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Lessons from Hedge Disasters    

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The news of a large trading loss always makes for a good story.  The recent “London whale” trading losses of around $6.2 billion by J.P. Morgan made headlines world wide.  J.P. Morgan has now agreed to pay more than $1.0 billion in fines to various U.S. and British regulators relating to this incident.  With thousands of large speculators it should not be surprising that there is the occasional large loss in the billions of dollars.  After all, the futures market is a zero sum game, meaning for every gain there is an equal sized loss.  Seven of the ten largest trading losses according to Time magazine were realized by banks and hedge funds.  This is not surprising since they use high leverage and trade large amounts of capital.  Even more interesting are non-financial companies that lose billions whose primary business is not speculating in financial markets.  If they are not speculators, then they must be hedgers.  The question then is what went wrong for a hedger to lose billions of dollars?  

The definition of hedging is taking a position in a financial instrument that is opposite to the company’s underlying business (cash market).  Hedging is risk reducing, and depending on the effectiveness of the hedge, can still result in either gains or losses on the combined cash/hedge position.  The other definition is exchanging price risk for basis risk, where basis risk is simply the risk of the hedge not perfectly matching the exposure in the cash market.  There is always some basis risk and the degree should be evaluated as part of hedge effectiveness.  Having losses on the hedge side alone is not an issue, as these should be largely offset by gains in the company’s underlying cash exposure, if they are indeed hedging.  Of course, when there are very large losses for a hedger it stands to reason that they really weren’t hedging, or at least strayed from the path.   

It is remarkably easy for a company to venture from hedging into speculating.  Referred to as “hedgulating”, it involves moving away from pure risk-reducing hedging, to incorporating positions that can generate profit beyond any basis gains.  For example, hedges can be placed in different futures months than the cash exposure, resulting in spread risk.  This may be necessary if liquidity is insufficient in the deferred months, or is simply a way for the company to trade, while ostensibly hedging.  Foreign exchange is another market in which to speculate as most companies have FX exposure and these may not be calculated properly and there is plenty of volatility.  Day trading is another favourite as exposures are likely only calculated on an end-of-day basis, giving traders some maneuvering room.  Finally, over the counter (OTC) hedging instruments present a whole new set of challenges for the middle office.  OTC derivatives can be structured in complicated ways including position size changing dramatically at certain price levels and marking to market OTC positions favouring the trader. 

Traders, by their nature, like to trade.  It doesn’t much matter which markets as long as they are active in the markets.  Brokers don’t mind companies trading up a storm as it generates healthy commissions.  Trading can be downright addictive and the high from making money when trading lights up the same areas of the brain as a high from cocaine or heroin.  The check against hedgulating is an experienced middle office that understands the hedging activity and has the power to stop trading activity not authorized under the corporate risk management policy.  When trader and management bonuses are largely dependent on profit, the incentive to hedgulate increases.  

The three non-financial companies that made the top 10 list of largest trading losses are Metallgesellschaft ($1.3 billion), Aracruz ($2.5 billion) and Orange County ($1.7 billion).  Let’s analyze Metallgesellschaft’s hedging activity.  Aracruz is also very interesting and is covered in another article – Foreign Exchange Hedging - Peculiarities and Pitfalls. 

By 1993, Metallgesellschaft’s trading subsidiary (MG Refining and Marketing - MGRM) entered into agreements with its customers to supply ten year fixed-price oil, amounting to about 160 million barrels.  Its customers were independent gasoline suppliers, manufacturing firms and some government entities whose margins and budgets were squeezed when oil prices rose.  MGRM offered its customers a number of different contracts including fixed volume and price, flexible volume and fixed price, a cash out option and a gasoline retailer margin contract.  MGRM ended up liquidating its entire position when oil prices fell by the end of 1993, as it reached the limit of its lines of credit, OTC counterparties refused to extend swaps, and the NYMEX suspended its hedge exemption requiring it to reduce its position.  What went wrong? 

The net exposure of MGRM was short oil and to hedge this exposure it entered into very large long futures and OTC swap positions in oil, gasoline and heating oil.  While the oil futures market is the largest in the world, there is little ability to hedge long term oil exposure without paying a substantial premium to other companies.  Trying to match its customer contracts in duration with OTC agreements would likely have eroded all of MGRM’s profit margin.  Therefore, it used the three nearby futures months and swaps based on those months to hedge its long dated pricing agreements.  This “stack” of futures positions needed to be continually rolled over into the next futures month as time passes, referred to as a “stack and roll” strategy.    

Providing customers with innovative pricing agreements is a perfectly legitimate business model and can be profitable.  However, hedging long dated oil pricing contracts is no easy feat, and presented MGRM with five major risks:

Rollover risk – the gains/losses by rolling futures contracts cannot be known with any degree of certainty as futures prices in the various months for storable commodities can vary greatly.  Spot prices and the nearby futures contract tend to be more volatile than the more deferred months.  As an aside, when the oil exchange traded fund USO was launched many participants got a rude awakening by its underperformance versus crude oil prices because of high rollover costs.

Funding risk – MGRM was long futures contracts and when oil prices fell it had to meet the unrealized losses (i.e., margin calls) on a daily basis.  The problem was that its long term pricing agreements did not provide for any offsetting funds.  Once the problems became known, MGRM’s OTC counterparties also refused to roll forward its swaps.

Credit risk – When oil prices fell, its customers would have an incentive to default on their agreements.  To mitigate this risk, MGRM limited its volume with each customer to 20% of their needs.  While not the risk that caused its downfall, credit risk could limit its ability to use these contracts as collateral.

Liquidity risk - By rolling its positions on a daily basis and using various OTC counterparties, MGRM could mitigate its impact on the market.  However, MGRM was up to 20% of the open interest in NYMEX which is a very large position.  Liquidity is typically not a problem when the hedge has gains, but when it all goes bad and the decision is made to liquidate the entire position, liquidity costs become very real.  It is hard to quantify such losses, but other traders undoubtedly would either hold off buying oil futures or simply get ahead of the liquidation and sell.  We have seen this many times in the Chicago grain pits where the floor traders are quick to take advantage.

Hedge size uncertainty – MGRM followed a 1:1 hedge ratio meaning that for every barrel it was short, it bought futures/OTC swaps.  Depending on which model is used to derive the “optimal” hedge size, it is impossible to know while hedging which is the most risk-reducing strategy.  This problem is directly related to the rollover risk and the different volatilities and correlations of all the futures months extending out to 10 years.  Even the academics can’t agree on this one, as this case has been analyzed in some detail.  However, considering the possible funding constraints and the fact that spot prices are more volatile than long dated contracts, less than a 1:1 hedge seemed a more prudent strategy.  At the time of liquidation the long-dated oil supply contracts had an estimated gain of $480 million, which was about half of the futures and OTC losses at that time.  Liquidity-derived losses on the futures/swaps muddy the analysis for the optimal hedge size, even after the fact.  Also, losses on the net position at any time do not necessarily indicate the hedge is poorly structured, as the basis risk may be very high contributing to high volatility in the net hedge P&L.

The Metallgesellschaft hedge provides a number of important lessons.  First, MGRM was not a novice hedger, but a firm whose business was to manage a hedge book.  So the lesson is that hedging can be complex depending on the nature of the underlying exposure.  The size of the hedge also needs careful analysis as it is not always clear what is optimal.  Second, funding risk is very real for all hedgers and management and the Board of Directors must be aware for the potential for large margin calls.  As a subsidiary, MGRM was removed from its ultimate funding source and communication was lacking in this regard.  Third, MGRM’s hedging policy allowed the use of oil, gasoline and heating oil by the traders, which increased its basis risk.  All firms need a well defined risk management policy otherwise traders will take advantage of the loopholes.  Finally, large, concentrated positions come with their own set of issues and must be carefully considered as liquidity costs can be very high.  There are few secrets in an industry when a company gets caught on the wrong side of a very large position.  Also, large positions draw the scrutiny of the various regulatory bodies which are starting to crack down on market manipulation and levying large fines.

If you’re a hedger it is worthwhile to study companies that ended up losing large amounts of money in their hedging program and ask the question – Am I exposed to this risk and can this happen to me?  While the idea of hedging is straightforward, its implementation and effective execution can be challenging in volatile markets.

Iebeling Kaastra, CFM FRM

 

Gibson Capital Inc.
Calgary, Alberta, Canada

Email: info@gibsoncapital.ca


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