LDCs and Derivatives: It's All Over Now, Baby Blue

♠ Posted by Emmanuel in ,,, at 9/09/2009 03:07:00 AM
You must leave now, take what you need you think will last
But whatever you wish to keep, you better grab it fast...

I've long tried to decipher what Bob Dylan meant when he wrote "It's All Over Now, Baby Blue." Like many, I first became familiar with the song via the famous cover by the Byrds. More recently, I've been listening to the same song performed by Matthew Sweet and Susanna Hoffs. In the tradition of apocryphal rock 'n' roll stories, I am firmly convinced that Bob was writing about LDCs using derivatives in 2008-09. As always, let me explain.

China and Mexico face situations typical of energy-exporting and -importing countries: whereas the latter would like to lock in a lower price on energy costs, the latter would like to lock in a higher price. No more was this more the situation more acute than during the volatile movements in energy prices experienced in 2008-09. From oil hitting $140-some a barrel and then falling precipitously to $40-some in a matter of months, it was truly a roller-coaster ride.

Recent news stories now reveal that these LDCs used options to try and manage this volatility to mixed effect. In China's case, the WSJ story I excerpt below almost certainly describes (the WSJ writers should be more specific) a case of using an option strategy known as a "reverse collar" that is defensive in nature . This strategy is most useful when prices of the underlying commodity--in this case of energy--are rising. How does a a "reverse collar" strategy work?

First, it involves buying call options that gives the buyer upside protection. For instance, Chinese energy users would want to lock in their maximum buying costs for energy. Therefore, they would buy call options giving them the right but not the obligation to buy fuel at, say, a strike price of $100 a barrel in the next six months. Of course, buying call options is not free. For obvious reasons, purchasing a call option with a lower strike price--say, $90 instead of $100--will cost you more. The amount paid to the writer of the option is called the premium. To help offset the cost of buying options, these Chinese firms also sold put options, which in turn earned them some premium. For instance, they could have written put options at $60 to help defray costs in buying call options in the expectation that fuel prices wouldn't fall that far so fast.

Unfortunately, that negative scenario sounds like what happened to many of these firms which used "reverse collar" strategies, exposing them to large losses since they had to sell at $60 when the prevailing price of a barrel when options expired was at $50 or even $45. From the WSJ:
China's government on Monday offered public encouragement to state-owned companies challenging foreign banks over huge losses from derivative contracts, a move that bankers say has raised the risks of dealing with some of China's largest enterprises. Some of China's biggest airlines and shippers lost hundreds of millions of dollars last year on derivative trades made with major international banks when the price of oil plunged. They are now seeking to claw back those losses.

In a statement on its Web site, the State-owned Assets Supervision and Administration Commission said it supported moves by unnamed Chinese enterprises to seek recourse for their losses in structured financial derivative contracts tied to the price of oil and reserved the right to file lawsuits itself...

"The move is a very normal action for enterprises to use legal tools to protect their deserved rights in commercial activities," said the one-paragraph SASAC statement. The commission is Beijing's umbrella organization responsible for companies owned by the central government, including 150 major state-owned enterprises.

With concern already rising in recent weeks that Beijing might challenge the fuel-derivative losses, bankers have been scurrying to protect themselves. One day last week, trading in certain contracts all but shut down in China, bankers say. Now, bankers are discussing how to impose stiffer collateral requirements for Chinese airlines and other companies that seek derivative contracts. "It significantly increases the cost for Chinese airlines," one person familiar with the matter said of the effort to require more collateral.

The statement is the latest reminder of how Beijing is ready to adopt forceful methods to support its resource-hungry companies. Last month, Shanghai police formally arrested four employees of Anglo-Australian miner Rio Tinto Ltd. on suspicion they illegally procured information to use in negotiating a multibillion-dollar deal to supply Chinese steel makers with iron ore.

In early August, China Eastern Airlines Corp., Air China Ltd. and China Ocean Shipping (Group)Co. sent letters to six international investment banks warning that certain transactions "may be void, invalid or unenforceable," said a person familiar with the letters. Among the banks understood to have received such letters are Deutsche Bank AG, Goldman Sachs Group Inc., J.P. Morgan Chase & Co., Citigroup Inc. and Morgan Stanley, according to three people familiar with the situation.
It's a rehash of the Rio Tinto episode of Beijing being more aggressive with foreign presences in China. While it's certainly fashionable to "stick it to the (white banker) man," the PRC must weigh the benefits against the costs of encouraging rough play with foreigners: does it really think derivatives will have little value going forward, will state banks offer derivatives themselves, or is the Chinese leadership simply not aware of the risks involved? The WSJ gives some hints to the latter, but things are still unsettled as to how they will play out given the famously opaque legal framework in the PRC. There's always the "I didn't know what my underlings were doing" defense...
Financial policy makers in China say government leaders often don't grasp how derivative products work and then react angrily when deals backfire...the recent events highlight the need for foreign institutions to ensure that Chinese entities have necessary authorization to enter a deal, since legal challenges are often grounded in an argument that the deals weren't permitted or were too complex. Also, contracts should specify that disputes will be settled via international arbitration, since China won't typically enforce foreign court decisions.
The highway is for gamblers, better use your sense
Take what you have gathered from coincidence...

But all is not doom and gloom for LDCs using derivatives; far from it. Mexico, an energy exporter, was conversely able to make a windfall by locking in higher prices via options near the peak of the energy bubble. What kinds of contracts could it have entered? First, they could've entered into forward contracts whose strike prices were high and pocketed the difference when energy prices fell precipitously as these options expired. Or they could have bought put options that did not cost so much in terms of premium when underlying prices of energy were high. Either way, Mexico made a killing, racking up $8 billion in energy derivatives according to the Financial Times:
Mexico is set to earn a record $8bn from financial contracts it bought last summer as insurance against weaker energy demand and lower oil prices this year, the Financial Times has learnt...Oil traders said the world’s sixth-largest oil exporter had started to hedge a small portion of its oil revenues for next year after it successfully locked in an average price of $70 a barrel for all its oil exports this year. The fresh deals were securing a lower price floor for 2010 of about $50-$55, they said...

Edward Morse, chief economist at LCM Commodities in New York, said Mexico’s accomplishment was “idiosyncratic to last year’s oil market”, when record oil prices of $150 a barrel allowed the country to buy cheap insurance for 2009. The success, he added, was unlikely to be copied by other countries.

Mexican officials have told lawmakers they expect to earn about 100bn-110bn pesos ($7.5bn $8.2bn) from the hedge as the prices the country has achieved for its oil exports so far this year have averaged less than $50 a barrel. The officials warned against expecting a similar gain next year.

[Mexican Finance Minister] Carstens took the gamble of hedging all Mexico’s oil exports for 2009 at a cost of $1.5bn with Goldman Sachs and Barclays Capital. The banks in turn offloaded their exposure, people familiar with the programme said. The bet was based on the belief prices would drop because of the impact of the financial crisis on energy demand.
Pretty nifty, eh? What both situations share is remarkable volatility unlikely to be repeated--for better gains or worse losses--in the near future. As Dylan once sang:

Strike another match, go start anew
And it's all over now, Baby Blue.