Canadian guilt, Russian oil

We Canadians are overwhelmingly pro-Ukraine and anti-Putin, so when the CBC published an expose last week about "banned Russian oil" sneaking into Canada, it was read in despair by most of us. What an awful failure of Canadian sanctions policy. 

As with a lot of sanctions media coverage, I saw things a bit differently: "Not bad. We're doing our part!" That's because if you add some more context to the CBC article, the data that it presents can be read as good news.

The article takes issue with 2.5 million barrels of refined oil products made from Russian-produced crude that have been indirectly imported into Canada since the start of Putin's invasion of Ukraine in 2022. Given that around 1,000 days have passed since the invasion, that works out to roughly 2,500 barrels per day of Russian-linked refined oil products arriving on Canadian shores. (Analyzing oil flows on a per-day basis is industry standard and also makes it easier for our brains.)

In the grand scheme of things, 2,500 barrels per day is a drop in the bucket. Canada consumes around 1.6 million barrels of refined oil products per day, according to CAPP, which includes stuff like gasoline, diesel, and jet fuel. So just 0.1% of our consumption is Russia-tainted. Even so, every barrel matters, and we should strive to avoid any contribution to Putin's war chest.

But there's more context. 2,500 barrels per day of Russian refined oil products is far less than what we imported prior to the war. According to the Canada Energy Regulator (CER), between 2017 and 2022 Canada was regularly importing around 10,000 barrels per day of refined petroleum products directly from Russia (see chart below). After banning imports of Russian crude and refined oil products, Canada's direct imports fell to zero in 2023. Into this void, indirect imports of 2,500 barrels per day of Russian-linked refined products, the flows that the CBC spotlights, have emerged.

A 75% decline from 10,000 barrels per day to 2,500 barrels per day is not too shabby.

Canada's direct imports of Russian refined petroleum products, which hit zero in 2023. Source: CER

2,500 barrels is still not zero. But we can also take comfort from the fact that those barrels are not as profitable for Russia as they used to be. In the pre-war era, Canada was importing refined petroleum products directly from Russia, but in the post-war era we are importing Russian oil indirectly via a third-party, India. More specifically,  oil in its raw form -- crude oil -- is being shipped all the way from Russia to India by tanker, where it is upgraded by Indian refineries, and only then is it onshipped to Canada.

This new workflow is a big downgrade for Russia. Before it can be used, crude oil has to be converted into pricier consumable types of fuel like gasoline for cars and jet fuel for planes. Upgrading crude oil creates extra profits for whoever does it. Russia's refineries used to capture the entire upgrading margin. They refined the raw oil after it was pulled out of the ground and then regularly sent 10,000 barrels per day of the final product to Canada. But now India is capturing those extra profits on the 2,500 barrels per day that are sent to Canada.

So not only has the quantity of Russian-linked refined products imported by Canada shrunk by 75% since the war began, but thanks to the interposition of Indian refiners at the expense of Russian ones, the quality of Russia's revenue stream has been downgraded: pound-for-pound, Russia's indirect exports to Canada are a far less lucrative for Putin than they were back in 2021, because his refining margin has disappeared.

Compounding Russia's woes is the much more circuitous route that its oil must now take. Prior to 2022, Russian refined oil exports were loaded onto boats in Russian ports like Saint Petersburg and shipped via the Baltic Sea to Canada, around 4,000 nautical miles away. That's a 15-day voyage according to Sea-Distances.

These days, that 15-day voyage has tripled, even quadrupled. First, Russian crude oil must travel from the Baltic to India, a 7,500 nautical mile journey that can take 30 days. That's if it goes through the Suez canal. Passing around the southern tip of Africa amounts to a 12,000 mile trip taking up to 50 days. Once refined in India, the product must travel another 8,000 miles from India to eastern Canada. 

What an incredible amount of travel to get a barrel of Russian refined oil to Canadian markets! A good way to visualize these new transportation frictions is provided by the Kyiv School of Economics, which charts the volume of Russian oil being transported by oil tankers over time. Thanks to the forced rerouting of crude to less efficient routes as countries like Germany and Canada close their borders to Putin, Russia's oil on water is 163% higher than the pre-invasion average.

Record volumes of Russian oil on water is not a good thing for Putin. It mean higher transportation costs. Source: KSE

The extra transportation and insurance costs that "oil on water" entails inevitably eat into the final price that Russia can negotiate with buyers like India for its barrels of crude. For these long distances to be financially worthwhile for Indian businesses, they will only buy Russian crude at a discount to the going world price. According to the Dallas Fed, the Russia discount regularly clocks in at around $20 below the market price. This constitutes a big step down for Russia -- prior to the war it was receiving the full world price.

The upshot is that Canadian imports of Russian oil are down, and even though some Russian refined petroleum products are indirectly making their way to Canada, this is only after we've extracted our pound of flesh from Putin by forcing him to give up his refining margin and by obliging him to accept a crude oil price discount on account of distance traveled. So let's take some pride from that.

Does that mean we shouldn't do anything about our indirect imports of Russian oil product?

I want to clarify that Canada isn't importing "banned" products or breaking Russian sanctions. For better or for worse, the coalition's sanction on Russian crude oil have been designed to allow crude to continue to flow around the world, the intent being to avoid a big spike in oil prices while still hurting Russia. The 2,500 barrels of indirectly-refined refined oil we get each day are fair game.   

But that doesn't mean Canadians should do nothing. The CBC article is a good effort to name-and-shame certain Canadian importers that are accepting Russian-linked crude from third-parties, including Everwind Fuel's Point Tupper oil storage facility in Nova Scotia. C'mon, Everwind. Why not choose better trading partners, ones who aren't acting as go-betweens for Putin?

However, the best step we can do to counter Russia is to focus on producing more renewables, crude oil, and other commodities, as well as to find reliable ways to get these resources to market. 

Unlike Europe and the U.S., which have plenty of economic and financial heft, Canada doesn't have any sizable economic chokepoints that we can lever to hurt Russia. We could cut down on the 2,500 barrels per day of Russian-linked oil imports, but as laudable as that might be it doesn't constitute a genuine chokepoint. Canada's edge is that our economy is remarkably similar to Russia. Both of us extract a bunch of resources. The more we compete with Putin in resource extraction, the more we reduce the prices he relies on, thus impairing his ability to fund his invasion of Ukraine.

The intensifying effort to isolate Russia's banks

Last week the U.S. government expanded the coverage of its Russian secondary sanctions program to encompass most of Russia's banks. It's a very big step, one that has been long-awaited by sanctions watchers, and will likely have significant repercussions for Russia and its trading partners. Here's a quick explainer.

Stepping back, we can think about the U.S.'s sanctions war on the Putin regime as an effort proceeding in two acts. The first involved a "casual" round of primary sanctions beginning as far back as 2014 when the Russians invaded Crimean. Then the heavy round began in December 2023, almost nine years later, with the arrival of secondary sanctions.

Pound for pound, U.S. secondary sanctions are far more impactful than primary sanctions. Primary sanctions cut off American entities from dealing with designated Russian targets but allow non-American actors to step into the breach and take their place. This merely shifts or displaces trade routes, creating a nuisance rather than reducing trade outright.

Secondary sanctions like those introduced last December aim to curb this displacement effect by extending prohibitions on dealing with Russia to non-U.S. actors, in particular foreign banks. The gist of secondary sanctions is: "If we can't deal with them, then neither can you!"

Why do non-American actors in third-party nations like China and Turkey bother complying with U.S. secondary sanctions on Russia? The U.S. wields an incredible amount of influence by threatening to cut third-parties off from the U.S. economy should their ties to Russia be maintained. The importance of accessing the U.S., in particular its financial system, far outweighs lost Russian business, prompting quick compliance.

So what exactly happened last week? Let's first re-explore what occurred in December 2023.

If you recall from my previous article, the December secondary sanctions targeted foreign banks. Their aim was to prevent bankers in places like India, Turkey, China and everywhere else from interacting with Russia, but only with respect to a narrow range of transaction types – those linked to the Russia's military-industrial complex.

More specifically, a Chinese or Turkish bank could continue to deal with Russian customers as long as the transaction in question involved goods like cars or dishwashers. The novelty is that they were now prohibited from conducting any transactions with Russia that involved weapons, military equipment, and dual-use goods, on pain of losing access to the crucial U.S. financial system.

In addition to a flat-out prohibition on military-industrial goods, the U.S. Treasury also compiled a blacklist of around 1,200 or so Russian individuals and entities that support Russia's military-industrial complex by working in allied sectors such technology, construction, aerospace or the manufacturing sectors. The December order stipulated that if caught dealing with any of these 1,200 or so names, a foreign bank could be cut off from the U.S. banking system. Russian individuals and businesses who were not on said military-industrial complex list, however, could still be served by foreign banks, even if they had been otherwise sanctioned. (Remember, primary sanctions only apply to U.S. actors.)

As I wrote back in February, anecdotal data from the first two months of secondary sanctions suggest that they are having an effect. Below I've updated the chart from an earlier tweet showing Turkish exports to Russia, which continues to trend downwards (note the 12-month moving average.)

In a recent article, The Bell assessed customs statistics and found that since the start of 2024, imports from some countries are down a third in some countries compared to 2023, notably Turkey (-33.8%) and Kazakhstan (-24.5%).

Source: The Bell

Which finally gets us to last week's announcement.

The scope of the secondary sanctions has been dramatically widened by adding around 3,000 or so additional names to the original 1,200 or so individuals and entities involved in Russia's military-industrial complex, for a total list that is now 4,500 long, according to FT. The reasoning for this extension is that now that Russian is a war economy, pretty much everyone is contributing to the war effort. 

The most important of the additions to the list are Russia's banks. The Treasury's press release drove home this point by specifically drawing attention to the branches of Russian bank in New Delhi, Beijing and Shanghai that are now are off limits.

Going forward, any bank in China or India that interacts with a Russian bank, say Sberbank, now risks losing its crucial connection to the U.S. This is huge! The majority of global trade is conducted by banks in one country interacting with banks in another on behalf of their respective customers. If Russian banks are cut off from this global network, that's tantamount to severing the entire Russian economy from the international economy. With their bankers now isolated, Russian firms won't be able to buy or sell stuff overseas, nor repatriate funds to pay their local employees.

I'm still trying to get my mind around the enormity of this. Russia has become the top destination for Chinese auto exports, for instance, and those purchases require getting a Russian bank and a Chinese bank to interact with each other. How on earth will Russia import Chinese cars without the intermediation of Russian banks? Or appliances, or smartphones?

There are two significant exemptions to the secondary sanctions coverage: agricultural products and  crude oil. What this means is that while a bank in India can no longer deal with a Russian bank like Sberbank, that prohibition ends if they want to conduct transactions with Sberbank that involve grain or oil. Since Russia's economy is so reliant on its oil exports, this exemption is a gaping hole in the sanctions wall that Ukraine's allies are trying to build.

How will Russia and its trading partners react?

A few sacrificial banks

To keep trade flowing between Russia and trading partners like China, it may be necessary for China to serve up a sacrificial bank or two to the U.S. sanctions regime. Who to sacrifice? A small bank with little to no U.S. business is a prime candidate. Such a bank may be able to afford being cut-off from the U.S. financial system in order to ensure that its mostly Russian-linked clientele can keep making bank-to-bank payments.

An example of a willing-to-be-sanctioned financial institution is the Bank of Kunlun, a small Chinese bank which continued to facilitate Iranian transactions even after secondary sanctions were levied on Iran in late 2011. The U.S. government reacted the following year as it had threatened that it would: it cut the Bank of Kunlun off from the U.S. financial system, a state of affairs that continues to this day. Kunlun remains the only bank in the world on the U.S.'s CAPTA (Correspondent Account or Payable-Through Account) list; a register of financial institutions which cannot get a U.S. bank connection.

An appearance on the CAPTA list hasn't stopped the Bank of Kunlun from doing business, however. According to the Atlantic Council, Kunlun has become one of the main connection for so-called Chinese "teapots" – small independent refineries – to buy oil from Iran. Apparently, one of its flagship products is "Yi Lu Tong," which means "Iran Connect." Of course, the Bank of Kunlun can't do a shred of U.S. business, which severely limits its clientele.

In any case, the Bank of Kunlun, or something like it, could end up being the linchpin of Russian sanctions avoidance.

AML-dodging stablecoins

Another alternative option for Russian trade will be to turn to U.S. dollar stablecoins like USDC and Tether. Stablecoins are blockchain-based payments platforms that offer balances pegged to national currencies, usually the U.S. dollar. Unlike banks, which do due diligence on their customers, stablecoin issuers will allow anyone to use their platforms, no questions asked. This feature offers Russian firms a reliable non-bank payments option for settling purchases of Chinese or Turkish products.

Stablecoins are not a new route for Russians keen to evade the long-arm of U.S. sanctions. I wrote last year about how intermediaries linked to a sanctioned Russian oligarch purchased oil from Venezuela's sanctioned state-owned oil company using Tether stablecoins, or USDT. "No worries, no stress," says the Russian to his Venezuelan contact. "USDT works quick like SMS."

"...quick like SMS" [link]

More recently, a Russian sanctions evader describes how he uses Tether to "break up the connection" between buyers like Kalashnikov and sellers in Hong Kong, making it harder for US authorities to trace the transactions. "USDT is a key step in the chain." 

Turning to the U.S., what might its next steps be in the sanctions war?

Extend the secondary sanctions to oil

Sanctions are a cat and mouse game. As Russia inevitably finds ways to adapt to last week's actions, the U.S. will have to find alternatives to keep up the pressure on the Putin regime. A prime candidate for the next ratcheting up of secondary sanctions will be to extend their reach to Russia's oil industry.

The U.S., EU, and other coalition countries are currently trying to cap Russian oil prices at $60 in order to reduce Russia's revenue base, with mixed success. One option would be bring the rest of the world into the price cap effort in order to make it more effective. A simple upgrade to the secondary sanctions regime would allow for this. Foreign banks would still be able to conduct transactions with Russian banks that involve oil, but only if these banks have verified that those purchases have been made at a price of $60 or lower. Any international bank caught breaking the price cap would risk losing its financial connection to the U.S.

Locked up in escrow

Another way to tighten the noose on Russia would be to modify the secondary sanctions program to impede the ability of Russian oil exporters to repatriate or easily utilize the funds they receive for oil sold abroad. 

How would this work? As before, foreign banks in, say, India would still be allowed to conduct oil transactions with Russian banks at prices not exceeding $60, subject to a new sanctions feature stipulating that all oil proceeds must be confined to escrow accounts in the buying nation, in this case India. If Putin does wish to use the funds in Indian escrow accounts to make purchases, they can only be used to buy Indian products. If an Indian bank fails to keep oil proceeds "locked up" in India, and lets them escape by wiring them back to Russia or a third party like Dubai, then it could face the threat of losing its U.S. banking access.

If implemented, this locking restriction would dramatically reduce Putin's ability to repurpose oil revenues. Stuck in foreign banks with only a limited menu of local goods to buy (and likely earning sub-market interest rates), Russian resources would languish, illiquid and uncompensated.

This sort of restriction isn't a new idea. It was successfully tried out on Iran beginning in 2013 in the form of the notorious Section 504 of the Iran Threat Reduction and Syria Human Rights Act (TRA), once described as a bit of sanctions warfare that was "so well constructed and creative that in some respects it can be considered… beautiful." I wrote about it eleven years ago. It's time to dust it off.

The first round of U.S. secondary sanctions on Russia is working

Turkish banks halted transactions with Russian banks last month and are only slowly reintroducing payments for a narrow range of products that are on a so-called "green list," reports Ragip Soylu. This broad debanking of Russia by Turkey is part of the fallout from President Biden's first round of secondary sanctions, announced on December 22. 

Ukraine/sanctions watchers around the world are breathing a sigh of relief. At last the cavalry has arrived! While the Russian sanctions program has often been described by the press as the "world's strictest", in actuality it has been (till now) alarmingly light-touched due to its lack of the toughest tool of financial warfare: secondary sanctions.

Primary sanctions vs secondary sanctions

Secondary sanctions, especially when applied to foreign banks, are far more damaging than primary sanctions, which to date have been the dominant type of sanction levied against Russia. 

With primary sanctions, it is the "primary" layer – U.S. citizens and companies – that are cut off from dealing with the designated Russian target(s). However, primary sanction don't prevent non-U.S. individuals or non-U.S. companies, say a Turkish bank, from filling the void left by departing American counterparts, often acting as a re-router of the very U.S. goods that can no longer be moved directly to Russia by U.S. firms. So rather than reducing the amount of Russian trade, primary sanction often lead to little more than a displacement of trade from one route to another. That's a nuissance for the targeted country, but hardly a game changer.

Secondary sanctions are an effort to combat this displacement effect. They do so by extending the trade prohibitions placed on the primary layer, U.S. actors, to the second layer, that is, to non-U.S. actors. In the case of Biden's December order, foreign banks can no longer facilitate certain Russian transactions that have already been off bounds to Americans for several years.

So far, Biden's secondary sanctions appear to be working. In addition to halting all transactions with Russia for a month, Turkish banks have completely stopped opening accounts for Russian customers. According to Reuters, Turkish exports to Russia fell 39% year-on-year in January. In China, reports say that banks have "heightened scrutiny" of Russian transactions, in some cases going so far as to cut off Russian banks. UAE banks have also begun to restrict linkages to Russia.

Why comply with the U.S.?

Why do non-U.S. actors bother complying with U.S. secondary sanctions? After all, if you're a Turkish banker in Istanbul, Biden has no jurisdiction over you. America can't put you in jail, or fine you.

The way that the U.S. is able to sink a hook into non-U.S. actors is by threatening to take away access to the U.S. economy. Foreign banks, for instance, are told they will be exiled from the all-important U.S. banking system if they don't severe or constrict their Russian relationships. Since access to the Ne York correspondent banking system is so important relative to the small amounts of sanctioned Russian business they must give up, foreign banks are quick to fall into line.

Biden's secondary sanctions on foreign banks only apply to a narrow range of transaction types, specifically those that support Russia's military-industrial base. In short, any foreign bank that is found to be conducting transactions involving military goods destined for Russia can be penalized. Those foreign banks that deal in, say, Russian food imports needn't worry.

In addition to obviously prohibited military items, like missiles and fighter jets, the U.S. Treasury has provided a list of not-so obvious items, such as oscilloscopes and silicons wafers, that it deems fall under the category of military-industrial goods. I've appended this list below. The Treasury suggests that these additional items might be used for, among other things, the production of advanced precision-guided weapons.

Source: OFAC

That's quite an extensive list.

Turkish banks appear to have overcomplied by dropping any transaction that even has a whiff of Russia. This de-risking effect is a common by-product of various banking controls, both sanctions and anti-money laundering, whereby banks cease dealing not only with prohibited customers but certain legitimate customers that are superficially similar to prohibited customers that they are deemed too risky and expensive to touch.

According to reports, Turkish banks have reintroduced transactions for green-listed products such as agricultural products, which aren't actually targeted by the U.S. secondary sanctions.

Turkish financial institutions may be particularly sensitive to U.S. sanctions given the fact that an executive of Halkbank, a Turkish government-owned bank, was sentenced to 32-months in U.S. jail in 2018 for helping Iran evade U.S. sanctions and money laundering. One of his evasion routes was the notorious gold-for-gas trade, which I wrote about here. Halkbank itself was indicted in 2019 for sanctions evasion; the case against it is ongoing.

An unforgiving legal standard

An important element of any alleged crime is the mental state of the alleged criminal, or their "intent." This gets us to another reason for the rapidity and breadth of the debanking of Russian trade. Biden's secondary sanctions have a novel legal feature. The legal standard on which they rely, strict liability, does not require that the prosecution prove intent.

Up till now, U.S. secondary sanctions have not deployed this sort of a strict liability standard. To demonstrate that a foreign bank has engaged in evading secondary sanctions on Iran, for instance, U.S. prosecutors have been required to show that the foreign bank did so knowingly. If the banker conducted prohibited Iranian transactions unknowingly (i.e. inadvertently or unintentionally), then they couldn't be found guilty of sanctions evasion.

Under the strict liability standard set out in Biden's December 22 order, there is no onus on U.S. sanctions authority to show that a foreign bank has knowingly conducted transactions linked to Russia's military-industrial complex. Even an unintentional transaction can be punished. Because this strict liability standard makes it so much more likely that foreign banks run afoul of sanctions and get cut off from the U.S. banking system, bankers are rushing to comply.

What's next?

When the U.S government asked domestic entities to stop dealing with Russia a few years ago, many of these transactions were quickly displaced to third-parties like Turkey. By deputizing foreign banks to be equally vigilant, secondary sanctions will likely crimp the original displacement effect, resulting in a big and permanent decline in Russian trade.

To get an idea for what might happen to Russia's military-industrial goods trade, take a look at how Iran's oil exports were halved after Obama imposed secondary sanctions on Iran in 2012, leapt when they were lifted in 2016, and crumbled again when Trump reimposed them in 2018.

The lesson is that secondary sanctions on foreign financial institutions can be very effective.

Evasion efforts will begin very quickly. When secondary sanctions were first placed on Iran in 2012, Turkish bank Halkbank introduced a forged document scheme in an effort to disguise trade in sanctioned crude oil shipments as legitimate food transactions. The U.S. will have to step up its enforcement efforts to plug these holes. Without proper enforcement, the effect of the secondary sanctions will remain muted.

Using the secondary sanctions on Russia's military-industrial complex as a model, there are many more sectors of the Russian economy on which secondary sanctions might be placed. The next round could extend to Russian automobile imports, its central bank, or the diamond industry.

Secondary sanctions to strengthen the oil price cap 

Even more useful would be to use secondary sanctions to strengthen the most important piece of financial artillery heretofore deployed against Russia: the $60 oil price cap. 

The price cap endeavors to force Russia to accept a below-market price for the oil that it ships, thus hurting its ability to finance its invasion of Ukraine. The cap is currently underpinned at the primary level by threatening banks, insurers, shippers and other businesses located in the EU, U.S., and other G7 countries ("the Coalition") with penalties if they trade in Russian oil above $60. Because Russia has historically been dependent on Coalition service provides for shipping oil, it has been getting less revenue for its oil then it would otherwise receive. 

However, over time a growing chunk of Russia's oil exports has been diverted away from Coalition service providers to third-parties in jurisdictions like Turkey and UAE that are not subject to the cap. This has allowed Russia to sell at prices in excess of $60 and thus recover much of its forgone revenues. If the cap were to be applied not only at the primary Coalition layer, but also at the secondary layer by requiring foreign financial institutions to join in via the threat of secondary sanctions, then much more Russia oil would brought back under the $60 ceiling, and Russia's ability to finance its war against Ukraine would be significantly crimped.

It's time to impose Iran-calibre sanctions on Russia

Russia is sometimes described as the world's most sanctioned nation. And while that's true, the long list of sanctions that the G7 coalition has placed on Russia in response to its attack on Ukraine are surprisingly light compared to the fewer but far more-draconian sanctions placed on Iran over the last decade or so.

This ordering of sanctions precedence is a mistake. With its all-out invasion of Ukraine, Russia has moved past Iran into top slot at world's most dangerous nation. Vladimir Putin merits a sanctions program that is at least as onerous as Iran, if not more so, yet for some reason he is getting off lightly. It's time to apply Iran-calibre sanctions to Russia.

What makes a draconian sanctions program draconian?

What makes the Iranian sanctions program so draconian is that many of the sanctions are so-called secondary sanctions, a feature that has been mostly absent in the Russian sanctions program.

When the U.S. or EU levy primary sanctions on an entity, they are saying that American individuals, banks, and businesses (and European ones, too) can't continue to interact with the designated party. This hurts the target, but it leaves foreign individuals, banks, and businesses with free reign to fill the void left by departing American and European actors, thus undoing part of the damage.

Secondary sanctions prevent this vacuum from being occupied. The U.S. government tells individuals or businesses in other nations that they, too, cannot deal with a sanctioned entity, on pain of losing access to U.S. economy. It's either us, or them.

When applied to foreign financial institutions (i.e. banks) secondary sanctions are particularly potent. The U.S. tells foreign banks that if they continue to provide banking services to sanctioned Iranians, the banks' access to the all-important U.S. financial system will end. Since the U.S. financial system is so crucial, foreign banks quickly offboard all sanctioned Iranian individuals and businesses. The sanctioned Iranian entity finds that it has now been completely removed them from the global financial system. This financial shunning effect is much more powerful than the effects created by primary sanctions or secondary sanctions on non-banks.

Notice that I've limited my commentary on secondary sanctions to the U.S. Since it first began to use secondary sanctions in 1996, the U.S. Treasury has become a master of the art, whereas as far as I know they are a tool the EU has long resisted adopting.

The bank-focused secondary sanction placed on Iran over the last decade-and-a-half have been particularly devastating because they target a broad sector of Iranian society, most crucially the Iranian oil sector, the life blood of Iran's economy. Secondary sanctions prevent foreign banks from processing Iranian oil trades on pain of losing access to the U.S., and so most foreign banks have chosen to cease interacting with the Iranian oil companies.

The chart below illustrates the effectiveness of this approach. When President Obama placed the first round of bank-focused secondary sanctions on Iran's oil industry in 2012, the nation's oil exports immediately cratered from around 2 million barrels per day to 1 million barrels. When he removed them in 2016, they quickly rose back up. And when Trump reapplied the same secondary sanctions in 2018, they collapsed once again, almost to zero.

Source: CRS [pdf]

In short, U.S. secondary sanctions imposed huge body blows on the Iranian oil industry. These same forces have not been brought to bear on Russia's oil industry.

A dovish Russian sanctions program

While the Russian sanctions program is often portrayed as being strict, it is far lighter than other sanctions programs, including the one placed on Iran, because it is comprised almost entirely of primary sanctions. (For a good take on this, see Esfandyar Batmanghelidj here). While a small list of secondary sanctions have been placed on Russia, for the most part they have not been of the banking type.*

The second reason why the Russian sanctions program is dovish is that the oil component of the EU and U.S. sanctions campaign has been particularly lenient. Take a look at the above chart of Iran oil exports and you can see very real evidence of damage from sanctions. Scan the chart of Russian oil exports below, however, and it suggests business as usual.

Source: CREA

Sure, the EU and other coalition partners have cut Russian oil imports to almost nil, and that's great. But overall, this effort hasn't done much harm to Putin, since over time the coalition's respective share of Iranian oil exports has simply been taken up by nations like India and China. Both before and after the 2022 invasion of Ukraine, Russia reliably shipped around 1,000 kt/day of crude oil and crude oil products.

Underlying this leniency, G7 businesses are still allowed to engage in the Russian oil trade, as long as this doesn't involve bringing the stuff back to the EU. For instance, foreign buyers of Russian oil (say like Indian refiners) are allowed to hire European insurers and shipping companies to import Russian oil.

There is a limitation on this. European insurers and shippers can only be used by an Indian refiner, or some other foreign buyer, if the purchase price of Russian oil is set at $60 or below. This is what is known as the G7 oil price cap.

Because the insurance and shipping industries of the UK, EU, and U.S. have a large share of the market, Russia has had little choice but to rely on coalition intermediaries for selling at least some of its oil at $60. This has come at a cost to Russia; it must sell at below-market prices. And that certainly makes Russia worse off than a world in which there was no oil price cap.

But the very fact that these purchases are occurring at all, compared to a world in which Iran-calibre sanctions would prevent them from ever taking place, illustrates how weak the oil price cap is. 

Russia's oil export income is the life-blood of Putin's war economy. These funds gets funneled directly to the front-line in the form of weapons and supplies. It's time to get serious about Russian sanctions, remove the dovish oil price cap, and apply to Russia the same calibre of secondary sanctions that so effectively crimped Iranian oil exports.

We may have to deescalate sanctions on Iran in order to escalate them on Russia

What has prevented the U.S. and its allies from applying draconian Iran-style sanctions to Russia? One of their main worries is that taking a major oil exporter out of the market will have major macroeconomic impact. 

Russia currently exports around 4 million barrels of crude oil per day, as well as a large amount of refined products such as gasoline. Assuming that half of this were to be removed by secondary sanctions, world oil prices would probably rise. Voters in the EU and US would get angry. Neutral countries dependent on oil imports – China, India, Brazil – would push back against the colation, because they'd have to scramble to replace a major supplier. Secondary sanctions aren't just a nuisance for these neutral parties. Due to their extraterritorial  nature, secondary sanctions impinge on the sovereignty of neutral nations. This creates hostility, understandably so, the negative blowback eventually flowing back to the U.S.

So if the EU, U.S. and the rest of the coalition are going to get serious about sanctioning the Russia's oil industry, and thus removing a few million barrels of oil per day from the world market, they may need to counterbalance that in order to soften the blow. One way to do so would be to free up more Iranian oil exports, which means softening the sanctions on Iran.

That doesn't mean not applying sanctions to Iran. A version of the $60 price cap on Iranian oil probably makes a lot of sense. However, a fully armed financial battleship – i.e. bank-focused secondary sanctions directed at a major crude oil exporter's oil industry – may be something that has to be reserved for one country only: Russia.

Now, I could be wrong about the world being unable to bear draconian sanctions on two major oil exporters. Maybe I'm creating a false dichotomy, and in actuality the choice is less stark and the coalition can actually apply draconian oil sanctions on both Iran and Russia. If so, I stand corrected.

Either way, Russia's oil industry has skated through the invasion and resulting sanctions remarkably unscathed, as the Iranian counterexample illustrates. It's time to cut off Russia's main source of revenues by putting the same set of secondary sanctions that Iran has faced on Russia's oil patch. 

---

* There are a few bank-focused secondary sanctions placed on Russia. Notably, Section 226 of CAATSA (2017) requires foreign financial institutions, or FFIs, to avoid certain sanctioned Russians or sectors on pain of losing access to the U.S. banking system. (See here, for example.) However, the U.S. must not be enforcing Section 226 very tightly because I haven't found a single case of a bank being punished under 226.

This December, another round of secondary sanctions was imposed on FFIs. Any foreign bank that facilitates transactions involving Russia’s military-industrial base may be cut off from the U.S. financial system. Additionally, any bank that conducts transactions for specially designated nationals who operate in Russia's technology, defense and related materiel, construction, aerospace or manufacturing sectors may face punishment. Note that both rounds of secondary sanctions leave the Russian oil industry untouched.

Gold's rising convenience yield

While I may have taken some jabs at the gold bugs in two recent posts, please don't take that to mean that I have it in for the metal itself. Gold is a fascinating topic with a history that is well worth studying. (See this, for instance). In that vein, what follows is some actual gold analysis.

Something weird is happening in gold markets. The future price of gold (its forward price) has fallen below the current gold price. Now in fairness, this isn't an entirely new phenomenon. Over the last year or two, the price of gold one-month in the future has traded below the current, or spot price, a number of times. However, this observation has grown more marked as both the three-month and six-month rates have also recently fallen below the spot price.

This degree of inversion is rare. Except for a brief flip in 1999 when near-term forward prices fell below zero for a day or two, future gold has almost always traded for more than current gold. See chart below, which illustrates the one-month to twelve-month forward price premium/deficit in annual percent terms:

Here's why this pattern has dominated:

Gold's forward price indicates the level at which a buyer and seller will contract to exchange gold at some point in the future. The seller must be compensated for a number of costs they will incur in holding the gold until the deal's consummation, including: 1) taking out a loan to buy the gold and stumping up interest expenses; and 2) paying to store and insure it in a vault. Together, these are called carrying costs.

The buyer of future gold needs to compensate the seller for these costs. Rather than paying the seller an up-front fee, the buyer builds a premium into the price they pay for future gold in-and-above the current spot price, say $5. The future seller of gold can use this $5 premium to cover their carrying costs, thereby coming out even in the end. So future gold trades above spot gold by the size of its carrying costs.

The current inversion of spot and future gold prices seems to break all these rules. The premium that sellers have traditionally required has not only shrunk to 0 but become a deficit. Put differently, sellers of future gold are no longer demanding a compensatory fee for storing and financing the metal. In fact, they seem willing to provide these expensive services at a negative price!

One explanation for the inversion is that with interest rates being so low, the costs of carrying gold have become negligible. This is only party correct. Minuscule carrying costs would imply a future gold price that is flat relative to the current gold price, when in actuality future prices are below present prices.

That leaves only one explanation for the inversion: there is some sort of hidden non-pecuniary benefit to holding the stuff. In futures-speak, this benefit is typically referred to as a commodity's convenience yield, a term coined by Nicky Kaldor in 1939. An analogy to oil markets may be helpful. Oil prices often invert because merchants see potential for future supply disruptions. Having oil on hand during these disruptions is immensely useful as it  spares our merchant the hassle of negotiating his or her way though an oil supply chain that may be severely crippled while ensuring that customer demand is smoothly met. So the convenience yield can be thought of as a flow of relief, or uncertainty-shielding services, provided to owners of inventories of a commodity. If that relief is sheer enough, than the convenience yield will be larger than the twin costs of financing and storage, resulting in inverted markets. (For an excellent explanation of the convenience yield in oil markets, check out this Steve Randy Waldman post).

That's what appears to be happening in gold. Gold merchants seem to be anticipating choppiness in the future supply and demand of the metal, and see growing benefits in holding inventories of the stuff in order to cope with this choppiness. The convenience yield on these inventories has jumped to a high enough level that it currently outweighs the costs of storing and financing gold, resulting in an inverted gold market.

Gold's convenience yield spikes every every few years due to market disruptions, with the last spike occurring during the 2008 credit crisis, the one prior to that in 2001, and the one before that in 1999 when central banks announced plans to limit gold sales. It just so happens that these earlier disruptions occurred when U.S. interest rates were already high enough that they continued to outweigh the metal's suddenly-augmented convenience yield. Inversions were brief and only on the 1-month horizon. Now that a disruption is occurring when interest costs are near zero, a more sharply inverted market is the result, dragging the 3 and 6-month horizons into negative territory. Going forward, all gold market disruptions could very well create sharp inversions of -1 to -2% in the 1 to 12-month horizons, insofar as we are living in an era of permanently low interest rates.

Is gold becoming money?

A number of gold bugs see the current inversion as something quite momentous. To understand why, you need to know that a gold bug's nirvana is when gold is once again 'money'. When something is money, it is highly liquid. The beauty of owning a highly liquid medium is that it can be mobilized to deal with almost any disruption to one's plans and intentions. Put differently, the convenience yield on stored money is very high. One measure of a paper dollar's convenience yield is the interest rate a government-insured certificate of deposit. Locking away cash for, say, 24 months means that the owner loses all the benefits of its liquidity. With 24-month certificates of deposit currently yielding 0.34% a year, the value of those forgone conveniences is 0.34%.

So when a gold bug's dream becomes reality and gold overtakes the dollar, yen, pound etc. as the world's most-liquid exchange medium, that is the equivalent of saying that gold is providing investors with the market-leading monetary convenience yield. And a permanently high convenience yield would result in a permanently inverted gold market (or at least a much flatter one).

Is the current inversion an indication that gold is becoming money? I don't think so. If the augmented convenience yield on gold was in fact rising due to gold's liquidity having surpassed that of fiat money, we'd expect this to be reflected not only in near-term forward prices but along the entire horizon of forward prices. Not only should the 3-month forward prices be inverted, but so should the 3-year forward price. Is this the case? Not really. If you've seen Crocodile Dundee, I'd suggest you go and check out this hilarious post by Bron Suchecki illustrating the extent of gold's inversion. If you haven't seen the movie (you should), check out the chart below.

The first data point is the spot price. Gold forward prices are inverted after that, but only over a narrow range of five or six-months. By mid-2015, forward prices return to their regular pattern of trading at a premium to current prices.

So no, gold is not becoming money. Rather, we are running into some short-term jitters, and merchants think that holding the stuff provides a few more ancillary benefits than before.

Could these short-term supply & demand problems crescendo into longer-term problems, resulting in inversion beyond 2015? I don't think so. Unlike oil and most other commodities, the supply of mined gold is never used up. Ounces that were brought out of the ground by the Romans are still in existence. This means that supply disruptions should never pose a significant problem in the gold market since gold necklaces and fillings can be rapidly melted down into bars and brought to market. While we care if Saudi stops all oil production or if the U.S. corn harvest is terrible,  if South Africa ceases to produce gold—meh.

This means that the convenience yield on inventories of gold will almost always be less than the convenience yield on stocks of oil, since the sorts of disruptions in the gold market will always be shorter and less extreme than in oil markets. Oil supply shocks can be so sharp and enduring that oil's convenience yield remains elevated for long periods of time. The result is an inverted oil market over the entire time horizon. Such inversions are fairly common events in oil markets (once again, see Bron's post).

Gold shocks can never be enduring, so the types of price inversions we'd expect will be fleeting and only appear in the near-term time horizon. Like the one we are seeing now. In sum, we've seen this all before, and no, it's not the end of the world.

Nineteen-eighty-three

The price of gold has fallen over $200 in the last two days. This sounds like 1983 all over again.

Not only did Star Wars Episode VI come out in 1983, but gold experienced its largest one-day fall in recorded market history. On February 28, 1983 the metal fell $56, a whopping 11.5%. The context in which this collapse happened is worth revisiting since it might help explain some of what we are seeing now. I'll take a short diversion through 1983 oil markets before getting back to gold.

There were plenty of worries of an oil glut leading up to the metal's 1983 collapse. OPEC, which had kept an iron grip on oil prices by adjusting production, had been steadily losing its dominant position as oil producer. In the 1970s the cartel controlled over 60% of world production. Small adjustments to the rate at which it extracted crude were sufficient to set a floor in the oil market. But increased supply in the UK, Norway, USSR, and Mexico had eroded this share to under 40% by the early 1980s. As a result, OPEC nations were required to remove ever larger amounts of oil from the market to support prices.

The coordination necessary to motivate these adjustments was lacking. Beginning in June 1982, OPEC tried and failed three times within seven months to set quotas. As a result, spot prices had begun to trade well below OPEC's benchmark Saudi light price of $34, a gap that started to expand quite dramatically in winter and early 1983, as the chart below shows.

Because of the glut, the cartel was breaking at the seams. On February 17, 1983, the British National Oil Company (a government marketing board that bought 51% of North Sea output) dropped its North Sea price by $3 to $30.50, quickly followed by Norway. Nigeria, an OPEC member, reacted on February 19 by ignoring OPEC and reducing the price of Bonny light, a crude stream similar to Brent, from $35 to $30.

A week later the gold price collapsed. And on March 14, 1983, OPEC announced the first ever decrease in its benchmark price, with Saudi light now being priced at $29, down $5 from $34. We know what happened next. The glut continued and oil prices steadily declined until all-out collapse to $12 in early 1986 when Saudi Arabia, tired of OPEC squabbling, decided to open the taps and let all their partners suffer.

Zoom forward thirty years and we also have an oil glut:

The tight-oil revolution, the realization that the drill bit can liberate oil from reservoirs once-considered insufficiently porous to yield sufficient oil flows, is coursing through North America and will inevitably spread to the rest of the world. There's so much oil collecting in the US that the price at Cushing, Oklahoma trades 10% below European Brent.

What are we to make of these twin episodes of crude glut/gold collapse? When returns on non-crude related capital projects are low, negative, or falling, there's little incentive to invest. Investors may as well hold some durable asset that costs only a few bucks to store, like gold. After all, in a zero return world a project will likely be a dud, but at least an ounce of gold will still be an ounce of gold a few years hence. As a result, gold prices get bid up, just like they did in the 1970s and 2000s. Gold bull markets are less about inflation than they are a reflection of poor returns on capital projects.

A glut-induced reduction in the price of oil suddenly improves the return on all non-oil related capital projects. The world now looks rosier to everyone who isn't an oil extractor. There's no point in storing gold when the return on most capital projects has perked up. Investors quickly reallocate portfolio space to productive projects, gold prices get ratcheted down, and equity valuations get bid up.

What about equities? In early 1983, the Dow Jones Industrial Average broke convincingly through the famous 1000 level, a line it had knocked up against repeatedly through the 1970s. In similar fashion, it was only a few weeks ago that the S&P500 broke through 1500, a ceiling that has contained it for all of the 2000s. There has been a disturbance in the force, it would seem, and just like 1983, we're watching the Return of the Equity.

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PS. If you're interested in the history of gold, do check out my wallchart: A Recent History of Gold, 1954-2010.

For more perspectives on the gold collapse, read David Glasner, Tyler Cowen, Izabella Kaminska, Washington's Blog, and Menzie Chinn.

The monetary noose tightens around Iran

Some interesting things have happened on the Iran monetary sanctions front since I last wrote on the topic.

In my first post I explained how the sanctions work. In my second post, I speculated about the so-called gold-for-gas trade, one of the routes Iran had been using to get around the sanctions. To recap, here's how the trade works. Turkish companies buy Iranian natural gas with Turkish lira deposits at Halk Bank, a large government-owned bank based in Ankara. Iran then converts these deposits into gold and re-imports the metal back into Iran (primarily via Dubai) in order to use it to purchase goods elsewhere or to fortify its FX reserves. There was nothing about the gold-for-gas route that contravened the letter of US sanctions.

Now there is a new rule that will plug the gold-for-gas trade.

Measures included in the 2013 National Defense Authorization Act signed by President Obama on January 3, namely Title XII, Subtitle D, known as The Iran Freedom and Counter-Proliferation Act of 2012 (IFCPA), require the President to impose sanctions against any financial institution that enables Iranian entities to purchase precious metals. These rules will come into effect on July 1, 2013.

This means that the so-called gold-for-gas trade has only a few months left to run. As of July 1, if Iran wishes to make purchases through its account, Halk Bank will have to ensure that whatever it buys does not include gold, silver, or platinum (no, there is no platinum coin loop-hole).

But there are even bigger changes afoot. As of February 6, 2013, measures enacted in last August's Iran Threat Reduction and Syria Human Rights Act of 2012 (TRA) restrict all buyers of Iranian crude to a purely bilateral trade relationship. In essence, buyers can only transact with Iran using financial institutions located in the buying country. Furthermore, TRA requires that any revenues that Iran earns from oil sales remain "locked" in accounts within the buying country. If these requirements are ignored, President Obama is required to impose sanctions on transgressing banks. Since these sanctions involve cutting off said bank's access to the US payments system, few banks are likely to risk ignoring them.

TRA will have major repercussions for the way Iran does business with its clients, in particular India. For the last two years, Iran and India have been transacting this way: 45% of Iran-India oil trading has been conducted in rupees using the Calcutta-based UCO Bank. Iran's national oil company exports oil to India, earns Indian rupee in its UCO account, then uses these rupees to purchase Indian grain and other goods. What it doesn't spend simply accumulates at UCO. Billions of dollars have accumulated at UCO because India simply doesn't produce enough goods and services that Iranians want.

The other 55% of the India-Iran oil trade has been conducted via the same Halk Bank that facilitates Turkey's gold-for-gas trade. India kept a euro account at Halk Bank which it used to pay Iran for oil. Given the wide liquidity of euros, Iran could easily spend these balances on. The TRA requirement that all transactions be bilateral forces India to cease Halk Bank payments and reroute everything to UCO. Huge rupee balances were already accumulating at UCO when 55% of crude oil trade was settled at Halk Bank. With 100% now being settled at UCO, Iran's rupee hoard will become even more massive.

Nor is this solely an Indian phenomenon. Iran will be prevented from repatriating profits earned in trade with all of its major oil customers. Going forward, large Iranian yen balances will steadily build up in Japanese banks, won in Korean banks, rand in South African banks, etc. These balances could be drawn down by Iranian purchases of permitted (ie. non-sanctioned) goods and services in the host country. But Iran tends to run current account surpluses with these partners – it exports more than it imports. The balances, therefore, are likely to continue accumulating in the host nation.

On an abstract level, the sanctions are dramatically reducing the liquidity of Iranian wealth. By impairing the ease of transacting in Iranian goods and Iranian-held foreign bank deposits, the US has reduced the extra bit of option-value that liquidity adds to wealth. In India, for instance, a rupee is worth a rupee, except if you're Iran. The range of options available to an Iranian-held rupee is far less than a regular rupee – as such they are worth less.

This demonstrates the raw monetary power that the US is able to exercise on the world by levering its central position in the international banking web. Americans may not feel the external effects of US monetary policy. But as we can see, this policy is creating large changes in the patterns of trade throughout the entire Middle East and Asia.

Turkey, Iran, and "gold for gas"

What should we make of the so-called "gold for gas" trade between Turkey and Iran?

Turkey depends on Iranian natural gas to produce a large part of its electricity. In normal times, the Turkish natural gas monopoly BOTAS probably would have paid for Iranian natural gas with euros or dollars. The transaction would have been settled through euro- or US-denominated accounts that both BOTAS and the the National Iranian Gas Company (NIGC) held at a bank in Europe. That's my guess, at least.

It's become dangerous for Iranian companies to keep accounts in Europe lest they be frozen. So the NIGC has probably opened an account at a Turkish bank like Halkbank, a large government-owned institution. BOTAS likely keeps an account there too. When natural gas gets delivered across the border, Halkbank settles the trade by crediting NIGC's account and debiting BOTAS's account.

What the heck does the NIGC do with all the Turkish lira it accumulates at Halkbank from gas sales? There's only so much Turkish stuff that Iranians need to buy. Converting it into dollars or euros and sending it to Europe is probably risky, if not impossible. One avenue open to the NIGC is to go to Istanbul's Grand Bazaar and buy gold with its stash of lira deposits, then ship this gold back to Iran. This explains the huge outflows of gold from Turkey starting in early 2012.

So assuming I've got the mechanics right, claims to the existence of outright gold-for-gas trade between Turkey and Iran are exaggerated. Turkey's natural gas purchases continue to be settled via the banking system, not by barter. The gold end of the trade is just the second leg of the round-trip.

Oddly, the value of gold flowing from Turkey to Iran represents far more than the value of natural gas flowing in to Turkey, implying that something else is at work. One explanation is that Turkey buys a lot of Iranian crude oil too. A temporary waiver granted by the US allows Turkish banks to settle Iranian oil trades. I'd bet that a lot of the deposits earned by Iranian institutions from oil sales are also being sold for gold at the Grand Bazaar.

Secondly, a large chunk of India's oil trade is settled in Turkey. Since 2011, Indian oil refiners have been opening euro-denominated accounts at Halkbank. They've used these accounts to credit the accounts of Iranian companies and banks, thereby paying for Indian oil imports. How useful are Turkish-domiciled euros? Can Iranian firms easily transfer them elsewhere in order to buy stuff? Probably not. My guess is that most international banks are hesitant to accept Turkish euros, especially if they're linked to Iranian trade. Buying gold and repatriating it may be the best way for Iranian companies get their hands on purchasing power.

Insofar as obeying US sanctions, there's nothing illegal in any of this. Turkey is allowed to buy as much natural gas from Iran as it wants, and the US waivers granted to Turkey and India allow oil trades to be cleared by Halkbank and other banks without sanction (see my previous post). Converting deposits into gold and shipping it back to Iran is hardly a dodge – it's a fallback towards an inferior medium of exchange. For Iran, in a world of bad payments options, gold is the least bad.

Nevertheless, various US senators want to put the kibosh on what they refer to as the "gold game". The idea here is to punish banks that settle Iranian natural gas trades by excluding them from the US banking system. Faced with this threat, Halbank and other Turkish banks would likely refuse to deal with NIGC and, as a result, the Turkey-Iran natural gas trade would collapse. Now, such an extreme outcome would be highly unlikely since Turkey depends on natural gas for electricity and Turkey is a US ally. Most likely the US would grant Halkbank some sort of waiver allowing it to keep accounts for NIGC as long as these accounts were monitored to prevent NIGC from purchasing gold.

Indeed, if you read the fine print of the Menendez-Kirk-Lieberman Sanctions on Iran document, it is stipulated that banks engaging in Iranian natural gas transactions will be exempted from being cut off from the US banking system "so long as the purchasing country holds the payment for Iran in an account to be drawn on for permissible trade." What qualifies as permissable trade will probably not include gold. If Menendez et al. passes into law, it'll probably reduce the outflow of Turkish gold. But if NIGC and BOTAS decide to skirt the banking system altogether and deal directly in gold and gas, then you'll really see the start of the "gold-for-gas" game.

From a "moneyness" perspecitve, here are my thoughts. The monetary blockade has increased the liquidity of gold, thereby building a larger premium into the gold price. Any return to a more normal situation ie. Iran clearing trades again via the USD clearing and settlement system, will hurt gold's moneyness and lower the gold price.

Data visualization: The US - From oil importer to oil exporter?

The US is currently importing significantly less crude oil and crude oil products than it did in 2005. Now if you were listening to the Presidential debates, then you probably heard Barack Obama take credit for this improvement. But the real driver has been improvements in technology, namely fracking and horizontal drilling. The chart below disaggregates the flow of petroleum into its constituent parts.

The US is certainly importing less crude oil than seven years ago. It is also now exporting significant quantities of refined crude products. The largest contributor to this shift comes from the distillate/diesel category. A lot of this diesel is going Rotterdam and from there to the rest of Europe. The switch from importing to exporting products isn't confined to diesel though, note how almost all the black arrows in the products section are now red.

Normal backwardation in crude oil markets

James Hamilton at Econbrowser had an interesting series of posts (here and here) on determining the effect of naive commodity index funds in crude oil and other commodity markets. His hypothesis was that:

the more futures contracts the funds want to hold, the more risk the counterparties who short the contract are exposed to. According to the model, the futures price must be bid high enough to compensate the short side for absorbing the risk. This compensation comes in the form of an expected profit to the short side of the futures contract. 

I pointed out in the comments that this sounded very familiar to me:

...isn't this an attempt to prove a version of Keynes's theory of normal backwardation? Here is Keynes: "If supply and demand are balanced, the spot price must exceed the forward price by the amount which the producer is ready to sacrifice in order to hedge himself, ie. to avoid the risk of price fluctuations during his productions period."

Keynes wrote that speculators would require a premium if they were to bear the risk of price movements. In a way, it seems you are substituting Keynes's hedgers with a more modern sort of naive indexer from whom speculators demand an extra return.

Unfortunately Hamilton did not find the data to back up his hypothesis. Too bad, it is a very elegant theory.

Some notes on market measures of inflation

I learnt some interesting facts about inflation-linked investment products. To begin with Sober Look had an intriguing chart showing an inversion in the TIPS yield curve.

Michael Ashton at Epiphany had an interesting explanation for this. Basically, short-dated TIPS begin to trade like gasoline futures. Like zero-coupon inflation swaps, TIPS are indexed to headline inflation, not core inflation. The most volatile component of headline inflation are gas prices, although in general large changes in gasoline prices will mean-revert to core inflation. We've had a large fall in gas prices, so near TIPS have fallen in value. More distant TIPS price in an expectation of gasoline reverting to core, and therefore are less sensitive to the fall in gas prices.

Michael explains here why inflation swaps are a better indication of true inflation than TIPS.

I learn here that the 5Y 5Y forward inflation curve is the market price for an inflation swap that starts in 5years and ends in 10 years.

In this post at David Glasner's blog, I point out that the fall in TIPS prices might not necessarily be a negative indicator. Starting with Michael's point about the sensitivity of near TIPS to gasoline prices, how much of the fall in gasoline prices is linked to fears of deflation, and how much to the massive rise in crude oil inventories coursing through North America? Domestic crude oil production is skyrocketing due to the technical combination of horizontal drilling and multiple stage fracturing. If this technological leap has contributed to the fall in energy prices, and the fall in energy prices has contributed to the fall in TIPS prices, then there is some component of ingenuity, and not wholly pessimism, at the core of the fall in TIPS prices.