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Sunday, January 24, 2016

Oil Prices and The Ghost in the Machine

by Roy C. Smith

Many years ago I asked the late Nobel laureate Paul Samuelson what was the most important thing he had not been able to learn about economics, and was surprised when he said “the formula for an avalanche.”

By this he meant how financial panics are triggered.  

At that time, financial panics were fairly rare, though mini-bubbles occurred periodically.  Today, especially after the 2007-2008 financial panic that began in mortgage-backed securities and spread to all forms of corporate securities, we are more aware of what might be called “volatility spikes.”  There have been three periods since 2008 when the volatility of the US stock market exceeded 35% (it normally is about 20%), not including the month of January 2016 when the VIX only reached a high of 27%).

Volatility, the variation of returns relative to an index or benchmark, can be measured for anything that trades, including stocks, bonds, currencies and commodities such as oil, which experienced one of its sharpest volatility spikes ever over the past 18 months when prices dropped 75%.  

Crude oil prices dropped by 72% in the year following the 2008 financial crisis, then the largest annual price change for oil since the Iran Revolution in 1979.

What interested Prof. Samuelson about avalanches, he said, was the sudden change from ”normal” conditions to highly abnormal ones in which everything that one knew about prices was suspended in favor of an irrational rush-for-the-exits mind set.

The Economics of Oil Prices

What we know about oil prices now is not much different from what we knew a year ago: Goldman Sachs forecasted an excess of global production over demand in 2015 of about 1.5 million barrels per day, or 1.5%. Though global economic growth was slowing, demand for oil was still increasing modestly, even after taking China’s slowdown into account. So the imbalance has been almost entirely because of supply factors. Saudi Arabia, which needs the cash but also wants to preserve its market share from encroachment by Iran, was the main reason, but US shale producers kept pumping too, apparently to avoid the cost of closing, then reopening their fields.

We also know that many new investments in exploration and oil field improvements have put on hold, which is logical when prices decline and cash is short, but as a result future production levels will decline until these investments are resumed. Thus there is a natural adjustment process built into the system that should stabilize prices over supply-demand cycles.

And, of course, the many economic benefits of lower oil prices should encourage global economic growth and future oil consumption, and therefore increase future demand.

So, how do we explain this year’s major collapse in oil prices, especially given the fact that the drop is not the result of a sudden political or economic shock that drove all the other instances of volatility spikes in oil?

Apparently the laws of economics, which would require some price adjustment but not one of 75%, seem to have been suspended in favor of a Samuleson avalanche.


You might think it is because of heightened “speculation” by hedge funds and commodities dealers. Maybe so. A 2014 IMF Working Paper by S. Beidas-Strom and Andrea Pescatori investigated the importance of speculation on oil prices and concluded that that speculation (investments by non-users of the commodity) explained between 3% and 22% of trades, a wide range but perhaps not enough to throw the whole pricing mechanism into disarray over an eighteen-month period.  Speculators operate on both sides of the market, so they actually can contribute to price stability during market upheavals.

No doubt we will soon be reading about the next “Big Short,” in which some obscure oil traders made billions shorting crude oil, or stocks and derivatives tied to it. But, just as in the mortgage-backed securities market rout of eight years ago, for every seller there is a buyer who thinks the fall has gone far enough and wants to profit from a recovery. So far, these buyers (including several well known hedge funds) have lost billions. Many financed their positions on margin, which leveraged their losses or subjected them to forced sell-outs at prices set by lenders as the market deteriorated further.

Even so, since 2010 most large Wall Street banks have ended or reduced their commodities trading activities for regulatory reasons, removing their considerable buying power from the market.  This has reduced the role of speculators in the oil market considerably.

Irrational Behavior

In 1967 Arthur Koestler wrote an insightful book called The Ghost in the Machine that dealt with the idea that human beings still possessed DNA inherited from primitive ancestors, which could force behavior that in modern times might seem irrational or self-destructive.  Koestler worried about this in the context of the nuclear age; we, however, might have to consider whether such a ghost (or maybe instead something very new) could be present in today’s trading machinery.

Of course, irrational behavior is nothing new in financial markets - indeed it’s not so irrational to sell a position because you are convinced others are selling theirs.  But to the extent that such behavior can produce huge unexplained volatility spikes in basic commodities that are sustained for a year or more may be something new.

Leon Cooperman, a hedge fund guru who manages the Omega Funds, has been dealing with irrational markets for more than forty years. On January 15, he said that the turmoil in the stock market was not fully justified by underlying factors. A bit later, though, after the turmoil had further increased, he said there was something going on in the markets that he was uncomfortable with that he could not entirely explain and had made him more cautious. 

What was that something?

In its January 23rd issue, The Economist had a leader entitled “Who’s Afraid of Cheap Oil?”  The article pointed out that rising oil prices were bad, and falling prices were good for economic growth, but this time prices falling so far and so fast might not have been good after all.  That’s because the global economy and political system may be too fragile to adjust to the price changes without immediate negative consequences that outweigh the usual positive ones.

Lower prices, the article says, have already caused a drop in new investment in the global energy industry (including coal and alternative energy sources) of about $500 billion, which will detract from global economic growth, the estimate of which recently was lowered by the World Bank to only 2.9% for 2016.

Lower oil prices are also already having a disinflationary effect on consumer prices, to the frustration of central banks seeking to revive inflation to the 2% area as an incentive for growth.

And, The Economist points out, declining prices severely impact the ability of some energy and related companies to service the considerable debt that has been added over the past few years when prices were much higher. Fears of defaults on risky debt have already pushed Emerging Market and junk bond spreads over Treasury rates to their highest levels since 2012.    

Weak Suppliers and the End of OPEC

But the real ghost in the machine and oil-market game-changer is the desperate need by major producers to keep pumping despite the serious negative effects low prices impose on them. OPEC no longer is able to manage prices by curtailing production. Saudi Arabia needs cash to service its growing external debt (its current budget deficit is 12.7% of GDP), to fund its challenges to Iran in Yemen and Syria, and to keep peace at home.  The Russian Ruble has collapsed along with oil prices; most of its economy, which fell by 3.8% in 2015, depends on oil and gas sales; sanctions still restrict the economy and inflation is around 15%. Venezuela, Libya, and Iraq are on the brink of economic collapse and must sell every barrel they can. Iran, with sanctions removed, wants to make up lost ground.  These troubled countries together account for about 40% of world production. 

The biggest buyers, who benefit the most from cheap oil,  (China, India, Japan, Korea, and – still- the US) have been able to play sellers off against each other in the spot market. 

And they probably still will be able to do so over the next few years as long as the political and economic instability among major producers continues.

Friday, January 15, 2016

China’s Transitions Should Not Freak Us Out

By Roy C. Smith

In December 2014 I wrote a column for eFinancial News noting the 25th anniversary of the great Tokyo market crash of 1989, after which all traces of Japan’s decade-long standing as an emerging economic superpower disappeared forever. The column compared Japan’s rapid postwar economic development and vulnerabilities with China, which has followed a similar economic strategy and now faces similar difficulties.  At the time no one paid much attention. China’s growing power was indisputable, and indeed, China was then beginning a broad economic effort to offset declining growth rates by stimulating domestic consumption.

The immediate impact of this effort, largely implemented by local and provincial governments and SOEs, was to inflate stock prices by about 200% over a nine-month period. The bubble collapsed last summer, and the government (similar to Japan in 1990) launched a series of heavy-handed efforts to force markets back to normal. These efforts worked for a while, but as soon as they were withdrawn, selling began again. The government’s interventions had in fact made the stock market riskier and more uncertain.

This year, stock markets have got off to one of their worse starts ever, largely because of an outbreak of further selling in China, complicated by “circuit breakers” that close markets after daily declines of 7% or so. (The New York Stock Exchange’s circuit breaks trip at a 20% change).

Western observers have interpreted the Chinese selling (SHCOMP is down 18.0% so far this year, despite considerable government support) to mean that the debt-laden Chinese economy will crash and drag down all the others.  The MSCI Emerging Market index is down 9.6% on the year, and even the S&P500 is down 8.4%

China’s economy does have some serious problems. Its estimated 2016 GDP growth rate is less than 7% -- the lowest since 1993 except for one-year crisis-driven drop to 6% in 2009 -- and many observers who now distrust Chinese economic data discount even this rate.  Conventional wisdom in and about China seems to hold that growth below 7% could generate widespread social unrest that could threaten the Communist Party control of the country.

This being the case, President Xi and his party have a great interest in using their considerable powers and skills to revive the economy.  When Xi came into office he appeared to understand that a major priority had to be to shift economic output from the export to the domestic sector, and for this to happen, market forces would have to play a more important role.

But market forces are hard to control, as the government has just discovered.  The dilemma for China is how much to rely on market forces to make the necessary transition to domestic consumption if these forces have such uncertain outcomes. Even so, China has sufficient market activity now to make a reversion to traditional “command” economics impracticable.  Mr. Xi and his colleagues have a lot at stake in getting this right.

In 1989 Japan was the world’s second largest economy; its market crash took about two years to reach bottom, where it remained for several more years. The early 1990s were stressful times in Western markets, but these markets recovered and were not much interested in what was happening in Japan.

Compared to the size of its economy, Chinese stock markets are small and should have minimal impact on Western markets. Fears of the contraction and of a credit crisis in China will reduce Chinese demand for imports (including oil), and lower its exchange rate, but not otherwise have lasting significant impact on US and EU economic conditions.

But the “three transitions” that China must make over the next decade – to domestic markets, to freer markets, and to improved political rights and opportunities -- will make things better in China over the long run s they have in other formerly authoritarian states like Taiwan and South Korea.  The Chinese transitions might be painful within China, but until they are completed, China’s role as an enduring economic superpower must be questioned. In any case, the transitions  are necessary and should not frighten us.

From eFinancial News Jan 13, 2016

Wednesday, January 6, 2016

Is Bernie Sanders Right About Glass Steagall?

By Roy C. Smith

Yesterday Sen. Bernie Sanders announced a seven-point plan to rein in Wall Street greed once and for all by “breaking up the big banks and re-establishing firewalls that separate risk-taking from traditional banking.” Sanders is a populist, so of course his plan has a populist ring to it; but, nevertheless the plan ought to be analyzed on the merits.

The key feature of the plan is to re-impose the 1933 Glass Steagall Act that separated traditional banking from the securities business, and which Congress repealed in 1999.  Much resisted by Wall Street when it was passed, the law changed the competitive environment of the US financial system, but led to fifty years of stability in banking and the development of robust capital markets that enabled companies to obtain large amounts of financing for longer term, riskier projects. By 1983, the US capital markets were the envy of the world and efforts to import US financial market technology and knowhow to Europe and Japan were well underway.

However, a global banking crisis began in 1984 with the Federal Reserve’s takeover of Continental Illinois Bank, which failed because of poor credit risk management and the consequent inability to roll over maturing deposits from large financial institutions. Other large banks had similar problems, so the crisis ultimately spread throughout the US, and then migrated to Europe and Japan, where, like the US, a Glass Steagall-type of law was also in place. Many banks had to be rescued by government funds during the fifteen years or so that the crisis endured. However, the suppression of bank lending imposed by government rescuers further shifted financial activity to capital markets, where corporate needs during the relatively high growth years of the 1980s and 1990s were fully met.

After the crisis, the banks realized that much of their business with large corporations had been disintermediated to capital markets where short term working capital could be raised more cheaply in commercial paper, medium tern notes and bond markets in the US and the Euromarket. The banks complained that their European competitors could participate fully in capital markets, but they were losing business because they could not. Bank loans, too, had become tradable in markets and had, partly through developments in derivatives technology and capacity, become integrated into fixed-income securities markets. Further, they argued, the Basel Accord that set a minimum requirement for risk-adjusted capital adequacy had been agreed, so another crisis was unlikely. It took several years to build support, but Glass Steagall was repealed in 1999.

After the crisis in 2008, governments around the world once again poured funds into large banks to prevent their failure and domino-like contagion of the problem throughout the global financial system.  The rescues involved several trillions of dollars (mainly expended by central banks through lender-of-last resort and market support activities) but stabilized the global financial system within a few months. 

Three observations of this history are worth making.

One – Glass Steagall did not prevent the banking crisis in the US and Japan in the 1980s and 1990s. Nor did the Basel Accord prevent the crisis of 2008.  Regulations don’t always accomplish what they intend.

Two – the crises involved many performance-oriented banks all around the world that were following similar business strategies in competition with each other (though under an extensive regulatory regime). These strategies focused on enabling companies and financial institutions to take on risk and projects necessary for growth. It was not just because of unlawful conduct, greed or incompetence that the crises occurred; it was much more a matter of systemic market failure. 

Three – government intervention was the only way that the financial system could be saved from total collapse with much more severe effects on the real economy than actually occurred. Too-Big-to-Fail policies were indeed necessary; the government was the only source of funds to act as a lender of last resort under such circumstances. Taxpayers actually made a considerable return on their investment in such programs as TARP and stabilization efforts by the Federal Reserve when these positions were unwound.

After the 2008 crisis when Congress was debating the Dodd-Frank Wall Street Reform and Consumer Protection Act (passed in 2010), a re-imposition of Glass Steagall was considered.  The arguments for it were that banks had become too big, clumsy and herd-like (and greedy) to manage market risk well enough to avoid the possibility of a future failure. The easiest way to reduce this risk would be to make banks give up capital market activities.  There was merit to the argument (that also applied in 1999) but banks strongly resisted a one-size-fits-all policy that would permanently bar banks from capital markets where three-fourths of the capital raised by large corporations occurred. They also objected to a policy that would affect them but not their foreign bank, or US non-bank, competitors.

Another argument was the extent to which bank lending had become integrated with securities markets, making activities difficult and expensive to separate, monitor, and enforce.

In the end, Dodd-Frank did not separate banking and securities businesses, or force banks to reduce themselves to smaller sized entities, but it did many other things that give much more power to regulators to control the financial system, and limit risk taking by banks. Dodd-Frank claims that it has eliminated Too-Big-to-Fail situations in the future, but it attempts to do so not by restricting their bigness (except in terms of a maximum market share of US bank deposits), but by restricting the amount of risk of failure than the banks can take on.

Dodd-Franks defines “systemically important” banks as those with assets greater than $50 billion (about 40 US banks), which are to be subject to much tighter regulations than non-systemic banks. It also empowers the government to designate “systemically important non-banks” (the so-called “shadow banks”) and to regulate these the same as the large banks (four non-banks have been designated as systemically important so far). 

Dodd-Frank has many other provisions, including annual stress tests necessary to pay dividends, regulation of proprietary trading (“speculation,” which Bernie wants to tax), derivatives markets, executive compensation, rating agencies (Bernie wants to force them to become non-profit organizations), and consumer protection.

The irony of all this is that the weight on the big banks of Dodd-Frank, Basel III (a tough upgrade of the original Basel Accord), and various new national banking rules around the world, has made it very difficult for banks to comply with all the new regulations and still make a return on investment greater than their cost of equity capital.  Almost all of the major banks have failed to produce a net positive return on equity since 2009, so all are required to alter their basic business models to enable improved returns.

Accordingly all banks have their eyes on one of their own, Well Fargo, which has sailed through the regulatory changes relatively unscathed.  Wells, essentially a retail and consumer bank, never had a very extensive capital markets activity beyond what was needed to service its mainly small and mid-sized corporate clientele. Today it is the world’s largest bank by market capitalization, trades at 1.7 times its book value (the rest trade at an average of about 1.0x), and generates 5% net return on equity (after subtracting the cost of equity).

For big US banks like JP Morgan Chase, Citigroup and Bank of America, the best approach to modifying their business models as a result of regulatory changes may be to spin off to shareholders their riskier and more capital intense investment banking units. Doing so would improve shareholder returns, make regulators happier and enable their investors to participate in two different, but separate, business models. Doing so would also, de facto, break up these banks as if Glass Steagall had been restored.

Bernie Sanders probably has the right idea about what would be good for the banks and everyone else. But, restoring Glass Steagall is not necessary because Dodd Frank imposes so much regulatory weight on them that their best way forward may be to break themselves up.

But, the banks haven’t done so yet, and don’t seem to be inclined to do so.

Maybe things will be different by the time of the election, or by 2017 when the new administration will be pulling its legislative agenda together. But, if Bernie should somehow pull off a win, then he still has to face a Republican House or Representatives (and maybe a Republican Senate to), which will make his financial reform package tough (probably impossible) to pass.