Streetwise Professor

Remember when the Russian government said it was going to privatize a piece of Rosneft? Hahahaha. That is so 2016–please try to keep up!  In its announcement of “Rosneft 2022” the company proposes to buy back about $2 billion in shares, which is just about 20 percent of the piece sold off in 2016–no, wait–2017–no, wait–2018.  Adding even more hilarity is that the buyback plan was apparently at the insistence of Qatar, the last buyer standing which agreed to buy most of the shares initially privatized, much to the relief of the banks (Intesa and unnamed Russian ones) who were wearing a big piece of the risk.

I’m guessing that this was one of the terms Qatar laid down to absorb the entire hand-me-down stake for the original 2016 price, even though in Euro terms Rosneft’s shares are substantially lower today (despite a rallying oil price!)

Quite the vote of confidence there, eh?  Well, not that that’s surprising.  The conspicuous failure of any Chinese buyer to step into the shoes of disgraced CEFC tells you just how much confidence Rosneft inspires these days.

I am hard pressed to recall such a farcical series of events involving a major company.  If this one of  Russia’s state champions, just think of the shape the palookas are in!

The WSJ reports that the Trump administration has told Germany that the US would restart talks on a trade deal with Europe if Germany pulls the plug on support for the Gazprom-led Nord Stream project.  I find the linkage rather odd, but we’re talking the Trump administration here, and moreover, it may well be a brushback pitch after all of the German-led Eurowhining about the US: “Think it’s bad now? Let’s see what it’s like when I put my mind to it.”

One EU official responded as follows:

“Trump’s strategy seems to be to force us to buy their more expensive gas, but as long as LNG is not competitive, Europe will not agree to some sort of racket and pay extortionate prices,” an EU official said.

I could perhaps take this seriously, were it not for the fact that Germany forces its own citizens to pay “extortionate prices” for power produced by outrageously uncompetitive means as a result of its idiotic energiewende policy.

How extortionate? How uncompetitive? The article claims that US LNG would cost about 20 percent more than Russian gas.  Well, Germans pay approximately 50 percent more for power than the average across the EU, and EU-wide average prices are about double the US average.

In other words, Europe has its own energy extortion racket in place, and doesn’t want to let in any Americans.

The other interesting aspect to this story is that it is yet another example (I’ve lost count of the number) of the alleged Putin pawn Trump taking a major shot at the Russians.  The Russians are not pleased:

The Kremlin shot back immediately as spokesman Dmitry Peskov called the U.S. efforts “a crude effort to hinder an international energy project that has an important role in energy security.”

“The Americans are simply trying crudely to promote their own gas producers,” he said.

All I can say is that if Trump was bought, he sure as hell didn’t stay bought.  Not that any of those who have invested their entire being in the Trump-Russia collusion narrative will bother to notice.

Speaking of the obsessed and delusional, yesterday represented an all time low in the dishonesty of the inveterate Trump haters.  In a meeting with law enforcement officers, Trump called members of the brutal Salvadoran gang MS-13 “animals,” but the media and many politicians widely asserted that he was referring to immigrants as a whole.  If you read the transcript, it is clear that only someone who is deeply and deliberately dishonest could make such an assertion.

The fallback position of these reprobates is that well, MS-13 members are people too, so it is wrong to call them animals.

All right, if that’s what you think–prove it.  Invite a few to move in with you, and you can discuss the nuances of “kill, rape, and control” (“mata, viola, controla“) which just so happens to be the MS-13 motto. (Some say that “rob” is part of the motto too.)  If you’re real nice, they just might honor your request not to bring those icky guns into your house, and will just bring their machetes instead.  After a few verses of Kumbaya, I’m sure that your common humanity will shine through, along with some light illuminating the hole in your neck where your head used to be.

Of course, that will never happen.  Those who are preening and posing would never dare even enter the neighborhoods where MS-13 and similar gangs operate, let alone invite them into their houses.

Further: by defending these beasts, our better thans are condemning decent and innocent people whom they claim to care about to their depredations.

This is the worst kind of moral posing by the worst kind of poseurs.  These are twisted partisan hacks pretending to be moral titans. To let their rank partisanship utterly blind them to the reality of evil, and to ignore those who will have to suffer from that evil, is appalling beyond words.

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.

The political and commercial elite in Germany generally, and Angela Merkel in particular, are having quite the meltdown of late.  Angela angrily said that Germany would no longer hold back its anger against the United States. And a mere few days after lamenting that Europe could no longer depend on the US to defend it, Merkel huffily said Germany would not comply with Trump’s “demand” that it increase its defense spending.

The proximate cause of Merkel’s rage was Trump’s decision to withdraw from the Iran “deal”–a secretly negotiated, and largely undisclosed, transaction negotiated between Obama and the mullahs, never submitted for ratification, and which therefore is a legal nullity insofar as the US is concerned.  Obama refused to formalize it because he knew such an attempt would fail, but figured that it would live on because Hillary would succeed him.  Ah, Barack, the best laid plans, eh? Your personal agreement as president could be undone by your successor, and with the same effort that was exerted to give it the force of law: that being none whatsoever.

Germany is particularly distressed at the prospect of losing investment in and trading with Iran.  Even if Europe does not reimpose sanctions, it knows that is irrelevant because the secondary US sanctions of the kind that cost BNP Paribas a cool $9 billion, and risk destroying Rusal, make it suicidal for any European company to deal with any Iranian entity the US sanctions.

One reason that Merkel, and other Europeans, are beside themselves is that their utter impotence is exposed.  They pretend as if they are an independent geopolitical force, but can act only at the sufferance of the US.   Being exposed as powerless and subordinate does breed rage, no?

The evidence of this is all around, both in Trump’s punitive actions (the sanctions on Rusal or ZTE, for instance), and in his proffers of mercy (again to Rusal or ZTE).  Mercy is the prerogative of the powerful: masters can extend mercy, and doing so is the most powerful demonstration thereof.

This whole episode also demonstrates the irrelevance of the Europeans to the process from its beginning.  What is happening now demonstrates that German, French, and British participation was utterly irrelevant to imposing economic hardship on the mullahs.  The US could have–as it is doing now–unilaterally deterred the Europeans from offering Iran aid and comfort.  Including them only led to a more Iran-friendly deal.  (Actually, it just basically cheer-led for Obama’s Iran friendly deal, because he was about as friendly as could be imagined to the mullahs.)

It must also be noted that the German posture towards Iran is beyond unseemly, given Germany’s history.  The moral obtuseness of Germany, of all nations, panting after the business of a nation that has vowed to destroy Israel is mind boggling.

It is especially mind boggling given the German predilection for moral preening, and their tendency to lecture all about their moral superiority.

If you think this is too harsh, consider the fact that Germany’s Incitement to Hatred law (i.e., its Holocaust Denial law) makes it a felony punishable by five years imprisonment for those who:

1. incites hatred against a national, racial, religious group or a group defined by their ethnic origins, against segments of the population or individuals because of their belonging to one of the aforementioned groups or segments of the population or calls for violent or arbitrary measures against them; or
2. assaults the human dignity of others by insulting, maliciously maligning an aforementioned group, segments of the population or individuals because of their belonging to one of the aforementioned groups or segments of the population, or defaming segments of the population,

So, if the mullahs did in Germany what they do in Iran on a daily basis, they’d be in the slammer for a nickel.  But they’re OK to do business with, even though they have far more power to act on their threats than some skinhead in Leipzig. AfD is beyond the pale, but the mullahs–now there’s somebody to do business with!

Got it.

As for Merkel’s threats to show her displeasure–who’s stopping you? Go ahead.  Act like any respectable Resistance member. Stomp your feet.  Roll around on the floor screaming.  Hold your breath until your face turns blue.

I won’t say that it won’t have any effect on me–because I’ll genuinely enjoy the spectacle, primarily because it just makes all the more clear your impotence.

As Putin is fond of saying: the dog barks, but the caravan moves on.

As for Trump’s “demand” regarding defense spending.  Um, this was a commitment that Germany voluntarily made to Nato, on more than one occasion long before Trump came to office.  So I guess it’s utterly outrageous for the US to walk away from a deal with the mullahs that did not involve the imprimatur of America’s designated representative body (the Senate), but it’s totally OK for Germany to stiff the US and other Nato allies–all European, mind you–because they are just too fucking cheap (despite having the healthiest fiscal condition of any large nation).  (I further note that Germany is more than happy to “stitch up” (Tim Newman’s phrase) its European confreres when there’s money to be made, kumbaya rhetoric notwithstanding.)

Churchill came close to the truth when he said that the Germans were either at your feet or at your throat.  They certainly go for the throat of the weaker members of the EU, and now at the UK for having the audacity to leave. These days, however, they don’t have the might to tear at the US’s throat, their presumptions notwithstanding.  So while they practice proskynesis at Persian feet, the best they can muster is to nip at Donald Trump’s ankles.

When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

The Fourth Branch of Government (the professional bureaucracy, especially its law enforcement and intelligence branches) seems incapable of doing anything in a forthright manner, acting instead like a cast of sidling crabs.  This perhaps reflects the fact that it has arrogated to itself this status, it being found nowhere in the Constitution, thus making it necessary to act by indirection.

The battle between the bureaucracy and the president, ostensibly over the “Russia investigation” is an ongoing (and going and going and going) illustration of this phenomenon.  Virtually every action undertaken by various bureaucrats that has advanced the investigation has been justified by a pretext that has nothing whatsoever to do with the real motives:

• A supposed violation of the hoary–and never enforced–Logan Act was a pretext for Sally Yates to order the unmasking of  Michael Flynn. (Hey Sally–no doubt if you were still in office you’d be siccing the dogs on John Kerry, right? Right?)
• The same supposed violation was a pretext for Yates to order the FBI to conduct an ambush interview of Flynn.
• The inconsistency between Flynn’s statement to the FBI and the NSA intercept of his conversation with the Russian ambassador was a pretext to prosecute him, in the hope of getting him to roll on Trump, and at the very least, give Mueller a scalp to justify his investigation.
• The dossier, with its farcical claim that Igor Sechin had offered Trump via Carter Page either (a) a 20 percent stake in Rosneft, or (b) a brokerage fee on the 20 percent stake (which is hard to say, given the idiotic wording of the dossier) was used as a pretext to get a FISA warrant on Page. (By the way, as @soncharm points out to me on Twitter, how could Qatar buy a stake in Rosneft if it had been promised to Carter Page? Great question! :-P)
• The FISA warrant on Page was a pretext to conduct surveillance on the Trump campaign.
• The Comey briefing of Trump on the dossier was a pretext to leak it to the media.
• Comey’s memos to himself, and the leak thereof, were a pretext intended to lead to the appointment of a special counsel.
• As US District Court Judge T.S. Ellis scathingly noted in a hearing yesterday, Mueller’s prosecution of Paul Manafort for crimes bearing absolutely zero connection with the ostensible purpose of the Mueller inquiry is a pretext to pressure him into rolling on Trump.
• Mueller’s apparently focus on obstruction of justice is a pretext to continue an inquiry that has apparently failed to find any evidence of the turpitude he was charged to investigate.
• Stormy Daniels was used as a pretext to conduct a raid on Trump’s lawyer.
• Rob Rosenstein’s and the FBI’s repeated claims of national security to justify refusal to produce documents or the heavy-handed redaction of the documents that they grudgingly do produce are merely pretexts to cover up their dubious behavior. (By the way, I am more convinced by the day that Rosenstein is the Iago in this entire affair.  On Thursday, I asked how given his involvement in many aspects of case–such as his involvement in the Page warrant–Rosenstein did not recuse himself.  Judge Ellis asked the same thing on Friday.  The guy is conflicted out the wazoo.  Recusal is required at a bear minimum.)

Indeed, the entire Russia collusion investigation is merely a pretext for the Fourth Branch’s rebellion against the elected president.

The repeated reliance on subterfuge and pretext is prima facie evidence of dishonorable motives and conduct by public “servants” who believe themselves to be rightfully masters, accountable to no one.  The pervasiveness of this conduct demonstrates that the importance of this issue transcends Trump.  It calls into question whether the federal government is in fact accountable, and subject to Constitutional checks and balances.  Indeed, it is worse than that: it largely answers that question, and the answer is disturbing indeed.

Glencore has just announced that the deal to sell Rosneft shares to CEFC has been terminated.  Furthermore, the QIA-Glencore consortium is being wound up, with virtually all of the shares going to QIA:

The members of the Consortium have agreed to dissolve the Consortium originally put in place in December 2016 for the purposes of acquiring a 19.5% stake in Rosneft and will take direct ownership of the underlying Rosneft shares.  In connection with that, the Consortium has today entered into an agreement to transfer a 14.16% stake in Rosneft to a wholly owned subsidiary of QIA (the “Transaction”) the consideration for which will to be used for the settlement of the Consortium’s liabilities. This agreement will become effective on 7 May 2018.

On completion of the Transaction, the Consortium will be wound up and the margin guarantees provided by Glencore will be terminated.  At that point, Glencore will retain an equity stake in Rosneft shares commensurate with its original equity investment announced in January 2017, which amounts to 0.57%, and QIA will hold an equity stake of 18.93%.

Meaning that in reality, as I noted at the outset of the deal, Glencore was basically a straw buyer–a beard–to provide the appearance of western corporate participation in the deal.

The price is also interesting:

The consideration for the Transaction attributable to Glencore’s interest in the Consortium (being 50% of the consideration for the Transaction) is approximately EUR 3.7 billion.

Well, the original December 2016 price was EUR 10.2 billion, meaning that this price is at a 25 percent discount from the original deal.

Who ate this difference?  Glencore?  I doubt it, but if it did, it would raise huge questions about its disclosures (or lack thereof) at the time of the original deal.  Regardless, this is yet another example of Glencore playing with fire.  What comes after trifecta?

I further note that whereas it was rumored that a Chinese state company would step into the shoes of CEFC, this hasn’t happened.  Yet, anyways.

Some state champion, that Rosneft, eh?

Update.  Some arithmetic.  The sums disclosed by today’s announcement basically indicate that Qatar assumed all but Glencore’s sliver at an amount equal to the original amount of the deal agreed to in December, 2016–including the mystery €2.2 billion which pretty much everybody but me and Ivan Tkachaev at RBC missed.  Qatar originally put up €2.5b, Glencore €.3b, and Intesa €5.2b, which adds up to €8b, or €2.2b short of the announced €10.2b.  The difference apparently came from as yet unnamed Russian banks, this in spite of Putin’s claim that Russian banks would not provide financing for a Rosneft “privatization.”

Today Qatar agreed to pony up €7.4b.  Add to that its original €2.5b and Glencore’s €.3b, and voila!, you have . . . €10.2b.  Miraculous, no?  Everybody remains whole!

Here’s the problem though.  Rosneft has been trading pretty much flat in RUB.  On 9 December, 2016, its share price was 370.8 RUB.  Today, it is 386.75 RUB, about 4 percent higher.  However, the RUB has depreciated about 12 percent against the EUR, going from 65.9707 to 75.155RUB/EUR.  So, in EUR terms, Rosneft is worth about 8.5 percent less than in December, 2016, but Qatar is paying the same price today as was agreed to then.

Why would Qatar do this?  Yes (as Ivan T points out to me) ~€1b is pocket change for the QIA, which has a $320b portfolio.  But still, you don’t get rich by gifting ~10 percent of deals.  So is there a side deal?

I’ve long been a Tesla–and Elon Musk–skeptic.  Indeed, I think it’s fair to say that I was one of the earliest doubters: my first posts on Tesla date to almost exactly 5 years ago–May, 2013.

Little has happened in the intervening five years to change my opinion.  Indeed, I make a conscious effort to battle confirmation bias, because most of the Tesla developments reinforce my opinion.  But no matter how hard I try to make the pro-Elon/Tesla case to myself, I come away unconvinced.

My two primary criticisms are (1) that rather than being a visionary genius who will revolutionize autos or space travel or whatever suits his fancy today, Musk is a rent seeker who has been most successful at exploiting government largesse, and (2) he is a serial exaggerator whose promises constantly–with probability one–greatly outstrip the execution.  Here I’ll focus on (2).

There are so many examples to choose from, but I’ll focus on one that I called BS on from the moment the words left Elon’s mouth: the merger of Solar City and Tesla.

The Musk narrative was that this was a strategic masterstroke, that would create a vertically integrated clean energy company: “We would be the world’s only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered. With your Model S, Model X, or Model 3, your solar panel system, and your Powerwall all in place, you would be able to deploy and consume energy in the most efficient and sustainable way possible, lowering your costs and minimizing your dependence on fossil fuels and the grid.”

I ascribed a very different motive to the deal: it was intended to prevent Solar City’s bankruptcy, which would have seriously damaged Tesla’s biggest asset: Musk’s reputation as a visionary genius:

Indeed, Tesla bleeds cash like a Game of Thrones battle scene. Hence the need to rush out the Model S (and collect deposits) while huge questions about production remain. Hence the repeated returns to the equity markets to issue new stock.

Which will now be harder, because paying for Solar City in stock–and hence diluting existing shareholders substantially–mere weeks after a big equity offering will make investors to whom Musk will have to sell stock in the future to meet his voracious needs for money think twice: will he take their money then dilute them again a few weeks or months later?

This move looks very short sighted, and it almost certainly is. But Musk is doing it because he needs to address very pressing immediate concerns, and he’ll worry about the future ramifications when the future comes.

Musk has made a living off of suckers. Suckers in government (including most notably the federal government, and the states of Nevada and California) who have lavished huge subsidies based the dubious environmental benefits of electric vehicles. Suckers enamored with the technology and performance of Tesla vehicles–despite the questions surrounding Tesla’s ability to produce those vehicles.

To keep the suckers coming, Musk has to perpetuate his image as the Great and Powerful Oz. A major fail–like the bankruptcy of Solar City–threatens to pull back the curtain and demolish that image. Musk needs to prevent that from happening. He needs to buy time, and to buy time, he is having Tesla buy Solar City.

Desperate times call for desperate measures. The proposed purchase of Solar City reeks of desperation, because it facially makes no business sense, and is explicable only as a way to keep a con alive.

Enough time has passed to evaluate who was correct.  And Musk has proved me right by deeds, not words.  If the “vertical integration” argle bargle was the truth, Solar City should have expanded.  If I was correct, out of necessity Tesla would have to scale back Solar City dramatically to stem the bleeding of cash.

The latter has clearly happened.  In 1Q18, installations by Solar City are down about 65 percent since 1Q16.  Installations in 2017 were down between 17 and 57 percent from the corresponding quarter in 2016.  The business is clearly in wind-up mode.

But Tesla continues to spout the bull, and truculently at that:

“Regardless of whatever misinformation critics happen to be pushing this week, we are building the world’s first vertically-integrated sustainable energy company, and solar is an important part of that effort,” Tesla said in a statement. “Far from being a cash burden for Tesla, our solar business was actually cash flow positive in 2017, and we expect that trend to continue in 2018.”

Who you gonna believe, Tesla or your lyin’ eyes?

Although Tesla is downsizing its solar business dramatically, legacy contracts and obligations still pose a threat to the merged company.  Elon kicked the can, but it still exists.

The other example is Musk’s earlier promise to revolutionize manufacturing, by almost completely automating the production of the Model 3.   This failed utterly–as even Musk was forced to admit when he conceded that the company was in “manufacturing hell” and that he had underestimated the challenges of automation.

What he had done, in fact, was ignore the experience of the entire automobile industry, which had found decades ago through bitter trial and (mostly) error that automating assembly was impractical.  That experience showed that auto assembly is a tightly coupled process, and that a glitch anywhere in the process can cause cascading failure.  Further, it learned that greater automation exacerbated the tight coupling problem, and greatly increased the risk of such failure cascades.

But Elon knew better.  Until he found out otherwise.

Yet despite earlier expressions of humility about the automation effort, in his crazed earnings call yesterday, Elon doubled down on automation promises, pledging that the Model Y will represent a “manufacturing revolution.”  Further, he promised that this revolution would be televised in 2020–but with no capex until 2019! New model, new assembly process, new plant and equipment, all completed within a year-plus.  Even established manufacturers take years to complete the construction of facilities to build relatively conventional vehicles.

The earnings call may be a watershed–an inflection point.  Musk faced the first serious skepticism from the analyst community, and he did not handle it well.  To put it mildly.  He had what to me appears to be a meltdown at the withdrawal of his narcissistic supply.

As a result, there is widespread shock on Wall Street, and even die-hard boosters (e.g., Adam Jonas of Morgan Stanley) are clearly shaken by Musk’s performance.

This is incredibly important because the only thing that has sustained Tesla through its incessant cash burn is the willingness of the markets to fund him by buying his stocks and bonds on the basis of faith in his reputation as a visionary (the same reputation that compelled the acquisition of Solar City).  That was Tesla’s primary asset–arguably its only asset.  If that Wizard of Oz aura is removed, it is hard to see how Tesla survives.  It still needs massive amounts of cash to implement its existing promises.  It has tapped many fragile sources of funding–customer deposits, and especially, credit from suppliers who wait months to get paid–but still depends on issuing equity and debt to stay afloat.  Doubts about Musk’s competence–and arguably, his sanity–clearly jeopardize Tesla’s ability to do that.

Skepticism will also cause people to revisit Musk’s previous promises, which are almost too long to list, let alone discuss in detail.  Solar roof panels? A national charging network? Autonomous driving technology? A $35K Model 3? Semis? And on and on.

There is also the serious risk that the SEC will start to revisit those promises–AKA “forward looking statements.”  How big does N have to get until the failure to deliver on N out of N promises constitutes securities fraud?

Then there is the issue of looming competition from companies that actually know how to make automobiles.  I also find it bizarre that Tesla’s fate supposedly rests on its ability to build in volume a type of vehicle–sedans–that buyers are shunning to such an extent that established companies are fleeing the space because of low margins.  (The strong preference of American drivers for SUVs and trucks casts doubt on the supposed EV revolution more generally.)

Where do things go from here?  I am obviously bearish, but predicting timing is devilish hard in these circumstances.  The timing of a jump from a high-trust to a no-trust equilibrium is very hard to predict, but these recent events have definitely increased the probability of such a jump.

Perhaps Musk’s hole card is the fact that he owes banks hundreds of millions, collateralized by Tesla stock.  Remember the old joke about if you owe the bank $500K and you can’t pay, you have a problem, but if you owe the bank $500 mil and you can’t pay, the bank has a problem?  Well, that’s a fair summary of the situation facing Goldman, et al.  They have an incentive to prop up the stock price, or at the very least, not to become very public doubters.

Perhaps it is too early to say it is the beginning of the end for Tesla and Musk (but perhaps not).  It is clear, however, that this is the end of the beginning because it is the end of the affair.

Even by the standards of the commodity business (and the commodity trading business in particular) Glencore is known for its appetite for political and legal risk, and its willingness to deal with sketchy counterparties.  It does so because by taking on these risks, it gets deals at good prices.  But the bigger the appetite, the greater the indigestion when things go wrong.

In the past several weeks, Glencore has hit the going wrong trifecta.

It has a longstanding relationship–including marketing deals and equity investment–with Rusal, entered when the Russian company’s reputation was particularly dubious in the aftermath of the aluminum wars, and its owners were involved serial litigation.

We know what happened to Rusal–it is in dire straits because of US sanctions.  Yes, the Treasury has indicated that it will take Rusal’s case on appeal, but there is no guarantee that it will grant a stay of execution when the appeal process is completed.

Glencore also partnered with very dubious Israeli businessman Daniel Gertler in the Democratic Republic of the Congo (DRC).  Gertler was sanctioned by the US government in December for a history of corrupt dealings in that country.  Glencore bought out Gertler in 2017.  After the sanctions were imposed, Glencore stopped paying Gertler royalties, but now Gertler is suing for $3 billion in royalties that he claims Glencore owes him.

Also in the DRC, Glencore is in a dispute with the government’s mining company, which claims that a Glencore subsidiary operating in the country is undercapitalized.  This is really a battle over rents: in essence, the government claims that foreign miners (including Glencore) overburden operating subsidiaries with debt in order to reduce dividend payments to the government (which is part owner).  The government has moved to dissolve the Glencore subsidiary.

I don’t know enough to comment on the substance of the various legal disputes in Africa.  But I can say that the risks of such disputes are material, and that they can be very costly.

In some respects, the Glencore political/legal risk strategy is like a short vol trade.  It can be a money printing machine when things go well, but when it goes bad, it goes really bad.

In a way Glencore is lucky.  It can withstand these hits now, having clawed its way back from its near death experience in the fall of 2015.  If these hits had occurred back then, well . . .

In sum, when you play with fire, eventually you are going to get burned.  Even if you are Glencore.

PS. The tumult in the Congo could disrupt cobalt supplies.  This would put pressure on one of my fave targets–Tesla–which is already in a parlous state.  Elon gave a crazed performance at today’s Tesla earnings call.  To me it came off as the meltdown of a narcissist who is facing failure and cannot handle being questioned.

I’ve been biding my time on some additional Tesla posts.  The time may be near!

Journalism on financial markets generally, and commodity markets in particular, often resorts to rounding up the usual suspects to explain anomalous price movements.  Nowadays, the usual suspect in commodity markets is computerized/algorithmic/high frequency trading.  For example, some time back HFT was blamed for higher volatility in the cattle market, even though such trading represents a smaller fraction of cattle trading than it does for other contracts, and especially since there is precious little in the way of a theoretical argument that would support such a connection.

Another case in point: a flipping of the relationship between London and New York cocoa prices is being blamed on computerized traders.

Computers are dominating the trading of cocoa in New York, sparking a dramatic divergence in the longstanding price relationship with the London market.

Speculative funds have driven the price of the commodity in New York up more than 50 per cent since the start of the year to just under $3,000 a tonne. The New York market, traded in dollars, has traditionally been the preferred market for financial players such as hedge funds.

The London market, historically favoured by traders and commercial players buying and selling physical cocoa, has only risen 34 per cent in the same timeframe.

The big shift triggered by the New York buying is that its benchmark, which normally trades at a discount to London, now sits at a record premium.

So, is the NY premium unjustified by physical market price relationships?  If so, that would be like hundred dollar bills lying on the sidewalk–and someone would pick them up, right?

Not according to this article:

The pronounced shift in price relationships comes as hedge fund managers with physical trading capabilities and merchant traders have exited the cocoa market.

In the past, such a large price difference would have encouraged a trader to buy physical cocoa in London and send it to New York, hence narrowing the relationship. However, current price movements reflected the absence of such players, said brokers.

Fewer does not mean zero.  Cargill, or Olam, or Barry Callebaut or Ecom and a handful of other traders certainly have the ability to execute a simple physical arb if one existed.  Indeed, given the recent trying times in physical commodity trading, such firms would be ravenous to exploit such opportunities.

What’s even more bizarre is that pairs/spread/convergence trading is about the most vanilla (not chocolate!) type of algorithmic trade there is, and indeed, has long been a staple of algorithmic firms that trade only paper.  Meaning that if the spread between this pair of closely related contracts was out of line, if physical traders didn’t bring it back into line, it would be the computerized traders who would.  Yes, there are some complexities here–different delivery locations, different currencies, different deliverable growths with different price differentials, different clearinghouses–but those are exactly the kinds of things that are amenable to systematic–and computerized–analysis.

Weirdly, the article recognizes this

Others use algorithms that exploit the shifts in price relationships between different markets or separate contracts of the same commodity. [Emphasis added.  I should mention that cocoa is one of the few examples of a commodity with separate active contracts for the same commodity.]

It then fails to grasp the implications of this.

One “authority” cited in the article is–get this–Anthony Ward of Armajaro infamy:

Anthony Ward, the commodities trader known in the cocoa market for his large bets, has been among the more well-known fund managers to close his hedge fund, exiting the market at the end of last year. Mr Ward, dubbed “Chocfinger” due to his influence over the cocoa price, blamed the rising power of algorithmic and systems-based trading for making position-taking based on “fundamental” supply and demand factors more difficult.

Methinks that the market isn’t treating Anthony well, and like many losing traders, can’t take the blame himself so he’s looking for a scapegoat. (I note that Ward sold out Armajaro’s cocoa trading business to Ecom for the grand sum of $1 in December, 2013.)

I am skeptical enough that computerized trading can distort flat prices, but those arguments are harder to refute because of the knowledge problem: the whole reason markets exist is that no one knows the “right” price, hence disagreements are inevitable.  But when it comes to something as basic as an intracommodity spread, I find allegations of computer-driven distortions completely implausible.  You can’t arb flat price distortions, but you can arb distorted spreads, and that business is the bread and butter for commodity traders.

So: release the suspect!

PS. For my Geneva students looking for a topic for a class paper, this would be ideal. Perform an analysis to explain the flipping of the spread.