Friday, December 03, 2004

When Is Risk Management Not?
I don't know how much I can add to what's being said about the problems of China Aviation Oil, a Singapore-based petroleum products trading company that has run up derivatives losses on jet fuel of around a half billion dollars in the last several months. The situation is being called everything from the result of a rogue trader to a warning about the governance of Chinese corporations. At a minimum, it serves as another cautionary tale on the need for absolute discipline in the area of price risk management.

We used to call this stuff hedging, until the proliferation of new tools such as options and derivatives--and the math and software to analyze and manage them--made the old term imprecise and unsophisticated-sounding. But for a firm with exposure to price risk on real physical barrels, the basic principles never really changed: understand the risk, match the "basis" (the relationship between what is being hedged and the commodity/location for which a futures/options/derivative contract is available) as closely as possible, see where you are at the end of every day, and never lose track of the connection between the value of your physical commodity and your profit/loss on the hedge.

What is not clear from the coverage I've seen is this final, all-important question about the value of the physical oil. If CAO was able to capture all of the upside on its physical jet fuel transactions that it gave away on the derivatives contracts it entered into, then what we have here is an accounting problem and a large opportunity cost. But if, as the articles hint, CAO was essentially buying and selling product at market prices, while taking a speculative bet on the price of jet fuel and rolling their losses forward in hopes of a market dip, then you have the worst possible nightmare for the person with ultimate responsibility for this activity: high-stakes casino gambling masquerading as risk management.

Derivatives make an easy scapegoat for losses like these, but I suspect the traders involved could have run up nearly as much red ink doing the same thing in the futures markets, or perhaps more, since they'd have been limited to the commodities and locations for which liquid futures exchanges exist, thus taking on not only price risk but large basis risk, as well.

Whenever an event like this occurs, it gives a black eye to trading and risk management, but it shouldn't deter anyone from using these extremely useful tools, as long as they have clear policies and controls in place, along with the kind of accounting that makes it difficult to obscure losses that are being rolled forward.

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