Author Archives: John Parsons

Dumbing down

John Kay’s column in the Financial Times yesterday uses the episode with the Swiss franc as a reminder about model risk.

Southwest Airlines Changes Tack

A key challenge in executing a sensible hedging strategy is the inevitable second guessing that happens with the benefit of 20-20 hindsight. Whenever a hedge loses money, outsiders question how much more profitable the company could have been without the hedge. Comparisons are made against competitors that did not hedge, and so performed better. No matter that the hedge accomplishes its objective—reducing volatility. When that reduced volatility is windfall profits foregone, the carping begins.

Last week, American Airlines was the last of the major U.S. airlines to report its 2014 financial results, and every airline was announcing improved operating cash flow due to the huge drop in jet fuel prices. Since American does not hedge, analysts were quick to announce that “they have won big time.”

Airlines that do hedge, have had to report losses on their hedge positions. Delta’s 4th quarter announcement revealed more than $1 billion in charges due to mark-to-market adjustments on its fuel hedges. The losses on hedges offset some of the benefits the airlines are capturing from the drop in fuel prices. If they hadn’t hedged, shareholders would have seen a larger gain from the drop in fuel prices. That puts pressure on management to get rid of the hedging program.

Southwest Airlines announced that it had eliminated its hedge on 2015 prices, so if the oil price drops any further, all of that will drop to its bottom line. It also reduced the scale of its hedging in 2016, 2017 and 2018.

Does it make sense to eliminate the hedge? Is this a case of trend following—having missed the initial decline, the company hopes to catch the next decline? Is this a case of not standing by a well thought through strategy when short-term events fail to go your way? These are real problems in executing a hedging strategy.

A case can be made for adjusting the hedge ratios in response to the fall in price. After all, as Southwest’s executives explained, the purpose of hedging is to provide “catastrophic protection”, meaning against sky high jet fuel prices. With prices as far down as they are, we’re far away from catastrophe. If prices start back up, and if the company is nimble, there will be time to insure against catastrophe.

New Semester, New Era of Oil Prices

Classes at MIT started yesterday, and this semester I’m teaching Corporate Risk Management again. The dramatic plummet in the price of oil over the last few months provides an outstanding live case study of all of the critical issues. To really get a flavor for what a major event this is, it’s useful to look back at the price over a long window of time.

Oil companies are facing a sharp cut in operating cash flows. How should they react? Should investments be cutback?

One factor in making the decision is the forecast of prices going forward. Are prices at a temporary low, from which they will bounce back? If so, cutting back investment may be unwise, sacrificing future profits.

Some companies may not have the luxury of deciding whether or not to cut investments. There may just not be enough cash. Of course, that’s where hedging could have helped, providing a cushion of cash flow to support ongoing investments through a tough patch like this. Companies have an amazingly diverse approach to hedging, and we can examine how different companies fare through these times.

Of course while a price drop is bad for producers, it is good for consumers. Airlines have been posting record profits, helped in part by the drop in jet fuel prices. Fares have not dropped in line with fuel costs, so the fuel cost savings have dropped to the bottom line.

 

End-User Horror Stories #1 – FMC

horror victim

ISDA, the trade association for OTC derivatives, released a paper today purporting to document the dangers of derivatives reform. As usual, the alleged victims are ‘end-users’, the non-financial firms using derivatives to hedge risk. The paper is organized around 4 case studies of firms and their OTC derivative hedges, and makes specific claims about their specific hedges. This is a refreshing change from the usual vague generalities, so it is worthwhile examining those claims in some detail. Moreover, ISDA hired two accomplished finance professors to author and lend their credentials to the paper, so there is a promise that the arguments will have more substance than the usual lobbying pitches.

Unfortunately, the promise of something new is unfulfilled. The paper repackages old, debunked claims. Its arguments are shallow and unpersuasive.

Take as an example the case of the chemical company, FMC, and its hedge of natural gas prices. Although the abstract says that the authors will examine hedge effectiveness, the accounting treatment and the impact on earnings per share, in fact, the paper does none of those things. Instead, it makes two other points which I will examine in turn.

First, the ISDA paper claims that the reform increases FMC’s administrative burden of hedging. How? By forcing FMC out of the OTC derivative market and into exchange traded futures. It takes a cumbersome assemblage of 13 futures to reproduce what can be done with 1 OTC swap. The paper implies that managing this cumbersome assemblage is costly, although it never really accepts the burden of quantifying the extra cost.

This argument does not stand up to scrutiny. The whole premise is wrong. The reform does not prohibit FMC from using OTC swaps instead of futures. So why is the comparison of 13 futures to 1 OTC swap relevant? The paper never explains the premise. It’s just implicit in the comparison of the burden of managing an OTC swap against managing a package of futures. Moreover, suppose we imagine that the OTC market was outlawed. Even then, there is nothing in FMC’s customized swap that cannot be reproduced in the futures market. Clearly the risk profile can be perfectly reproduced, as the package of 13 futures demonstrates. So the only problem we are left with is the administrative burden. FMC cannot handle the 13 contracts itself in house. That’s why it’s dealer constructed a packaged swap. But our imaginary prohibition of the OTC market doesn’t outlaw all forms of financial services. FMC’s banker is free to offer the service of managing a package of 13 futures which replicates FMC’s desired risk profile. In fact, that’s exactly what FMC was getting from its OTC derivative dealer. And you can be sure that FMC paid for that service, although the paper’s authors conveniently overlooked the price charged. There is absolutely nothing in the derivatives reform that stops FMC from outsourcing the management of its natural gas exposure using futures contracts. And there is absolutely nothing in the ISDA paper to suggest that it is more costly for the finance industry to provide that service using futures contracts.

Second, the ISDA paper claims that the reform increases the amount of margin FMC must post, and the paper calculates the margin on FMC’s natural gas hedge. The paper implies that this extra margin is an extra cost. This assumes a false equality between margin paid and cost incurred. An OTC derivative saves FMC the burden of paying margin only by having the dealer extend FMC credit. You can be sure that FMC is charged for that service. Unfortunately, the ISDA paper completely overlooks the price paid for credit risk. My paper on “Margins, Liquidity and the Cost of Hedging,” with my colleague Antonio Mello, shows that when you take into account credit risk, FMC’s costs are exactly the same whether they use the non-margined OTC swap or a fully margined futures package.

Flash Futures

flash boys

Michael Lewis has written a gripping and penetrating book about high frequency trading and the current state of U.S. equity markets. Lewis, of course, knows how to tell a good tale, so the book is fun to read. But the big payoff is insight. The book is astonishingly good at crystallizing what’s going on and why.

Flash boys is all about stock markets, where the accidents of history happened to have spawned a particularly freakish evolution of automated trading. Derivatives markets have only a cameo role through the geographic placement of stock futures in Chicago. In the news frenzy following the book’s release, securities regulators have put out obligatory releases meant to tamp down public anxiety. According to Silla Brush at Bloomberg, the CFTC’s Acting Chairman Mark Wetjen was among them:

“I don’t have the impression at the moment that futures markets are rigged.” The CFTC and its enforcement division are reviewing trading practices in the futures market to ensure they aren’t manipulative, Wetjen said. The agency is also reviewing relationships between exchanges and trading firms, he said.

Hopefully, the reviews Chairman Wetjen is referring to are substantive. Insiders know that the issues at hand in Flash Boys are all too pertinent to derivatives markets. The precipitating event underlying the story is technological change. The drama is in how social forces negotiate that change. Nothing distinguishes derivatives markets from equity markets in the grand scheme of things. But, more accidents of history did initially immuniz derivatives markets from some of the ugliest practices detailed in Lewis’ book. But derivatives markets are undergoing a major restructuring in the wake of the 2008 financial crisis, and that restructuring undermines some of that immunity. So it is vitally important that the CFTC take full advantage of the breathing room it has in order to harness technology in the service of vibrant markets serving the productive economy. Otherwise, the confluence of these two streams—derivatives reform and technological change in trading—could prove treacherous.

It takes 2 to tango, and 3 to intermediate.

The Wall Street Journal ran a story last week about Citigroup and Deutsche losing money on the oil hedge they sold to Mexico. The article talks of a loss totaling $5 million on a put sold for a premium of $450 million, so, in the grand scheme of things, this is not a big matter. However, it does raise an interesting puzzle in light of the Volcker Rule’s prohibition against proprietary trading.

Matt Levine over at Bloomberg does a nice job of dissecting what the banks are doing in the deals with Mexico. It’s part intermediation – taking a portion of the oil price risk from Mexico and reselling it through the oil futures market. But it’s also part acting as a principal – taking another portion of the oil price risk from Mexico and putting it onto their own balance sheets.

Are they allowed to do that – put the oil price risk onto their balance sheet? How is that different from proprietary trading? If Mexico weren’t involved, and the other side of the trade were a hedge fund, would that be any different, as far as safety and soundness is concerned?

Matt Levine thinks the story is a nice example of the banks doing their job. Sure enough, it’s a job that needs being done. But is it really the job of the banks to warehouse oil price risk? It may be socially useful, it may be a valuable financial activity, but it’s not an activity that belongs on a bank balance sheet. Levine’s column reflects how hard it is to get away from the old mentality in which banks think their job is to sell their balance sheet. The problem is, of course, that it isn’t their balance sheet that they are selling. It’s the taxpayers’.

Never give information to the enemy.

Loose Lips

Douwe  Miedema of Reuters covered yesterday’s meeting of the CFTC’s Technology Advisory Committee and reports that:

The U.S. derivatives watchdog on Monday chided the industry for providing gappy data on the $630 trillion market… “I do want to get away from the handholding,” said Vincent McGonagle, the CFTC’s head of the Division of Market Oversight. “It is clear that there are issues where parties are not reporting,” he said.

What is he talking about?

I’m guessing that this is an example. ICE Trade Vault is a Swap Data Repository for commodity products, including financial power. In addition to running its data repository, ICE is a lead platform for trade in these products. According to data compiled by one of its platform competitors, Nodal Exchange, and provided to the CFTC’s Division of Market Oversight, the data feeds from ICE Trade Vault lack some of the most pertinent information about transactions:

…of the 33,030 financial power transactions reported by ICE Trade Vault in 2013, we found that 21,054, or 64% were listed as “exotic” and lacked basic transaction information such as the unit of volume and the product transacted. Furthermore, only 11,973 transactions, or 36%, of all financial power transactions reported by ICE Trade Vault contained any price information.

We were also dismayed to see that for even the relatively well described transactions denominated in Megawatt Hours (MWh) reported by ICE Trade Vault, the vast majority (11,214 of 11,893 transactions, or 94.5%) had, at best, only a generic region or Regional Transmission Operator (RTO) or Independent System Operator (ISO) identified. We believe this lack of specificity is largely unwarranted. For example, many transactions reported by ICE Trade Vault simply show “PJM”, a Regional Transmission Operator covering all or parts of 13 states plus the District of Columbia. However, on ICE Futures U.S., ICE offers futures contracts covering 13 distinct zonal locations and four hub locations within PJM, providing a ready basis for more specific locational reporting for ICE Trade Vault as well. Financial power information is really only useful if it conveys what product is traded (specific power location), at what price, and for what volume. This information is available on only 607 of the 33,030 financial power transactions, or 1.8%, as reported by ICE Trade Vault.

Trade reporting is the law, but there is obviously a long way to go before its a reality.

Unhedged. …oooops.

Clean Currents

What happens when you sell your customers power at a fixed price, and you buy your power at a floating price? A local DC green electricity marketer, Clean-Currents, found out as last month’s frigid temperatures sent wholesale power prices rocketing. It’s now out of business, and the customers who had those contracts are…back on the market either getting their power from the incumbent utility or looking for a fresh deal.

Clean-Currents sent this message to customers:

Dear Customers:

We are writing to inform you, with deep regret, that the recent extreme weather, which sent the wholesale electricity market into unchartered territories, has fatally compromised our ability to continue to serve customers.

We are extremely saddened to share this news with you.

What does this mean for you?

All Clean Currents’ customers will be returned to their utility service, effective immediately. You should see this change in service on your next bill, or the bill after that, dependent on your meter read cycle. If you so choose, you are able to switch to another third party electricity supplier, effective immediately. Clean Currents waives any advanced notice requirement or early termination fee provisions in our contracts.

Please contact your utility if you have any questions about your change in service:  …

We are deeply grateful that you chose to be a Clean Currents customer. It has been a pleasure to serve you. We hope you will still choose renewable energy for your home or business.Sincerely,

Gary Skulnik & Charles Segerman, Clean Currents Co-Founders

 

 

American Airlines Stops Hedging

Image

On its quarterly earnings call earlier this week, the new American Airlines confirmed speculation that it would end the company’s legacy policy of hedging jet fuel prices. The hedges that are in place will be allowed to runoff, but they will not be replaced.

American’s merger with US Airways was completed in December, and the combined company is being led by US Airways’ management team. For a number of years now, since 2008, US Airways has shunned hedging. Now that policy is being extended to the merged firm.

Why?

Experience is one factor. Going into 2008, US Airways hedged jet fuel prices just like other companies. But 2008 was a wild ride for all businesses in which fuel costs are a major line item, airlines especially. Oil prices spiked dramatically during the first half of the year, and then collapsed even more dramatically during the second half. While the company may have profited off of its hedges in the first two quarters, it reported whopping losses on its hedges in the last two–$488 million in the 3rd quarter and another $234 in the 4th quarter, each time approximately half the company’s total loss in the quarter. Of course, at the same time the airline was paying a smaller price to buy jet fuel, so the company’s net cash flow on fuel plus the hedge showed less volatility. That’s how a hedge is supposed to work. But hedge decisions are always second guessed whenever the financial leg of the package earns a loss.

The second guessing at US Airways goes a little deeper than usual, and the management team’s rationale deserves a fair hearing.

Management seems to think that hedging somehow invites companies to be less ruthless about cost discipline. At it’s Q2 earnings call last year, US Airways President Scott Kirby said

And our cost discipline has been equally impressive. First, since US Airways stopped hedging fuel we’ve had the lowest or second lowest cost of fuel in 10 of the last 14 quarters, a strong validation of our no hedging strategy.

Management also thinks it isn’t really as exposed to fuel costs as many imagine. Casual observers focus too narrowly on jet fuel costs alone, the company points out. Looking at operating margin – revenue less variable cost – the company has a much smaller exposure to jet fuel prices than first meets the eye. Here’s Scott Kirby again, from a 2012 conference:

I think a non-fuel hedging program is the most effective and the most rational program because we have a natural hedge. This is a natural hedge — fuel prices versus demand. When fuel prices are going up, in most cases revenue is going to follow and vice-versa. Fuel prices are driven in many regards by the economy. That’s not the only driver of fuel prices, but it’s probably — over a longer time horizon, it is the principal driver of fuel prices as what’s happening with the economy, and so we have a strong natural hedge. And if we hedge jet fuel prices or hedge oil prices, you’re breaking this natural hedge, not to mention the expense of hedging but just the natural hedge that you have between jet fuel and revenues.

So a sizable financial hedge is not necessary, and might even increase the airline’s risk.

I have a hard time believing that the right hedge is zero. Ticket prices don’t move one-for-one with jet fuel prices, at least not immediately. Many tickets are sold in advance, whether individually or as a part of corporate and other packaged sales. And the quantity of sales will be affected by the price, too, so that the company is exposed on an aggregate basis even when its operating margin is not.

Of course, that argument does not take into account the cost of hedging. In order to cover those costs, Kirby said, fuel prices would have to rise 30% year-over-year, something he obviously doesn’t think is likely.

Since US Airways inaugurated its new policy of not hedging, oil prices have stayed in a relatively narrow band, so the policy has not yet been stress tested. Now that policy is being extended to the larger, combined American Airlines. It will be interesting to see whether it runs into any stormy price swings, and how it fares under stress.

Riddle or Ridicule? Reprise or Rehash?

One of my husband’s many incisive stories from his career as an educator reports on an incident in the teachers’ lounge at a high school after an exam. In comes one of the more senior teachers, griping about his students’ poor performances: “I’ve given the same exam now for 20 years, and they still get the same questions wrong.” My husband, of course, thinks the teacher’s complaint reflects more on the teacher’s weaknesses than on the students’.

I was reminded of this story by University of Houston Finance Professor Craig Pirrong’s blog post complaining that although he has been making the same argument since 2008, the critics of speculation still don’t get it. Speculation, he claims to prove, cannot cause price levels to trend up.

In his blog, Professor Pirrong’s favorite pose is ridicule, and this post is no exception. He proclaims his argument is just an application of basic finance theory, which the critics of speculation are too dim to appreciate. But, a number of well credentialed economists who are well versed in basic finance theory take exception to Pirrong’s argument. In particular, I’ve written elsewhere that speculation can cause the price of oil to trend up. We can have a reasoned argument about speculation and price levels, but it’s time to drop the ridicule.

Like the pompous high school teacher who wielded his authority against his students, Professor Pirrong brandishes his knowledge of finance against the untrained complaints of the public about speculation and proudly announces himself the victor. It is true that many of the untrained critiques of speculation imagine a simple, overly mechanical relationship between the volume of speculation and the level of prices. But where is the glory in taking an untrained critique and finding a flaw?

The volume of speculation matters. It may not be a regular direct cause of a price bubble or other problems in a commodity market. But it can be a symptom and it can be an indirect cause and it can also occasionally be a direct cause. Ignoring the volume of speculation is foolhardy.

Professor Pirrong is extreme in the weight he gives to ridicule in his argumentation. There are plenty of other economists who share his underlying critique, while maintaining a more respectful demeanor in the conversation. The annual convention of economists is taking place right now, and the issue of commodity speculation is on the agenda in a couple of sessions, including one on Saturday afternoon sponsored by the International Association of Energy Economists and the American Economics Association. There will be plenty of space given to the critique that speculation has not been responsible for moving prices. But there will also be presentations by other credentialed economists whose talks will reflect the same stubborn ignorance of the basic finance for which Professor Pirrong chides less credentialed critics. I will be among them. I’m looking forward to a substantive discussion free of invective.

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