Category Archives: hedging

Tax Reform & Derivatives

Representative Dave Camp, Republican Chairman of the House Ways and Means Committee, has released a discussion draft on new rules for the taxation of derivatives. The press release is here. Detail material is found here.

In the draft, derivatives used for hedging are excluded. The criteria proposed here for determining whether a derivative is used for hedging in tax accounting are similar to the criteria already applied in financial accounting. However, a large fraction of derivatives held by non-financial companies are not accounted for using hedge accounting. So, it seems to me that this proposal would probably affect the tax treatment of those holdings.

It will be interesting to see how this discussion unfolds.

Crude oil basis risk is receding… for now.

Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.

However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.

Historical Spreads 2

This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.

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Prop Trading at JP Morgan

JPMorgan’s management released its Task Force Report (Report) on the trading losses at its Chief Investment Office (CIO). It’s very clearly written tick-tock and provides a good account of how various controls broke down. Taking for granted the task assigned to the traders running the CIO’s Synthetic Credit Portfolio, the report outlines where things went wrong.

As an accident of timing, the losses were first disclosed in the midst of a public debate about the Volcker Rule’s prohibition on proprietary trading at banks. So, for the public, the case became a test of whether the proposed regulations implementing the Volcker Rule had any teeth: would they prohibit the trades being done at JPMorgan’s CIO once they came into force? Management has always contended that the Synthetic Credit Portfolio was run to hedge the bank’s natural long position in credit risk, and that it was not proprietary trading and would not be prohibited under the Volcker Rule. That contention is repeated summarily in the Report when it gives an introductory overview of the Portfolio’s origin and operation. But, the contention is never actually substantiated: indeed, the Report does not purport to address the prop trading question directly.

There is much in the Report that would lead a reader to doubt management’s contention and to conclude instead that the Synthetic Credit Portfolio was a classic example of prop trading.

A key forensic test for distinguishing prop trading from hedging is the compensation criteria. A hedger’s success is not measured by his or her own profit and loss on the hedge trades. Instead, a hedger’s success is measured by how well his or her own profits and losses track and set off the losses and profits on the assets being hedged. The metrics for performance on hedging should incentivize minimizing net risk. The metrics should measure net risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one. The JPMorgan Report strongly suggests that the traders on the Synthetic Credit Portfolio expected to be rewarded on their own profit and loss, not on how successfully they hedged the bank’s natural long position. That compensation system fits prop trading, not hedging.

The Report does briefly consider the wisdom of the compensation scheme, but not from the perspective of the Volcker Rule and identifying prohibited activities. Instead, the Task Force was just concerned with the question of whether the profit and loss criterion was overvalued to the exclusion of other criteria management imposed on the unit.

So, it looks as if JPMorgan’s CIO, and its Synthetic Credit Portfolio provide a useful test case for the Volcker Rule going forward. The original regulations proposed for implementing the Rule did include an assessment of compensation criteria. Whether that will continue in a final rule is yet to be seen. And then comes the question of enforcement.

 

 

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.

Prop-Flow stands convicted, too.

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.

Was Ina Drew a Hedger or a Speculator?

This Sunday’s New York Times Magazine included a piece by Susan Dominus about Ina Drew, the former Chief Investment Officer (CIO) at JP Morgan who resigned following the outsized trading loss in her unit. The focus of the piece is on the rough and tumble of a woman trying “to succeed as an interloper in the Wall Street boys’ club. But buried within the piece is a repeated confusion of hedging with proprietary trading. Dominus repeatedly describes Drew as responsible for hedging this or that risk facing the bank, but immediately afterwards Dominus lauds Drew’s uncanny ability to predict where the market was heading and so to be a profit center. Since the question of whether JP Morgan’s CIO was or was not hedging is at the heart of the public policy dispute surrounding JP Morgan and the Volcker Rule (see here and here), it is worthwhile addressing the confusion in Dominus’ piece.

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¿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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Exelon’s On- and Off-Balance Sheet Collateral Costs

In covering the Intercontinental Exchange’s decision to move its energy swap trades onto its futures exchange, the Wall Street Journal’s Jacob Bunge and Katy Burne cited data on the power company Exelon in order to highlight how this move might impact end-user costs:

One company worried about costs, Exelon Corp., said in a regulatory filing on May 10 that “even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral.”

But the $1 billion figure is only half the story. The other half of the story is the contingent capital that Exelon saves. But since that contingent capital is off-balance sheet, it is commonly overlooked, leading both corporate executives and reporters to significantly exaggerate the cost of using cleared futures exchanges.[1]  In comparing the financing costs of non-margined OTC trades against the financing costs of exchange-traded derivatives, it’s important to look at both the on- and off-balance sheet capital demands.

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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.

Chesapeake’s Two Natures

In yesterday’s post I said that Chesapeake’s management was speculating on natural gas and oil prices. But Chesapeake claims that it is a hedger. Speculating and hedging are different things, so is Chesapeake a hedger or a speculator?

In representations to regulators, Chesapeake’s Vice President for Finance and Assistant Treasurer, Elliot Chambers, has stated categorically that “we never speculate.” Is that true? Is his definition of a speculator the same as mine?

Chesapeake is a hedger. It uses exchange traded futures and options, OTC swaps, and a specialized financing vehicle called Volumetric Production Payments, among other things, to mitigate the price risk on its production and “predict with greater certainty the effective prices we will receive for our hedged production.” (10K for FY2011 p. 72)

But Chesapeake is also a speculator. The company is straightforward in its SEC filings that it tries to profit off of price swings: “We intend to use this volatility to our benefit by taking advantage of prices when they reach levels that management believes are either unsustainable for the long term or provide unusually high rates of return on our invested capital.” (10K for FY2011 p. 6) “Depending on changes in natural gas and oil futures markets and management’s view of underlying natural gas and oil supply and demand trends, we may increase or decrease our current derivative positions.” (10K for FY2011 p. 59) “Our general strategy for attempting to mitigate exposure to adverse natural gas and oil price changes is to hedge into strengthening natural gas and oil futures markets when prices allow us to generate higher cash margins and when we view prices to be in the upper range of our predicted future price range. Information we consider in forming an opinion about future prices includes general economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.” (10K for FY2011 p. 87) As I related in yesterday’s post, Chesapeake’s decision last fall to remove its natural gas hedge was based on its prediction that prices were temporarily low and would recover, allowing it to replace the hedges and capturing a profit on the short-run volatility. This is all speculation.

A company can be both a hedger and a speculator.

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