A Banana Worth Squeezing

“To me, left unchecked, the price of carbon goes to infinity.” – Lawson Steele

On Friday, October 24, 2008, Volkswagen’s (VW) stock closed at EUR 210 per share, down 50% over the prior two weeks. Like many manufacturing companies, VW was reeling from the global financial crisis. Because of its high debt load and diminishing prospects, the stock was a popular pick among short sellers and approximately 13% of the total shares outstanding were sold short. That might not seem like a very high number, but as a percent of the company’s free float it was substantial. At that time, Porsche owned 42.6% of VW’s shares and the German state of Lower Saxony held 20.3%.

On Sunday, October 26, 2008, Porsche issued a press release that would kick off one of the most famous short squeezes of all time. Here’s how the English version of the release began (emphasis added through this piece):

“Due to the dramatic distortions on the financial markets Porsche Automobil Holding SE, Stuttgart, has decided over the weekend to disclose its holdings in shares and hedging positions related to the takeover of Volkswagen AG, Wolfsburg. At the end of last week Porsche SE held 42.6 percent of the Volkswagen ordinary shares and in addition 31.5 percent in so called cash settled options relating to Volkswagen ordinary shares to hedge against price risks, representing a total of 74.1 percent. Upon settlement of these options Porsche will receive in cash the difference between the then actual Volkswagen share price and the underlying strike price in cash. The Volkswagen shares will be bought in each case at market price.”

Further down in the same press release, Porsche lays bare their motivations and strategy with classic German humor:

“Porsche has decided to make this announcement after it became clear that there are by far more short positions in the market than expected. The disclosure should give so called short sellers - meaning financial institutions which have betted or are still betting on a falling share price in Volkswagen - the opportunity to settle their relevant positions without rush and without facing major risks.”

It doesn’t take a PhD in mathematics to understand that if Porsche claims to own 74.1% of VW and Lower Saxony has 20.3%, that leaves only 5.6% for everybody else. With short sellers on the hook to buy back 13% of the shares outstanding, panic buying in an effort to close out their short positions ensued. VW’s stock soared in the days following Porsche’s audacious gambit – at one point crossing EUR 1,000 per share – temporarily making the struggling automaker the most valuable company in the world. The crisis abated when Porsche announced it would close a portion of its option position, thereby freeing up float for short sellers to cover. Market participants lost billions in the fiasco, and there’s no telling where the price of VW might have risen absent Porsche’s opening of the release valve.

As argued in this outstanding and comprehensive research paper published just months ago in the Journal of Financial Economics, Porsche’s move was blatant and plainly illegal stock manipulation driven by their own looming insolvency. Ironically, Porsche’s bankruptcy risk arose from the very same options strategy it bragged about in its press release, although a critical detail went undisclosed: to pay for its call options in VW, Porsche had sold put options on the stock. As VW’s stock fell in the weeks prior to the infamous press release, Porsche faced a series of margin calls as those puts went in the money. If it had fallen much further, Porsche would have defaulted on its obligations. Instead, Porsche pocketed at least EURO 6 billion in illicit gains from the squeeze, turning a catastrophic and undisclosed trading blunder into a windfall.

Short squeezes are a hot topic in today’s frothy markets, which is ironic given how few short sellers are left standing. This is especially true with meme stonk AMC Entertainment Holdings (AMC), which we’ve written about here and here. There’s an entire cult of retail investors – the self-described AMC apes – who are conspiring together in the hopes of recreating a VW-like frenzy in what they call the mother of all short squeezes (MOASS). No really, MOASS is a thing. Find your way onto their Twitter Spaces “conference calls” and you’ll hear talk of dark pools, evil hedge funds, and various other theories concocted to rationalize why this squeeze has thus far failed to materialize.

Putting aside the fact that conspiring to manipulate the price of any security is illegal – even for a group of retail investors openly doing it on social media for all the authorities to see – we submit that the apes are chasing the wrong banana, because the real MOASS might well unfold in Europe in the coming months.

We tell the VW short squeeze story – and direct the apes to turn their attention to Europe – because we were reminded of both when we listened to this spellbinding edition of Chris Dark’s fantastic podcast Dr Dark After Dark. Dark interviewed Lawson Steele, a Senior Analyst at Berenberg Bank who has covered utilities for nearly three decades. In early 2018, Steele made a prescient call on where he thought the price of carbon credits was headed in Europe. Since he got long the trade, the price of those credits is up twelvefold, and he makes a compelling case for why this may be just the beginning. You can follow Dark’s Twitter account here and Steele’s account here.

The European Union Emissions Trading System (EU ETS) is designed to leverage market forces to achieve the EU’s aggressive emissions reduction targets, specifically its commitment to reduce carbon emissions 55% by 2030 (from the 1990 base). Here’s a relatively benign overview of the system from Wikipedia:

“Under the ‘cap and trade’ principle, a maximum (cap) is set on the total amount of greenhouse gases that can be emitted by all participating installations. EU Allowances for emissions are then auctioned off or allocated for free and can subsequently be traded. Installations must monitor and report their CO2 emissions, ensuring they hand in enough allowances to the authorities to cover their emissions. If emission exceeds what is permitted by its allowances, an installation must purchase allowances from others. Conversely, if an installation has performed well at reducing its emissions, it can sell its leftover credits. This allows the system to find the most cost-effective ways of reducing emissions without significant government intervention.”

This all sounds well and good, but, as Lawson describes, there appears to be a significant flaw in the design of the EU ETS: emitters are net short and the free float is shrinking.

Integrated across the European economy, companies are emitting far more CO2 than allowed by their ever-more-aggressive targets, and Lawson sees the situation getting worse in the years ahead. If a company has emitted more than the number of allowances it owns, it must go into the open market and procure more. If it fails to do so by the annual deadline of April 30, two things happen. First, the company must pay a fine of EURO 110 for each allowance shortfall, and – most critically – paying this fine does not alleviate its obligation to deliver the allowances! The obligation merely rolls forward to the next period, thus increasing the demand for next period’s limited allowances. Naturally, the market has begun to digest this dynamic and the price of these credits has soared, although they still trade well below this EURO 110 fine.

To compound matters, the EU measures and publishes the Total Number of Allowances in Circulation (TNAIC) and it uses this measure to further reduce the number of new allowances made available for auction in the upcoming period. Here’s a quote from a European Commission press release on the matter which was published in May of last year:

“The European Commission published today the total number of allowances in circulation on the European carbon market. It amounts to 1,578,772,426 allowances. At the same time last year the amount was 1,385,496,166 allowances.

The total number of allowances in circulation plays an important role for the operation of the Market Stability Reserve (MSR), which began operating in January 2019. This indicator shows the amount of allowances in circulation in a transparent and predictable manner.

As long as the indicator exceeds the threshold set in the legislation of 833 million allowances, a certain share of the total number of allowances in circulation is placed in the MSR each year. For the years 2019 to 2023, this share is set at 24% of the total number of allowances in circulation. Allowances are placed in the MSR by decreasing the amount of allowances that Member States auction.

Based on the indicator published today and on the provisions of the legislation (Decision 2015/1814, the MSR Decision), auction volumes from September 2021 to August 2022 will be reduced by 378,905,382 allowances, which will be placed in the MSR.”

This is, in effect, a HODL Mechanism™.  While the EU ETS reduces its newly issued allowances, their scheme simultaneously encourages outside speculators to buy and hold existing allowances, soaking up supply knowing full well there is a forced buyer on the other side of the trade. As the opening quote of this piece by Lawson accurately summarizes, absent a political intervention it is difficult to see a scenario where a VW-type short squeeze can be avoided. Of course, such intervention can happen at any moment, and Lawson and Dark spend a fair amount of time debating at what price a political relief valve must be opened. Since they are both bullish on the trade, it is natural that they agree that price is much higher, and we find it tough to argue with their informed opinions.

Europe has been doing its level best to hammer its domestic power producers and erode its industrial base for years. What stops foreign adversaries from helping them along by bidding up the price of these carbon credits to create economic advantage for themselves? How much money would it really take to double or triple the price of carbon in the EU from here? Whatever happens, this is one of the most fascinating stories we’ve come across in quite some time.

We should close with an important disclaimer. We do not give investment advice at Doomberg, nobody on our team has any investments related to these carbon credits schemes, and we will not open any positions for at least 72 hours after this piece publishes, if at all. There are several ways in which investors can participate in this market, including by directly speculating in futures or by using ETFs that attempt to track this and other carbon markets globally, and we encourage our readers to do their own due diligence before making investment decisions. In the Chicken Coop™, it’s every ape for themselves.

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