Oil Pipelines and Refineries

Earlier in the semester I posted about crude oil, and how it has to go through a refinery, and is often used quite close to the source.

Pipelines for water, oil, and natural gas are an essential part of the broader class of infrastructure.

Visual Capitalist has posted a map of North American pipelines and refineries. This is a screen capture:

 

The graphic on their site is interactive, and worth a visit. Lots more there.

Our local pipeline is not on here. It is big enough to be included, so perhaps the underlying data is old, or difficult to acquire in complete form. Also not on here is the Enbridge 5 pipeline from Michigan to Ontario, where needed upgrades are being blocked for political reasons (basically, a politician is against oil — which is OK, that's why we have elections — so they're blocking upgrades to something that's working fine ... which is kind of jerky). Also not shown is the partially built, but now cancelled, Keystone XL pipeline, which would have been just another one in the big complex going across the plains from Alberta to Texas.

So, a few macroeconomically important things here. 

First, pipeline work best where it's flat-ish: they're mostly across the middle of the country. This makes it easy for them to ship stuff all over, which means less price volatility in these regions. It does not usually mean lower prices: regional differences with that usually have a lot more to do with excise tax differences.

Second, the east and west coasts are isolated by mountains. Most of their oil is shipped in (on the right coast), or drilled in state (the left coast). This makes them subject to more volatile price fluctuations: they are oil islands.

Third, the biggest refineries are along the Gulf coast. This is only partially because Texas has a lot of oil. It's also because, historically, Venezuela was a huge input source for those refineries. Later on Mexico came online too. The economic suicide of Venezuela over the last 25 years has greatly reduced the workload at those refineries.

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A personal note here: if you know what to look for, you'll see a lot less oil trucks, oil train cars, and big storage tanks in the central part of the country. They're much more common east of the Mississippi and Ohio Rivers, and west of the Rockies. This is because the alternative to pipelines is not less oil, it's more truck and trains and tanks (and accidents). Most of you are economics majors, and you should always condition yourself to think about tradeoffs: lots of weak economic thinking by non-economists is not thinking enough about tradeoffs and alternatives.

European Natural Gas Infographic

How dependent is Europe on natural gas from Russia? This may help answer the question:

 

First, a couple of details. 

Natural gas can be produced, and is, in many more places than this (note how big the "Other Europe" band at the lower left). But there are economies of scale in its production (like crude oil, it's a high volume low margin business). 

This isn't showing production or consumption, just exports and imports. Some of the countries may be satisfying most of their gas consumption with their own production (recall the lecture in the old classroom where I noted that we draw invisible lines on maps call borders, and then treat trade across them as different or more important or more worthy of our attention).

Also, natural gas can be liquefied and shipped by land and sea, but this is still fairly rare. Almost all of it goes by pipeline. And that's what this graphic shows.

Then there's a physical feature to keep in mind. Gases are unruly, in a way that liquids and solids aren't. To work, a gas pipeline has to be under pressure, and to be under pressure it has to be full all of the time, and constantly resupplied. You can turn them on and off, but there isn't much leeway in the middle. So once you build the things, you have to use them at full capacity most of the time.

So in the graphic it shows that the real dependency on Russian gas is in Germany, while Italy and Turkey also rely on it heavily. What's not shown in detail is what's in those "Other Europe" receivers. Since most of the countries shown specifically are in western Europe, I'd imagine that those are eastern European countries along the pipelines. The big ones macroeconomically are Poland ... and Ukraine.

Russia is Running Out of Room for Oil

A few weeks back I spent most of a class day talking about a long post about how the oil industry works.

One of the things I noted in passing is that there's never that much oil in storage. Some, but there's just not infinite room for it. Also, a good fraction of the oil that is "stored" is not actually in tanks, but in the pipelines from the tanks and wells to the refineries (basically, the pipelines can hold a lot). There's actually an aphorism for this: "store it in the ground" by not bringing it to the surface just yet.

A seemingly unrelated issue that I also mentioned at some point regarding Russia is that many oil wells can't be turned off readily. The oil is coming up, and it has to be sent somewhere. In many cases, to stop a well from production pretty much means to ruin it for good. It's not straightforward, and there are safety issues. In the U.S., when well are shut down it's required by law that they be sealed by pouring concrete down them so they can't be opened up again. Safer to drill a new one from scratch off to the side, than to re-open them.

Anyway, if you put those two together, a slow moving problem that has been approaching Russia is that if they can't sell their oil, and their storage fills up, they'll have to destroy wells.

That day may be here. Transneft is a Russian company that operates the largest pipeline network in the world. This map is in Russian, but is all I could find:

Transneft has notified oil drillers that they are out of room, and are limiting intake. Further, they want proof that there is a buyer who will take any oil they agree to store.

The article does talk optimistically about future upturns in Russia's oil sales. I'm not clear on this, but my guess is that what is going on is that the oil firms are still booking sales for April and May that may ultimately be cancelled.

Cryptocurrency Seizures Not That Easy (Not Required)

I'm not sure how this number will turn out for Russia (seeing that sanctions on official accounts for conventional money appear to be only about 60% effective).

But the evidence is that Canada was only able to seize/block about 30% of Bitcoin donated to the protesting Canadian truckers. Not sure about other cryptocurrencies either.

The main reason appears to be the choice of "wallet" used. Those who kept passwords on their own still have their money. Those who lost it used services where passwords were maintained in a centralized database: basically, is the key needed to make your password work stored on your own device or on a server somewhere.

The link is here, but it is not open, so it's not required. You do get a free look if it's your first time on the site.

Yield Curve Inversion as a Signal of Recession

Using the yield curve as a tool to forecast recessions is ... popular again ... but still probably for no good reason.

First off, recessions aren't really predictable at all. This is what makes them a problem. 

FWIW: forecasting recessions is arguably the single most studied problem in human history. If it had an easy answer, don't you think we'd just tell you?

Second, the yield curve is kind of mysterious. Because it isn't a number. It's a curve. How do you summarize it quickly? I know what it means to say that a number X causes a number Y, or that when X goes up by 1%, Y goes up by 3%. I don't know what it means to say a curve (or the shape of a curve) causes a number. Huh?

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A lot of people don't even know what a yield curve is, in the sense of how you'd put one together if you were doing it by hand. 

Here goes. First, you'd need to have securities from which you can measure interest rates. Second, you need those securities to have different maturities. Third, they need to be securities on the same sort of thing, because rates can differ across different securities depending on risk, preferences, senior vs. junior status, bankruptcy features, covenants, and so on.

When you think about this, you can't really form a yield curve from say, car loans. Yes, they do have different maturities. But they also have rates that depend on buyer features (like income) and seller features (like how badly they want to get the car off the lot).

Ditto for mortgages. Ditto for corporate bonds, unless you found a corporation that issued debt at a lot of different maturities, and was representative of the whole country.

You're really just looking at government bonds then. So if you were to put together one for the U.S., you'd need to get rates on all the bonds of all maturities. At least this route is possible.

Then you plot, for a point in time, all those rates on the vertical axis, against their maturity on the horizontal axis. If you do you usually get something that's upward sloping.

Inversion is when it's downward sloping.And people on the internet usually start squawking about inversion when any part of the yield curve is downward sloping, even if overall the whole thing seems to be generally upward sloping.

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A better way to summarize this information is with a gap, usually between the rate on a long maturity bond and a short maturity bond. Usually the latter is lower. An inversion would be when it's higher.

You can actually get this for free from FRED using the keywords fred, yield, and curve in Google. It will be listed as something like: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity.

BTW: you can "get" this because it's a number. How would you "get" a curve to download?

If you look, sure enough, it "predicts" recessions.

But what sort of prediction is it? First off, it screams recession over on the left, but nowhere else. The early 80's were bad, but comparable to 2007-9 where it didn't scream recession. Second, the time before a recession is not the same, and it's not that close either. Third, it forecast the 2020 recession, which everyone is pretty sure that was about a pandemic and lockdown. So are we to believe it forecast those too?

It's better to view the gap as reflecting Fed policy. The Fed has much more control over short rates than long rates. And the Fed tends to start "tapping the brakes"  by raising rates late in an expansion. So, if they can't budge the long rate, and they start raising the short rates, the gap will go towards zero ... late in an expansion.

That explanation is a good one. The thing is ... the yield curve doesn't add anything on top of that. So what's the point?

Cynically, I think the point is that it's one more piece of data that doomsayers can crow about. It's up to you to decide if it's one more valuable piece of data.

Those Tricky Russians

Russia is demanding that western Europeans pay for the oil they want in rubles.

Macroeconomically, Russia isn't that big. Depending on how you measure, it's roughly 5% of the world economy. 

Most international trade is conducted in dollars, euros, yen, and pounds. Some is also done in yuan, but it's a smaller proportion than China's share of trade. Little is done in rubles because the only place you can spend them is in Russia.

So, Russia needs a lot of dollars, euros, yen, pounds, and yuan. Few other countries need rubles, and therefore they don't have FX accounts filled with them.

My guess is that the backend of the story is that Russia will make compromises for buyers who are short of rubles. You know ... like we'll do the exchange for you ... as long as you bring dollars, euros, yen, and pounds in briefcases of unmarked currency ... that they can keep in embassies, safe deposit boxes, and numbered bank accounts around the world.

New On Bloomberg Today

Severstal, the Russian steelmaker is unofficially in default. Officially being in default does require the firms who are owed money to file for that. They have not done so, because they'd rather have their money sent on to them. Severstal's bank has told them that they need to get a permission letter from the U.S. Treasury to get their payment to move forward. 

Severastal is not under sanctions, and neither is the particular oligarch who is its largest shareholder. So no one is quite sure what the hold up is.

Evraz, another Russian steelmaker, did have their payment go through.

But Evraz's majority shareholder is an oligarch who's been sanctioned (he also was the owner of the Chelsea football club in London). No one understand why this one went through.

***

Oil is back up. Brent is at $119/barrel, WTI is at $113/barrel.

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Financial contagion is starting to be a bigger worry. Russia has problems with its dollar-denominated debt. The dollar-denominated debt of all  the countries and firms in those countries that are in bad shape is over $500B.

A way to judge what "in bad shape" means is to use an interest rate cutoff. That $500B comes from counting only those countries whose interest rates are more than 10% higher than that of the U.S.

The big one is Belarus, but Ukraine is also near the top of the list. Lebanon (a failed state for other reasons) is another. The rest of the list is Sri Lanka, Zambia (which defaulted in 2020), El Salvador, Tunisia, Ethiopia, Suriname, Tajikistan, Argentina (which defaulted twice this century), Ghana, and Pakistan.

What they're worried about with contagion is that investors start to worry about getting payments from these countries, so they start selling bonds by dropping their asking price, and that pushes up interest rates. So the rate isn't really important; rather it's the measure of problems. 

The problem with international financial contagion is that there really doesn't have to be a well-connected cause for it to happen. It's like a bank run. Except on countries, and their big tax-paying employers.

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Egypt has applied to the IMF for a special loan. This suggests they are having trouble too. Reports are this is from an expected huge drop in tourism: it's a short and straight shot south from Ukraine or Russia, and apparently 40% of tourists in Egypt are from those 2 countries. Who knew??

Fitch Backs Out of Russian Private and Public Ratings

Amongst the ratings agencies, Fitch is the one with the biggest coverage of Russian issues. They've announced they're stopping rating them completely.

The simplest interpretation of this is that most investment finance is barred from buying things that are unrated. So Russia (the government) and Russians (firms and people) won't be able to borrow money as easily. 

I wonder whether or not that will make a difference to their economy. It's not like anyone is lining up to loan them money now.

But there's a bigger and subtler issue.

When an institution wants to borrow they sell a bond to a buyer. The payment for the bond is the loan. But that's just the first seller and first buyer. The bond is a security and can be resold. So the first buyer becomes the second seller of that security, and goes and finds a second buyer. All of those sales from the second on are called seasoned. 

On the surface, Fitch's move will help shut down initial offerings, but at the deeper level, it will also shut down the sale of seasoned Russian securities too, since most institutions can't buy unrated bonds.

The macroeconomic consequence of that is that institutions make themselves more liquid by selling bonds they own (which, by definition, are all seasoned). So Fitch's move blocks conversion to liquidity of part of the portfolio of many institutional investors. So where will they get liquidity? By selling more of the bonds of other countries. To sell them they will need to drop their price, pushing up interest rates for (new borrowing) for those countries. In essence, it will be an external creation of more contractionary monetary policy. That will be met with an intentional and internal expansionary policy in those countries ... encouraging inflation there. 

Great. Juuuust great.

Private Defaults in Russia?

The Russian government may have been able to make its debt payment in dollars last week, but it's not clear that some Russian private firms can make their payments this week. They may default on Wednesday.

A Russian steelmaker, Severstal, claims to have forwarded a $12M payment on its bonds. But again, the bankers are not sure they can accept the money if it is under sanctions.

Nickel Shenanigans?

The Wall Street Journal (in an op-ed piece) accused parties unknown of manipulating the nickel market to help reduce the outstanding margin call (from $15B to $8B) of the Chinese tycoon known as "Big Shot".

In particular, as it became clear that Big Shot was in trouble, traders took advantage by buying nickel to drive up the price, increasing his margin calls. The accusation is that the Hong Kong based owners of the exchange retroactively cancelled profitable trades.

I'm not sure what to make of all of this macroeconomically, but the $8B he did come up with, apparently with the backing of the government in Beijing, is a large some for a financial system to come up with quickly. Keep in mind that this is 70 times as big as the payment that Russia almost defaulted on last week.

And ... not a good thing for China when China seems to have a whole lot of other macro-financial problems.

A G20 Move?

The G20 is covered in the infamous Chapter VI of the Handbook.

In short, it's an international organization of some of the largest economies BUT they're mostly chosen for political reasons, which is kind of weird.

Anyway, the leaders of the G20 have summits where they try to coordinate macroeconomic and regulatory policies internationally (which is a good thing). For example, the Biden administrations trial balloon of a uniform tax on corporate profits across countries of 15% is a G20 idea.

Today's news is that Poland has asked that Russia be expelled from the G20,† and the U.S. views that suggestion positively. This would be another way to sanction Russia.

Note that there's a smaller group of bigger economies called the G7. It used to be G8, but they booted out Russia after they invaded Ukraine in 2014, so there is a precedent for this.

† This is a little strange too. The composition of the G20 includes 4 big European economies, but it also includes the European Union of which 3 of them are members. The idea is that the EU votes on behalf of the other 24 countries (including Poland). But it might also imply that Germany, France and Italy get 1+ votes in the meetings? Maybe so.

Don't Forget About China

I started the semester with financial problems in China, that could have macroeconomic consequences since China is one of the big two economies in the world. 

And while no one is paying attention, there's still all sorts of juicy stuff coming out, none of it good.

• COVID-19 on the rise, and new lockdowns enacted.
• Their stock market is off 60% since last year. Macroeconomically, stock markets are overrated ... but 60% is an awful lot for things not to be generally lousy.
  
• Their bond markets are also doing badly (and it's unusual to get both markets down at the same time). Higher rates and lower prices go together, and that either means people aren't buying (demand shifted left) or there's a lot more borrowing (the supply of bonds shifted to the right). Not so ...
  
• Property developers continue to go bankrupt, because ...
  
• Households aren't borrowing to buy new apartments.
• China practices floating exchange rates. Bad news with this policy shows up as the acceptable bands for exchange rates widen (and they have). Usually this means that a central bank is having trouble keeping the rates within narrower bands as people bail out of the currency.
• International investors adjust their liquidity by buying and selling government bonds. Developing markets like China's typically offer higher rates, which investors also like. Closing of markets in Russian debt have encouraged some investors to look towards other big markets where they can still sell out. Of course, the U.S. market is bigger still, but we're the market people buy into when they're worried; China is a market the sell out of.

Update: After class, news came out that creditors seized $2B in bank accounts from Evergrande. Suspicions are that the money was taken by a Chinese bank over unserviced loans. This is a weird situation. China doesn't usually let things like this happen. What does it mean for their macroeconomy if Beijing can't control things?

If You Like Cars (Not Required)

Lamborghini has decided to restart production of its discontinued Aventador line after the last 15 of them burned and sank to the bottom of the Atlantic.

Presumably, those had been pre-purchased (most expensive, custom, vehicles are), and at about $500K a piece, perhaps it makes sense to restart production.

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If you pay attention around southern Utah, you'll see one of these every year or so. Many or them are owned by rental places in Las Vegas that target high rollers and last night's big winners.

The Heat Is Still On Under the Inflation Kettle

Inflation continues to rise. Here's the story with consumer prices, and producer prices (which lead consumer prices by several months) are worse.

Outside of macroeconomics class, your response to friend's and family about this should be ... "Duh". This is what inflation does. 

It is like putting a pot of water to boil on the stove, and when it start to rise up to overflow the pot you need to do something about the cause. Hopefully you have several causes in mind, and an awareness that this didn't happen overnight. Or not.

We're not really doing much at all about those, but do keep in mind that it's early, this won't be easy, and we live in interesting times. Continue to bet on it getting worse before it gets better.

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It is hard to explain to students who've never lived through an inflationary period what it's like. Here's someone's reminisces of the 1970's.

Many of you have connections to California, and there are reasons that gas is always more expensive there. Some of those have been around for a long time; more recent environmental policies have made it worse.

COVID-19 and Lockdowns in Hong Kong and China

Oh yeah ... COVID-19 didn't go away. We just gave up. Maybe it's even on the way back in the U.S. Won't that be fun.

Hong Kong is currently experiencing the highest death rate of any region ... ever. It's approximately 3 times the rate for the U.S. at our worst (in January '21, before they even started coming up with Greek letter names, when that was known as the third wave). 

This is macroeconomically important because Hong Kong ... by itself (!!!) ... is in the 80's for its percentile of countries around the world as ranked by GDP — comparable to Nigeria, Denmark, Israel, Colombia, or South Africa.

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China used the world's inattention during the first 9 months of COVID-19 to seriously take over the political and social system in Hong Kong.

So this is happening in spite of China's zero tolerance policy towards infections.

Instead, the problem appears to be that China has its own vaccine, but hasn't been that great at vaccinating a big proportion of their population. Macroeconomically, self-sufficiency is not a great thing.

This breakout has spread to Shenzen (badly), and Shanghai (somewhat). These are the 3rd biggest, and biggest cities in China. Shenzen is locked down.

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I am not a great believer in the position of the Biden White House that current inflation is due to supply chain problems which are due to COVID-19 issues. It's a factor, I just don't think it's the big one.

Shutting down Shenzen is going to make this a much bigger factor for the U.S. through summer.

Crude Oil Is Going Back Up

Brent (the benchmark for Europe) is back up to about $115/barrel. WTI (the benchmark for our hemisphere) is around the same price.

Hard to say where this is heading. But for macro purposes, the big deal is that it isn't $80/barrel like a few months ago, or $40/barrel like a year ago.

Russia Repercussions

After worrying about ruble depreciation, price increases for CDS's, sanctions, oil prices, and defaults ... the list starts to expand to other countries. 

The problem is financial contagion. It's not happening yet, but it does happen, so ... now the worries are global liquidity, remittances, Russian domestic borrowing, and depth of involvement in Russian markets.

Bonds are straightforward to price, so they tend to be sold readily when investors need more liquidity. Russian bonds used to be fairly high on the list of what's available in quantity from developing countries where interest rates are often higher. So if people can't sell their Russian bonds as needed, they'll sell something else. We're beginning to see investors selling off more than the usual amounts of bonds (driving down their prices, and driving up their rates) in other large, emerging markets, including China, Indonesia, Mexico, and Thailand. Not a big worry yet. Higher CDS prices also indicate nervousness amongst investors in El Salvador, Ghana, and Tunisia.

Remittances are the shares of incomes that immigrants (permanent or temporary, legal or illegal) make in a higher-paying host country, which get sent home to families where the money goes further. People in rich, developed, countries tend not to know this, but these are often a major component of the GDP of small, poor, countries. The problem here is that Russia is one of those host countries. So sanctions are going to start hitting countries like Tajikistan, Uzbekistan, Armenia, and Georgia in fairly short order. That risk gets amplified if those countries in turn have debts requiring interest payments in euros or dollars.

The bonds I've discussed so far are international borrowing. But, like other countries, the government of Russia also sells bonds inside the country (nicknamed OFZ's). These are often used for managing cash flows and liquidity. Here's the thing: if they're bonds, even if you sell them locally, anyone internationally can buy them from a reseller. Russia has already sort'of defaulted on these. Interest payments on them that were due this month were paid on time to Russian holders. But no payments went out to foreign holders. Everyone is wondering why these have not been declared to be in default yet. But the expectation is that at some point they will be. Russia's quasi-default in 1998, which in part led to Putin succeeding Yeltsin, involved Russia honoring its international bond payments, but defaulting on its domestic ones (which probably made Russians leery of financing their government, which then went more international over the last 15 years).

Lastly, there's the general problem of outstanding investments in Russia. The sovereign debt (the part borrowed by the government) of Russia is about $60B, of which a third require interest payments in euros or dollars (we just dealt with $4.5B of that yesterday). But private Russian firms have borrowed about $250B from western investors, and those firms often have little latitude to make their interest payments (some are already defaulting, but they're all small). The biggest exposure is in France, Italy, and Austria. Those are the place that will get wobbly with sanctions first.

May You Live In Interesting Times 2 (Not Required)

Ummm ... is it weird if another ship carrying cars sank? 'cause I don't remember this happening very often before ... or probably ever before.

Anyway, the ship went down in bad weather in the Persian Gulf. No news on what type of cars were on this ship. No one knows what happened. Almost all of the crew were rescued from the water (a sign that the sinking was fast).

The Rest of the Story (for This Week) On Russia's Bonds

The news hit the internet at 11:17. We were in class, but it was there when we got out and checked the Bloomberg terminal.

Russia did pay the dollar-denominated interest on those two sets of bonds, on time.

This is a strong signal that default scares the c**p out of Putin and other decision-makers.†

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So, there are sanctions on Russia's accounts in the west. But they aren't complete.

On Monday, Russia got a communication, presumably without using SWIFT, to its correspondent bank, J.P. Morgan. This connected them to an account somewhere with dollars in it that was not under sanction. Russia has about $100B in FX in China, but it's not clear if that's held in dollars or not.

J.P. Morgan did not know if this was OK, so they contacted the U.S. Department of the Treasury. There, the Office of Foreign Asset Control (I'd never heard of that either) made the decision that 1) they can do whatever they want with non-sanctioned accounts, and 2) it's OK for anyone to accept money from Russia (it's not clear if that is only from non-sanctioned accounts or all accounts). Both of those are OK until some time in May.

When that came through, J.P. Morgan forwarded the money to Citibank, which handles disbursals for those bonds. Investors started getting there money by this afternoon.

This all sounds a little hokey. But, the idea of sanctions is to get the money out of Russian hands. Allowing the payment got non-sanctioned money out of Russian hands, and  kept international investors happy, so it's a win-win.

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So, not only didn't Russia default (this time), they paid in dollars instead of rubles.

I had missed this, but apparently the CDDC ruled on Friday that paying the interest on those bonds in rubles — because it was part of the contract — was OK.

But Russia didn't take advantage of that. Why?

My guess is that even though it would have been legal, the Russians were told that if they did this it would not be viewed as a good faith payment, and that institutional investors would hold that against them (by charging them a much higher rate) in the future.

***

Earlier this week you could've bought those Russian bonds for about 20% of their maturity value. Now that's up to 40%.

The price of CDS's on Russian 5 year bonds has dropped down to about $1,700.

Next up are payments that have to be made in euros on the next two Mondays.

† Why are bond defaults such a bad thing? Because no one will loan you new money until you settle the old loans. The Washington Post reports in "Will Russian Bonds Default? There's Debate About That" that some bonds from Czarist Russia that were repudiated by Lenin after the Russian Revolution were settled in 1986. And a letter to the editor of the Wall Street Journal notes that before France would allow Russia to sell bonds there in 2001, they had to make payments on bonds people had been holding onto since the 1890's, which had also been repudiated by Lenin. I hadn't heard of the first case, but I do recall being amused at the second one when it was in the news.

Russia Surprises Bond Markets

This is still up in the air ... but it seems like Russia made its interest payment in dollars yesterday like it was supposed to.

But no one is being clear on this.

The Russians say they paid.

Holders of those bonds are saying they didn't get any interest ... yet.

And the banks that would make all this happen ... haven't said a word.

My guess is that there are some legalities involved in whether the dollars that were used were actually accessible, either by Russia, or by the banks clearing the loans. 

While the U.S. and others have blocked a lot of Russia's financial capabilities, the U.S. Treasury issued a statement saying that if money from Russia actually makes it as far as you, you're allowed to accept it. But this begs the question of who is not accepting funds that are available to them, because somehow no one is saying there's a default either. If there was, a 30 day grace period would need to be publicly declared. But for now, the Russians are saying that they have not received confirmation that their payment has been accepted or declined.

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There's an aphorism that you should get used to. It says something along the lines of "May you live in interesting times.". It's not intended to be a compliment.

Federal Reserve Policy Shift

The FOMC shifted into a contractionary monetary policy at this week's meeting. Their target interest rate was raised by 0.25% (or 25 basis points) to a range of 0.25-0.50%.

This move was expected. However, the repercussions of the war in Ukraine are broadly expected to have a contractionary effect too. I think this made some members a little leery of taking this step (the vote was 8-1, with the no vote wanting a bigger 0.5% increase). (In a post yesterday for my principles classes, I put the odds on a 0.50% increase at 20%, 50% on the 0.25% increase they chose, and 30% on no change at all).

Even so, inflation is a problem, and the Fed is the institution primarily responsible for addressing this. The underlying idea is that inflation results from more willingness to spend than ability to produce. Raising interest rates will discourage some spending.

I describe monetary policy in the U.S. as a sequence of baby steps. In this chart you can see extended periods where rates are raised or lowered several times in a row.

This is intentional, so we can probably expect rates to be raised many times over the next couple of years.

The FOMC releases an extensive report after its meetings. One of the items in there is the forecasts of where the individual members think interest rates will be in the future (at year's end):

There is a little bit of a trick here. The FOMC is composed of the 7 Governors from the Board of Governors in D.C., and the Presidents of the 12 Federal Reserve Banks around the country. That's 19 people in the meeting. But not all of them vote:

• 7 Governors always vote
• 1 President, of the Federal Reserve Bank of New York, always votes
• 4 out of the other 11 Bank Presidents vote on a rotating basis (for a year, roughly every third year)

The thing is, sometimes there are vacancies, particularly amongst the Governors (there are vacancies amongst Bank Presidents, but they have day-to-day local duties, so those jobs aren't open for long). Currently there are 3 vacancies amongst Governors. So, 16 people were in the meeting (and there are 16 dots in each group on the graph), while 9 people voted. 

FOMC meetings are scheduled in advance. There are 6 more this year. The dot that's lowest on the left, the member that expects the least rate increases) is forecasting 4 more increases of this size for this year. The median forecast is 6 for 6. 

On the top chart, some of the steps are wider, and that indicates ac couple of meetings in a row in which they voted for no change. 

Of course, they could always go for a bigger increase at some meeting, but the top chart shows they haven't done this any time in the past 25 years. They have brought their target down in big steps a few times.

Also, the FOMC can have emergency meetings between scheduled ones. For example, two years ago, just before the lockdowns, they dropped interest rates twice between meetings, in anticipation of the economy going downhill rapidly.

***

There are fairly serious arguments made by academic macroeconomists that the FOMC was not aggressive enough at raising interest rates after the 2001 recession, and that this encouraged the formation of an asset price bubble that contributed to the financial crisis of 2006-9. The argument here is that interest rates that were too low encouraged people to buy assets they could not afford later on.

The same argument was made 4-10 years ago about the Fed's behavior then. However, we did not end up with a price bubble or financial crisis.

Yesterday, in a strongly worded opinion piece, the Wall Street Journal emphasized the position that the Fed is too timid about fighting demand pressures.

***

You may be wondering why I emphasize this topic less than the popular media does. This is because the time series portion of this course teaches us that it's just not as big a deal as it's made out to be. Look for that message when we start covering in class what's called Case 5 in my text.

Disconnecting Is Hard

Western European purchases of natural gas from Russia are up since the invasion.

 

This is one reason why sanctions aren't that effective. The Europeans have painted themselves into a corner, and really don't have any choice but to continue buying Putin's gas. On the good side, 90% of Russia's oil and gas profits come from oil, which is easier to shut down.

Oil Prices Are Back Down Again

Prices for benchmark crudes (WTI, Brent, and Dubai) are back down into the high 90's.

The big drop is a reflection of the fact that both the supply and demand for crude are inelastic. So all the volatility is in P rather Q. 

And somehow pressure was relieved this week: either supply shifted to the right, or demand shifted to the left. It appears to be the latter. It's probably unwise to think this will be the new normal.

This does not seem to have much to do with the situation in Ukraine. Well, maybe a little: negotiators between Ukraine and Russia sounded a little more hopeful yesterday.

A bigger factor is that COVID-19 is flaring up in China again, with their largest lockdowns since this all started in early 2020 (also see "China's COVID Lockdowns Set to Further Disrupt Global Supply Chains" which The New York Times appears to be making freely available). 

***

China does not have a lot of oil, so they are the world's biggest importer (they produce 20% of what we do, for an economy of comparable size). They are the second largest consumer of oil, and the second largest refiner, although they don't export too much (remember, it's a low margin business, and the first thing you do is refine close to the source and then sell close by too). If you're curious, I found this accessible short article with graphics for most of this; recommended.

But recall that most oil isn't stored much — it goes ground to refinery to consumption fairly quickly. China is about halfway through a long committed investment (in the 20-30 year range) designed to increase its oil storage capacity to about a 100 day supply. 

Numbers out of China are always sketchy, but estimates were they were up to 280 million barrels in storage capacity about 6 years back. Current estimates are that they can store enough oil for 40-50 days worth of imports. At 12 million barrels/day of imports, that's in the 500-600 million barrel range. It is believed this storage has been filled as soon as it's built. That's about what the U.S. can store, but we've got a lot more coming out of the ground, so we have less need.

***

BTW: this is a good example for the stock-flow arithmetic. With round numbers:

(600M barrels)/(12M barrels/day) = (600M barrels)(day)/(12M barrels) = 50 days

***

In other news, there's this tidbit: Saudi Arabia might start selling some of oil it sends to China for yuan instead of dollars.

What Does a Russian Default Mean?

A Russian bond default means a lot and not very much. It depends.

***

Governments borrow money. People borrow by going to banks for a loan. Institutions borrow by selling bonds. Those bonds pay interest, usually due every 6 months.

If you're 1) a rich country, 2) have well-developed financial markets, and 3) have a government that's trusted by your citizens — then you sell those bonds on your own domestic markets. This is what the U.S. does.

But most countries fail one or more of those, and in the case of Russia probably all three. Countries like that sell their bonds in other countries' financial markets. Usually they have to offer a higher interest rate.

But how to pay that interest? Generally, if you sell a bond in America it stipulates that you have to pay interest in dollars, in the EU  in euros, and so on.

Bonds are sold in big blocks. Russia does stuff like sell bonds with a face value of $3,000,000,000 by selling 15,000 of them with a face value of $200,000. Then they might sell multiple blocks like that with  different starting dates.  Those starting dates determine when the interest is due: usually every 6 months after that, until the bond matures. Choosing a bond maturity is part of the process, but Russia (like other countries) sells bonds with different maturities: 10 year, 30 year, and so on.

Russia has 2 blocks of bonds, with interest denominated in dollars, that are due tomorrow:

• One is for $3,000M face value of 10 year bonds with a 4.875 coupon rate that pays semi-annually. This means they owe $3,000M x .04875 x 0.5 = $73,125M.
• The other is for $1,500M face value of 30 year bonds, with a 5.875 coupon rate that pays semi-annually. This means they owe $1,5000M x .05875 x 0.5 = $44,062.5M.

Russia has other bonds denominated in euros. One is due next week, for about €65M, and another for €102M due the week after that.

Russia has the foreign exchange to pay for those. But no one will let them access their funds.

That money is owed to western investors. So this is very much a situation of "let's put sanctions on Russia that actually hurt us first". That's why sanctions are such a difficult thing to pull off.

***

These Russian bonds are special. They allow for interest payments in dollars or in rubles (same with those eurobonds).

This is an unusual feature, but with bonds you can put these in the contract and see if you get buyers. If they buy, they agreed. Generally, to do something like this that could favor the seller, you have to offer a higher interest rate (and these bonds to carry a higher rate than other issues sold by Russia). Caveat emptor.

***

Let's start with default. This means a bondholder fails to make an interest payment (on time, and then there's a grace period). 

Default is an official designation: like a "mark on your permanent record". 

Generally speaking, if Russia defaults, no one will loan them anymore money. This is not a big deal for Russia right now: no one will deal with them anyway.

It's more of a problem down the road when there's peace and Russia wants to move on from this conflict. Lenders will be more wary of them, and not buy without a much higher interest rate.

***

Then there are the CDS's sold to insure Russian bonds.

The declaration of default is important. If that happens, the CDS counterparties will pay the holders of Russian bonds. The lenders won't get back everything, but they'll get back a significant fraction of the money they're owed ... including future interest payments.

In exchange, those counterparties take possession of those bonds. They can then try and recoup the money from Russia. That will go nowhere for a while. But here's the thing ... down the road ... when there's peace ... and Russia wants to borrow again ... those counterparties will be first in line and no one will loan Russia money until they pay up.

Argentina went through this several years back. An investment company had bought their defaulted bonds, and sued, and finally go their money after about 15 years. There return over the entire period is estimated at 1500-2000%.

***

The amounts here are not huge: less than 1% of what the U.S. government borrows. 

And while those interest payments sound large, they are small compared to Russia's foreign exchange.

My bet is that default is declared, once the war is over Russia settles up fairly quickly, and the world moves on. I very much doubt that this will turn out to be a big issue that forces Russia to back off any time soon.

The Nickel Panic Is Over

China has backed their tycoon "Big Shot" in making his margin call. Banking intermediaries are happy again, and the nickel markets are set to open again on Wednesday. 

It's probably good news for the U.S. that China took care of this. But bailing out their tycoons is not a bright thing for them to do, macroeconomically speaking.

If You Haven't Been Paying Attention (Not Required)

While all the attention is on Russia, Israel is under a pretty serious cyberattack (believed to be coming from Iran), a bunch of ballistic missiles were fired at Iraq (by Iran, because they claim the Israelis are working from there), the Israeli's hit Syria with missiles last week because Syria is an Iranian puppet from which attacks are made on Israel, and it just came out this past weekend that there was a huge strike on drone bases in Iran about a month ago (suspected of being a pre-emptive attack by Israel).

Macroeconomically ... Iran, like Russia, is much tamer when oil prices are low. They're not, and they're going up. Expect more of this. 

The Israeli's don't need an excuse: Iran has made public announcements for years that they intend to liquidate Israel. They take dictators at their word.

Oh ... and ... Saudi Arabia and the U.A.E. snubbed Biden's oil outreach last week. Hmmm. Do you think they might be doing that because oil prices are high (so they're flush with cash), and the Biden administration has been mending fences with Iran (which has been picking fights with the Arabs too)?

Le Keqiang to Step Down (Not Required)

On paper, China is ruled by the communist party (the CPC). But the reality is that there are factions within the part which are where all the action is.

Xi has broken with tradition going back about 75 years. He is supposed to serve two 5 year terms and step down. He made it clear early on that he had no such intention, and accumulated power to make it so.

At the top, China is run by a bunch of ... managers. In this, China is like France: identify the young people who are both smart and well-connected, and then groom them for decades to lead the country. Political buffoons (so common in the U.S.) are rare in China. There's a top level of a few vice-premiers, then a central committee that adds a handful more, and then a Politburo that adds another dozen or so on the bottom.

So, just because Xi is not resigning like he's supposed, does not mean that the others who came up alongside him are not retiring when they're supposed to. They will be replaced by younger members of those groups. And they will all come Xi's offshoot branch of the Shanghai faction: rich, well-educated, children of generals who fought in the Chinese Civil War that ended in 1949. Xi prefers a subgroup of those, who started working together in Fujian province in the 1980's. These guys aren't really communists. They still use that name, but they're a lot closer to an old boys network at a country club. Some called them "princelings" before they rose to power in 2012.

Le Keqiang was the first to announce his retirement. He's been the (weak) # 2 in China for 10 years. He is well-known to macroeconomists for admitting publicly that China's GDP numbers are a fiction, and that they are simply not believed at the top levels of government. Le was not a member of the Fujian faction.

Liu He is retiring too. It seems like he will be replaced by He Lifeng. He is part of the Fujian faction.

Yes, this is kind of an odd thing to pay attention to as a macroeconomist. But ... do some of you wish you'd pay more attention to who was making the decisions in Russia the past few years?

***

Not to put too fine a point on this one too, but China used to have a mandatory retirement age of 65 (or the end of your current term) for the people in charge. Xi was pushed to the top 10 years ago from the # 6 position because he was young enough to serve 2 terms before retiring. But now he's hanging on to power (the plan is, for life), pushing out Li at the retirement age, but elevating He at the same age rather than someone younger. So again, this is another case of a system that has come to be dominated by old guys who like to tell other people what to do.

Russian Oligarchs (Not Required)

I mentioned this in class, so here's a follow-up. Quoting the Financial Times article entitled "Inside Putin's Circle — the Real Russian Elite" (link, probably gated, but they do allow you to register for free):

The western media employ the term “oligarch” to describe super-wealthy Russians in general, including those now wholly or largely resident in the west. The term gained traction in the 1990s, and has long been seriously misused. In the time of President Boris Yeltsin, a small group of wealthy businessmen did indeed dominate the state, which they plundered in collaboration with senior officials. This group was, however, broken by Putin during his first years in power. 

Three of the top seven “oligarchs” tried to defy Putin politically. Boris Berezovsky and Vladimir Gusinsky were driven abroad, and Mikhail Khodorkovsky was jailed and then exiled. The others, and their numerous lesser equivalents, were allowed to keep their businesses within Russia in return for unconditional public subservience to Putin. ...

So, basically, talk of oligarchs is old school. Who's in charge now?

Under his leadership, they have plundered their country (though unlike the previous oligarchs, they have kept most of their wealth within Russia) and have participated or acquiesced in his crimes ...

...

These men are known in Russia as the “siloviki” — “men of force” ...

The article lists 5 of them. 

Some of the most effective pressure on Putin’s elite may come from their own children. The parents almost all grew up and began their careers in the final years of the Soviet Union. Their children, however, have in many cases been educated and lived largely in the west. 

...

... The siloviki have been accurately portrayed as deeply corrupt — but their corruption has special features. Patriotism is their ideology and the self-justification for their immense wealth. I once chatted over a cup of tea with a senior former Soviet official who had kept in touch with his old friends in Putin’s elite. “You know,” he mused, “in Soviet days most of us were really quite happy with a dacha, a colour TV and access to special shops with some western goods, and holidays in Sochi. We were perfectly comfortable, and we only compared ourselves with the rest of the population, not with the western elites. 

“Now today, of course, the siloviki like their western luxuries, but I don’t know if all this colossal wealth is making them happier or if money itself is the most important thing for them. I think one reason they steal on such a scale is that they see themselves as representatives of the state and they feel that to be any poorer than a bunch of businessmen would be a humiliation,...

The macroeconomic import of this is that sanctions targeted at oligarchs may miss the mark because this newer group isn't holding their wealth in the west, and is may be more concerned with power rather than money. 

***

Not to put too fine a point on it, but Putin and all five soliviki are over 60 and half are over 70. So this is another case of a system that has come to be dominated by old guys who like to tell other people what to do.

A Seemingly Important Bit of Russia News (Not Required)

I've tried to avoid purely political items in my Russia-Ukraine coverage, and focus on the macroeconomic consequences ... but this one seems possibly important for macroeconomics.

The Times (that's the one in London) reports (and it's been confirmed) that Putin had some of his top spies arrested. The charges (embezzling) are trumped up, but the real crime is that they misinformed him about conditions inside Ukraine that were materially important making his invasion plans a success.

The article is gated (but not very hard to find), but The Times official Twitter feed covers most of it.

So ... yeah ... all the macroeconomic consequences might flow from these "yes men".

From the Bloomberg Terminal

I've been checking up on this before class, and sometimes on off days. I've also reported to class from my notes, but I haven't posted them here. So this is just a record of what I found this past week.

On 3/11

It's come out that some of the big investors who may have to pay up if Russia is declared in default are Pimco and Credit Suisse, both on the hook for around $2B.

CDS, oil, and ruble prices are holding steady.

Surgut (the short name for a Russian oil company that sells ESPO in the Pacific) is apparently willing to deliver oil to interested takers who promise to pay ... sometime in the future. Unwritten in discussions about that is that it probably means all their storage is full, and if they don't move something they will have to start capping wells. Most wells are ruined by capping and have to be redrilled.

It has come out that about a third of Big Shot's investment was funded by J.P. Morgan, which did pay its $1B margin call on Monday before presumably getting him on the phone to cover that.

It has also come out that Big Shot is being indirectly bailed out by the government in Beijing, which has ordered (you can do that in China) smaller regional banks to make new loans to him to pay off his margin calls, which came from earlier loans. So China is paying off one credit card with another. Sometimes that works. But it is a bit desperate. 

The far higher nickel prices are expected to translate into price increase of about $2,000 for EV's. Tesla has already increased prices on the cars they sell in China to cover that.

Fitch downgraded a bunch or Russian utilities to CC. Presumably, they also borrowed in the west and have upcoming interest payments.

On 3/10

Russians have offered Urals crude for a $28 discount off of Brent, up from $11. They got no takers.

Meanwhile, there are still 11 tankers scheduled to make pickups in the Baltic of Urals crude that's already been paid for.

Eurobond traders are becoming more confident that the CDDC will rule Russia in default if it pays interest in rubles, and that their CDS counterparties will have to make their promised payments. Estimates are that this will be about $40B (yes, billion). That committee met on Wednesday, and Thursday, and is meeting again on Friday, and has not issued a ruling yet, so this is all based on rumors.

The problems in the nickel market are becoming clearer. A big investor had shorted the metal (borrowed it now to return in the future when it is cheaper to replace with new purchases) as a bet that it is overpriced. Wrong! The thing is that shorting is basically done on margin (borrowed money). So this investor put up a little (their equity) and borrowed the rest. The value of that equity has gone to zero as the price rose, so the people who run the market demanded he come up with the money. They first went to his bankers and made a margin call on them, who passed it back to him. Here's the problem: the big investor is a Chinese billionaire who owns the biggest steel company in the world, one of his banks if one of the "big four" in China, and his total margin call is in the range of $8B. With a margin call you're basically supposed to come up with the money ... now. Having said all that, if someone in a market is wiped out by a margin call, someone else won that bet, right? The way these things are settled is that the loser is shut out of the market for good (or a long while), while the winners give back some of their winnings to keep the banking intermediaries in good shape. BTW: the nickname for the steely tycoon is "Big Shot". Insiders say he was aware of the risks, and understood the problem, but was not paying enough attention to the news from Ukraine (interestingly, experts in China were just as surprised as Americans and Europeans that Putin went this far).

On 3/8

Russia had put investors on notice that there is a clause in many of their Eurobonds allowing for payment of interest in rubles (rather than Euros). But this may trigger a declaration of default if the suits decide this is not what those contract clauses were intended for.

CDS's on Russian 5 year Eurobonds (the standard one used to evaluate this market) are up to 5,800 to insure 10,000. That price was in the 100-200 range last week, and this high price indicates a near certainty of default.

Not all Russian Eurobonds have that ruble clause. Turns out it is just 6 series of them. But they are big series. Took notes on those, but I have to sit down for an hour and crunch some numbers to figure out what it all means. Check back in a few days.

There is a committee that decides questions about bond clauses called the Credit Derivatives Determination Committee (CDDC). It is set to meet on the 9th to discuss those Russian bonds.

The exchange rate is holding fairly steady at a rate of around 120 rubles to the dollar. Holding steady indicates that people who wanted to get their wealth out have already done so. It doesn't hurt that Putin is preventing others from getting any more wealth out in the future.

There are no takers on offers of Russian oil (branded as Urals, ESPO and SOKOL). Urals is sold mostly through the Baltic and Black Seas. ESPO and SOKOL are sold from the Pacific coast of Siberia.

Trading on the main international nickel markets has been shut down, after prices doubled rapidly, and then doubled again on Monday morning. This is a new story. More later as it evolves. Russia is a large producer of nickel, maybe the largest. Will have to check that. Nickel is mostly used to make stainless steel, but is also used in some varieties of EV battery.

China gets a lot of bad press in the U.S., but my opinion from the news as I read it is that at the top levels they are generally steering towards the anti-Russian position. They're just less anti-Russian than most countries. So big Chinese refineries are cutting back on their purchases of ESPO and SOKOL. A worry though is that small, privately owned, refineries ... known as 'teapots' ... are snapping up cheap Russian oil.

The price for WTI (the benchmark for this hemisphere) is at $131/barrel. For Brent (the benchmark) for the other hemisphere the price is 127. These are record highs, in nominal terms.

D.C. is planning on banning purchases of Russian crude oil. But apparently, our purchases are down about 70% from last summer anyway. Not sure why ... probably just getting better deals elsewhere. Also, U.S. west coast refineries are already starting to buy more Iraqi and Ecuadorean crude as a substitute. Proportionally, the biggest American buyers of Russian oil are in Hawaii (whch makes sense: Alaska and Hawaii are closest to Russia, and Alaska has their own oil). 

Russia, Oil, and Sanctions

In the class quodlibet, JH asked about macroeconomic myths and folktales. Many of those are untrue. Understanding what goes on with oil requires unlearning a whole bunch of things you probably are sure are true.

***

There's always stuff on the news about oil prices. But price of what exactly?

Almost always those are prices for crude oil. This week it's up to $130/barrel, but there are expectations that it might go as high as $150-200/barrel within the next few weeks.

What's crude oil? It's the black to tan liquidy stuff that comes out of the ground. It's found all over the world, but is concentrated in about 20 major spots, and a lot of minor ones: Texas, Alaska, North Dakota, California, Pennsylvania, even Utah; and in countries like Saudi Arabia, the UAE, Kuwait, Iraq, Iran, Libya, Russia, Venezuela, Mexico, the UK, Norway, Romania, Indonesia, Ecuador, Gabon, and so on.

What's a barrel? Well, that's pretty obvious. It's also a measurement: 42 gallons. 

Got questions about what some of these things are? McKinsey has a glossary that covers many of them.

Crude oil is heavy. A barrel weighs about 300 pounds, so it's a notional estimate. No one actually has barrels of the stuff around except for waste oil in shops.

Now do the math. Oil was about $40/barrel for years, went up to about $80/barrel due to COVID-19 lockdowns, and is now up even further. Those correspond to about $1, $2, and $3 per gallon. 

This site breaks down retail gas prices in California each week. You can see that right now the cost of crude is about 55% of the retail price. But, if you scroll back a few weeks, you'll notice that all the other items add a consistent $2.30 to $2.35 to the cost of the crude. So all the ups and downs are coming from the cost of crude, and not from what refiners and shippers do.

***

Crude oil has different qualities. Each well is different, but it's a commodity: traders buy it in volume, so they tend to view all oil from one region as just about the same. Kind of like saying California oranges (which look better), and having people know those are different from Florida oranges (which taste better).

 

The grades do get finer than this, but what you need to know is light and sweet (up and to the left on the chart). Crude oil is either light or heavy, depending on whether it's less dense or more dense. Crude is also sweet or sour, depending on how much refining it takes to get the nastier stuff separated out. Lighter and sweeter is better, and therefore more expensive.

***

Most crude is priced relative to widely available types that everyone uses for comparison. These are Brent (from the UK side of the North Sea) and WTI which is short for West Texas Intermediate. Their prices are close, and not surprisingly Brent is used a lot in Europe and WTI in America. The prices you see are usually quotes for these. Other crudes are usually quoted with a negative price, indicating that they are being sold at, say, $5 less per barrel than WTI.

Russia has lighter sweeter crude coming from the Ural Mountains in the left center of the country. This is usually loaded on tankers in the Baltic. It sells for a small discount off of Brent. After the invasion it was being offered for $11 off of Brent and no one would take it. 

Russia also has newer oil wells in eastern Siberia that produce a heavy sour oil. And they have a lot around the Caspian Sea, which I think is also light and sweet, but I'm not sure.

***

Getting oil is not cheap. It costs between $30 and $90 per barrel to get it out of the ground. There's harder to get oil out there, but no one produces it unless the price gets high enough.

People think oil is always a profitable business (it's like you're own printing press for money). Wrong. Unlearn that.

Oil companies are big. You all took micro. When you see an industry where all the firms are big ... it's because they either get big or they die in bankruptcy. Small oil producers are not very profitable because there's economies of scale in this industry. This isn't wrong or bad or unfair, it just is. 

Because the firms have to be big, they can make a lot of profits. But they do not have a high rate of profit, which is what everyone who's had more than 6 weeks of economics or finance classes cares about. You can invest in oil companies, but they aren't a great investment. Apple is a good investment, and it's bigger than most oil companies, but somehow it has a good rep. Go figure.

A more appropriate view of oil producers is that they're like Walmart. They make a tiny little bit on each part of a high volume operation. People like Senator Warren, who claim otherwise, are either morons ... or they think voters are morons. You decide.

***

So why do we think of countries when we think of oil?

Here we combine both ignorance, and the law.

We've covered the ignorance. People think you drill and then buy a yacht. If it worked that way you'd be planning on staring an oil company after graduation. But it doesn't. Amongst the most ignorant are politicians and bureaucrats in countries that are trying to get bigger and richer (the country gets the first and the politician gets the second). Oil works best for them if they 1) have a lot of it, and 2) don't have very many citizens to worry about. This is why we associate oil riches with desert Arab countries. But if you don't have a lot of oil, you stay poor, as in Egypt, and even if you have a lot of it you won't get rich if you try to support too many people off of it, as in Nigeria. I suspect a lot of rulers in these countries start out with the idea that the oil is free, and then find out the hard way that it's expensive to get out of the ground and sell.

And the law is, that in most places, while you may own land, you only own the surface. You don't own what's underneath. The U.S. is one of the exceptions to this: if you drill for oil on your land, it's yours. But most countries aren't like that: in them, the government claims to own all the mineral wealth under the ground. That's really convenient if there's oil down there. (For what it's worth, in the western U.S. the states own all the water under the surface, just like oil in other countries).

So, for a lot of countries, there are oil "companies", but they're only nominally independent of the government. So Mexico has Pemex: a state monopoly. Russia has a few oil companies, but they are controlled by oligarchs. A lot of countries also lease the oil they own to those big American and European oil companies: Exxon, Chevron, BP, Shell, and so on.

Countries with oil can earn a lot of foreign exchange by selling their crude on international markets. This is where Russia gets most of its money. I remarked earlier in the semester that Putin can cause trouble now because he's flush with FX from recent increases in oil prices, and new fields in Siberia coming online. But he's making all that money on volume, not margins.

***

But crude is only the first part of the story.

Have you heard that America is dependent on foreign oil? Don't be stupid. Unlearn that one too.

Crude oil is close to useless. It used to just lay around the surface of the earth in pools. It still does in the La Brea Tar Pits, and elsewhere. And people used it for very little, except waterproofing.

Over the years refining developed. There's not a ton of money in this either, but there's more than in crude.

Crude oil is like an old car that's worth more in parts than as a vehicle. Refining does two things: 1) separate out the oil into different products by density, and 2) chemically alter some of them to turn them into more desirable products. This page has details on what comes out of crude oil (for Utah kids familiar with ranching ... it's similar to the idea that no part of a cow goes to waste).

The lightest parts of crude oil is stuff like the butane in cigarette lighters. "Light" is the name used here, but what they really mean is least dense. Gasoline is also pretty light. Gasoline isn't that special: there's just a lot of it in crude oil, it flows well, it vaporizes easily, so it got adopted for engines (invent the engine for the new-ish fuel that's useful and easy to get, right?). It's not a coincidence that oil drilling, refining, and gas engines all came online one right after the other in the last half of the 19th century.

 

The heavier parts of crude oil get refined into other stuff: diesel, jet fuel, motor oil, heating oil, gasoil, bunker fuel (for ships), tar, asphalt, precursors for plastics, and even stuff like vaseline (that's a brand name for the product petroleum jelly). The goal is to find a buyer for all of it: think about, there's aren't big pools of leftover oil residue all over the place.

 

Coming out of the refinery, a barrel of gasoline is light enough to float on water. A barrel of tar, on the other hand, weighs most of the 300 pounds that the barrel of crude did.

If the crude oil is sour, it contains more impurities. This makes refining more expensive. Nasty smelling but fairly harmless sulfur is the big problem here.

Light sweet crude oil sells for more than heavy sour crude oil because you get more valuable stuff out of it more easily. But refiners can use both.

The trick is that a refinery is designed and geared for the sort of oil that's it's likely to be used for. They can be repurposed, but it requires shutting them down for weeks or months to retool.

So, America is supposedly "dependent on foreign crude oil". Yeah ... right. The correct story is that we have a lot of refineries because we're smart and rich. In fact, there's no problem in having more refineries than you have oil. So while America has always been a big producer of crude oil, and has been the biggest over the last 10 years, it's an even bigger refiner. We do all of ours, plus a lot of other countries because it's a good idea. Duh.

Oh ... and people excessively focus on how much crude oil the U.S. imports. They ignore the even larger amount of refined products we export. It's almost like they're trying to suppress the real story, isn't it?

This site has some accessible details about the economics of refining. This page is a little more involved, but has some cute econometrics. Both sites discuss the 3-2-1 crack spread, which is a simple convention for figuring out if refiners are making more or less money than they were before.

***

We're getting towards the end now. Gas used to be about $3/gallon, and a dollar of that was from crude. Now the crude has gone up to $2-3 per gallon, adding $1-2 to the price of gallon of gas. The other $2 in between is the costs of refining, transporting, taxes, and profits.

Transporting oil is fairly cheap (transportation usually is), but remember that this is a high volume low margin business, so any transportation cost is an issue.

Storing oil is also fairly dangerous (and it's getting stored for a while as it's being transported, right?). 

But doing either for oil is safer than doing it for gasoline, the major component.

So the economically efficient way to do things is to 1) refine what you need between the well and the city, and 2) ship the rest of it to big refineries somewhere else. For example, most gas bought in Utah comes from the refineries near Woods Cross, that get most of their oil from around Vernal and Wyoming.

Thus, the prices on the spot market for oil associated with countries is for shipments of what they are producing in excess of local needs. It gets shipped to refineries, that then ship finished products to regions that don't have any wells or refineries.

Even so, oil of a certain grade is usually shipped to refineries set up to handle that grade, which are located as close as is feasible. For example, Texas has refineries for light and sweet crude from Texas, but it also has them for heavy and sour crude from Mexico and Venezuela. Part of the reason that the oil industry wanted the Keystone XL pipeline was to bring more crude oil from Canada (really heavy and sour) to refineries set up for that in Texas, which didn't have much business because Venezuela's incompetent government killed their oil drilling industry over the last 25 years. Tons of people understand this, but the just-so story of pipeline=bad was what dominated the news. Few people realize that the alternative is not no oil being shipped across the country to Texas, but rather oil going in tanker trucks and rail cars through peoples' neighborhoods. Oops. Face palm.

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Oh ... one last tidbit. Oil tankers are big because they have to be efficient to reduce costs because it's a low margin industry. So most oil tankers won't fit through the Suez or Panama canals.

Thus middle-eastern oil often goes to Asia, Russian oil to Europe, and so on.

For America, this means that oil imported to the east coast often comes from the UK and Norway, but not Russia because it's a bit further away. But Russian oil goes to, say, Germany, because it's just as close as the UK and Norway.

Russia also sends oil out through the Black Sea to countries around the Mediterranean. And they send oil from eastern Siberia to China, South Korea, and Japan. A lot of that goes by pipeline rather than ship.

And, maybe you're seeing this coming: also to the west coast of the U.S., and especially Hawaii. The left coast also gets a lot of oil from Ecuador and Indonesia.

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Because of Russia's invasion of Ukraine, some countries want to shut off Russia's oil exports. Here's some of the issues. 

Low margins on the production side mean that there is rarely a lot of spare capacity in the oil industry. It's all going all the time, or it's shut down. But shutting down wells isn't easy: they're pretty much ruined and have to be redrilled. This means that supply is inelastic.

It's worse because refineries are set up for the oil that's nearby. So can Europeans get oil from elsewhere? Sure. Can they get the oil that won't require shutting down and retooling their refineries? That's tougher. Yes, but at a price. And when they stop buying Russian oil, it gets picked up by the Indians because (at a discount) it's competitive with oil from the Middle East. And we're worried about what the Chinese will do because they get their Russian oil in a pipeline, which is easier to hide. 

It's worse because our demand for oil is also inelastic. This is why they worry about Russia's oil and gas being cut off during what's left of the European winter.

Combine inelastic supply and inelastic demand and you get a lot of variability in prices without much variability in quantity. This is why prices at the gas pump change so much in normal times, much less this year.

Now, Russia is a big exporter of oil, but no country is huge. The figures I saw is that Russia export 8% of the world's oil, and comprises 3% of U.S. imports of oil. But it will be the west coast and especially Hawaii that will bear the brunt of this week's ban on oil imports from Russia. All prices will go up everywhere, but it will be worse to the west of us. Utah will have less of an effect because there aren't many pipelines bringing oil in from the coast: we have our own little insulated oil region in the Great Basin.

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Biden is being made to look the fool this week around some of these issues.

He called Saudi Arabia and the UAE and they refused to take his calls! The goal here was to ask them to ramp up production. This is a dumb political move that only dumb political people could think would work (again, a few weeks in a micro class would help them out). The issue is, what exactly did they think Saudi Arabia and the UAE were doing before? Not ramping up as fast as they could?? Oil prices have been increasing for a while. All these countries were hurt by low prices in 2020-21. They already are ramping up as fast as they can to take advantage of better prices. Asking them to do more is just for show, and kind of insulting to boot.

(In addition, Saudi Arabia and the UAE see the Biden administration as favoring Iran over them. Do you think they're going to let that slide when he comes begging for more production?).

Then there's the Biden administrations overtures to Venezuela. This can be presented to the gullible media as "let's stop hurting the country with the leftist government"). But it's worse than that. If they had not stopped the Keystone XL pipeline, there would have been less need for this since Gulf Coast refiners would have already been going full speed ahead. So this also is tied up in politics and the politicians are hoping you and I won't notice that they're doing politics again. Whatever.

I have some charts and figures to attach to this post, but it's taken me so long to write, that I'll be adding them before and after class. I'll note them with updates down here.

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3/12 Update: Preliminary reports show that imports of Russian oil were already down to zero in the last week of February. This is before Biden's ban, and was accomplished by decentralized decision-making in the private sector.

3/14 Update: Here's that tweet about the price of gas now versus the zombie movie I Am Legend. (with pictures) ;-)

Russian Debt Downgraded

I was writing this from home on Tuesday when we lost internet connectivity for about a day.

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The rating agency Fitch downgraded Russian bonds. This seems to be in anticipation of default being declared if the Russians try to make interest payments with rubles.

Each rating agency has a slightly different scale for rating bonds. But charts like this one are easy to find:

Fitch downgraded Russian bonds from somewhere in the B's to C. Of course, the bottom of the list indicates near-certainty that the issuer of the bonds will default on them.

Investment grade means that firms that have some fiduciary responsibility towards clients are allowed to buy. Non-investment grade bonds are commonly and pejoratively called "junk bonds". Lots of people and firms buy those for their higher yields, they're just generally not doing that with other peoples' money.

Bonds towards the bottom of the list have to promise to pay a higher rate of interest at the time of issue in order to entice potential buyers to commit to their risk.

Once bonds are in circulation, and can be resold from the initial buyer to anyone else, the ratings agencies re-evaluate them periodically so that inattentive holders have a clue.

Generally speaking, when it becomes less likely for a bond to pay its income stream, investors have been watching the news and already see this coming. So holders of those bonds become interested in getting rid of them, and are willing to accept a lower price to get rid of them. When the price gets low enough, some bargain hunter may decide the risk is worth the lower price. As discussed in principles classes, bond prices and interest rates go in opposite directions. So price and ratings move together, and interest rates (yields) and ratings move in opposite directions.

While the rating agency decisions make the news, they often reflect (rather than lead) a reality in that market that holders are trying to get rid of the things.

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Of course, someone might know a bond they hold is getting riskier. But they might think it's worth something more than what they can get for it. This is where the CDS market I've mentioned a couple times in class comes into play. 

If the bond issuer does not make an appropriate payment, bondholders can ask for a determination of whether or not that is considered a default. If it is, the entity that gambled and sold the CDS to the bondholder pays up. If it isn't, the CDS continues to be valid until it expires. 

Russia has interest payments starting to come due. Some of their bonds stipulate that the interest may be paid in rubles. But bondholders may make the case that exercising that stipulation is a form of default because at the time they agreed to it, no one envisioned Russia behaving bizarrely. A committee was set to meet on this issue as early as Wednesday the 9th.

SWIFT Banishment Not All It's Cracked Up to Be

Eurointelligence, a site associated with Harvard and the Financial Times, reports that banning Russia from SWIFT has been far from complete.

There is no direct link for this story. Instead, go to the main webpage, and scroll down to March 3. The FAZ it refers to is a German newspaper.

The story is that a list went out of banks whose relationships with SWIFT were to be shut down. But then individual EU states complained about individual banks that were tightly entwined with their country, and they were removed from the list.

The post uses an acronym for this that you should start to become familiar with: SINO, short for Sanction In Name Only.

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The same post does not that Putin apparently did not expect Russian central bank to be cut off from western markets. Phew. At least something might work.

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And today there was news that they might want to kick Russia out of the IMF. This would block some of Russia's available funding. But there are political problems with this move. 

Also, the article does not mention one salient economic point: bigger and richer member countries pay dues to the IMF. So kicking them out and keeping their dues would reasonably be argued as much more akin to theft than other actions.

Turkish Snark

About a year ago I posted how Turkey had done more things right to get into the European Union than many other countries, but has been waiting for admission ... for 35 years. I attributed this largely to prejudice. 

Some of you no doubt saw that Ukraine has asked for immediate membership in the EU.

Here's Erdogan's take on that:

Asked about Ukraine's bid for European Union membership at a joint news conference with Kosovo President Vjosa Osmani in the capital Ankara, Erdoğan said Turkey, an EU candidate for decades, would support any enlargement of NATO and the EU. 

"We appreciate the efforts to get Ukraine EU membership. But I ask the EU members, why does Turkey's membership in the EU worry you?" he said. 

He called on the bloc to show the "same sensitivity" it showed for Kyiv's membership bid for Turkey's application, and slammed member states for being "not sincere." 

"Will you put Turkey on your agenda when someone attacks (us) too?" he said.

The man's got a point.