Author Archives: John Parsons & Antonio Mello

Reading the Term Structure of Futures Prices

Over the last few years, natural gas prices in the U.S. have been pounded by a variety of factors. Front and center are the continuing breakthroughs in horizontal drilling and hydraulic fracturing. On top of this, the winter of 2011-2012 was the fourth warmest on record, according to the National Oceanic Atmospheric Administration (NOAA), and those temperatures slashed demand. From a peak of over $13/mmBtu in July 2008, the price fell to almost $2/mmBtu in March 2012.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

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Sweeping for cash in the hedges

Natural gas producers in the US are faced with tough choices. Advances in drilling technology have made low cost production from shale resources viable on a large scale, and the industry has been in a race to lay claim to the most valuable properties and to capture a competitive advantage in mastering the technology. But at the very same time, the price of natural gas has collapsed, erasing profits. This has pinched budgets and forced companies to be creative in finding fresh sources of capital. It has also forced companies to re-evaluate development plans and resource acquisitions.

The price of natural gas in the US has been falling almost continuously since mid-2008 when it peaked at over $13/mmBtu. It now lies just above $2/mmBtu.

Despite the falling price, natural gas production in the US has continued to climb. According to data from the EIA, between July 2008 and January 2012 US production increased 17%. Companies have been slow to adjust their expansion plans to the falling price. Finally, in late 2011 and early 2012, companies have begun to adjust their capital expenditures to the current low natural gas price reality. Gregory Myers has reported on this in the Financial Times, citing decisions at Chesapeake Energy and ConocoPhillips. In 2011, Encana Corp finally confronted reality and abandoned its 2008 pledge to double production.

Even as capital budgets are cutback, companies still face a need to raise new cash. The new technologies can also be applied to production of unconventional oil resources, like the tight oil in North Dakota’s Bakken Shale or Texas’ Eagle Ford Shale, as well as to development of liquid rich gas fields. Since the price of oil remains high, it can pay to develop these resources. But many natural gas companies with experience in the new technologies find themselves cash poor due to the low operating profits on their gas properties. Cash poor, and prospect rich.

These companies are selling their traditional gas assets to buy higher value shale deposits. Equity issuance is also at historically high levels. Dealogic estimates that share issuance by the sector represents one-fifth of all the US equity raised this year.

A more interesting development is to get cash from accrued gains with pre-existing hedges as reported by Ajay Makan in the FT. An example would be of a company which had entered in 2009 into short positions in forward/futures natural gas contracts for the next six years, until 2015. Right now, in March 2012, the company has on its books gas contracts with maturities varying from June 2012 to 2015. Since the gas yield curve back in 2009 when the company initiated the positions was significantly higher than the current gas yield curve, the company is sitting on significant unrealized gains. Consider just one of its many futures positions: 1000 contracts sold in 2009 with maturity March 2014. The price in 2009 of a March 2014 contract was around $4. Now the same 2014 futures price is around $3.4. Since each contract is for 10,000 mmBTU, the company can close the position and make a profit of 10,000 mmBTU x ($4-$3.4) = $6,000 per contract, for a total of $6 million.

The companies can close out these contracts in order to cash in on the gains.

A couple of questions are in order:

1. Why would the companies want to do that?

2. If the companies sold the hedges wouldn’t they become unhedged and exposed to greater risks?

The answer to the first question lies in the fact that with low gas prices, companies are not able to generate enough cash from operations to fund investment in land, drilling and exploration of shale gas fields, when the industry faces a lot of competition to own such assets.  Faced with an operating cash squeeze, the companies are tapping their reservoir of gains generated by pre-existing hedges.

But, going forward, won’t the companies be much more vulnerable to price gyrations if they liquidate their hedges?

No.

The companies can immediately lock into new forward contracts at the prevailing forward price. The companies are simply realizing past gains on their outstanding contracts in order to plough the money back into their businesses. Unrealized gains are a wasted resource. The companies are free to establish new hedges. Analysts who claim that companies are taking on more risk to avoid cutting back on investment are just wrong.  There is not a conflict between cashing in on unrealized gains from past hedges and being hedged going forward.

Credit Suisse note is not a solution to bonus culture

Credit Suisse (CS) has announced it will pay a portion of its bankers’ bonuses with a structured note instead of cash. The note pays a fixed coupon of around 6% per year, and is backed by a package of derivative contracts currently in the balance sheet of CS. Since the value of the portfolio is risky, the payout is not guaranteed.

In a memo to staff, CS CEO Brady Dougan touts the structured note as a way to address the criticism made against the financial industry’s bonus structures. But is that true?

The central criticism is that the relationship between risk and return is out of whack. The principal behind past bonus structures has been “heads I win, tails you lose”. Performance has been rewarded without regard to risk. Losses have been put to shareholders or to taxpayers. A related criticism is that the process for setting bonuses is opaque and managed by insiders, at the expense of shareholders and taxpayers. This makes it unlikely that insiders ever fail to succeed against the benchmarks that are set, and ensures that the system is skewed against shareholders and taxpayers.

Does the new CS structured note address these criticisms?

No it doesn’t.

It was designed with an entirely different purpose in mind, which is strengthening the bank’s capital position in light of new banking rules. The derivatives portfolio backing the structured note comes from CS’s balance sheet, and CS hopes the move will decrease the measured risk of its balance sheet and improve its capital ratio under the new Basel III agreement. CEO Dougan is straightforward about this strategic objective. But he also wants to advertise the move as addressing shareholder and public concerns on bonus rules.

The structured note fails to address either of the two key criticisms.

Most importantly, it is terribly opaque. Many details haven’t yet been released, but in his memo to staff, CEO Dougan acknowledged that “Instruments such as PAF2 are inherently hard to value. It’s obviously not something that is traded in regular markets so has to be modeled.” Only an investment banker still locked in a pre-2008 mindset would structure a note like this as a step forward to transparency and accountability?

It is also hard to see how the structured note provides a sensible risk-reward relationship for the bank’s senior staff. No one starting from a blank piece of paper would design a compensation scheme based this way on the portfolio of derivatives now on the bank’s balance sheet. Indeed, CS has designed the arrangement with an escape hatch should the capital regulations surrounding its real strategic objective change:

PAF2 represents an effective and real sharing of risk but, nonetheless, we still need to reserve the right to amend this structure in the event of changing requirements. The most likely change would be to amend PAF2 to an instrument that instead of referring to our specific portfolio would reference a public index of credits. In our view this would be just as good for our employee investors. We also need to include a call at market value in case these requirements change so materially that the instrument is no longer effective.

If the note were also a real solution to the bonus problem, it would survive changes in the regulatory capital rules that are its real objective.

If CS’s management were serious about addressing the compensation problem, they would design a durable scheme, not a one-off gimmick. The scheme would include a clear downside for managers and a clear tie to the long-term fortunes of the bank. Simon Nixon at the Wall Street Journal’s Heard on the Street column mentions UBS’s plan to pay bonuses as contingent convertibles as one example in this direction. Another alternative would be the explicit clawback provisions being pushed by New York City Comptroller John Liu. The key is that managers should not be able to walk away from the future fortunes of the bank, and the scheme should encourage cross monitoring of risks among managers within the bank. And these incentives should be clear to all, inside and out. The CS proposal is not a step forward on this front.

Banking apples and oranges

Vikram Pandit, the CEO of Citigroup, used an opinion piece in last week’s Financial Times to make an interesting proposal on risk disclosures: banks and other financial institutions should be required to report how their internal modeling assesses the risk in a “benchmark” portfolio. Regulators would define the contents of this hypothetical portfolio, and banks would report “a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets.”

It’s a useful proposal that could give investors and other market participants additional useful information. But it also has its limitations, and does not resolve some inherent problems with risk-based capital requirements, and does not eliminate the need to control bank size and risk by other means.

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The lesson from MF Global for the management of a prop trading unit.

Much has been said about MF Global, the US brokerage and clearing group that filed for bankruptcy in late October. In March 2010, when Jon Corzine was brought in as the CEO, MF Global’s franchise in brokerage and clearing operations was strong, but had tallied a string of losses. Corzine was tasked with cutting expenses and returning those operations to profitability. But that wasn’t good enough for him. He wanted to transform the firm into a major league investment bank, expanding into market making in fixed income instruments as well as adding asset management, advisory and capital market services. Corzine also sought to transform proprietary trading into a major source of profit for the firm.

Proprietary trading was something more to Jon Corzine than simply another line of business. He personally stepped in to make an outsized bet on the Eurozone sovereign debt crisis. The firm took a long position in bonds of financially stretched European countries with loans secured by the bonds themselves. To avoid the risk of refinancing, MF Global arranged the trade to be funded until the maturity of the bonds. If everything went according to plan, for a ten percent haircut on the collateral, the spread between the EU high bond yields and the overnight rate would generate €400-€500 million in profit for the company.

As Aaron Lucchetti and Julie Steinberg, of the Wall Street Journal report, MF Global’s Chief Risk Officer, Michael Roseman, warned of the dangers of the trade: he “contended MF Global didn’t have enough spare cash to withstand the risks of its position in bonds of Italy, Spain, Portugal, Ireland and Belgium. He also presented gloomy hypothetical scenarios of what could happen if MF Global’s credit rating was downgraded because of the exposure.” Nevertheless, Corzine held firm and the Board did not restrain him.

MF Global’s lenders grew worried over the summer as the collateral lost a good deal of value. They demanded the company post additional margin, and when the company was unable to do so, they called the loans. With no additional credit available to the firm, MF Global had no choice but to liquidate the portfolio at very disadvantageous prices, for the market for bonds of highly indebted European countries is very illiquid. Ultimately, the bad bet forced the company into bankruptcy.

There are many lessons that can be drawn from the collapse of MF Global. One that we would like to highlight has to do with the proper place of prop trading in a larger business. We see no problem with standalone prop trading units – hedge funds, as they are sometimes called. When the prop traders are gambling using their own balance sheet, they are forced to fully bear any risk of failure. But when the prop traders share a balance sheet with other lines of business – like MF Global’s brokerage and clearing operations – the danger arises that they are gambling using the capital of other units without paying for it. When MF Global’s bet went bad, it lost more than the price of that bet. It wiped out the long-term health of the brokerage and clearing franchise. That is a dead weight cost produced by having the two operations share a balance sheet.

Was that potential cost factored in when taking the original bet? We doubt it. Measuring the capital at risk from proprietary trading is a difficult task. Traders habitually underestimate the risks of their trades and the capital required to run their operation. MF Global structured it’s repo-to-maturity deal to seemingly hedge out key risks, thereby benefitting from an accounting trick that kept its bet off of its balance sheet and out of sight of the market. But that accounting treatment ignored the huge liquidity risk created by the need to hold onto the position to maturity. That liquidity risk put the entire balance sheet of the firm on the line. Ultimately, one of MF Global’s regulators, FINRA, flagged the risk and demanded more capital, forcing more disclosure.

One way to discipline traders is to give them their own balance sheet. With no one to blame but their operation, the tradeoff between risk and return is more carefully scrutinized. A stand alone balance sheet isn’t the only tool for disciplining traders, but it is certainly the most reliable. Companies that decide, for whatever reason, to put the proprietary trading unit onto the same balance sheet with other activities, had better have superior disciplinary tools at their disposal than what MF Global had.

Prop trading under the guise of hedging: The forgotten lesson of Metallgesellschaft and the Volcker Rule

In the world of finance, the name Metallgesellschaft (MG) is known primarily as one of the early “derivative disaster” cases. MG was a metal, mining and engineering company, and the 14th largest corporation in Germany. At the start of 1994, the company stood on the brink of bankruptcy because of more than $1 billion in losses racked up by a small trading office in New York with a big bet in oil futures. MG’s debacle sparked a vigorous debate—our contribution is here, and a collection of many contributions is available here.

MG was short on a set of long term contracts for the delivery of refined oil products to small businesses for periods of up to 10 years. Many of the contracts were negotiated with a fixed price, while others had more complicated terms. On the other side, MG was long a set of crude oil futures or OTC swap contracts for delivery in one to six months. Taken together, this looked like a long dated short position in the physical hedged by a short dated stack of futures. The critique focused on two questions. First, was the short dated stack a successful value hedge, or had traders at MG failed to accurately “tail the hedge”? Second, did the attempt to hedge such a long horizon physical obligation using derivatives subject the firm to one-sided margin calls, producing a liquidity crisis that the firm could not withstand? From these two questions flow a host of related questions about alternative designs of a better hedge, about the accuracy with which the accounting reflected the underlying financial reality, and governance.

From the narrow perspective of financial engineering, these are all useful questions to consider. However, these questions all start from the premise that the task is to hedge the company’s given exposure on the physical contracts. That is what the situation looked like at first glance, from outside. But courtesy of the acrimony between the team that crafted the failed futures trading strategy and the corporation that dismissed them, a number of internal documents with details on the strategy became public.

Those documents reveal that this premise was incorrect. The traders at MG operated under a very different premise: the long futures position was the real source of profit. If it had been up to them, they would have concentrated on building it up. However, corporate risk management rules limited the quantity of long futures contracts to the volume of physical deliveries. The traders, therefore, had an incentive to market the physical delivery contracts. The more they expanded their long positions in the futures contracts, the more they could loosen the limits imposed by the internal risk limitations, and expand speculative trades. The long futures position only looked like a hedge. In fact, it was a speculation. Traders used hedging to engage in risk taking.This was a classic prop trade disguised as a hedge of a customer facing transaction. When the prop trade blew up, it nearly brought down the entire firm. This aspect of the case is often forgotten.

Eighteen years later, this lesson from the MG case has renewed relevance in light of the $2 billion trading loss by trader Kweku Abdoli at the Delta One desk of the Swiss bank UBS. That spectacular loss gave a fresh reminder of the dangers posed by prop trading at banks, and of the need for prohibitions like the Volcker Rule. So long as taxpayers are the backstop for banks, the traders, the management and shareholders do not suffer the full penalty of the risks from trading. Opposition to the Volcker Rule by bankers is strong, and takes many forms. They argue that any customer facing business, like a Delta One desk, is protected from the prohibition by the mere fact that it is customer facing. This is nonsense. Thankfully, the current draft regulations for the Volcker Rule look to all of the fingerprints of prop trading, and do not provide any such simplistic exceptions. Both the MG case and the UBS case show that prop trading can operate under various guises. It’s prop trading that is the problem, regardless of how it is cloaked.

The Promise and Pitfalls of Indexed Debt

The promise

We saw two recent commentaries by eminent economists advocating the use of indexed debt instruments.

Ken Rogoff, of Harvard’s Economics Department, was interviewed in the McKinsey Quarterly about the current Great Recession and what can be done about it. Among a number of other points about long-run structural reforms, he says that:

And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.

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A Silver-Linked Dividend Without the Silver Lining

Hecla Mining Co. is copying Newmont’s strategy. It announced last month that its dividend will be linked to the price of silver:

All dividends, including those in the third quarter, would increase or decrease by $0.01 per share for each $5.00 per ounce incremental increase or decrease in the average realized silver price in the preceding quarter.

Here’s the resulting payout diagram:

Data from January 1999 to October 2010 show that, with the brief exception of the summer of 2008, silver prices have never been above $25. Prices above $30 are a phenomenon of the last twelve months. Expecting silver prices to go up in the future, Hecla is giving investors extra leverage…if its prediction comes true.

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It’s not all about end-users.

The US Chamber of Commerce is hosting a “fly-in” of corporate representatives tomorrow to lobby Congress and regulators on derivatives reform. They are advocating for a House bill (H.R. 1610) that would block financial regulators policing the risk on bank balance sheets.

The Chamber says it wants to allow end-users to buy swaps and other derivatives without posting margin.

But that’s not really what’s at issue. The Dodd-Frank Act already includes a specific exemption for end-users who are hedging their business operations.

What’s at issue is how much credit risk ends up on the balance sheet of banks. Banks are free to sell end-users non-margined swaps. But each non-margined swap the bank sells adds credit risk to the bank’s balance sheet. That credit risk adds up.

A prudently managed bank will have policies, procedures and controls to assess how much total risk it has in its portfolio of non-margined swaps. It will have to put aside capital in proportion to the risk.

Not all banks can claim to have an impeccable track record in managing the risks on their derivatives portfolios. As if 2008 wasn’t enough of a lesson, the recent $2.3 billion loss at UBS is another reminder. Apparently at UBS the cause was compliance failure. Systems cost banks money, and the incentives to dedicate resources to maintain controls at times vanish. Remember BP’s Horizon deepwater well? No difference, here.

Risk management is also quite challenging when banks and swap dealers offer counterparties tailor-made and complex derivatives contracts – the so called Level-3 assets, which may not trade and are priced based on an in-house model, precisely the swaps that are non-margined.

All this calls for banks to put aside more resources to manage risks and more capital.  The problem is that both eat into banks’ return on equity.

In April, five regulators – the Federal Reserve Board, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Office of the Comptroller of the Currency – published a proposed rule detailing what would be required of the banks. Under the rule, banks are free to sell an end-user a non-margined swap. But banks must have appropriate policies in place to assess and manage the risk and must put aside capital to cover the risk.

H.R. 1610 is a directive to the financial regulators to turn a blind eye to the credit risk from non-margined swaps.

From exemption to exemption, from special case to exception, if we follow the Chamber down this path, we will find ourselves in another financial mess.

A gold-linked dividend in the modern gold rush

Earlier this year, the Newmont Mining Corporation announced that future dividend payouts would be linked to the price of gold. For every $100 increase in the average price received on its sales of gold, the annual dividend would be increased by 20¢ a share. From the Newmont deck:

What does the promise of a gold-linked dividend provide above and beyond what investors in Newmont already had?

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