With a hedge, could Conoco have it all?

January 7, 2013 – 2:25 pm

conoco logo

Liam Denning’s Heard on the Street column in this morning’s Wall Street Journal is reliably hard-nosed about budget trade-offs:

Investors want it all—but they should be careful about companies that promise it.

ConocoPhillips is a case in point. … E&P stocks tend to compete on growth, whereas the integrated majors are prized for how much cash they return to shareholders. Conoco offers both. It targets annual production growth of between 3% and 5% a year out to 2016. And it offers a dividend yield of 4.6%, around double the average for its peers.

What’s not to like about that?

…Conoco’s near-term strategy implicitly relies on high oil prices, not merely to provide operating cash flows but also to attract high prices for disposals. The danger is not that Conoco suddenly can’t pay its dividend; indeed, it has prioritized it. Rather, it is that weaker prices or unexpected costs would upset the cash-flow math and force investors to dial back their enhanced expectations–and Conoco’s valuation with them.

Conoco’s exposure to oil prices is a matter of choice, not circumstances. The company does practically no hedging. The company’s stated “policy is to remain exposed to the market price of commodities.” In fact, the company takes this curious commitment so far that “we use swap contracts to convert fixed-price sales contracts which are often requested by natural gas and refined product customers, to floating market prices.”[1]

Conoco has good company as a non-hedger. We’ve written before about the notable fact that ExxonMobil refuses to hedge. But even among smaller E&P firms, roughly 50% of the firms report no hedges at all in any given year.[2]

Perhaps Conoco can afford to remain exposed. Its balance sheet is in very good shape so that it has unused debt capacity which could cover some shortfall. Nevertheless, if exposure to commodity prices were truly a threat to Conoco’s twin goals of investing for growth and paying a reliable dividend, the company could do something about that. But to do so would require giving up its third goal of being fully exposed to oil prices.

Two out of three ain’t bad.

[1] ConocoPhillips Form 10-K for FY2011, p. 74.

[2] Haushalter, G. David, 2000, Financing Policy, Basis Risk and Corporate Hedging: Evidence from Oil and Gas Producers, Journal of Finance 55, 107-152.

By John Parsons & Antonio Mello | Posted in commodities, financial policy, hedging | Comments (0)

Congressional Intent & Futurization

December 13, 2012 – 11:55 am

The Capital Markets subcommittee of the House Financial Services Committee held a hearing yesterday on the derivatives portion of the Dodd-Frank Act — Title VII. The question of the futurization of swaps captured a good bit of attention.

House Hearing

Representative Bachus, who chairs the full Committee, said (at 14:04 in the video),

If all derivatives were supposed to be traded on an exchange, then they would all be futures. [Swaps] are differeent from exchange listed products, and imposing the listed futures or equity market model on [swaps] is not the mandate of Title VII.

Read More »

By John Parsons | Posted in Dodd-Frank, OTC reform, packaging risk, regulation | Comments (1)

Reading the Term Structure

December 10, 2012 – 1:25 pm

Natural gas prices have been rising recently. But I always like to look at the whole term structure of futures prices to get a better sense of what is really going on. My colleagues at CRA, Billy Muttiah and James Dunning, prepared this chart which overlays snapshots of the term structure at the start of the last several months. It tells a simple story.

Natural Gas Futures Prices - 12-05-2012

What’s going on is mostly a story about the long-run. Only a small amount of recent spot price changes are due to short-run factors and changes in the spot vs. futures price. Prices at all maturities have been going up. And the shifts are roughly parallel throughout the term structure.

A quick look like this doesn’t clarify whether it is long-run demand shocks, long-run supply shocks or any number of other combination of factors. But it does focus attention in the right place.

By John Parsons | Posted in commodities, markets, volatility | Comments (0)

How Futures Can Steal Market Share from Customized Swaps

December 6, 2012 – 11:50 am

alterations

Many people underestimate the threat that futures markets pose for the OTC swaps industry because they have been suckered into thinking of swaps as carefully custom tailored instruments. It’s true that a small fraction of the OTC swaps market cannot be replicated in the futures marketplace. And it is good that the Dodd-Frank Act preserved a space for customized swaps. But the vast majority of swaps are not custom tailored, or the custom tailoring is so inconsequential that it will be an easy matter for the futures market to serve the same purpose.

Even when the swap does contain some important element of customization, that is usually not the whole story. Many customized swaps can be broken up into 2 pieces: (i) a basic, plain vanilla swap, plus (ii) a small bit of customization that adapts the plain vanilla swap around the edges. The futures market can substitute for the plain vanilla swap, and then the OTC swap market can provide the customization around the edges.

It’s like buying a suit ready-to-wear, but having the tailor adjust the hems or waistline a little bit. So long as the adjustments are small, its an economic alternative to true customization.

An illustration of how a custom swap can be broken up into two pieces appears in an article by Sean Owen, Director of Fixed Income Research and Consulting at Woodbine Associates, published in a recent special issue of the Review of Futures Markets. He breaks up an irregularly amortizing 10-year interest rate swap into (i) a 7-year bullet interest rate swap, and (ii) a customized swap that produces the irregular amortization relative to the 7-year bullet. (H/T to CFTC Commissioner Scott O’Malia for highlighting the article)

measure

By John Parsons | Posted in Dodd-Frank, OTC reform, packaging risk | Comments (0)

Futurization advances in interest rate products

December 4, 2012 – 4:01 pm

The NYSE Liffe is moving to adapt their futures products to grab more business away from the OTC swaps market. It announced changes yesterday to enable large block trading in 3 of its products–three month Euribor futures, three month sterling futures and long gilt futures. The block trades will be handled on its Bclear system. The service is scheduled to be available starting December 10.

The FT’s coverage is here. It will be interesting to see how the new service does and how it affects the overall flow of trade in those futures contracts.

This looks to me like another example of the futures marketplace easily being expanded to offer a service in standardized derivatives formerly performed OTC. There was never any special economic rationale for this business in standardized derivatives being handled OTC. This move exposes, once again, the fallacy that the OTC swaps market was dominated by customized products that are ill-suited to standardized markets like futures exchanges.

By John Parsons | Posted in Dodd-Frank, financial innovation, markets, OTC reform, packaging risk | Comments (0)

Futurization #4 — an agenda item for the CFTC hearing

December 2, 2012 – 9:47 am

In a speech this past Friday, CFTC Commissioner Scott O’Malia once again voiced his concern that burdensome swap dealer registration rules and disadvantageous margin requirements for swaps may be driving the futurization of derivatives trading. He proposed that the Commission host a hearing on the futurization question in order to inform development of the right rules for the swaps market.

In order for a hearing to be informative, it is essential to put the right questions on the agenda. I suggest the Commission squarely ask what swap markets are for?

Read More »

By John Parsons | Posted in commodities, Dodd-Frank, financial innovation, markets, OTC reform, packaging risk, regulation | Comments (0)

Futurization #3 — long live innovation and customization

November 26, 2012 – 10:56 am

Defenders of the OTC swaps model like to talk a lot about the ability to custom tailor the terms of a swap to each customer’s particular needs, and also about the room given to innovate new product designs. The listed futures exchange model cannot accommodate this degree of innovation and customization. That’s true, as far as it goes.

Fortunately, the Dodd-Frank OTC derivative reforms preserve a space for this element of the OTC swaps model. Customized swaps are still allowed. Swaps that implement new product designs are still allowed. Exchange trading is not mandatory for all swaps. Clearing is not mandatory for all swaps.

When we talk about futurization of swaps, we are talking about the larger subset of swaps that are either already marketed as off-the-rack products, or that can be easily repackaged as such. This represents the vast majority of OTC swap trading.

Dodd-Frank was architected to allow standardized derivative trading either on the newly created swap exchanges or on the pre-existing futures exchanges. The current talk about futurization is all about the choices being made for trading these standardized derivatives. Instead of transitioning onto swap exchanges, they are moving out of the swaps marketplace and onto the futures marketplace. Customized derivatives will have to continue to be offered as swaps, which Dodd-Frank explicitly allows.

Moving standardized derivatives onto exchanges, and clearing those transactions can benefit customers. There is a lot to be gained from encouraging efficiency and product development in ready-to-wear derivatives.

Artisinal production has its benefits, but mass production does, too. The Dodd-Frank reform permits both.

By John Parsons | Posted in commodities, Dodd-Frank, financial innovation, markets, OTC reform, packaging risk, regulation | Comments (1)

It never hurts to check the data

November 26, 2012 – 9:07 am

This coming Friday the CFTC will be hosting a Research Conference on derivatives markets. The agenda touches on HFT, swaps market structure and the financialization of commodities.

Read More »

By John Parsons | Posted in commodities, Dodd-Frank, markets, OTC reform, regulation, systemic risk | Comments (0)

Prop-Flow stands convicted, too.

November 21, 2012 – 10:30 am

The trial of UBS trader Kweku Adoboli ended yesterday with his conviction on two counts of fraud and the dismissal of the accounting allegations. Some news accounts have noted that testimony at the trial also exposed embarrassingly shoddy risk management at UBS. Prop-flow also stands convicted.

Prop-flow is one of those wonderful neologisms of the investment banking world. UBS’s Delta One desk, where Kweku Adoboli was employed, is a classic example of the prop-flow trading model. Ostensibly, a Delta One desk is serving customers, manufacturing risk exposures that the clients want, and earning revenue for providing that service. But the testimony at Adoboli’s trial leaves no doubt that his assignment was proprietary trading, pure and simple. He wasn’t convicted because he did prop trading, but because of how he did his prop trading. The testimony leaves no doubt that his UBS managers always expected him to be placing proprietary trading bets. The only dispute was about how those bets were managed and recorded, and the scale of the bets along the way.

How much tolerance bank Boards of Directors and bank regulators have for neologisms like prop-flow will be an important question in the coming years as the Volcker Rule and similar prohibitions come into force.

By John Parsons | Posted in Dodd-Frank, hedging, regulation, speculation | Comments (0)

SEC Staff examines copper ETFs with blinders on

November 20, 2012 – 2:39 pm

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

The SEC can do better. It must. American industry depends on it.

By John Parsons | Posted in commodities, financial innovation, markets, regulation, speculation | Comments (3)
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