Better the Devil You Know: Changes in the commodity market over the last 10 years: Lindsay Horn

Less than 10 years ago the Wall Street Banks were on top of the oil trading heap and their client business in derivatives was an important source of profit for the banks and a major entry point for any corporate hedger.   Things have changes in the last 10 years.

First, some open disclosure. I worked at Goldman Sachs for 17 years and I am still a shareholder. All my comments here are completely based on data in the public domain.  Here are some of the main changes in the commodity business over the last ten years. These have led to some unexpected consequences and it seems that corporate hedging is moving backwards rather than forward. Might corporate hedgers been better to stick with the devil they know?

Many things have gradually changed in the commodity markets over last 10 years. The Lehman Brothers’ bankruptcy and the 2008 crash are the stand-out events, so this is probably the best place to start.

1. Lehman Brothers (LB) bankruptcy leads to wider counterpart dealing.  Apart from triggering the 2008 financial crash, the LB bankruptcy also had the very simple effect of stopping the polarization of business within a very small group of banks.  I recall getting sometimes as much as 50-75% of a corporate client’s business. Very few banks lost money to LB as all their deals were under a zero margin trigger in their ISDA Credit support annex. A zero margin trigger means that mark-to-market position is always zero. Monies change hands ever day throughout the duration or tenor of the transaction, either positive gains or negative losses, until the final settlement day. However, the potentially daily exchange of monies requires an active treasury department. Most corporates could either not manage such daily transactions or could not be bothered. Corporate clients did lose money in the LB bankruptcy, because they did not want to post margins to Lehman or any other bank, as they were dealing on an open credit basis. In return for not paying any variation margin to LB, their corporate clients did not in turn receive any positive variation margins from Lehman Brothers. It was these mark-to-market gains that were lost in the bankruptcy. LB was no different from any other banks in its dealings with corporate clients on open credit. Sadly, it was Lehman that went bankrupt.

   It is in the public record the Lufthansa lost $20 million in the Lehman LB. Lufthansa has one of the most respected treasury departments in the airline business. It was well known in the industry that Lufthansa has a graduated hedging program that extended out to 4 years in the future. In fact, they were considered the best hedging practice model for other airlines to follow.  It was their mark-to-market gain from this hedging programme that was lost.  As the oil market fell from its peak of $145/bbl in mid-2008  to a low of $38/bbl in December 2008 many corporate clients had massive mark-to-market losses. The losses were largely on the side of consumers who are naturally short in the market and have bought forwards oil positions. As most corporates did not have margin triggers in their contracts with the banks, it was the banks who had the problem.  Thus the oil market became part of the global banking crisis

   The regulatory framework had officially changed prior to the 2008 crash when MIFID I came into effect in November 2007. Now every bank preferred to deal only with “counterparts” who, by definition, were market professionals and met high minimum net worth criteria.  Post -November 2007 any reference to client or advice was removed from all bank presentations. This was considered to release the banks of any fiduciary duty to “clients”.

2. Credit pricing or CVA. Credit Valuation Adjustment, or a price for every client that takes account of their market-determined credit valuation, is now standard when trading OTC with counterparts.  The CVA charges will take account for the counterpart’s credit rating and the price of their credit default swaps in the market. There is no CVA when counterparts deal with each other under a zero-margin trigger as there is no risk in this type of deal. A zero margin trigger means that mark-to-market position is always zero. Monies change hands ever day throughout the tenor of the transaction, either positive gains or negative losses, until the final settlement day. However, the potentially daily exchange of monies requires an active treasury department. Most corporate could either not manage such transaction or could not be bothered. Corporate clients did lose money in the LB bankruptcy, because they did not want to post margins to LB or any other bank, as they were dealing on an open credit basis. In return for not paying any variation margin to Lehman Brothers, their corporate clients did not in turn receive any positive variation margins from LB. It was these mark to market gains that were lost in the bankruptcy. LB was no different from any other banks in its dealings with corporate clients on open credit. Sadly, it was Lehman that went bankrupt.

   Zero margin trigger business was standard with interbank dealings and deals with hedge funds.  When CVA was introduced more widely post the 2008 crash, it was no longer simply a question of what price a dealer was prepared to do the transaction at, but a combination for transaction price and CVA charge. Initially different banks had a very different view of how to charge CVA. Those banks that did not charge CVA gained market share over those who did. This helped Continental European and Canadian banks get a leg up on Wall Street.  It is rather Ironic that the first-class banks who were acting in the best interest of market best practice and their shareholders lost business to second and third tier banks whose credit operation were more basic.

   Post 2008 the corporate clients still wanted to deal on open credit with no variation margin arrangement.  Lufthansa led a campaign suggesting that airlines should be excluded from the financial margining and compulsory clearing proposals agreed at the G20 Summit in London in April 2009. (These has still not been fully implemented.) One of the simplest way to limit your risk and maximize your credit lines was to use more banks as counterparts. It is not at all surprising for airlines now to have 20-30 counterparts for hedging. What this means is that the amount of business many banks get from a counterpart is now so small that they are simply not worth covering from a bank sales perspective. So all sorts of ancillary services, such as what was previously called “advice” or “research” may now be lost to the client. All corporate clients are now classified as “counterparts”. As mentioned above this is considered to relieve the banks of many fiduciary duties to what used to be called clients. De facto it now also means that what were previously regarded as client services are now being cut to the bone.

   One of the alternative ways to avoid CVA is to buy options. This limits the banks credit risk to the payment of the premium on “T+2”. In other words payment of the full option premium is due two days after the transaction date. Many corporates were so obsessed with what their credit charges were for different counterparty banks that they may have lost sight for what the risk management strategy was aiming to achieve. It is now more than 30 years since NYMEX (now the CME) and shortly followed by the IPE (now ICE) began their traded options market in crude oil. Yet many corporates still “do not do options”.

   Funny how the senior executives of corporates can get their mind around their own personal stock options, but cannot manage traded options to hedge their businesses.

3. Dodd Frank. The post-crash Dodd Frank (DF) legislation in the US, specifically the Volcker Rule, and its equivalent elsewhere has put severe limits on proprietary (Prop) trading. The DF description for Prop trading runs to 300 pages.  Additionally, since all the Wall Street Banks are now supervised by the Federal Reserve, they need waivers to continue to trade in physical oil. The fall in Prop trading has impacted the volume and liquidity in the markets. Today algorithmic trading dominates 60-65 % of all futures transactions. Longer dated business has dried up.
4. Accountancy rule changes. From 2005 through to 2009 international accountancy rules changed on issues of mark-to-market on hedges and open disclosure to shareholders and investors. For example, embedded optionality is a powerful asset for any corporate. Post 2009, many firms were not prepared to openly declare their embedded options within hedges and they reverted to plain vanilla structures.  By not monetizing “natural options” that firms possess, firms may be missing a trick. In today’s market any corporate selling “natural options” with the exchange or its OTC counterparts would have to pay a variation margin. Even though this may in fact be in the best interest of the firm, it is something that many corporates cannot be bothered with.
5. Cleared business.   The G20-mandated move to make clearing compulsory has focused attention for many medium-size oil companies as to what exactly their “trading operations” are trying to achieve. Specifically, many firms are worried that they may be dragged into some form of vast regulatory net, with implication for their capital structure. This fear now seems to be limiting many firms’ risk management activity in the futures. It is easier to say that the firm does not use these trading instruments than to face what many corporates think is a potential regulatory quagmire. Opportunities are being lost.

In my many years working within the banks that offer energy derivatives, some of my corporate clients (now counterparts) knew exactly what they wanted to do. However, on many occasions I had to research the financial structure of the firms and study their annual reports and investor presentations to come up with the most efficient and effective hedges. How many banks are paying people to do this today? Not many.

I notice that a few banks have moved some key commodity people from their FICC (Fixed Income, Currencies and Commodities groups) to their Investment Banking divisions. This means that advice can be given to key corporate clients from the banking division. The other corporates that are not large enough or interesting enough to investment banking clients, will need to fend for themselves amongst the pared-down commodity banks, oil traders, futures brokers and “trading boutiques” that have sprung up since 2008. Wouldn’t it have been better to stick with the devil we knew?

Lindsay Horn. Visit Lindsay's bio HERE