« Part 1: The IPO
With the 7th of October announcement the Company, apart from the estimated loss of USD 22 million, started disclosing new important features of the pursued risk management strategy. Information is however ambiguous and in some important parts even contradicting.
"As part of its risk management policy, OW Bunker hedges its commercial inventory and marine fuel transactions within an expected oil price range. Consequently, price fluctuations within such range only have a marginal effect on OW Bunker's results. Conversely, when the oil price breaks the expected range, it may affect a given quarter by changes in the valuation (mark to market) of the derivatives contracts used for hedging of inventory and marine fuel transactions".
It is difficult to interpret this statement. The starting point should be the exposure generated by the physical business, i.e. "its commercial inventory and marine fuel transactions", before hedging with financial derivatives is put in place. Any exposure can be either "long" or "short". A long exposure will gain money if price increases and will lose money if price reduces. For a short exposure, the opposite would happen. In the IPO prospectus it is stated that "Our typical open position before hedging varies from a long position of 250,000 tonnes to a short position of 100,000 tonnes". However the company never clarified if the physical exposure, in the months preceding the bankruptcy, was actually short or long.
Let's assume that the physical exposure was long, but the reasoning would be still valid in the opposite case. In order to hedge this long physical exposure, the company needed to be short on financial derivatives, by selling Futures, Swaps, Options or combinations of them. In this way, apart from problems related to the efficacy of the derivatives hedging instruments ("marginal effect"), the combined physical plus derivatives transactions should deliver rather predictable financial results. In the statement reported above, the company clarified that this was the case, but the global hedging strategy was more complex. In fact, at that point OW Bunker's hedging strategy was active "within an expected oil price range", i.e. within a high and a low price boundary, normally identified as "cap" and "floor", constituting overall a "collar".
A collar can be built exclusively with derivatives instruments, not with physical deals, and it consists of a combination of long and short options. If we believe in what the company management was announcing, then the derivatives collar was counterbalancing the physical exposure only inside a price range. If prices would move outside the range, then the derivatives will become inactive and the company will be simply un-hedged on the physical business.
If the physical exposure was long, a reduction in oil prices under the collar floor would have finally determined realised losses on the physical business without any benefit on the financial derivatives side.
The company further announced that "The recent slide in the oil price, in particular during September, is outside the range expected and OW Bunker will as a consequence of its risk management policy report an unrealized accounting loss before tax of approx. USD 22 million in Q3 2014. This is based on a mark to market valuation of OW Bunker's derivatives contract as at end September 2014".
At this point it seems that the company is not giving a complete picture, because it is discussing exclusively the derivative contracts. It is true that the value of the collar derivative contract should change even when prices are outside the collar range. However, at the same time, also the physical exposure would change in value. If, for every metric ton of physical exposure, one metric ton of collar was executed in the financial market, then the change in value of the physical exposure should be more important than the change in value of the collar contract. In fact the physical exposure is linear while the collar one is not.
Issues related to accountancy rules do not seem to bring an explanation to the incongruence of the announcement. In the IPO prospectus the company had stated that its derivatives did not qualify for hedging accounting treatment. Consequently, "Changes in the fair value of these derivative instruments are recognised immediately in the income statement", while changes in value in the physical transactions would be recognised at a later stage. This is quite common for commodity trading firms and it does not bring any surprise.
Why, then, in the 7th of October Company announcement nothing is said about the value of the physical transactions and the fact that the loss recognised on derivatives in Q3 2014 will be balanced later by the physical part of the business? The obvious explanation of the omission about the physical business can be only one: the volume of traded derivatives was much bigger than the physical exposure. At least at this point in time, the main driver of company results was constituted by the derivative contracts. Profits or losses on the physical business could not counterbalance the derivatives results. Amusing conclusion from a starting point in which derivatives were meant to counterbalance the results of the physical commercial activity!
Furthermore, the 7th of October Company announcement informs that the loss of USD 22 million "includes a substantial element of protection taken up against further falls in the oil price" and that "We have taken action to minimize risks against further oil price falls […]".
This information is not sufficient to make clear what was put in place. However the "Investor Presentation of the Interim Results Q3 2014", released on the 23rd of October, would incidentally clarify that this was a purchased Put option and it was already in place by the end of September, 2014. This part of the announcement seems then rational: in order to enter in a long Put option and hedge from possible further oil prices reduction, OW Bunker had to pay a premium and this was included in the communicated USD 22 million loss.
As a side note, we should remark that the paid premium was to be considered as already realised, and consequently it was not accurate to classify the USD 22 million loss as fully unrealised. Moreover, the impact of this loss on the 2014 outlook was reduced by making the simplistic assumption of USD 10 million of "expected regain on hedging". This point was made clear only later in the Investor presentation of the 23rd of October.
"If the oil prices rise again, we will gain on our derivative contracts […]". This part of the 7th of October Company announcement is not simple to decipher, but can finally clarify OW Bunker's exposure to oil prices. The company indirectly suggests again that the physical exposure is negligible in the global picture. Excluding the results of the additional long Put option already mentioned, what we know at this point is that:
OW Bunker was losing money on derivatives because of the reduction of oil prices.
OW Bunker would gain money on derivatives if prices would increase again.
This position is nothing else than a combination of a long Call and a short Put, where the strike price of the Put is lower than the strike price of the Call. By adding later the long Put, the company allegedly covered against further downside, but preserved the upside. Not much more can be said, based on the public information that was released at this point.
Bigger clouds on the horizon
On the 23rd of October the Company produced an Interim Financial report for Q3 2014 and a related Investor Presentation, shedding some more light on what was happening. In summary:
The losses for Q3 2014 reached USD 24.5 million, 2.5 million higher than before.
The forecasted "regain" of USD 10 million on derivatives was cancelled.
Using Company words, "The estimated unrealised risk management loss of approx. USD 22 million as announced […] on October 7, 2014, ended at a USD 24.5 million loss when final calculations were made". It was just an additional 2.5 million loss, but it was a symptom of a serious illness. First of all why "final calculations" were necessary? The IPO prospectus clarified that the company traded in financial derivatives which fair value was classified, according to IFRS definition, as "level 1" and "level 2", i.e. value essentially based on prices promptly available from market sources. Were or were not OW Bunker's state of the art risk management system able to calculate the value of positions at least daily (baseline in this industry)?
Additional information allows to have a better idea regarding the derivatives position in place. In fact a "possible reduction of the unrealised risk management loss, including the additional USD 2.5 million risk management loss, requires a Brent oil price of around USD 92 per barrel. In case of an average Brent oil price of USD 92 per barrel in Q4 2014, the unrealised risk management loss may be reduced by around USD 12.5 million […]. In case of an oil price below this level, OW Bunker does not expect a reduction of the unrealised loss in 2014. However, OW Bunker is protected against further losses than the above mentioned without additional cost to protect against further oil price falls."
The described position resembles again the payoff of a long call option. By paying a premium, the Company allegedly secured profits in case of an increase in prices, but would not suffer from a further reduction. However, the wording above suggests that the option was not a simple call option, but something similar to a "digital" call option or a "knock-in" one. These options deliver a payoff different from zero only if the underlying price reaches a certain level. We may use simple algebra and the hypothesis that the possible USD 12.5 million profit was based on a comparison between 92 and 84 USD per barrel, 84 being the Brent crude price in the middle of October as reported in the Interim Financial report. In this way we obtain a necessary volume of derivatives of approximately 70,000 metric tons for each of the three months in Q4 2014, i.e. about 210,000 metric tons in total. We need to consider that these derivatives were options, and the exposure they generate is less than linear. Moreover, these options were out-of-the money, which further reduce the exposure.
Once again nothing is said about the exposure generated by the physical business. If that exposure was positive, then the company was long on physical and long on derivatives, i.e. the derivatives were not hedging the physical business. If the physical exposure was short, than an increase in oil prices would generate money on the derivatives but lose money on the physical business. As said before, the only way to believe what the Company management was communicating at this point is to suppose that the exposure generated by derivatives deals was much bigger than the physical one.
Consequently we need to conclude that this derivative position was not built for hedging purposes but it was instead a bet on prices going up. That would still not constitute a breach of the limit of 100,000 metric tons. In fact the IPO prospectus clarifies that, inside that limit, even pure derivatives positions could be put in place. Moreover, the CEO could have approved a limit extension to 200,000 metric tons, which was under his powers without approval needed by the Board of Directors. However this is not mentioned in the Interim Financial report or in the Investor presentation.
In the latter document, some additional piece of information is given. The loss of USD 24.5 million is allocated to three main factors:
Purchase of Put option derivative contract to protect from further price reductions.
Change in forward oil price market structure, from Backwardation to Contango.
Change in the absolute level of oil prices.
The first two factors raise some suspicions. Regarding the first point, this form of insurance is said to be in place already at the end of September, and "Subsequently protection has been moved down in light of oil price decrease". It must be considered that, once a protection with a long Put option is in place and the underlying price moves down surpassing the strike price, this financial instrument delivers money to the holder in a linear way. Consequently, why OW Bunker did need to move down the protection?
The sentence could be explained by the fact that the long puts, already in place at the end of September, had a short term maturity. Later on other put options were bought at a lower strike price, consistently with the additional price reduction that underwent in the market in the meantime. Incidentally, the Investor presentation communicates that the underlying of the Put options is gasoil price, while it suggests a couple of times that the benchmark price for OW Bunker business is the price of bunker and fuel oil. This should have raised some questions about the efficacy of these Put options as hedging instruments.
The second bullet point above mentions the impact of "Contango" in the market. This is a situation in which prices for prompt delivery of goods are lower than prices for forward delivery. The opposite is true in case of "Backwardation". Exploiting price time-structure in Contango when it appears in the markets is one of the simplest, lowest risk and most profitable way to make money for commodity traders. It is sufficient to buy the goods, store them, and then sell the goods for forward delivery or sell derivatives maturing in some months and the game is done. The fact that OW Bunker lost money because of market prices going from Backwardation in to Contango tells something more about the radical payoff modification that was achieved by trading derivatives.
Essentially, the Company was long on short-dated maturities and short on longer ones. This short time-spread position would deliver money in a market that moves in to Backwardation. On the contrary, such position would lose money in a market where Backwardation reduces or even changes in to Contango, and the latter was the case for OW Bunker. However the Company affirms that it would not be caught by surprise again: "With the current hedge, OW Bunker will not be impacted by changes in market structure (i.e. a reverse of the current contango market structure to backwardation)". Even this assertion sounds strange. In order to become insensitive to changes in the market price time structure it is necessary to have all exposures concentrated in the prompt month.
The third point above communicates that, in addition to the time spread position, the Company had an outright long position and this lost money due to oil market prices reduction. Here again the Company does not miss the opportunity to confuse stakeholders. In the Investor Presentation one can read that "Typical implications from […] oil price changes to the business" are that "the strategy with low prices is to increase long exposure as prices fall", while under high prices "it is preferred to be long going into an environment with rising prices".
All in all, the message delivered to the markets was negative for the moment being but reassuring for the future: "Current marine fuel price exposure: Downside risk protected and upside potential kept".
The Company had neutralized possible further losses on derivatives in case prices would continue to reduce. At the same time, should prices go up again, either the financial profits will be stable or they could even rebalance the previous loss. However, again nothing is said regarding the exposure generated by the physical business, which is appalling for the World's number one trader of physical marine fuel. At least this point, management principal or even unique matter of concern was the financial derivatives position.