OW Bunker: From IPO to Bankruptcy - Part 3, The Point of No Return

« Part 2: Fall Brings Bad News

The catastrophe was disclosed on the 5th of November. A fraud had been discovered in Dynamic Oil Trading, an OW Bunker subsidiary in Singapore, generating a loss of USD 125 million. Moreover "a review of OW Bunker's risk management contracts has revealed a significant risk management loss in addition to the loss of USD 24.5 million announced on October 23, 2014 […]. As of today, the mark to market loss is around USD 150 million".

The breaking news compare with the "Downside risk protected" picture depicted on the 23rd of October, less than two weeks before. At that time the loss was supposedly USD 24.5 million. That would imply that in eight business days  (markets are closed on weekends) OW Bunker cumulated an additional unrealised loss of around USD 125 million, i.e. a daily average of USD 15.6 million. Considering the price change in the same period, i.e. approximately 4 USD per barrel down on crude oil, a rough estimate brings to an exposure in excess of 4 million metric tons. It is very improbable that this loss was cumulated on new derivatives contracts executed after the 23rd of October. The 5th of November Company announcement suggests that the loss was substantially there already on the 23rd of October and even before, but it was not made public. Probably on the 5th of November the people familiar with the outstanding derivatives position could not conceal the catastrophe anymore because the counterparties issued margin calls and OW Bunker was not in the position to pay for the margin increase.

If we still believe in the information released before and after the IPO, then we must infer that the loss was necessarily the result of a radical change in the amount of market risk the Company was facing. In the Annual Report 2013 one can read that "If the commodity prices increase by 1% […] with all other variables being held constant, the profit for the year will be increased by USD 0.3 million (2012: increased by 0.1 million 2011: lower by 0.5 million) as a result of the changes in the oil derivative contracts as of end of the reporting period." If the risk profile in 2014 was really kept similar to the 2013 one and the exposure was linear, then a loss of USD 150 million would request a price reduction in the order of 500%, i.e. price should become negative. Another absurd conclusion.
We can guess some possible explanations about the lack of communication related to the change in risk profile and the subsequent loss:

• The top management knew about the derivatives position and they authorized that. They knew losses were cumulating, but did not communicate it till the 5th of November, hoping that the market prices trend would change.
• The top management did not know, but the risk management function did know about that and did not communicated to top management.
• Nobody knew about the total derivatives position and/or the financial loss, due to issues in risk identification, analysis and valuation.

Whatever the truth is, it is highly probable that the total exposure of the company was in excess of the well-known 100,000 or 200,000 metric tons by some multiples. OW Bunker built an exceptional position in derivatives, probably utilizing combinations of options, that overall resulted in a long exposure to oil prices.

A Broken Risk Management Process

This catastrophe shares many common points with other horror stories in which derivatives trading turned sour. From now on OW Bunker will be in good company with the likes of Metallgesellschaft, Amaranth, MotherRock and China Aviation Oil, just to name a few which got in trouble by trading financial derivatives on commodities. As far as the OW Bunker case is concerned, it is actually difficult to find any original point or lesson to be learnt for future memory and which was not already included in the horror stories gallery. For example, many other disasters did happen because of sudden changes in market conditions, after they had shown a stable and profitable pattern for a long period. Often the mechanisms and the ultimate responsibilities behind these disasters have not been completely clarified. However, as OW Bunker was a public company, we have here a certain amount of information delivered to the market, which has been the basis for the previous pages of this article. Far to say that this information has been clear or exhaustive. Anyway, it needs to be noted that even this limited information should have justified some reasonable doubts in the company stakeholders.

From the narration and the analysis of the events and company documents, it is evident that OW Bunker actively engaged in the trading of financial derivatives. By saying that "a significant risk management loss […] is around USD 150 million" it was finally made clear that in OW Bunker "risk management" was synonymous of "derivatives trading". In the IPO prospectus the company specified the operational aspects of this trading activity: "Daily marine fuel and marine fuel component price risk management is handled for the entire Group by our central risk management department. All operations hedge their exposures with the risk management department, which, in turn, hedges the Group's open position in the market." In this sentence, even the word "hedging" should be read as "derivatives trading".

Derivatives trading activity was put in place to reach objectives that often surpassed the pure hedging of exposure originated by the physical business. This is normally called speculation and it is not forbidden by any law or any best practice or standard in risk management. Inside the general risk management process, derivatives trading is an effective way of "risk treatment", the sub-process that allows modifying the risk profile of a company. Risk treatment, and consequently also derivatives trading, allows moving from a certain risk profile to another, the latter being closer to the company risk appetite. Risk treatment does not necessarily mean risk reduction, and it can be actioned also with the objective of risk increasing. OW Bunker's fault is not in the increase of exposure to market risk by using derivatives but in the lack of communication of this strategy to its stakeholders, in the first place its shareholders.

Communication of risk is a crucial part of any risk management process. Communication should be correct and clear, but OW Bunker failed on both. From the pages before it is evident that the released information was lacunose and misleading. Additionally, OW Bunker's risk communication was flawed by design. As already discussed, trading limits expressed in metric tons do not tell much about the amount of risk a company is facing. Modern risk communication should be based on risk measures of monetary loss, such as Value-at-Risk and stress testing.

An important objective of risk communication is to make sure that the level of risk the company is bearing is aligned to the level preferred by its stakeholders. If this is not the case, either the company should modify its risk profile or the stakeholders should leave the boat. In fact, stakeholders' risk appetite is the king, not the company management one. Even if stakeholders, and shareholders in particular, liked to bet on oil prices, this does not imply that OW Bunker was authorized to place those bets or was best placed to take those positions in the interest of its shareholders. Nowadays there are different ways to get exposure to commodity prices, for example by investing in commodity Exchange Traded Funds (ETF). Everybody can invest a sum of money directly in oil prices-linked financial instruments. Trading shares in public companies is far from being the first best if the investor is looking exclusively for oil price exposure.

Risk treatment and risk communication do not exhaust the list of risk management sub-processes. Risk assessment is another crucial step. It should come before risk treatment and should be performed periodically, even more frequently than daily. In fact new deals and the modifications of existing ones, both physical and financial, continuously change the exposure to risk. We have clarified, in the previous pages, the reasons why there are doubts about the quality of risk assessment techniques in OW Bunker. While this is a serious issue in any case, it becomes of dramatic importance whenever a company actively engages in financial derivatives trading. There are reasons to believe the dynamic and massive utilization of financial derivatives, beyond the scope of hedging the physical business, was already there when the company started the IPO process. One can read in the Investors Presentation of the Q3 2014 Interim results that "Historically we would have moved our hedging out in time […] ", where again "hedging" is the word OW Bunker used in order to identify "derivatives trading" activity.

Other doubts should be raised around the crucial topic of risk governance. In the IPO prospectus the company proudly discuss the "Robust Risk Management System and Culture that Underpins Stable Performance", clarifying that "Our conservative operating philosophy and corporate culture are reflected in our overall governance approach, including our risk management function" and that "Our risk management department […] is responsible for centrally managing our global risk exposure in line with the risk management policy approved by the Board of Directors". Well, we have not seen a copy of this risk management policy. How then risk governance and controls were shaped, if they were, in OW Bunker?

We have already discussed the controversial role, inside the OW Bunker's organization, of the employee in theory responsible for the risk management function. In the Company announcement of the 5th of November, it was made sure to communicate that the "Head of Risk Management and Executive Vice President" was dismissed as "a consequence of the risk management loss". There is no more mention to the fact that the same employee was first of all in charge of physical distribution.  Why the head of risk management was dismissed but not the head of trading? Is not the trading function, in a trading company, the first responsible for the results of trading activity? Has the head of physical distribution/head of risk management been another scapegoat in the gallery of scapegoats we have seen in the past?  Was OW Bunker a shop in the same mall described by Daniel Pennac in his famous novel "Au bonheur des ogres"?

The IPO prospectus does not use even a single time the word "segregation", let alone "segregation of duties". It is probably out of fashion now, but we were taught that best practices in risk management included giving responsibility for creating value and responsibility for controlling it to different employees, in order to properly manage conflicts of interest. It seems there was not such a segregation in OW Bunker. In general this is bad, but it gets much worse when money-making objectives are assigned to the risk management function.  Nowadays we continue to hear that the modern trend is that risk management should be a "business partner", where "business" means "trading". OW Bunker had probably embraced this new trend and went one step further: risk management function was part of the trading function. There was probably some specialization in place: "traders" were managing the physical deals while "risk management" was taking care of the financial derivatives. In this setup, who will control risk management employees while they are striving to make money?

OW Bunker's risk management function had monetary value creation objectives. In fact, the company was selling other services to its customers, including "risk management solutions". In the IPO prospectus we may read that "we are also able to provide risk management solutions as part of our customer offering […]. Our risk management solutions include a broad range of financial and trading instruments, such as physical fixed price contracts, swaps, caps, collars, three-way options and other tailor-made solutions."

It is true that the IPO prospectus further specifies that this was a marginal driver of value creation. However marginality is not sufficient to justify lack of control. In this type of setup the incentive for cross-subsidization, i.e. using profit in one business unit to subside another, is very high. This cross-subsidization is normally put in place ex post, when profits or losses materialize. Probably in OW Bunker there was no segregation between the hedging part of the derivatives portfolio and the part that was held to support the risk management solutions. Using a food analogy, this situation normally cooks a big soup in which becomes impossible to distinguish single ingredients, until one becomes so preeminent and even disgusting that you need to throw the soup away. The incentive to conclude "discretionary", i.e. speculative, deals grows higher because these deals can be easily reported as part of the "risk management solutions" portfolio. Later, if profits materialize, they will be considered in traders' bonus compensation. On the contrary, if losses are realized, then these deals will be ex-post considered as meant for hedging purposes, consequently dampening the result of the rest of the physical business but not traders' compensation. When results are just too bad, the entire company is affected.

This could be the setup possibly used to conceal the real situation to the eyes of top managers in OW Bunker, if they were really not aware. They were told that the massive amount of derivatives deals, the same ones that finally brought to the catastrophe, were entered in order to support "risk management solutions" products. However those products did not exist in that scale.

Click to Read Part 4: Parting Thoughts »