Category Archives: commodities

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


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.


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.

Be careful how you swing that hatchet!


During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.

So this story in today’s Financial Times gave me a good chuckle:

US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…

Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.

Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.

And so, another industry funded hatchet job on the Dodd-Frank financial reform ages poorly.

Backwardation in Gold Prices?

Izabella Kaminska at FT Alphaville clarifies what’s going on.

Smooth Talk About Gold

Bruce Bartlett used his New York Times Economix blog post today to argue that “Gold’s Declining Price Is a Reversion to the Mean”. He buttresses his argument by pointing out that,

In a recent paper, the economists Claude B. Erb and Campbell R. Harvey present strong evidence that the gold market was severely overbought. The increase in gold prices did not represent a change in the trend of inflation. As the chart indicates, even with the sell-off, the price of gold is still high and has a long ways to fall to get back to the “golden constant” that gold-standard advocates cite as proof that the dollar should be pegged to gold.

Bartlett Harvey

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Gold’s Random Walk

A number of journalists are helping to broadcast Goldman Sachs’ latest prediction for gold prices. Goldman’s press agents planted the story in the Wall Street Journal, the Financial Times and the New York Times, among other places.

This is silly. There’s plenty of scientific evidence that the gold price is a random walk. Here’s an old reference: Eduardo Schwartz’s Presidential Address to the American Finance Association back in 1996. There are older and more recent papers finding the same.

Last week I wrote a post in which I mentioned that the time series of commodity spot prices are often mean reverting. They contain an element of predictability. Gold, however, is the exception. Gold is very, very, very cheap to store. And it is widely held purely as a store of value without any use value. Consequently, the spot price of gold quickly incorporates changing market views about future supply availability and any other fundamentals like those itemized in the Goldman report. For all intents and purposes, a physical investment in gold is a financial security, which means that the spot price is a martingale. The distinction I made in my last post between the spot price series for a commodity and the time series for a specific futures price is a meaningless distinction for gold.

Dynamic Hedging or Futile Speculation?


Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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