USSR, which was economically ruined attempting to compete in military power with a far more economically vibrant and productive rival–the west generally, and the US in particular. If anything, the economic gap has widened since the Cold War.  Indeed, this is especially the case in most military production: the hollowing out of the Russian military-industrial complex is manifest, and the loss of skilled labor in particular has been severe.  The USSR was unable to compete in an arms race, and Russia is in an even worse position to do so.

Yet Putin is announcing a new arms race.

Perhaps this is why Putin’s speech focused on nuclear weapons.  It is the one area in which Russia is competitive, and may actually have some advantages.

But the enemy (and Putin definitely perceives the US to be an enemy) gets a vote too, and Putin cannot unilaterally limit the locus of competition to nuclear weapons.  The US is likely to respond to a more truculent Russia with some new nuclear weapons (e.g., air-launched cruise missiles), but also by expanding conventional forces, and by innovating in technologies that Russia cannot hope to compete in.

This is a sobering thought though–or if you look at it a little differently, one that might get you to hit the bourbon. If nukes are the only tool in Russia’s kit, the likelihood of use becomes higher.

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I’ve Been Talking About Igor For Years Now, Thank You

Filed under: Commodities,Energy,Russia — The Professor @ 10:20 am

The FT ran a long profile of Igor Sechin today.

Nothing in the piece should be news to those who have followed my coverage of his escapades over the years. (I still miss the mullet!)

There are some interesting numbers in the piece that do speak volumes.  Such as Rosneft’s market cap–$65 billion. (ExxonMobil–$324b. Shell–$266b.) The number of employees–almost 300,000. (ExxonMobil–73,500.  Shell–92,000.)  The fact that Rosneft paid $55b for TNK BP–and still has a market cap of only $65b.

Rosneft is a Frankenstein’s monster that has been stitched together over the years from stolen body parts.  Igor is therefore a fitting name for its CEO.

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Putin: Living Down to Caricature

Filed under: Economics,Politics,Russia — The Professor @ 10:11 am

The old caricature of the Soviet Union–which like most caricatures merely exaggerated a fundamental reality–was that it was “Upper Volta with missiles.”  In his State of the State address today, Vladimir Putin gave ample proof that the caricature applies to contemporary (I won’t say “modern”) Russia as well.

The most memorable part of Putin’s speech was a growling, defiant boast–complete with animation–that Russia had introduced new nuclear missiles that could not be defeated by missile defenses.  He also brandished new cruise missiles (which seem to breach the INF treaty, despite previous Russian claims to the contrary) and a submersible drone carrying a massive nuclear warhead.

The rest of his speech was boilerplate about promising to halve Russia’s impoverished population (an implicit acknowledgement that it had grown in his most recent term), and raising expenditures on infrastructure and health care (which has also suffered greatly in recent years).  Lost in the rhetoric was the Russia has stagnated economically under his rule.  The country is a caught in a double trap: the middle income trap and the resource economy trap.  Further, Putin has no real prospect of escaping either, let alone both.

The speech reveals, I think, that Putin understands all this.  Frankly, he realizes that the only reason Russia matters now is its nuclear arsenal, and the widespread belief that it is willing to use it.  He further realizes that this reality will only grow in the remainder of his political life, as Russia falls further and further behind economically.  So he brandishes his missiles, and mouths platitudes about economic development.  Upper Volta with missiles–and nuclear sub drones!–indeed.

As such, the speech gives a clear foreshadowing of what is in store for post-re-election. International pugnacity combined with domestic political and economic Potemkin villages. The Putin Hamster Wheel keeps spinning.

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