Give me oil, but not yet
One thing that people like to invest in is oil. You can buy oil to refine into gasoline or whatever, but you can also just buy it as an investment, or a speculation, or a hedge. You buy oil today for $35, if the price of oil goes up to $65 you make money, if it goes down to $15 you lose money, it is a bet like any other.
Or that’s the idea. In fact there is a practical problem with bets like that, which is that oil is voluminous and oozy and poisonous and flammable and smelly. If you want to bet a few thousand dollars of your retirement account on your belief that the price of oil will go up, you will not want to actually fill your garage with barrels of oil to implement that bet. That would be inconvenient.
So instead you turn to financial markets to buy, effectively, abstract oil. You buy a financial instrument that goes up if the price of oil goes up and goes down if the price of oil goes down. That’s what you want, a bet on oil prices without the inconvenience of owning a lake of flammable liquid.
It would be nice if there were just, exactly, that thing. “Permanent abstract oil,” you buy it for the price of oil today and sell it for the price of oil when you want to sell it. But there isn’t, quite. There are oil futures: You buy abstract oil today and it converts into real oil in May, or whenever. You do not want real oil, in May, or ever. Perhaps your bet is just “the price of oil will go up by the end of April.” Then you buy May futures today, sell them by the end of April, collect your profit (or loss) on the bet, and never get any real oil. (The futures you buy and the ones you sell offset; no one delivers you any oil, and you never deliver anyone any oil.)
But more likely your bet is just “the price of oil will go up sometime.” (Just like buying a share of stock is a bet that its price will go up sometime: You are not locked into any time frame.) You do not actually want the May futures, exactly; you just want abstract oil. So what you do is you buy the May futures, to bet on the price of oil without owning actual flammable oil, and then as the expiration date of the May futures gets close you sell those futures and buy the June ones instead. (This is called “rolling” the futures.) As the June expiration approaches, you do it again. You keep owning oil-but-not-quite-yet, giving you exposure to oil prices without the inconvenience of actual oil.
There are legendary stories on Wall Street about newbie commodities traders who forgot to roll their positions and had to scramble to find somewhere to store 10,000 pork bellies or bushels of wheat or barrels of oil or whatever. These stories are funny because they are rare, perhaps mythical; mostly financial traders just remember to keep their commodities trades in the world of financial abstraction.
This is, for instance, what oil exchange-traded funds do. An oil ETF gives its investors permanent exposure to abstract oil, but it generally doesn’t do that by actually owning a giant tank of oil; it does it by buying futures and rolling them. One way to think about this is that someone has to store the oil—the actual oil—that you own abstractly. If oil prices are in contango—if the price of June oil is above the price of May oil—then by rolling the futures (selling the cheap May one and buying the more expensive June one) you are effectively paying someone else to store the oil for a month. Someone else can buy the cheap May contract, sell the expensive June one, take delivery of the oil in May, keep it in their garage for a month and deliver it in June. (If oil prices are in backwardation then someone is paying you to take the oil out of storage because they really need it now.)
Occasionally you will have the odd situation in which (1) people think that oil is valuable and want to bet, abstractly, on its future prices but (2) no one wants any actual oil right now because no one is using it and they have nowhere to put it:
Oil plunged the most on record to below $12 a barrel in New York as a historic demand slump fills inventories to the brim.
Futures fell as much as 40%. While the collapse reflects the most immediate May contract expiring on Tuesday, it nonetheless highlights a fast-growing glut of oil, and rapidly expanding stockpiles at the American hub at Cushing, Oklahoma. OPEC+’s record production cuts from next month are paling in the face of this evaporating demand.
The upcoming May contract’s expiry means traders are shifting their positions to June as they try to avoid taking deliveries of cargoes because of the lack of space to store them. That has opened up an unprecedented discount of more than $10 between the two nearest contracts.
This situation—in which the price of the June contract is far above that of the May one—apparently delights in the name “super contango.” People put a price on oil—they think it has value and want to own it at that value—but they also put a price on not having it now, and the latter price is quite high relative to the former. Conceivably, in theory, the latter price (what you’d pay to not have oil now) could exceed the former (what you’d pay to have oil eventually), leading to negative spot prices. We’re getting there:
There are signs of weakness everywhere. Buyers in Texas are offering as little as $2 a barrel for some oil streams, raising the possibility that producers may soon have to pay to have crude taken off their hands.
In ordinary economics, things do not have negative prices: If nobody wants a thing, if you’d have to pay them to take the thing, you just don’t make it. Oil is a little weird—it is hard to shut in and then restart an oil well, and there are all sorts of weird cartels and game theory involved in oil pricing and production—but the other thing going on here is that a global pandemic is pretty weird for commodity prices. The price of oil is not approaching zero because nobody needs oil; you can look into the future—or at futures prices—and see that, in fact, there is demand for oil. But right now, with the world economy closed, people need much less oil than they’ve got. If you have a thing that lots of people want, but that no one wants right now, it is hard to put a normal price on it.
PPP
My general impression of the role of banks in the current financial crisis is that the response to the last financial crisis worked pretty well. In 2008, banks were at the center of the trouble in the economy, and the regulatory response was to make them far better capitalized, less exposed to market risk, and generally more responsible. In 2020, banks are not the cause of the trouble, and the fact that they were well capitalized and responsible going into the crisis has made it possible for them to be part of the solution. They can lend and offer forbearance on loans and waive covenants and intermediate trades and generally be supportive of their customers because they have reasonable amounts of capital, and because the market has a reasonable amount of trust in them. Also because of massive Fed programs, to be clear; this is not a story of purely private-sector bankers coming together to save the world. Still the basic public/private partnership of bank and regulatory responses to the last crisis seems to have held up pretty well in this one.
There will be tradeoffs. For instance part of the response to 2008, and to a lot of post-2008 scandals for that matter, has been to try to make big banks do fewer crimes than they used to. Mostly a good plan! On the other hand, if your regulatory approach for the last decade or so has been to force big banks to be more careful, to demand extensive compliance programs and punish them severely for compliance failures, there is always the risk that they will have too much compliance. “Too much compliance” is almost never a complaint that anyone but a banker will take seriously: Ooh, you poor babies, you are spending too much money on not doing crimes, you are doing too few crimes, tell me more about your troubles.
But sometimes! Here’s Bloomberg’s Hannah Levitt:
Small businesses that rushed in vain to tap $349 billion in emergency U.S. loans to survive the coronavirus crisis are facing a harsh reality: Some of the nation’s top banks lagged behind relatively tiny rivals in handling applications. ...
Such figures, just starting to trickle out of U.S. lenders, are bound to fuel more anger over the chaotic Paycheck Protection Program administered by the Small Business Administration.
Part of this is presumably that small banks are better at working with small businesses than large banks, which tend to do more business with large businesses. Part of it is that if you are a giant bank, everything you do needs to be scalable in a way that is not required at a small bank:
As banking giants tried to automate the process, hundreds of employees at Texas lender Cullen/Frost Bankers Inc. volunteered to fill out forms manually, working late into the night in homes to set up $3 billion in loans. That contrasts with Wells Fargo & Co., which arranged only about $120 million by the time the program was depleted this week, according to people briefed on its progress.
But part of it does seem to be that big banks have gotten in lots of trouble for their compliance failures in the recent past, and now have more conservative compliance cultures than small banks:
Big banks that paid billions of dollars in sanctions after the 2008 financial crisis for flaws or omissions in loan applications -- in that case, mortgages -- assumed paperwork submitted to the SBA would need to meet high standards, or they would risk getting in trouble again. Wells Fargo has been under particular pressure to show that it overhauled its internal controls.
Some big banks spent days trying to get more guidance from the agency about elements of the application process, according to people with knowledge of the talks.
Meanwhile, executives at major banks told their employees to make sure that they had validated financial information from small businesses before submitting packets to the government. Some were floored when the SBA posted a notice on its website on Tuesday, confirming that’s necessary but saying that “lenders who did not understand that these steps are required” didn’t need to withdraw applications already submitted. That essentially gave an edge to lenders that had skipped that time-intensive step to get their customers’ applications in first...
Community banks probably punched above their weight because they were more willing to act while awaiting additional information, said Paul Merski, an official at the Independent Community Bankers of America who oversees its work with Congress.
Obviously this is not great in the narrow sense that it would be nice if Wells Fargo’s customers got a lot of PPP loans, since they need the money. But that’s mainly a problem of the PPP being too small so far (it might get bigger); given that some small businesses that need money won’t get it, We are not sure it matters too much if it’s Wells Fargo or Cullen/Frost customers who miss out.
But it does tell a more general story about the big banks, that they have invested so much in at least the formalities of compliance that they have become worse than small banks at making loans to new customers. That’s neither entirely good nor entirely bad, is it? What we want from our banks is basically that they make loans and not do crimes. In normal times the crimes tend to be more salient than the lack-of-loans, so there is an emphasis on compliance. The last couple of weeks were an unusual period in that people paid a lot of attention to banks’ ability to rapidly make loans to small businesses, and it turns out that our big banks have gotten worse at that.
“Much less real estate”
One fact about investment banks, and particularly the trading desks at investment banks, is that they are full of people who like to come into the office and sit next to each other and yell at each other and give each other nicknames and make fun of each other and haze the interns and generally participate in a certain intense and specialized culture, as well as pressing the buttons and making the phone calls to do the actual trades. Part of this is just, you know, they are human, their culture helps define them, they like the camaraderie and the nicknames, or at least, they have been indoctrinated into the culture so thoroughly that they think they like it. Part of it is that sitting next to each other and yelling at each other all day probably does improve profitability: You know what your colleagues are up to, you can share information, you can fire each other up, everything is just easier if you’re all sitting next to each other.
And so during the coronavirus crisis we have talked a few times about senior traders telling their subordinates to come into the office, at significant risk to their health, because there are trades to be done and good traders are supposed to be in the office. Was that a judgment that came from real business necessity? Or was it just, like, there is a culture of hanging out and yelling at each other, and senior traders have spent the most time in that culture, and they’d feel weird if everyone just pressed the buttons at home?
But the thing is that the coronavirus crisis is going to force traders, and their bosses, to confront those questions. If everyone trades from home for six months, and it’s fine, will they all forget the joys of sitting around nicknaming each other? Will some of them conclude “actually having some quiet and not commuting is even better than making interns do eating challenges”? Will the culture change? Will that matter, in terms of making money?
I don’t know but here’s James Gorman:
James Gorman is hesitant to make predictions about the future with so much about the coronavirus pandemic still uncertain. One thing is clear, however: Morgan Stanley will have “much less real estate.”
“We’ve proven we can operate with no footprint,” Gorman, the firm’s chief executive officer, said in an interview Thursday with Bloomberg Television. “Can I see a future where part of every week, certainly part of every month, a lot of our employees will be at home? Absolutely.” ...
Gorman, 61, had run the bank from self-isolation while recovering from the coronavirus. He said he’s surprised that a firm as complex as Morgan Stanley has been able to function “extremely well” with so much of its workforce off site.
“That tells you an enormous amount about where people need to be physically,” he said in the interview after Morgan Stanley announced first-quarter results.
From a business perspective it just works: “We’ve proven we can operate with no footprint.” From a cultural perspective, three months ago everyone would have said that it's weird to have traders working from home all the time; that was not how big bank trading desks worked. Now it is. If it stops being weird, will traders want to go back?
Dividends
We have talked a few times recently about the notion that companies can’t cut their dividends. Legally speaking dividends are entirely optional and gratuitous gifts of money to shareholders, and boards can change or cancel them whenever they like, but there is a widespread belief that cutting the dividend sends a bad signal, undermines confidence in the company and limits its ability to obtain future financing. If you believe this—I don’t know if you should, but people certainly say it—then dividends should make you nervous. On the other hand you could believe something like “it is bad for a company to cut its dividend when no one else does, but in a global pandemic when everyone is conserving cash it’s okay for each company to cut its dividend.” It’s a safety-in-numbers argument that is probably basically correct.
We don’t seem to have a universal answer one way or the other but it seems like companies have at least started to feel pretty okay about cutting their dividends. Here, for instance, is Las Vegas Sands Corp. Chief Executive Officer Sheldon Adelson in a press release from Friday:
“As the largest shareholder of this company, my interests are very directly aligned with the interest of all shareholders. I know that the dividend is important to all our shareholders, as it is to me. I am known for the phrase, ‘yay dividends!’, and I assure you that it is still my mantra. But a strong balance sheet is also a vital and necessary component to realizing stockholder value in the decades ahead. As I look forward to the day—soon let us hope—when this terrible virus is no longer of concern—I see many strategic opportunities for our company precisely because of our financial strength. It is because of this optimism that we are suspending the dividend so that we have maximum optionality in pursuing our strategic vision and in producing future returns. I commit to my fellow shareholders that we will revisit the suspension of the dividend at the earliest reasonable opportunity,” stated Mr. Adelson.
Adelson is of course famous for several different things, though we cannot say we have ever heard that he’s famous for
Everything is mask crime
We talked last week about a hypothetical minimalist legal system with only two crimes: Wire fraud, for stuff you do in your house, and coronavirus-related curfew violations, for stuff you do outside your house. If you go to someone’s house and murder them, that’s violation of your local stay-at-home order and you can be arrested for that; who needs a law against murder? I wrote:
You’d need a regime of sentencing enhancements (leaving the house to do murder is worse than leaving the house to jaywalk), and you’d probably need like one more law for domestic violence, but the point is that you can get a pretty parsimonious legal system if that’s what you want. We do not actually think it’s what you want.
The reason you shouldn’t want it is that any sort of minimalist legal system like this leaves huge room for discretion. If the only crime is a fairly common and trivial one like leaving the house, then the people who get prosecuted and severely punished for it might be the ones who leave the house to do murders, but they might not be. They might be people who leave the house and are otherwise disfavored by the police, prosecutors, judges and juries. Poor people, members of minorities, people with unpopular political beliefs, that sort of thing.
Anyway a fun fact about New York state law (via public defender Sam Feldman) is that now:
- It is illegal to be around people without a mask, and
- It is illegal to be around people with a mask on.
There’s an executive order requiring masks in public when you cannot social distance, and a state law forbidding them. So pretty much anyone who goes outside in New York is breaking the law. Presumably they won’t all be prosecuted.
