Monday, January 30, 2006

Why We Trade (Futures and Derivatives)

My posting two weeks ago on energy trading elicited several comments, including one requesting my views on how risk management benefits those with actual supply or demand, as opposed to a purely speculative interest in the market. This is a question I used to field on a regular basis, when I was in the market. The top managements of companies that produce, refine and distribute oil and gas are often suspicious of these trader types--including their own trading staffs, at times--so I had to have a ready answer for this. As the market became more sophisticated with the introduction of all sorts of derivatives, the answer got a little more complex, too.

There are at least two fundamental reasons for "hedging" commodity price risk using futures, options and derivatives . I have always felt the second was more important (and valuable) than the first, though they can wind up overlapping for smaller firms:

During the time a barrel of oil is produced, transported, refined, and distributed to the point of sale, market prices can change significantly. This creates a whole chain of realized or unrealized profits and losses along the way, depending on whether the transactions involved are between business units of one company or between unrelated companies. Being able to fix, or "lock in" all or a portion of the revenue as soon as the oil is produced or acquired makes the resulting cash flows, which may be large enough to affect the firm's bottom line, much more reliable and predictable. The key is making sure that the financial instrument used for hedging has a close enough correlation to the actual commodity being hedged, to match paper profits or losses to their physical-world counterparts. In other words, as an old boss of mine used to say, "What you lose in the grapes you make up in the bananas."

There's an argument in finance that the transaction costs of this kind of activity are simply a drain on shareholders. Equity investors should be astute enough either to manage these risks for themselves, or ignore them, because they are part of the risk they want to hold. Anyone who has seen the price of a company's stock drop 10% or more because it missed a quarterly earnings-per-share estimate by 5 cents will be pretty skeptical of this advice. And note that a routine program of executing market transactions to smooth commodity cash flows is philosophically (and legally) very different from doing extraordinary, off-market transactions to shift profits or losses from one period to another, or manufacture them out of thin air.

The deeper argument for hedging is that it enables companies to do deals they wouldn't do otherwise, because they couldn't stomach the resulting risk. Doing riskier deals and laying off some of that risk is thus a non-zero-sum activity, because it provides economic value from activities that wouldn't have happened without a hedge. An example might be in order:

If you live in the Northeast and use heating oil, you've probably at least been tempted to buy your oil at a fixed price for the entire winter season, or the whole year. But when you look at the way heating oil prices fluctuate, as a function of crude oil prices, refining margins, and other supply and demand factors, you can appreciate that your local heating oil company--probably a fairly small business, compared to the major oil or refining companies--couldn't possibly absorb all that volatility without running a big risk of going bankrupt every year. Instead, they--or their supplier--hedge that risk using some combination of futures, options and derivatives to create a fixed price contract, which they can then extend to you, for some fixed markup.

All of this hedging depends on a liquid market--one in which transactions of the necessary size can be done whenever needed--with enough counterparties willing to go the other way. If the only players in that market were your competitors in the same segment of the industry, e.g. other heating oil suppliers, isn't it likely that most of them would want to go the same direction on any given day, because you're all looking at the same business drivers? That's where speculators come in. This is no different than the stock market; when you sell shares, you need there to be someone willing to buy them at a mutually-agreeable price, and not just because his situation mirrors yours perfectly.

Multiply this across the whole market, and you get a pretty complex place filled with producers, refiners, marketers, end-users and lots and lots of speculators from Wall St. firms and hedge funds. Each needs the others, if the market is going to serve their collective needs. And as long as the markets aren't manipulated or "cornered", society as a whole benefits from economic activity at every level of the market, at least some of which wouldn't have happened otherwise.

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