Monthly Archives: May 2012

The unorthodox model of risk pricing behind the UK EMR #6: it gets better

Earlier this week, the UK government submitted draft legislation on its Electricity Market Reform (EMR).  In a series of blog posts from last July, I critiqued the central premise underlying this insurance proposal. The touted benefits overlook the cost of risk passed along to UK taxpayers or ratepayers. They are based on a fanciful imagination of the costs of nuclear new builds, how risk factors into investment decisions, and the ease with which the relevant risks can be transferred at the stroke of a pen. Of course, so long as the government’s scheme remains an abstract plan, this critique remains a theoretical one. It will only be once an actual price insurance contract is laid on the table in order to finance an actual nuclear new build that the faults in the government’s scheme will reveal themselves in specifics. The new draft legislation includes a little more information, but not much. However, I did enjoy the footnote to a curious calculation, which reads: “The following simplifying assumptions have been made: that required debt returns are fixed as long as minimum cover ratios are met, and that equity investors’ hurdle rates do not vary with gearing/variability of prospective equity returns.” (emphasis added) That’s exactly the type of simplifying assumption one needs to make sense of the plan.

Show me, per Dodd-Frank

The finance lawyer who blogs at Economics of Contempt has a very nice summary of what is required for JP Morgan to claim that the trades at the CIO unit are allowed under the Volcker Rule because they were “portfolio hedging”. It is a more comprehensive and textual version of our requirement that JP Morgan “show me”.

Show me

JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?

Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.

So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.

Two points about hedging…

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Delta’s Refinery Gambit: It’s Not About Volatility

Delta Airlines’ deal to buy the Trainer Refinery owned by Phillips66 was formally announced yesterday. The 8K filing is available here and includes the press release and slide show. Until yesterday the deal was being talked about as a way to hedge the fluctuating price of jet fuel oil. But the announcement makes clear that the objective is something different entirely: battling the rising jet fuel crack spread in the Northeast U.S. where Delta has critical hubs at LaGuardia and JFK.

This is one of the key charts from Delta’s slideshow highlighting the rising crack spread Delta has paid over the last three years.

The possibility of further closures of East Coast refineries threatened to drive the local spread even higher, Delta claimed. Delta believes that by investing in the refinery, including $100 million in investments to shift even more of its production to jet fuel, it will be able to source its fuel cheaper and able to bargain better for the balance of its needs.

The title of Delta’s presentation reads “Addressing Rising Jet Fuel Risk”, and it does contain talk about how “jet fuel crack spreads cannot be cost-effectively hedged”, among other language evocative of risk management and hedging. But it would be a mistake to try and understand this as a hedge in the traditional sense. Delta isn’t trying to limit volatility: at least not volatility around a mean. It’s trying to put direct pressure on the mean level of the jet fuel spread. That’s a different thing entirely.

This is an attempt to gain a strategic advantage in the airline industry. Will it payoff? Apparently yes, according to Delta’s projections. Even if the Brent-WTI spread reverses and becomes negative and many East Coast refineries reopen for business, that will likely take longer than one year, as much time as Delta believes is needed to payback the investment. Time will tell.

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Update: Liam Denning at the WSJ provides some useful statistics:

The Justice Department considers a market with a Herfindahl-Hirschman Index score above 2,500 to be “highly concentrated.” In 2010, the East Coast refining market’s score hit 3,255, against a nationwide one of 680, according to the Federal Trade Commission. If Pennsylvania’s Trainer facility had stayed idle rather than be bought by Delta, the score would likely have surpassed 4,000, according to the American Antitrust Institute.

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