Streetwise Professor

January 29, 2019

Bo Knows Hedging. Not!

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 7:42 pm

Chinese oil major Sinopec released disappointing earnings, driven primarily by a $688 million loss at its trading arm, Unipec. The explanation was as clear as mud:

“Sinopec discovered in its regular supervision that there were unusual financial data in the hedging business of Unipec,” it said in a statement. “Further investigations have indicated that the misjudgment about the global crude oil price trend and inappropriate hedging techniques applied for certain parts of hedging positions” resulted in the losses.

Er, the whole idea behind hedging is to make one indifferent to “global . . . price trend[s].” A hedger exchanges flat price risk–which, basically, is exposure to global trends–for basis risk–which is driven by variations in the difference between prices of related instruments that follow the same broad trends. Now it’s possible that someone running a big book could lose $688 million on a big move in the basis, but highly unlikely. Indeed, there have been no reports of extreme basis moves in crude lately that could explain such a loss. (There were some basis moves in some markets last year that were sufficiently pronounced to attract press attention but (a) even these did not result in any reports of high nine figure losses, and (b) nothing similar has been reported lately.)

The loss did correspond, however, with a large downward move in oil prices. Meaning that Unipec probably was long crude. Some back of the envelope scribbling suggests it was long to the tune of about 17 million barrels ($688 million loss at a time of an oil price decline of about $40/bbl.) Given that Unipec/Sinopec is almost certainly a structural short (since Sinopec is primarily a refiner), to lose that much it had to acquire a big enough long futures/swaps position to offset its natural short, and then buy a lot more.

One should always be careful in interpreting reports about losses on hedge positions, because they may be offset by gains elsewhere that are not explicitly recognized in the accounting statements. That said, as the Metalgesellschaft example cited in the article shows, for a badly constructed hedge, or a speculative position masquerading as a hedge, the derivatives losses may swamp the gains on the offsetting position. In the MG case, Merton Miller famously argued that the company’s losses on its futures were misleading because daily margining of futures crystalized those losses but the gains on the gasoline and heating oil sales contracts the futures were allegedly hedging were not marked-to-market and recognized and did not give rise to a cash inflow. I less famously–but more correctly ;-)–did the math and showed that the gains on the sales contracts were far smaller than the losses on the futures, and what’s more, that the “hedged” position was actually riskier than the unhedged exposure because it was actually a huge calendar spread play: the “hedge” was stacked on nearby futures, and the fixed price sales contracts had obligations extending out years. This position lost money when the market flipped from a backwardation to a contango.

Mert did not appreciate this when I pointed it out to him, and indeed, he threw me out of his office and pointedly ignored me from that point forward. This led to some amusing lunches at the Quandrangle Club at UC.

So perhaps the losses are overstated due to accounting treatment, but I think it’s likely that the loss is still likely a large one.

The Unipec president–Chen Bo–has been suspended. I guess Bo didn’t know hedging.

Bo wasn’t the only guy to get whacked. The company’s “Communist Party Secretary” did too. So Marxists don’t understand hedging either. Who knew?

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18 Comments »

  1. What this reminds us, yet again, is there is a large part of the world that completely, totally fails to understand what a hedge actually is, does, or should be expected to deliver.

    I once listened to a presentation given by some guys from, I think, Deloitte. They audit 30% of the world’s airlines or something, so they did some research among their many airline clients into the effectiveness of their hedge policy versus its aims.

    The standout finding was that, broadly, airlines didn’t agree even at the same company on what those policies’ aims were.

    – The purchasing director typically thought hedging was for making jet fuel cheaper, and if it didn’t, it failed.
    – The sales director thought it was to enable him to discount seat prices.
    – The operations director thought the airline hedged because the other airlines hedged, and why would you introduce a new variable?
    – The FD thought it was to make earnings projections more accurate and thereby make finance cheaper.
    – The CEO often thought it was “a crap shoot” but a potential source of speculative profit.

    One airline gave its fuel hedge desk a budget of $10 million to spend on option premia. The C-suite were happy because this crafty restraint on its traders meant the airline could never lose more than $10 million, right?

    Here are two fun news stories about Air China. From 2012, “Air China’s jet fuel costs were Rmb34.7bn last year, accounting for nearly 38 per cent of overall expenses. Its hedging positions – holdovers from before the ban – allowed it to recoup a mere 0.2 per cent of those costs.”
    https://www.ft.com/content/ffe9bca2-782e-11e1-b237-00144feab49a

    From 2015, “Air China…said profit rose 17 percent last year as the company’s decision not to use fuel hedges meant the plunging price of fuel lowered its operating costs.”
    https://skift.com/2015/03/27/air-china-didnt-hedge-fuel-costs-and-its-winning-as-a-result/

    Sane fucking airline. You couldn’t make it up.

    As you say, a refiner should be structurally short futures. Broadly, if you set up a new 100mb a day refinery that brings crude in by 2,000mb VLCC from a point six weeks’ voyage time distant, it will be short 4,000 lots of futures the day it refines its first barrel. After 10 days it will have refined 1,000mb of oil and should have bought back 1,000 lots of futures. But then it will buy another VLCC and short hedge another 2,000 lots.

    In a falling market they will made a lot of MTM money on crude short-hedges, cancelled by MTM losses on the value of their inventory. It should be a push more or less.

    The company probably does not understand what its traders have actually been doing, and I suspect that these figures and this commentary could well significantly mis-state the true position.

    Comment by Green as Grass — January 30, 2019 @ 4:44 am

  2. * tried to post this before but it’d not appearing… *

    What this reminds us, yet again, is there is a large part of the world that completely, totally fails to understand what a hedge actually is, does, or should be expected to deliver.

    I once listened to a presentation given by some guys from, I think, Deloitte. They audit 30% of the world’s airlines or something, so they did some research among their many airline clients into the effectiveness of their hedge policy versus its aims.

    The standout finding was that, broadly, airlines didn’t agree even at the same company on what those policies’ aims were.

    – The purchasing director typically thought hedging was for making jet fuel cheaper, and if it didn’t, it failed.
    – The sales director thought it was to enable him to discount seat prices.
    – The operations director thought the airline hedged because the other airlines hedged, and why would you introduce a new variable?
    – The FD thought it was to make earnings projections more accurate and thereby make finance cheaper.
    – The CEO often thought it was “a crap shoot” but a potential source of speculative profit.

    One airline gave its fuel hedge desk a budget of $10 million to spend on option premia. The C-suite were happy because this crafty restraint on its traders meant the airline could never lose more than $10 million, right?

    Here are two fun news stories about Air China. From 2012, “Air China’s jet fuel costs were Rmb34.7bn last year, accounting for nearly 38 per cent of overall expenses. Its hedging positions – holdovers from before the ban – allowed it to recoup a mere 0.2 per cent of those costs.”
    https://www.ft.com/content/ffe9bca2-782e-11e1-b237-00144feab49a

    From 2015, “Air China…said profit rose 17 percent last year as the company’s decision not to use fuel hedges meant the plunging price of fuel lowered its operating costs.”
    https://skift.com/2015/03/27/air-china-didnt-hedge-fuel-costs-and-its-winning-as-a-result/

    Sane fucking airline. You couldn’t make it up.

    As you say, a refiner should be structurally short futures. Broadly, if you set up a new 100mb a day refinery that brings crude in by 2,000mb VLCC from a point six weeks’ voyage time distant, it will be short 4,000 lots of futures the day it refines its first barrel. After 10 days it will have refined 1,000mb of oil and should have bought back 1,000 lots of futures. But then it will buy another VLCC and short hedge another 2,000 lots.

    In a falling market they will made a lot of MTM money on crude short-hedges, cancelled by MTM losses on the value of their inventory. It should be a push more or less.

    The company probably does not understand what its traders have actually been doing, and I suspect that these figures and this commentary could well significantly mis-state the true position.

    Comment by Green as Grass — January 30, 2019 @ 4:46 am

  3. I don’t suppose we’ll hear a peep out of Bo.

    “Merton Miller”: I’ve heard that almost all famous economists are arseholes. Can it be true? After all Adam Smith was a famously pleasant and convivial chap so why should the fellows who write footnotes to his work be so different?

    Comment by dearieme — January 30, 2019 @ 5:16 am

  4. I was a second quarter Ph.D student at the University of Florida in the early 70’s. Merton was there for a football game and my department head had me talk with Merton about my “research” which was essentially non-existent at the time. Anyhow, told him I was interested in how long it took information to get impounded in stock prices. Took me about 2 minutes and Merton went off on a very vicious, personal and direct tirade. It was an extraordinary overreaction. I was really hurt and depressed for a while but pressed on in the program. Then, in 1978 I published what (I think) was the first event study in the Journal of Finance. It showed that it takes about 45 days for unexpected earnings changes to get impounded in stock prices. Sent it to Merton but never heard from him.

    In re Sinopec: A lot of what is called hedging is really selective hedging wherein the firm puts on the hedge based on an opinion of the future direction of cash prices. You can call it a hedge all day long but it is really just speculation by another name.

    Comment by Profbrown — January 30, 2019 @ 6:42 am

  5. I had a case once where the company lost money on its commodity “hedge” positions and on the fuel inventory in the same month, which was a signal to management that the person responsible for hedging perhaps was just speculating. Indeed, that was true. There was no relationship between position size and timing and changes to fuel inventory.

    Comment by Jim — January 30, 2019 @ 2:10 pm

  6. Craig, and you were absolutely right! And although the publication of that article was LONG before my time on the staff, it is still a source of embarrassment. That article, and his related treatment of you, are the only bonehead moves I can recall MM ever having made.

    Comment by John L. McCormack — January 30, 2019 @ 5:03 pm

  7. @dearieme–Little Bo (Won’t) Peep? LOL.

    I can’t attest to “all,” but there are more than a few.

    Comment by cpirrong — January 30, 2019 @ 10:01 pm

  8. @John–You (well, JFCA) are allowed one screw up in 25 years. Don’t let it happen again! 😉

    The more Mert was criticized, the more defensive he became. He could not bear to admit that he could be wrong. That was really disappointing.

    Comment by cpirrong — January 30, 2019 @ 10:04 pm

  9. ‘Mert did not appreciate this when I pointed it out to him, and indeed, he threw me out of his office and pointedly ignored me from that point forward.’

    ‘The more Mert was criticized, the more defensive he became. He could not bear to admit that he could be wrong. That was really disappointing.’

    Belief Preservation/Perseverance is one hell of a drug.

    Comment by Global Super-Regulator on Lunch Break — January 31, 2019 @ 5:48 am

  10. Completely O/T but I came across this and thought it would interest you:
    U.S. Still Paying a Civil War Pension
    A North Carolina woman is the daughter of a Civil War veteran, and still collects his benefits.
    https://www.usnews.com/news/articles/2016-08-08/civil-war-vets-pension-still-remains-on-governments-payroll-151-years-after-last-shot-fired

    Comment by Green as Grass — January 31, 2019 @ 8:22 am

  11. Thanks @Green–interesting. 87 year old father. Well, I guess it’s possible, but . . . .

    Also interesting that he switched sides. Not that unusual in NC, especially in the mountain regions of the western part of the state. Secession not popular there.

    Comment by cpirrong — January 31, 2019 @ 3:42 pm

  12. O/T, but last I read and it was recently, President John Tyler’s two grandsons are still with the program, one living near the family homestead. Same deal, John Tyler had children very late, as did his son. History isn’t dead, it isn’t even past.

    Comment by The Pilot — February 1, 2019 @ 11:48 am

  13. Off topic Prof, thanks for writing your blog, I was just reading about Zero Hegde on wiki and you are in the footnotes.

    Thanks for expressing your views, it is difficult to find news sources I trust, what websites do you look at for news?

    Comment by Joe Walker — February 4, 2019 @ 7:42 am

  14. In the same vein there was a series of letters in the newspaper 20 odd years ago about what one might call living eyewitnesses. A chap in his 90s related how as a child he had talked about the battle of Waterloo to an elderly relative who was there. He was 10, the eyewitness was 106, and the conversation took place in 1916. The elderly gentleman was a camp follower – his father a soldier, his mother a cantiniere.

    Another letter was from someone who had once been scolded by a relative for speaking ill of Oliver Cromwell. The relative’s first husband’s first wife’s first husband had liked him very much.

    How that happened was that the woman was 90-odd when the conversation happened in 1930. She had been married at 16 (in 1850) to an old boy of 80; his first wife (when he was 16) was somehow a woman of 60-odd, born in 1720; and her first husband, also elderly, had met Cromwell 72 years before as a small boy.

    Astounding really.

    Comment by Green as Grass — February 4, 2019 @ 10:04 am

  15. This highlights what I refer to as “career risk” for the employee actually doing the hedging. The employee puts on a hedge, it “works” (e.g. there are financial gains on the hedge side), but the physical side “looses” (prices moved against the physical). The hedger/employee is happy because the hedge “worked.” In the mean time “pain” is felt throughout the company because the physical or core side of the business is hurting (for a producer that means lower physical revenue, plus it’s difficult to be 100% hedged for 100% of the foreseeable future). The hedge “made money” but the company starts laying off employees, reducing capital expenditures (for example). Take the flip side: the hedger/employee puts on the hedge (lets assume appropriately), the market moves “against” the hedge, the company “rationalizes” hedge “losses,” and in a worse case scenario for the hedger/employee, the company sh*t-cans the hedger or hedging group for “loosing money” on ill-timed, or ill-placed hedges. Career risk: heads you win, tails I loose.

    Comment by Bill Coorsh — February 5, 2019 @ 12:20 pm

  16. Craig,

    Did you ever read this paper by Bollen and Whaley?

    http://www2.owen.vanderbilt.edu/nick.bollen/research/nw4.PDF

    (Sorry I couldn’t link to the published version).

    From the abstract: “Further, using the actual series of prices since 1993, we show that the program would have generated more than $1.1 billion by March 1997 if left intact.”

    Also, Culp and Miller quote Holbrook Working on hedging as arbitrage, not _only_ for risk management purposes. Thought?

    Comment by TJB — February 16, 2019 @ 2:40 pm

  17. @TJB–Yes, I’m familiar with the Bollen & Whaley paper. What you quote actually undercuts the assertion that the strategy was a hedge. The huge variations in mark-to-market value of the strategy indicate just how speculative it was. And not surprisingly. It was a huge spread play.

    As I recall, Working essentially said that hedging is speculation on the basis. In this case, the strategy was a speculation on time spreads, and product spreads (because MG was hedging gasoline and heating oil prices using crude for the most part). The point is that the structure of the position was a huge spec, especially on calendar spreads. The people at MGRM told the MG supervisory board that the strategy would make money on the roll, and was a hedge, i.e., it would reduce risk. Both of these things are bullshit. There is no such thing as a roll profit based on backwardation (something I’ve blogged about in the past, and one of my pet peeves). It was not a hedge in any way shape or form. It did not reduce risk–it increased it.

    In my article I show that MGRM’s position was riskier with futures than without it (in essence because the position was more than 2x the variance minimizing hedge). No matter how Miller, Culp, Whaley or MGRM management try to spin it, it was a massive spec play that lost real money. The fact that it would have made money if held brings to mind the gambler’s fallacy.

    Culp-Miller also claimed that the losses were illusory because they were the result of a cash flow mismatch (futures being subject to variation margin, the sales contracts not). Also bullshit. The position lost massively on a MTM basis. The margin flows were bigger than the MTM loss because the gains on the contract indeed offset some of the futures losses, but the position was a bull spread and the spread declined substantially, meaning that it lost bigtime on an MTM basis.

    Comment by cpirrong — February 16, 2019 @ 6:04 pm

  18. @cpirrong – Re: Gambler’s fallacy. I don’t think it can just simply be this. At the end of your paper, you state:

    “Given the huge losses incurred in late 1993, a Bayesian estimating the probability distribution of MG’s information advantage would almost certainly place little weight on the possibility that the firm was well informed, and great weight on the possibility that it did not possess superior information, regardless of the charitability of his priors concerning the prescience of MG’s managers.”

    It seems like Bollen and Whaley call you on that, and simulate from the (almost Bayesian) predictive density and find that early in the program the probability of major losses is high, but that it rapidly declines after about month three. Past that, nearly every path (5,000 repetitions) is profitable. On average the program was highly profitable. What they do is not quite Bayesian (but a poor man’s Bayes perhaps): they fit a bivariate model of synthetic supply via MLE and simulate from the fitted equations. I might do it differently today, but it was a good empirical strategy. It at least looks out of sample.

    Does the debate come down to the loss function imposed on the hedging strategy? Culp & Miller and Bollen & Whaley seem to take MGRM at their word and use a profit-based loss function. You impose a minimum-variance loss function. Working warned that not all hedging is risk minimizing, and that is often at best a secondary consideration. B & W showed that the hedge did reduce the variance of cash flows relative to no-hedge, but it did not minimize them. Instead, it maximized the expected profits. The program was capital intensive, but profitable. The program managers were guilty of not assessing operational risk (the board yanked the hedge), but it seems their hedging strategy (when assessed with their own loss function) was appropriate.

    What am I missing?

    Comment by TJB — February 17, 2019 @ 9:32 am

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