Commodity Trading and Risk Management
 

CTRM Blog


21.02.2019

Commodity trading disasters and how to identify them before they bite - Part 1

I thought I would start to share some of my experiences of the risk management “disasters” I have come across in  commodity trading businesses and maybe help others identify the warning signs in their own environment. I will not name people or companies but will explain clearly what was being presented and what turned out to be the, usually expensive, reality.

Commodity trading companies work on a mark-to-market basis. What that means is that as well as having realised deals which have been received or delivered and invoiced or paid, there are many deals which will only be executed in the future. These need to be regularly valued at market obtainable rates to understand what the current value of the business would be should it need to be liquidated. The valuation also allows transparency of the risk that a commodity trading book contains at any given time and allows the most accurate calculation of profit/loss .  

Finding a correct price for a forward contract can vary from straightforward, for example when there is a liquid exchange contract which is directly related to the product in the forward trading book, to extremely difficult, when a physical product appears in the book but is very rarely traded or has very few participants providing pricing. 

I have seen many ways in which the forward book valuations have been manipulated to produce better results. 

The first example was a capacity contract on a pipeline. When you wish to transport natural gas or liquids that you have purchased at a given origin, you also need to buy capacity on a pipeline to carry the product to a hub where you wish to resell it. In this case the source was offshore and the product was being bought onshore. There was a very long-term contract which had been purchased and it had a very large mark-to-market profit. By the time I was investigating this contract, it was two years since it had been purchased and the company was in administration. I noticed the origin and destination on the contract and I was familiar with both of these because I had been studying the supply/demand of this market in some depth only a year before. The origin was interesting to me as I knew that the supply there was going to be exhausted in only 4 years. The capacity contract was surprisingly for 8 years duration. So effectively, the capacity could only be used for 4 years but the trader had structured an 8 year deal knowing only the first 4 years would have any realisable value. This did not stop the trader from marking the last 4 years of the deal at a similar price to year 4. As a result there was a mark-to-market value for the last 4 years of many millions of dollars that, in reality, was worthless. 
This should have been spotted at the point when the deal was placed on the book because a very large day-1 mark-to-market should have lead to an examination of the structure of the deal and the viability of the marketplace. The deal was priced at a similar profit margin year 1 -8 which meant that it was very cheap vs. market for the first 4 years and very expensive in the back four when the real market would have been 0. 
As it was, this deal was only spotted when the book was being closed. The trader who transacted the deal had since left the company having received a bonus based upon false results. No action was subsequently taken against the trader and the deal was restructured and closed with the counterpart.

The lesson: Day-1 mark-to-market is important to monitor. Any trade which suddenly shows a day-1 result which is an outlier needs to be scrutinised. In addition it is important to have controllers and risk people that understand the market they are monitoring so that they can spot deals which look out of place. 
 
more to follow……many more….

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