Streetwise Professor

There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:

Thanks to the Biden administration’s religious war, this country is about to run out of diesel fuel.https://t.co/51oLY1LDak pic.twitter.com/mwuBQcLu5u

— Tucker Carlson (@TuckerCarlson) October 28, 2022

Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.

First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.

Stocks v. flows, Tucker, stocks v. flows.

Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.

Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.

Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.

The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.

For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).

To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.

Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.

And that’s basically what has happened in the diesel market.

Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):

Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.

In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.

To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.

As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.

I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.

Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.

Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.

But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:

This is throwing pearls before a swine, but here goes. Investment raises wealth and wages, and lowers prices. People invest only if they expect to earn a return. https://t.co/LjC2zdrlg4

— streetwiseprof (@streetwiseprof) October 28, 2022

Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.

Yeah. That’ll fix things.

What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.

And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.

If you would have asked me in February, or even early-March, whose rear areas would be more vulnerable, Ukraine’s or Russia’s, I would have said Ukraine’s without a doubt. Russian airpower would be able to roam at will over the length and breadth of Ukraine, attacking its headquarters, supply areas, and lines of communication. It would also be able to obtain targeting information for its standoff weapons to attack such military resources.

Wrong! Russia’s air campaign has been the dampest of squibs. It’s pathetic, actually. And its standoff weapons (cruise missiles, Iskanders, etc.) have mainly hit civilian areas–apartment buildings, shopping centers, and the like.

In contrast, in recent weeks and days Ukraine has hit numerous Russian rear area targets by a variety of means.

The arrival of HIMARs has allowed the Ukrainians to take out numerous headquarters, including army-level headquarters. (Though to be fair, Russian armies are really just big divisions or at most a corps, compared to WWII antecedents.) HIMARs have also wreaked havoc on Russian ammunition depots vital to their artillery-centric tactics–which is precisely why their assaults in Donbas have ground to a shuddering halt. HIMARs have also inflicted substantial damage on bridges essential to the Russians for supporting their units on the north/west bank of the Dnipro around Kherson.

But the Ukrainians have also mounted several attacks in Russia proper, through means not fully known. In particular, military targets in Belograd oblast have been hit: these include an oil refinery and yet more ammunition dumps.

Some of these attacks appear to have been carried out by helicopters and rockets. But others are more likely the result of sabotage. And recent explosions in Crimea are almost certainly the result of sabotage operations. The most notable occurred at an airbase at Saki which per satellite photographic evidence destroyed nine or ten front line Russian aircraft. But in the last few days there have been explosions at ammunition dumps in Crimea and even in Sevastopol.

One thing I did get kind of right was predicting that the Russians would be vulnerable to partisan and guerrilla activity in their rear areas. But I was only kinda right because I envisioned this would occur after they had rolled across most or all of Ukraine. The fact that even what should be secure Russian and largely Russified areas are at risk is pretty staggering.

At the tactical level, this means that the Russians will have to divert already scarce manpower from the front to secure their rear, thereby reducing their offensive capacity. Guerrilla/commando/partisan warfare is an economy of force tactic, and it will almost certainly perform that function here.

At the strategic level, the impact will be largely psychological. And I don’t say that to diminish its importance. War is often won by breaking an enemy’s morale and psychologically unbalancing him into making mistakes.

The strikes on Crimea are especially salient in this regard given the psychological value of that region to Putin, and to Russians generally. Putin’s bloodless conquest of Crimea is his crowning achievement, and his prowess is severely tarnished if he can’t even defend it from saboteurs and “terrorists” (something else Putin has claimed to vanquish).

Given the neuralgia Putin has about Crimea, it is not beyond the realm of possibility that these attacks, and continued attacks there, will unbalance him sufficiently to induce him to do something rash–and stupid.

The military damage inflicted by some of the Crimea attacks appears to be small (Saki being an exception). But frequently small events can have outsized consequences if they strike at the leadership’s pride.

Consider the 1942 Doolittle Raid, which had virtually no direct military consequences. But striking the Japanese homeland and at least theoretically threatening the life of the Emperor so shocked and humiliated the military and naval leadership who had promised that such a thing was impossible that they launched the Midway operation (because they viewed Midway as the keyhole through which the Americans had gained access to Japanese airspace). The catastrophic failure of that operation was the beginning of the end for Japan.

Partisan/guerrilla/commando operations in Russian rear areas, and especially in Crimea, are deeply humiliating to Putin and the Russian high command. If they continue, and especially if they escalate, honor (one of the main motivators of war, according to Thucidides) will compel Putin to exact revenge. Given that he has proven incapable of doing so against Ukraine conventionally, the forms that revenge could take are sobering.

So today inflation as measured by the Consumer Price Index checked in at 8.6 percent annualized. Which is an uptick in the rate rather than the promised easing.

Sic transit transitory.

The Queen of Transitory, Janet Yellen (Jerome Powell being the King) acknowledged as much earlier this week in Congressional testimony, admitting that her prediction had been wrong. Whoopsie!

One wonders about her (and Powell’s and the rest of the herd’s) mental model of inflation, especially under current circumstances. The usual explanation is some version of the Phillips Curve inflation-unemployment tradeoff. Which is stupid because it is just a correlation, and a worthless one at that since it is about as stable as Amber Heard.

But even that idiocy obviously won’t fly here, so Yellen mumbled about COVID and supply chains and Putin and blah blah blah (as well as holding forth on gun control and abortion, which are OBVIOUSLY primary responsibilities of the Treasury Secretary). These explanations are also inadequate.

Insofar as COVID is concerned, arguably the policy response to it (not COVID itself) shifted back supply curves as stores were closed and people stayed home from work. But those restrictions peaked in early-2021 and have been easing then, so can’t explain by themselves accelerating inflation in the subsequent months.

Yes, COVID has had lingering effects on certain sectors that have constrained supply while demand has rebounded. For example, a lot of truckers that left the industry in 2020-2021 haven’t come back. Interestingly, trucking schools shut down during the pandemic, which has constrained the flow of new labor to the market. In industries such as lumber and oil refining, the largely policy-driven collapse in demand in 2020 led to actual disinvestment and a loss of capacity. We saw the impacts of that in the lumber market a year ago, and are seeing it in the markets for refined products now.

But those factors alone cannot explain the recent spikes: demand has to be part of the equation as well.

Also, supply constraints (and supply chain bottlenecks) cannot explain increases in the general price level, especially as measured by broader measures such as the Producer Price Index and the GDP Deflator. Here’s a straightforward example.

Consider computer chips, inadequate supplies of which hit the auto industry hard, and which are blamed as a major culprit for inflation. Yes, the chip supply constraint limited the production of new automobiles, raising the prices of both new and used cars (which are substitutes for new ones). But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.

Put differently, bottlenecks increase prices on one side of the bottleneck relative to the prices on the other side. One cannot attribute a rise in the price level (in which the prices of most if not all goods and services are rising, albeit some more than others) to bottlenecks, at least not directly. Bottlenecks can cause prices to fall too. You can’t just look at the impact on the downstream side.

A more indirect story is that by limiting output (and therefore income) bottlenecks cause real income to be lower, thereby reducing the demand for real money balances. Given the nominal supply of money, the only way to equilibrate the now lower demand for real balances with a given nominal supply is to reduce the real value of the money stock by increasing the price level.

Color me skeptical that this can explain the magnitude of the inflation we’ve seen. (The Fed juicing base money by almost 50 percent in 2021 could have added to this impact.)

I therefore am deeply skeptical that supply constraints, attributable to COVID or otherwise, explain the broad rise in prices that has been accelerating over the past year plus.

What about Putin, Biden’s favorite scapegoat? Well, the Ukraine War doesn’t really explain the timing. Consider diesel prices.

There was a spike in the crack spread right at the time of the invasion in late-February, but that subsided quickly. The subsequent runup, especially the ramp-up in mid-April, is harder to ascribe to the war and almost certainly reflects some demand side factors.

Furthermore, it usually takes some time for upstream shocks to translate into higher prices at the consumer level (e.g., a wheat price shock impacting retail food prices). Meaning that a lot of the impact of a disruption first occurring in March is yet to have been fully felt. Good news all around, eh?

No, I think that the stock explanations that the likes of Yellen, Biden and the media fall back on to explain the accelerating inflation are woefully inadequate. Supply chain (and the effects of COVID thereon) in particular.

The most plausible explanation to me is the fiscal theory of the price level, developed formally some years ago by Thomas Sargent and recently studied deeply by John Cochrane. In a nutshell, the theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus. Holding primary surplus constant, an increase in government obligations requires a price level rise to reduce the real value of outstanding debt by the amount of the new debt. Similarly, given the level of government debt, any reduction in expected future surpluses requires a rise in the price level. (The theory is obviously a lot more complicated: that’s a Cliffs’ Notes version of the Cliffs’ Notes of John’s book.)

The massive COVID-driven fiscal stimuluses of both Trump and Biden dramatically increased the nominal value of US government debt. Moreover, the clear preference of this administration and Congress is to expand government spending (and debt) further (e.g., student debt forgiveness, among other things). (It will be interesting to see what happens to inflation if there is a big shift in Congress in 2022.)

I would also suggest that the big regulation plus big “green” agenda pursued by this administration and Congress are also inimical to growth, and expectations about growth. (I put “green” in quotes because as I’ve written before, a monomaniacal focus on CO2 is not a balanced environmental policy, and is indeed inimical to the environment in many ways.)

The green agenda is particularly pernicious. BIden and others (not just in the US) keep yammering away about the wonderful transition to green energy that will occur. What this really means is a transition to more expensive energy and lower incomes. Sic transit transition? I wish.

Less growth means lower future GDP means less future government revenue means smaller primary surpluses.

Meaning that both from the debt side and the growth/surplus side the COVID and post-COVID years are, according to the fiscal theory of the price level, a recipe for large increases in the price level. We’ve seen just such an increase. The timing works out. The fact that the increase in prices is broad works out.

This administration–of which Yellen is unfortunately an accurate avatar–not only does not believe in the fiscal theory, but finds it an anathema because its implications regarding the need to restrain government spending and to jettison onerous regulations and its cherished CO2 agenda require it to become, well, Reaganites. So what is likely the right model of the current inflation will never be their mental model.

Which means we will not be able to say sic transit inflation anytime soon.

Mark Twain never grows old:

“Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

This came to mind when reading about the proposal of Rep. Katie Porter to impose some sort of price control on gasoline:

Oil giant @Shell reported a record $9 billion in quarterly profit—3x its earnings a year earlier. Like @exxonmobil and @Chevron, it plans to use windfall profits to enrich shareholders.

I just introduced a bill to crack down on Big Oil's price-gouging.https://t.co/qsF5wmLJ4Y

— Rep. Katie Porter (@RepKatiePorter) May 6, 2022

Since the beginning of recorded history–and that is not hyperbole–the stock government response to high prices is price controls. The Pharaohs. Hammurabi. Diocletian. And many other examples. And it continues through the ages to more recent history, e.g., rent control in NY starting in WWII, Nixon in 1973.

And the result is always the same: economic disaster. It is price controls result in real shortages: people standing in lines, empty shelves, etc.

Always. If price doesn’t clear the market, waste (e.g., time spent standing in line) will.

But politicians never learn.

Nancy Pelosi (who is old enough to remember gas lines–hell, she’s probably old enough to remember the Code of Diocletian, if not that of Hammurabi) is of course fully on board. Which is an illustration that the adage “those who don’t remember the past are condemned to repeat it” is wrong: many who can remember the past repeat its errors nonetheless.

Elizabeth Warren hasn’t weighed in on this yet, but you know she will, because she’s the main spokes-shrieker for The Gouger Theory of Prices.

The Gouger Theory is stupid on its face. Did oil companies wake up one morning and realize: “Whoa! We coulda jacked up prices and gouged the suckers! What were we thinking?” Did they have some sort of epileptic fit in 2020, when prices crashed? What were they thinking?

No. This isn’t gouging. This is-as it almost always is-fundamentals.

Oil prices are high. But in this week’s edition of “Find the Bottleneck,” that’s only one of the drivers (no pun intended) behind high gasoline and diesel prices. The bottleneck is in refining.

How do we know? Let’s look at the diesel crack:

It’s gone from around $22/bbl to as high as $70/bbl. (And the $22 is high compared to what it was a year ago). (Gasoline crack somewhat similar though not as bad–though it is likely to get so when the peak demand season kicks in.)

A high refining margin means that refinery capacity is constrained. And yes, it is constrained: it’s not as if refiners are exercising market power (i.e., gouging) by withholding output. Here is the capacity utilization in the US over time:

It’s running at pre-Pandemic levels.

And here’s another thing: post-Pandemic capacity is well below pre-Pandemic capacity:

That drop from pre-Pandemic levels is around 5 percent. That’s a lot.

So refineries are running flat out, and refinery capacity is down. What do you get?: big refining margins and high prices at the pump. Yes, it’s good to be a refiner now (though not so much two years ago). But it’s not good because you get to exercise market power. It’s because even under competition it’s highly profitable because of supply-demand fundamentals.

A variety of factors have contributed to this. The loss of a good chunk of Russian oil output is keeping the price of oil up, but the loss of Russian diesel supplies to Europe is probably a bigger factor. The US is to a large extent filling the gap, to the extent it can, by exporting.

But no matter how you break it down, it is clear that this is fundamentals driven. It is not gouging. And capping prices on the delusional belief that it is gouging will wreak economic havoc.

Which has never stopped the Democrats before, I know. (And Republicans too, e.g., Nixon).

One thing here does deserve emphasis. The decline in capacity is directly attributable to the Pandemic. Correction: it is directly attributable to the horrible policy choices that politicians and bureaucrats forced on us in the name of the Pandemic. The lockdowns in particular.

Like many, many things going on in commodity world right now, the current spike in product prices overall, and relative to crude, is yet another baleful consequence of completely mental decisions to shut down economies and crater the economics of producing and processing commodities.

In other news of economic-related political hysteria, there is also a lot of finger pointing going on about baby formula. I don’t have the information at hand to analyze in the same way as I can refined petroleum prices, but I can say what it isn’t. It isn’t “oligopoly.”

But again, those educated in politics (did I really use “educated” and “politics” in the same sentence?) and not economics immediately seize on this as an explanation.

Er, the baby formula business was an oligopoly a year ago. And a year before that. And a year before that. So . . . why all of a sudden did they supposedly decide to create a shortage? And pray tell–how do you make money if you aren’t selling stuff?

So whenever Congresspeople, or people who buzz around them like insects (yeah, I’m looking at you, journalists) come up with some economic brainstorm, remember Twain. They’re idiots. Dangerous idiots.

The tumult in the commodity markets has led to suggestions that major commodity trading firms, e.g., Glencore, Trafigura, Gunvor, Cargill, may be “Too Big to Fail.”

I addressed this specific issue in two of my Trafigura white papers, and in particular in this one. The title (“Not Too Big to Fail”) pretty much gives away the answer. I see no reason to change that opinion in light of current events.

First, it is important to distinguish between “can fail” and “too big to fail.” There is no doubt that commodity trading firms can fail, and have failed in the past. That does not mean that they are too big to fail, in the sense that the the failure of one would or could trigger a broader disruption in the financial markets and banking system, a la Lehman Brothers in September 2018.

As I noted in the white paper, even the big commodity trading firms are not that big, as compared to major financial institutions. For example, Trafigura’s total assets are around $90 billion at present, in comparison to Lehman’s ~$640 billion in 2008. (Markets today are substantially larger than 14 years ago as well.). If you compare asset values, even the biggest commodity traders rank around banks you’ve never heard of.

Trafigura is heavily indebted (with equity of around $10 billion), but most of this is short term debt that is collateralized by relatively liquid short term assets such as inventory and trade receivables: this is the case with many other traders as well. Further, much of the debt (e.g., the credit facilities) are syndicated with broad participation, meaning that no single financial institution would be compromised by a commodity trader default. Moreover, trading firm balance sheets are different than banks’, as they do not engage in the maturity or liquidity transformation that makes banks’ balance sheets fragile (and which therefore pose run risk).

Commodity traders are indeed facing funding risks, which is one of the risks that I highlighted in the white paper:

The extraordinary price movements across the entire commodity space have resulted in a large spike in funding needs, both to meet margin calls (which at least in oil should have been reversed with the price decline in recent days–nickel remains to be seen given the fakakta price limits the LME imposed) and higher initial and maintenance margins (which exchanges have hiked–in a totally predictable procyclical fashion). As a result existing lines are exhausted, and firms are either scrambling to raise additional cash, cutting positions, or both. As an example of the former, Trafigura has supposedly held talks with Blackstone and other private equity firms to raise $3 billion in capital. As an example of the latter, open interest in oil futures (WTI and Brent) has dropped off as prices spiked.

To the extent margin calls were on hedging positions, there would have been non-cash gains to offset the losses on futures and other derivatives that gave rise to the margin calls. This provides additional collateral value that can support additional loans, though no doubt banks’ and other lenders terms will be more onerous now, given the volatility of the value of that collateral. All in all, these conditions will almost certainly result in a scaling back in trading firms’ activities and a widening of gross margins (i.e., the spread between traders’ sale and purchase prices). But the margin calls per se should not be a threat to the solvency of the traders.

What could threaten solvency? Basis risk for one. For examples, firms that had bought (and have yet to sell) Russian oil or refined products or had contracts to buy Russian oil/refined products at pre-established differentials, and had hedged those deals with Brent or WTI have suffered a loss on the blowout in the basis (spread) on Russian oil. Firms are also likely to handle substantially lower volumes of Russian oil, which of course hits profitability.

Another is asset exposure in Russia. Gunvor, for example, sold of most of its interest in the Ust Luga terminal, but retains a 26 percent stake. Trafigura took a 10 percent stake in the Rosneft-run Vostok oil project, paying €7 billion: Trafigura equity in the stake represented about 20 percent of the total. A Vitol-led consortium had bought a 5 percent stake. Trafigura is involved in a refinery JV in India with Rosneft. (It announced its intention to exist the deal last autumn, but I haven’t seen confirmation that it has.). If it still holds the stake, I doubt it will find a lot of firms willing to step up and pay to participate in a JV with Rosneft.

It is these types of asset exposures that likely explain the selloff in Trafigura and Gunvor debt (with the Gunvor fall being particularly pronounced.). Losses on Russian assets are a totally different animal than timing mismatches between cash flows on hedging instruments and the goods being hedged caused by big price moves.

But even crystalization of these solvency risks would likely not lead to a broader fallout in the financial system. It would suck for the owners of a failed company (e.g., Torben Tornqvuist, who owns ~85 percent of Gunvor) but that’s the downside of the private ownership structure (something also discussed in the white papers); Ferrarri and Bulgari sales would fall in Geneva; banks would take a hit, but the losses would be fairly widely distributed. But in the end, the companies would be restructured, and during the restructuring process the firms would continue to operate (although at a lower scale), some of their business would move to the survivors (it’s an ill wind that blows no one any good), and commodities would continue to move. Gross margins would widen in the industry, but this would not make a huge difference either upstream or downstream.

I should also note that the Lehman episode is likely not an example of a domino effect in the sense that losses on exposures to Lehman put other banks into insolvency which harmed their creditors, etc. Instead, it was more likely an informational cascade in which its failure sent a negative signal about (a) the value of assets held widely by other banks, and (b) what central banks could or would do to support a failing financial institution. I don’t think those forces are at work in commodities at prsent.

The European Federation of Energy Traders has called upon European state bodies like European Investment Bank or the ECB to provide additional liquidity to the market. There is a case to be made here. Even though funding disruptions, or even the failure of commodity trading firms, are unlikely to create true systemic risks, they may impede the flow of commodities. Acting under the Bagehot principle, loans against good collateral at a penalty rate, is reasonable here.

The reason for concern about the commodity shock is not that it will destabilize commodity trading firms, and that this will spill over to the broader financial system. Instead, it is that the price shock–particularly in energy–will result in a large, worldwide recession that could have financial stability implications. Relatedly, the food price shocks in particular will likely result in massive civil disturbances in low income countries. A reprise of the Arab Spring is a serious possibility.

If you worry about the systemic effects of a commodity price shock, those are the things you should worry about. Not whether say Gunvor goes bust.

For 5+ years I have been calling oil-linked LNG contracts a “barbarous relic” (echoing Keynes and the gold standard). This opinion was widely castigated when I first voiced it, but I had a strong basis for it: oil and LNG prices are driven by totally different fundamentals, and as a result oil prices are almost always disconnected with gas market fundamentals.

My presentations include a graphic and some statistics to make the point: correlations between oil and gas prices (measured by the Japan-Korea Marker, or JKM) are about zero, and so are the correlations between gold and gas prices. So it makes about as much sense to index LNG contracts to gold as it does to index them to oil.

Platts has released a report making the same point:

Asian utilities buying liquefied natural gas under rigid long-term contracts linked to oil prices risk paying an average of $20bn more each year up to 2022 than if they bought the superchilled fuel directly in the market.

S&P Global Platts, which sets the benchmark LNG price for the region, said there was a “huge disconnect” between the of cost oil-linked contracts and prices in the so-called “spot market” for LNG.

Nice of you to catch up, Platts. This “huge disconnect”–the exact phrase I’ve used in public presentations for years–has been evident in the data . . . for years. Indeed, since the beginning of the JKM index.

Platts spins this as utilities paying too much. It wouldn’t be any better if they paid too little. The point is that divergences between contract prices and product values cause misallocations of resources, including transactions costs associated with trying to circumvent contracts with prices that are misaligned with fundamentals.

There are still some who are in the thrall to the barbarous relic:

Jera, the world’s biggest buyer of LNG, said that oil-linked contracts still often made sense. The spot market was still small and vulnerable to volatile spikes as seen in early 2014, it said, while long-term contracts offered “stable procurement for buyers”, as well as providing a guarantee of demand needed by developers to launch new LNG projects.

This is a jumble of sloppy thinking.

Volatile spikes? If the spikes are driven by gas market supply and demand conditions, tying contract prices to gas prices rather than oil is a feature not a bug. You want prices that reflect fundamentals, and if fundamentals are jiggy, so be it. And, er, last time I checked, the oil market was subject to “volatile spikes” despite its greater size. And this is a bug, not a feature, when it comes to LNG because these oil price spikes are almost always unrelated to gas supply and demand conditions.

That is, it is better to tie LNG contract prices to markets with jumps that reflect gas fundamentals, than it is to tie prices to markets with jumps that don’t.

There can be a role for long term contracts, though the transactions cost (“opportunism”) related reasons for such contracts become less important as the short-term market becomes more liquid. Furthermore, even to the extent that long term contracts facilitate investment, it is a non sequitur to conclude that these long term contracts should be indexed to oil, rather than a gas price (be it JKM, or Henry Hub, or TTF, or whatever). The contracts will perform better–transactions costs will be lower–the lower the likelihood that pricing terms become misaligned with fundamentals. Gas indexing results in lower probability of misalignment than oil indexing.

For years, the mantras in the LNG market have been “security of supply” and “security of demand”, and that long term contracts are the only way to secure it:

David Thomas, an independent adviser with experience at Vitol and BP, said that Japanese utilities “value security of supply and there’s a strong relationship between buyers and sellers” but that was changing as the LNG market became more liquid and Japan’s gas and power markets liberalize.

The oil and refined product markets rely on markets for security of supply and demand. A big refinery or a major oil development are as, or more, capital intensive than an LNG product. But these things get created without long term contracts because liquid markets allow transactions at prices that reflect supply-demand fundamentals.

Long term contracts play a role when spot markets aren’t “thick” enough: under these conditions, opportunism (“holdup”) is a problem, and long term contracts can mitigate that problem. The evolution of spot markets in LNG will progressively mitigate the potential for holdup problems. And as I’ve noted, this is a virtuous cycle: as spot markets become more liquid, the need for long term contracts will decline, which will contribute to greater spot market liquidity, which will vitiate further the need for long term contracts.

As the producer of the JKM index, Platts is obviously talking its book here. But that’s not to say that it’s wrong. It isn’t. And economic reality will inevitably push contracting practices in the LNG market away from the barbarous past. Or perhaps I have the tense wrong there: is pushing would be a better way of putting it.

Totalitarian and authoritarian regimes are noted for their vicious internecine battles between the lords of various economic fiefdoms: Nazi Germany presents a classic example (and perhaps a good thing too, because these battles crippled German war industry). Not-quite-totalitarian Russia is seeing such a battle today, over the fallout from the Druzhba pipeline fiasco. Pipeline operator Transneft and oil producer and refiner Rosneft are at it hammer and tong over the issue:

Russian state-owned pipeline monopoly Transneft launched a broadside at Rosneft on Monday, publicly criticising the oil producer for dragging its feet over oil quality controls and making unsubstantiated damages claims.
Transneft said that Rosneft had been unwilling to help resolve a contaminated oil crisis in the Russian Druzhba export pipeline which began in late April and that the oil producer was seeking compensation from it without any grounds.
Rosneft did not immediately responded to a request for comment.

For his part, Putin is steering clear:

The dispute between Rosneft and Transneft (TRNF_p.MM) is not a matter for Russian President Vladimir Putin to intervene in because it is a corporate matter, Kremlin spokesman Dmitry Peskov said on Wednesday.

As if Putin never got involved in corporate matters before. Hell, this is supposed to be his job. As I have pointed out for well over a decade, Putin’s primary function in the Russian “natural state” has been to be the balancer, the adjudicator of conflicts within the Russian economic elite, and the distributor of rents among them.

So why is he standing aloof? His power has eroded to the point that he can’t dictate or even negotiate a settlement? Or does he actually quite like economic titans bashing out each other’s brains, thereby distracting them from scheming against him?

I’m guessing the latter. After some more weeks or even months of Tokarev and Sechin bashing one another, he’ll swoop in and graciously broker a solution.

An aside on Transneft’s criticism of Rosneft dragging its feet on “oil quality controls.” To me that is an implicit accusation that the massive contamination wasn’t caused by a handful of mopes currently enjoying the hospitality of a Russian prison, but was the result of something Rosneft did (or didn’t do). Given the volumes involved, that’s quite plausible.

And if true, it would make Sechin’s demand for compensation, and his praise for the operators of Rosneft’s German refinery, truly awesome examples of chutzpah. But we all know that chutzpah is one thing Sechin is expert at. Or should I say the one thing?

In recent weeks, the flat price of crude oil (both WTI and Brent) has moved up smartly, but time spreads have declined pretty sharply.  A common mistake by oil market analysts is to consider this combination of movements anomalous, and an indication of a disconnect between the paper and the physical markets.  This article from Reuters is an example:

Oil futures prices have soared past three-year highs, OPEC’s deal has cut millions of barrels of inventory worldwide and investors are betting in record numbers that prices could rocket past $80 and even hit $90 a barrel this year.

But physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

The divergence is notable because traditionally, physical markets are viewed as a better gauge of short-term fundamentals. Crude traders who peddle cargoes to refineries worldwide say speculators are on shaky ground as they drive futures markets above $70 a barrel, their highest levels for three-and-a-half years, on concerns about tighter supply from Venezuela and the potential impact of U.S. sanctions on supply from Iran.

Investors have piled millions of dollars in record wagers in the options market, betting on a further rally on the back of rising geopolitical tensions, particularly in Iran, Saudi Arabia and Venezuela, and the global decline in supply.

“Guys who are trading futures have a view that draws are coming and big draws are coming,” a U.S.-based crude trader at a global commodity merchant said, adding that demand could ramp up as global refinery maintenance ends.

. . . .

BIG DISCONNECT

Those on the front lines of the physical market are not convinced. Traders say the surge in U.S. exports to more than 2 million bpd has saturated some markets, leaving benchmark prices ripe for a correction.

“There is a huge disconnect between futures and fundamentals,” a trader with a Chinese independent refiner said. “I won’t be surprised if prices correct by $20 a barrel.”

In fact, the alleged “disconnect” is readily explained based on recent developments in the market, notably the prospect for interruption/reduction in Iranian supplies due to the reimposition of sanctions by the US.  The situation in Venezuela is exacerbating this situation.  Two things are particularly important in this regard.

First, the Iranian situation is a threat to future supplies, not current supplies: the potential collapse in Venezuela is also a threat to future supplies (although current supplies are dropping too).  A reduction in expected future supplies increases future scarcity relative to current scarcity.  The economically efficient response to that is to share the pain, that is, to shift some supply from the present to the future by storage.  To reward storage, the futures price rises relative to the spot price–that is, the time spread declines.  However, since the driving shock (the anticipated reduction in future supplies) will result in greater scarcity, the flat price must rise.

A second effect works in the same direction. This is a phenomenon that I worked out in a 2008 paper that later was expanded into a chapter my book on commodity price dynamics.  Both the US actions regarding Iran, and the current tumult in Venezuela increase uncertainty about future supplies.  The efficient way to respond to this increase in fundamental uncertainty is to increase inventories, relative to what they would have been absent the increase.  This requires a decline in current consumption, which requires an increase in flat prices.  But incentivizing greater storage requires a fall in calendar spreads.

An additional complicating factor here is the feedback between inventories or calendar spreads (which are often used as a rough proxy for inventories, given the opacity and relative infrequency of stocks numbers) and OPEC decisions.  To the extent OPEC uses inventories or calendar spreads as a measure of the tightness of the supply-demand balance, and interprets the fall in calendar spreads and the related increase in inventories (or decline in the rate of inventory reductions), it could respond to what is happening now by restricting supplies . . . which would exacerbate the future scarcity. Relatedly, a known unknown is how current spread movements reflect market expectations about how OPEC will respond to spread movements.  The feedback/reflexivity here (that results from a price maker/entity with market power using spreads/inventory as a proxy for supply-demand balance, and market participants forming expectations about how the price maker will behave) greatly complicates things.  Misalignments between OPEC behavior and market expectations (and OPEC expectations about market expectations, and on an on with infinite regress) can lead to big jumps in prices.

Putting to one side this last complication, contrary to what many analysts and market participants claim, the recent movements in flat prices and spreads are not sending mixed signals.  They are a rational response to the evolution in market conditions observed in recent weeks: a decline in expected future supply, and an increase in fundamental risk.  The theory of storable commodities predicts that such conditions will lead to higher flat prices and lower calendar spreads.

Platts has announced the first major change in the Brent crude assessment process in a decade, adding Troll crude to the “Brent” stream:

A decline in supply from North Sea fields has led to concerns that physical volumes could become too thin and hence at times could be accumulated in the hands of just a few players, making the benchmark vulnerable to manipulation.

Platts said on Monday it would add Norway’s Troll crude to the four British and Norwegian crudes it already uses to assess dated Brent from Jan 1. 2018. This will join Brent, Forties, Oseberg and Ekofisk, or BFOE as they are known.

This is likely a stopgap measure, and Platts is considering more radical moves in the future:

It is also investigating a more radical plan to account for a possible larger drop-off in North Sea output over the next decade that would allow oil delivered from as far afield as west Africa and Central Asia to contribute to setting North Sea prices.

But the move is controversial, as this from the FT article shows:

If this is not addressed first, one source at a big North Sea trader said, the introduction of another grade to BFOE could make “an assessment that is unhedgeable, hence not fit for purpose”. “We don’t see any urgency to add grades today,” he added. Changes to Brent shifts the balance of power in North Sea trading. The addition of Troll makes Statoil the biggest contributor of supplies to the grades supporting Brent, overtaking Shell. Some big North Sea traders had expressed concern Statoil would have an advantage in understanding the balance of supply and demand in the region as it sends a large amount of Troll crude to its Mongstad refinery, Norway’s largest.

The statement about “an assessment that is unhedgeable, hence not fit for purpose” is BS, and exactly the kind of thing one always hears when contracts are redesigned. The fact is that contract redesigns have distributive effects, even if they improve a contract’s functioning, and the losers always whinge. Part of the distributive effect relates to issues like giving a company like Statoil an edge . . . that previously Shell and the other big North Sea producers had. But part of the distributive effect is that a contract with inadequate deliverable supply is a playground for big traders, who can more easily corner, squeeze, and hug such a contract.

Insofar as hedging is concerned, the main issue is how well the Brent contract performs as a hedge (and a pricing benchmark) for out-of-position (i.e., non-North Sea) crude, which represents the main use of Brent paper trades. Reducing deliverable supply constraints which contribute to pricing anomalies (and notably, anomalous moves in the basis) unambiguously improves the functioning of the contract for out-of-position players. Yeah, those hedging BFOE get slightly worse hedging performance, but that is a trivial consideration given that the very reason for changing the benchmark is the decline in BFOE production–which now represents less than 1 percent of world output. Why should the hair on the end of the tail wag the dog?

Insofar as the competition with WTI is concerned, the combination of larger US supplies, the construction of pipelines to move supplies from the Midcon (PADDII) to the Gulf (PADDIII)  and the lifting of the export ban have restored and in fact strengthened the connection of WTI prices to seaborne crude prices. US barrels are now going to both Europe and Asia, and US crude has effectively become the marginal barrel in most major markets, meaning that it is determining price and that WTI is an effective hedge (especially for the lighter grades). And by the way, the WTI delivery mechanism is much more robust and transparent than the baroque (and at times broken) Brent pricing mechanism.

As if to add an exclamation point to the story, Bloomberg reports that in recent months Shell has been bigfooting–or would that be trolling?–the market with big trades that have arguably distorted spreads. It got to the point that even firms like Vitol (which are notoriously loath to call foul, lest someone point fingers at them) raised the issue with Shell:

While none of those interviewed said Shell did anything illegal, they said the company violated the unspoken rules governing the market, which is lightly regulated. Executives of several trading rivals, including Vitol Group BV, the world’s top independent oil merchant, raised objections with counterparts at Shell last year, according to market participants.

What are the odds that Mr. Fit for Purpose is a Shell trader?

All of this is as I predicted, almost six years ago, when everyone was shoveling dirt on WTI and declaring Brent the Benchmark of the Forever Future:

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.

That’s exactly how things have worked out, even down to the point about the difficulties of getting the big boys to play together (a lesson gained through extensive personal experience, some of which is detailed in the post). Just call me Craignac the Magnificent. At least when it comes to commodity contract design 😉

There is a boomlet in economics and legal scholarship suggesting that increased market power has contributed to income inequality, and that this can be addressed through more aggressive antitrust enforcement. I find the diagnosis less than compelling, and the proposed treatment even less so.

A recent report by the President’s Council of Economic Advisors lays out a case that there is more concentration in the US economy, and insinuates that this has led to greater market power. The broad statistic cited in the report is the increase in the share of revenue earned by the top 50 firms in broad industry segments. This is almost comical. Fifty firms? Really? Also, a Herfindahl-Hirschman Index would be more appropriate. Furthermore, the industry sectors are broad  and correspond not at all to relevant markets–which is the appropriate standard (and the one embedded in antitrust law) for evaluating concentration and competition.

The report then mentions a few specific industries, namely hospitals and wireless carriers, in which HHIs have increased. Looking at a few industries is hardly a systematic approach.

Airlines is another industry that is widely cited as experiencing greater concentration, and which prices have increased with concentration. Given the facts that a major driver of concentration has been the bankruptcy or financial distress of major carriers, and that the industry’s distinctive cost characteristics (namely huge operational leverage and network structure) create substantial scale and network economies, it’s not at all clear whether the previous lower prices were long run equilibrium prices. So some of the price increases may result in super competitive prices, but some may just reflect that prices before were unsustainably low.

Looking over the discussion of these issues gives me flashbacks. There is a paleo industrial organization (“PalIO”?) feel to it. It harkens back to the ancient Structure-Conduct-Performance paradigm that was a thing in the 50s-70s. Implicit in the current discussion is the old SCP (LOL–that’s the closest I come to being associated with this view) idea that there is a causal connection between industry structure and market power. More concentrated markets are less competitive, and firms in such more concentrated, less competitive markets are more profitable. Those arguing that greater concentration increases income inequality go from this belief to their conclusion by claiming that the increased market power rents flow disproportionately to higher income/wealth individuals.

The PalIO view was challenged, and largely demolished, in the 70s and 80s, primarily by the Chicago School, which demonstrated alternative non-market power mechanisms that could give rise to correlations (in the cross-section and time series) between concentration and profitability. For instance, firms experiencing favorable “technology” shocks (which could encompass product or process innovations, organizational innovations, or superior management) will expand at the expense of firms not experiencing such shocks, and will be infra marginal and more profitable.

This alternative view forces one to ask why concentration has changed. Implicit in the position of those advocating more aggressive antitrust enforcement is the belief that firms have merged to exploit market power, and that lax antitrust enforcement has facilitated this.

But there are plausibly very different drivers of increased concentration. One is network and information effects, which tend to create economies of scale and result in larger firms and more concentrated markets. Yes, these effects may also give the dominant firms that benefit from the network/information economies market power, and they may charge super competitive prices, but these kinds of industries and firms pose thorny challenges to antitrust. First, since monopolization per se is not an antitrust violation, a Google can become dominant without merger or without collusion, leaving antitrust authorities to nip at the margins (e.g., attacking alleged favoritism in searches). Second, conventional antitrust remedies, such as breaking up dominant firms, may reduce market power, but sacrifice scale efficiencies: this is especially likely to be true in network/information industries.

The CEA report provides some indirect evidence of this. It notes that the distribution of firm profits has become notably more skewed in recent years. If you look at the chart, you will notice that the return on invested capital excluding goodwill for the 90th percentile of firms shot up starting in the late-90s. This is exactly the time the Internet economy took off. This resulted in the rise of some dominant firms with relatively low investments in physical capital. More concentration, more profitability, but driven by a technological shock rather than merger for monopoly.

Another plausible driver of increased concentration in some markets is regulation. Hospitals are often cited as examples of how lax merger policy has led to increased concentration and increased prices. But given the dominant role of the government as a purchaser of hospital services and a regulator of medical markets, whether merger is in part an economizing response to dealing with a dominant customer deserves some attention.

Another industry that has become more concentrated is banking. The implicit and explicit government support for too big to fail enterprises has obviously played a role in this. Furthermore, extensive government regulation of banking, especially post-Crisis, imposes substantial fixed costs on banks. These fixed costs create scale economies that lead to greater scale and concentration. Further, regulation can also serve as an entry barrier.

The fixed-cost-of-regulation (interpreted broadly as the cost of responding to government intervention) is a ubiquitous phenomenon. No discussion of the rise of concentration should be complete without it. But it largely is, despite the fact that it has long been known that rent seeking firms secure regulations for their private benefit, and to the detriment of competition.

The CEA study mentions increased concentration in the railroad industry since the mid-80s. But this is another industry that is subject to substantial network economies, and the rise in concentration from that date in particular reflects an artifact of regulation: before the Staggers Act deregulated rail in 1980, that industry was inefficiently fragmented due to regulation. It was also a financial basket case. Much of the increased concentration reflects an efficiency-enhancing rationalization of an industry that was almost wrecked by regulation. Some segments of the rail market have likely seen increased market power, but most segments are subject to competition from non-rail transport (e.g., trucking, ocean shipping, or even pipelines that permit natural gas to compete with coal).

Another example of how regulation can increase concentration and reduce concentration in relevant markets: EPA regulations of gasoline. The intricate regional and seasonal variations in gasoline blend standards means that there is not a single market for gasoline in the United States: fuel that meets EPA standards for one market at one time of year can’t be supplied to another market at another time because it doesn’t meet the requirements there and then. This creates balkanized refinery markets, which given the large scale economies of refining, tend to be highly concentrated.

Reviewing this makes plain that as in so many things, what we are seeing in the advocacy of more aggressive antitrust is the prescription of treatments based on a woefully incomplete understanding of causes.

There is also an element of political trendiness here. Inequality is a major subject of debate at present, and everyone has their favorite diagnosis and preferred treatment. This has an element of using the focus on inequality to advance other agendas.

Even if one grants the underlying PalIO concentration-monopoly profit premise, however, antitrust is likely to be an extremely ineffectual means of reducing income inequality.

For one thing, there is no good evidence on how market power rents are distributed. The presumption is that they go to CEOs and shareholders. The evidence behind the first presumption is weak, at best, and some evidence cuts the other way. Moreover, it is also the case that some market power rents are not distributed to shareholders, but accrue to other stakeholders within firms, including labor.

Moreover, the numbers just don’t work out. In 2015, after-tax corporate income represented only about 10 percent of US national income. Market power rents represented only a fraction of those corporate profits. Market power rents that could be affected by more rigorous antitrust enforcement represented only a fraction–and likely a small fraction–of total corporate profits. If we are talking about 1 percent of US income the distribution of which could be affected by antitrust enforcement, I would be amazed. I wouldn’t be surprised if its an order of magnitude less than that.

With respect to how much of corporate income could be affected by antitrust policy, it’s worthwhile to consider a point mentioned earlier, and which the CEA raised: the distribution of corporate profits is very skewed. Further, if you look at the data more closely, very little of the big corporate profits could be affected by more rigorous antitrust–in particular, more aggressive approaches to mergers.

In 2015, 28 firms earned 50 percent of the earnings of all S&P500 firms. Apple alone earned 6.7 percent of the collective earnings of the S&P500. Many of the other firms represented in this list (Google, Microsoft, Oracle, Intel) are firms that have grown from network effects or intellectual capital rather than through merger for market power. They became big in sectors where the competitive process favors winner-take-most. It’s also hard to see how antitrust matters for other firms, Walt Disney for instance.

Only three industries have multiple firms on the list. Banking is one, and I’ve already discussed that: yes, it has grown through merger, but regulation and government are major drivers of that. There have also efficiency gains from consolidating an industry that regulation historically made horrifically inefficiently fragmented, though where current scale is relative to efficient scale is a matter of intense debate.

Another is airlines. Again, given the route network-driven scale economies, and the previous financial travails of the industry, it’s not clear how much market power rents the industry is generating, and whether antitrust could reduce those rents without imposing substantial inefficiencies.

Automobiles is on the list. But the automobile industry is now far less concentrated than it used to be in the days of the Big Three, and highly competitive.  Oil is represented on the list by one company: ExxonMobil. Crude and gas production is not highly concentrated, when one looks at the relevant market–which is the world. This is another industry which has seen a decline in dominance by major firms over the years.

Looking over this list, it is difficult to find large dollars that could even potentially be redistributed via antitrust. And given that this list represents a very large fraction of corporate profits, the potential impact of antitrust on income distribution is likely to be trivial.

(As an exercise for interested readers: calculate industry profits by a fairly granular level of disaggregation by NAICS code, and see which ones have become more concentrated as a result of merger in recent years.)

In sum, if you want to ameliorate inequality, I would put antitrust on the bottom of your list. It’s not where the money is because the kind of market power that antitrust could even conceivably address accounts for a  small portion of profits, which in turn account for a modest percentage of national income. Market power changes in many profitable industries have almost certainly been driven by major technological changes, and antitrust could reduce them only by gutting the efficiency gains produced by these changes.