Tuesday, May 31, 2005

Trading Lessons
It's easy to imagine that the global crude oil price increase of the last eighteen months or so has created fat times for oil traders, and indeed a number have made vast sums by being on the right side of this market. But as this recent story from the Financial Times (subscription may be required) reminds us, oil trading is far more complex than simply betting on the absolute price of oil. The changes in supply and demand underlying the higher oil price have also distorted many of the traditional relationships among various grades of oil and petroleum products. A little further explanation is in order, to understand how the trading profits and losses from this kind of transaction might overwhelm those of the overall market runup.

Trading in oil commodities has become as sophisticated as that in equities or bonds. While the futures and options on the New York Mercantile Exchange (NYMEX) and London's International Petroleum Exchange (IPE) are the most visible manifestations of this trade, oil traders--including those at energy companies, banks and hedge funds--have been using a variety of derivatives for more than fifteen years, in order to address price relationships not directly covered by the futures markets.

For example, an airline interested in protecting itself from spikes in jet fuel prices has several alternatives for managing this risk. They might simply look for a fixed price contract, putting all of the risk onto their supplier. Alternatively, they could choose to manage only one facet of their risk, such as the differential between jet fuel and diesel fuel, the production of which refiners can maximize at the expense of jet, particularly for winterization. (Ordinary diesel fuel has a tendency to gel at very low temperatures, and the addition of kerosene, the main component of jet fuel, combats this tendency.) In this case, they'd buy a derivative, or swap, covering that difference only, for a specified time period. If the actual price relationship were wider than what was agreed, they'd collect enough to cover the difference, and if it ended up narrower, they'd pay out the difference but still have the benefit of what they had "locked in."

Such "differential swaps" are extremely common and cover every imaginable difference in grades of crude oil and refined products. Each is customized to the situation. Although I'm not aware of any industry statistics on this, I wouldn't be surprised if the dollar volume of such swaps approached the magnitude of all bets on absolute price. But as the FT suggests, these swaps can generate surprising outcomes that are difficult to manage further. If I sold a swap of a million barrels volume on a differential that historically varied between 10 and 50 cents per barrel, I might gauge my exposure to be between $100,000 and $500,000. But if this relationship blew out to $2/barrel, I might be on the hook for four times what I expected, when the contract expired and was settled. These are the kinds of losses that some traders may be facing today.

In my experience, even many professional derivative traders lack sufficient experience with the physical commodities that underlie these "paper products", and so have only a superficial understanding of the production, refining, and distribution complexities involved. Most of the time, this doesn't matter, but when the market is changing fundamentally, as it may be currently, its capacity to create expensive surprises grows dramatically. Individual investors should think long and hard before dabbling in such instruments, as an alternative to more staid investments.

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