Author Archives: John Parsons & Antonio Mello

Regret in the here and now, joy in a parallel universe


Steven Davidoff, the New York Times’ Deal Professor, thinks that management and shareholders at the Morgans Hotel Group got suckered back in October 2009 when they sold their souls a PIPE for cash. Davidoff implies that the investor, Ronald Burkle’s Yucaipa Companies, is doing fine, while management and the other shareholders are squirming to escape as various control triggers are closing in on them.

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Margins, Liquidity and the Cost of Hedging


Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.

Two Tales of Debt Financing

Debt financing is always a gamble. And often a seductive bet.

The Financial Times’ Andrew Jack reports on the pharmaceutical company Valeant which has been on a buying spree financed by debt. For an ambitious businessman with a view, debt is the tool that makes scale feasible. And, as long as everything works out as planned, the returns are great.

But what if they don’t work out as planned? Who’s bearing that risk?

The Deal Professor, Steven Davidoff over at the New York Times takes a look at debt financing concocted the other way ‘round. Instead of used as a tool to enable acquisitions, it is offloaded as a part of a spinoff.

In these cases, it’s often much clearer who is bearing the risk.

Captives and Contagion


The French automaker Peugeot is in trouble. Automobile sales in Europe saw a dramatic 8.6% slump in 2012. For Peugeot it was even worse: a 15% drop. Since the company relies overwhelmingly on sales in Europe, the company was burning through cash at a rate of €200 million per month, according to the Financial Times. Earlier today the company reported a loss of €5.01 billion in 2012. Already last March, Moody’s had downgraded the company’s credit rating to junk. To stabilize its finances, management last year initiated a program of asset sales, an issue of new equity, and the closure of one of its manufacturing plants near Paris.

Like many other manufacturers, Peugeot owns a captive finance arm, Banque PSA Finance (BPF). The bank has a special access to Peugeot-Citroen dealer networks and supports automobile sales by offering loans, leases and insurance to customers.

The bank gets its funds in the wholesale market, as shown in the figure below, taken from the bank’s 2012 annual report.


BPF’s captive relationship with Peugeot-Citroen exposes it to the risks of the car company. The sales volumes achieved on Peugeot and Citroën cars directly affect the bank’s own business opportunities. The ownership relationship, too, creates exposure. Accordingly, the credit rating agency Moody’s determined that its rating of the bank is constrained by its rating of the parent.

In 2012, the automaker’s financial problems infected the bank. As the parent was downgraded, Moody’s also reviewed the rating of the bank, and it was downgraded. In July, the parent was downgraded to junk, and Moody’s announced that the bank’s credit rating was in review for possible downgrade to junk status.

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With a hedge, could Conoco have it all?

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.

¿Prepare for the bad, close your eyes to the worst?

Javier Blas at the Financial Times reports on the Mexican state’s new strategy for hedging the oil price. In recent years, the state had bought puts. But in the last couple of years, those puts expired out of the money. Whenever that happens, people start second guessing a strategy. The premium paid begins to look expensive. So this year the Mexican state has found a way to save on the premium. Instead of buying a simple put with an exercise price in the range of $80-85/barrel, it is buying a put spread with a second strike price around $60/barrel. If the price drops below the first strike around $85, then the put begins to payoff. But below the second strike of $60/barrel, the gains on the put are capped. The cost of the simple put on approximately $200 million barrels is said to be in the neighborhood of $1-1.5 billion. Using the put spread, the costs are halved, according to the Financial Times.

Of course, the cost is less because the Mexican state is buying less insurance. What is odd is that it is foregoing insurance exactly when the state will be in direst need.

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“A lot of weather we’ve been having lately.”

The winter of 2011-2012 was the fourth warmest on record in the U.S., according to the National Oceanic Atmospheric Administration (NOAA). One consequence of this has been a sharp drop in demand for natural gas use to heat buildings, and that is a hit to the bottom line of many gas distribution utilities with revenues tied to the quantity of gas consumed. For example, the Delta Natural Gas Company, a Kentucky utility, reported in its second quarter 10Q that:

Heating degree days were 78% and 84% of normal thirty year average temperatures for the three and nine months ended March 31, 2012, respectively, as compared with 102% and 105% of normal temperatures in the 2011 periods. … For the three months ended March 31, 2012, consolidated gross margins decreased $890,000 (7%) due to decreased regulated and non-regulated gross margins of $707,000 (7%) and $183,000 (6%), respectively. Regulated gross margins decreased due to a 26% decline in volumes sold as a result of warmer weather, as compared to the same period in the prior year. … Non-regulated gross margins decreased due to a 26% decline in volumes sold due to a decline in our non-regulated customers’ gas requirement, partially offset by a decline in the cost of gas and the sale of natural gas liquids.

Some of this quantity risk might be hedgeable using weather derivatives. And hedging this risk can decrease the volatility in corporate cash flow, increasing both the company’s debt capacity and its dividend ratio and ultimately raising shareholder value.

A research paper by Francisco Pérez-González of Stanford University and Hayong Yun of the University of Notre Dame, forthcoming in the Journal of Finance, uses this setting to explore the question of whether financial innovation is useful to the real economy. They take the case of the innovation of weather derivatives in 1997 as a kind of natural experiment and explore the cash flow volatility situation for natural gas and electric utilities before and after the introduction of this risk management tool. Altogether, they examine stock market and financial statement data on 203 companies over the years 1960 to 2007. Their data show that the utilities most likely to use weather derivatives are those with the greatest cash flow sensitivity to weather, and that those that do make use of the derivatives significantly decrease the volatility of their cash flows. This increases the debt and dividend ratios of these utilities, and ultimately their share prices, too.

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.


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.

CVA Lessons: Is it better to charge or to subsidize credit risk?

One often hears that competition promotes the efficient and weeds out the inefficient. Yes, but only insofar as there is a level playing field. Give special privileges to certain players, and the best might end up dominated by the inefficient.

Analysts who overlook the power of privileges may mistake dominance for efficiency, getting backwards the true state of affairs.  They also miss that the distortion reduces the welfare of society and redistributes wealth and power in favor of the inefficient.

That’s true in any industry and especially relevant in the case of the dominance of OTC derivatives markets over exchange trading during the last three decades.

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