Streetwise Professor

This WSJ article (subscription required) warns about Russia’s creation of an oil exchange that will “shift energy business away from existing global financial centers.” St. Petersburg’s historic Greek Revival Bourse building is being restored to house it. Author Judy Shelton says that this is just one effort among many by Putin to challenge America’s (and to a lesser degree Europe’s) global financial primacy.

My fearless prediction: within months of its opening, you will hear crickets chirping on the trading floor. I base my prediction on two factors, one common to all attempts to start new exchanges, one specific to Russia and other nations that do not respect property rights and which are dominated by lawless governments.

The universal problem is liquidity. It is notoriously difficult to start a new market, or to launch a new contract, especially in competition with existing markets. This is due to the difficulty of attracting liquidity. As a result of the Catch-22 nature of liquidity, nobody wants to enter a market where no one else is trading. Potential traders are like Alphonse and Gaston, each waiting for the other to go first.

There is an excellent example of this right now in the very oil market that Russia hopes to enter. The world’s oil supply is increasingly sour and heavy, but both major pricing benchmarks—Brent and WTI—are sweet and light. Thus, oil traders, producers, consumers, and marketers have been seeking a viable sour/heavy price benchmark and hedging vehicle. Both ICE and the Dubai Commodity Exchange (“DCE”) launched Middle East crude contracts (tied to Omani crude) that would meet these needs. After the typical initial flurry of activity, volume in both contracts has declined dramatically, and ICE has pulled its contract. These problems follow the pattern of earlier failed attempts to launch a heavy/sour contract (NYMEX tried back in the 1990s.)

Both ICE and DCE are excellent exchanges operating under secure legal and contractual regimes. Both have spent a lot of money designing, developing, and marketing their contracts. Despite these efforts, both contracts have withered, and I have little faith that this trend will be reversed.

The specifically Russian problem? That should be problems, plural. Futures and commodity markets are markets for promises. If there is even a modicum of doubt that contractual promises will be honored, a futures market cannot develop. Russia’s lack of a rule of law, and its recent flouting of laws and contracts, creates a something well beyond a modicum of doubt regarding the sanctity of contractual commitments.

One can easily imagine scenarios in which contracts are abrogated or undermined. Let’s say that a politically connected individual or firm (a member of the siloviki, for instance, or Rosneft or Gazprom) takes a big position that loses a lot of money. The loser raises a hue and cry that the market has been manipulated, and a sympathetic government (which may include people with a direct financial interest in the losing company, or who can be “persuaded” with a well-placed gratuity) brings its investigative and police powers to bear. It finds manipulation, and either explicitly abrogates the contracts, or exerts pressure that leads to a “negotiated” settlement that makes the loser whole—and maybe even more than whole. This outcome is particularly likely if the party on the right side of the market happens to be a foreigner.

If you think this is far-fetched, you obviously haven’t been paying attention to the way that Putinworld works, cf. Yukos, Rusoil, Ukrainian gas, Sakhalin II, BP/TNK, maybe Sakhalin I, etc.

And speaking of manipulation, let’s turn the example on its head. A playah—a Rosneft or a Gazprom—has incredible leverage through its control of physical assets to manipulate prices. Consider this very real possibility: Remember that pipeline that is the source of deliveries against the futures contract? Well, it just sprung a leak, and darn it, we really don’t know how long it will take to fix. So deliverable supply has just gone to zero. And wouldn’t you know it, we just happen to be long. Sorry about that, suckers . . . we mean shorts. Better luck next time. Or a connected a firm can just run the tried-and-true squeeze play.

In either instance, is there any reason to believe—any at all—that the Russian authorities would intervene, or impose penalties on the connected malefactor?

As a quick example, I read some months ago how Gazprom was using its market power to hammer the Russian electricity behemoth EES. (I also read another article that specifically discussed a gas auction which resulted in EES paying much higher prices. There were allegations that Gazprom withheld output from the auction. It’s in my clip files–I’ll try to dig it out.) Were there consequences? Surely you jest.

Moreover, although the Russian government is no doubt happy now that oil markets are establishing high prices, but will it be so happy if (and I should actually say “when”) the worm turns, and prices move lower? The government’s temptation to interfere with the market, or to shut it down, will be very great. Shooting the messenger is not unknown in Russia (and unfortunately, the shooting is arguably not just metaphorical.) The government may like the market’s message now, but will not like it nearly so much in the event of a price decline, and in my view it is highly likely to act aggressively in that event. This is another major political risk that will impede the development of an open oil trading market in Russia.

Vertical integration is another obstacle to a successful Russian energy futures market. Vertical integration impedes the development of a viable futures market. There are fewer arms-length transactions that need to be priced and hedged in a highly integrated chain, as opposed to a dis-integrated one. Energy trading is all about identifying and pricing transformations in space, time, and product. These transformations are internalized in an integrated structure, and hence there are fewer trading opportunities.

The Russian energy infrastructure is already highly integrated, and becoming even more so as the result of conscious political decisions, rather than economic forces. The “power vertical” in the energy industry means that vertical integration is the dominant form of organization in Russian energy. Indeed, Russia is trying to integrate extensively into marketing, distribution, transportation, and refining outside of Russia. This integration will impede the development of a Russian energy exchange.

Information asymmetry is another impediment to the development of a liquid market. The notorious lack of transparency in Russia aggravates information asymmetries. And there is incredible opacity obscuring the kinds of information that are particularly important in Russia—such as political information and operational information relating to the Russian energy infrastructure. Energy has been identified as a primary pillar of Russian state security, and the aggressive use of state secrecy and espionage laws that has characterized Russia in recent years strongly suggests that these laws could readily be directed against those attempting to ferret out price-relevant information in the energy market. Indeed, since information advantages would tend to redound to the politically connected in Russia, there is a direct economic incentive to use the state’s powers to preserve those information advantages.

In sum, launching a new exchange is hard enough in a country subject to the rule of law, with independent enforcers and a tort system available to crack down on manipulators, a culture of transparency, and a relatively unintegrated market structure. The fundamental defects of Russia’s political, regulatory, and economic structure make the prospects for an energy exchange dim indeed. Inside a cave at midnight dim. And this is true in spades for Iran, another country that has made noises about starting an oil bourse to undermine American economic hegemony.

So, it’s nice and all that a historic building with ties to Russia’s financial past is being refurbished. It is a nice symbol of the demise of communism, and of the fact that Russia is at least paying lip service to markets. But don’t expect much of consequence beyond the architectural preservation/revitalization. A la the military posing I analyzed in an earlier post, this seems just another Potemkin moment. Viable markets need the appropriate institutional and legal infrastructure, and those are woefully underdeveloped in modern Russia–when, indeed, they are not actively undermined by the actions of the state and politically connected companies.