Published on EBF 301: Global Finance for the Earth, Energy, and Materials Industries (https://www.e-education.psu.edu/ebf301)

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Lesson 12 - Risk Controls in Energy Commodity Trading

Lesson 12 Introduction

Overview

On December 2, 2001, Enron Corp., at the time the world's largest energy trading company, declared bankruptcy, causing a loss of $11 billion dollars for its shareholders and billions morefor its trading counterparties. At the time, it was the largest bankruptcy filing in US history. As events unfolded and the investigations took place, it was revealed that there were several "off-sheet," "paper" companies churning-out false earnings. These were "mark-to-market," unrealized earnings, that had no cash gains associated with them. Ultimately, it was a lack of controls, or a failure to adhere to them, that allowed this to occur. Top executives at Enron were convicted and sent to prison, and their outside auditors, Arthur-Andersen, would go out of business.

In this lesson, we will learn about other famous cases where financial disasters took place due to a lack of controls and oversight. We will explore concepts such as "mark-to-market," and "Value at Risk," both financial risk measures that are mandatory for today's publicly-traded energy companies who deal in financial derivatives.

Learning Outcomes

At the successful completion of this lesson, students should be able to:

  • Be familiar with famous case studies prompting risk control measures.
  • Understand how and why risk controls were implemented in the energy industry.
  • Define risk control responsibilities and key risk measures.
  • Be able to recognize a proper risk control structure.

What is due for this lesson?

This lesson will take us one week to complete. There are a number of required activities in this module. The chart below provides an overview of the activities for this lesson. For assignment details, refer to the location noted.

All assignments will be due Sunday, 11:59 p.m. Eastern Time.

Lesson Requirements
REQUIREMENT LOCATION SUBMITTING YOUR WORK
Reading Assignment: Case Studies Reading Assignment page No submission
Mini-Lecture: Risk Control Mini-Lecture: Risk Control page No submission
Lesson Activity: Baring's Bank Case Study Analysis Lesson Activity page Submit through Canvas
Lesson 12 Quiz
Fundamental Factors (on-going)
Summary and Final tasks page
Summary and Final tasks page
Submit through Canvas
Submit through Canvas

Reading Assignment: Lesson 12

Reading Assignment:

Read each of the following case studies (on the following pages) before viewing the lecture.

  • Case Study 1: Barings Bank, PLC. [1]
  • Case Study 2: Orange County, CA [2]
  • Case Study 3: Metallgesellschaft (MG) [3]

Case Study 1: Barings Bank, PLC.

In February, 1995, Nick Leeson, a “rogue” trader for Barings Bank, UK, single-handedly caused the financial collapse of a bank that had been in existence for hundreds of years. In fact, Barings had financed the Louisiana Purchase between the US and France in 1803. Leeson was dealing in risky financial derivatives in the Singapore office of Barings. He was the lone trader there and was betting heavily on options for both the Singapore (SIPEX) and Nikkei exchange indexes. These are similar to the Dow Jones Industrial Average (DJIA) and the S&P500 indexes here in the US.

In the early 90s, Barings decided to get into the expanding futures/options business in Asia. They established a Tokyo office to begin trading on the Tokyo Exchange. Later, they would look to open a Singapore office for trading on the SIMEX. Leeson requested to set-up the accounting and settlement functions there and direct trading floor operations (different from trading). The London office granted his request and he went to Singapore in April, 1992. Initially, he could only execute trades on behalf of clients and the Tokyo office for "arbitrage" (Lesson 10) purposes. After a good deal of success in this area, he was allowed to pursue an official trading license on the SIMEX. He was then given some "discretion" in his executions meaning; he could place orders on his own (speculative, or "proprietary" trading).

Even after given the right to trade, Leeson still supervised accounting and settlements. And there was no direct oversight of his "book" and he even set-up a "dummy" account in which to funnel losing trades. So, as far as the London office of Barings was concerned, he was always making money because they never saw the losses and rarely questioned his request for funds to cover his "margin calls" (Lesson 3). He took on huge positions as the market seemed to "go his way." He also "wrote" options, taking-on huge risk (Lesson 10).

He was, in fact, perpetuating a "hoax" in his record-keeping to hide losses. He would set the prices put into the accounting system and "cross-trade" between the legitimate, internal, accounts and his fictitious "88888" account. He would also record trades that were never executed on the Exchange.

In January, 1995, a huge earthquake hit Japan, sending its financial markets reeling. The Nikkei crashed, which adversely affected Leeson's position (remember, he had been selling Options). It was only then that he tried to hedge his postions, but it was too late. By late February, he faxed a letter of resignation, and when his position was discovered, he had lost ($1.4 billion USD). Barings, the bank which financed the Louisiana Purchase between the US and France, became insolvent and was sold to a competing bank for $1.00!

(If you are interested in more details regarding this infamous case, you can read "Rogue Trader" by Nick Leeson himself. There is also a movie of the same name starring Ewan McGregor which should be available for rent in DVD format.)

The following two cases are brief descriptions of similar, catastrophic losses by traders with little, or no, oversight.

Case Study 2: Orange County, CA

Robert Citron was the Treasurer for Orange County, California, in the early 90s. He was solely responsible for investing several of the county’s funds which totaled about $7.5 billion USD. Despite having no background in trading financial instruments, he decided to invest in risky interest rate swaps that were tied to the US Treasury Department’s rates.

Citron was a County Tax Collector with no college degree who was later elected to the position of Orange County Treasurer. In this capacity, he was able to push for California legislative approval for county treasurers to increase their use of financial instruments for investment and fund management.

He was attempting to artbitrage the difference between short-term and long-term interest rates. His position was sound and he could make money so long as short-term rates remained low. During his tenure, the average return on county investments was a healthy 9.4%, but interest rates had been low for that long.The position he took would lose money if interest rates rose. And, he inflated the county’s volumetric position by entering into other derivatives that would also be negatively impacted by higher interest rates.

Beginning in February, 1994 the Federal Reserve Board made the first of six consecutive interest rate hikes. Between February and May of that year, the County had to produce $515 million in cash (margin) to cover its position. Further margin calls would occur throughout year, leaving the County's cash reserves at only $350 million by November, 1994.

When word got out about the County's troubles raising cash, investors sought to retrieve their money, and by December 6, 1994, the County declared bankruptcy and lost ($1.64) billion.

Case Study 3: Metallgesellschaft (MG)

MG was a huge, German industrial conglomerate that decided to open an energy trading office in the US in the early 90s.

The original plan was threefold:

  • Sell refined products in the forward, physical market.
  • Invest in refining capacity to produce the products.
  • Hedge the forward sales through financial derivatives.

When the strategy was first implemented in 1992, current physical prices were lower than the futures prices. So the sales contracts were set at those higher future prices. And it meant that purchasing the "near" month futures contracts would be profitable. So MG developed a strategy whereby they would cover the long-term, fixed-price sales by buying contracts in these few, near months. As each month "rolled-off," they would merely buy contracts in the next month. It was their intent to continue this process until the physical product sales contracts expired in (10) years. This strategy worked as long as the futures market was "backwardated," whereby each successive month is lower than the prior one (Lesson 3).

One of the major flaws in this approach, however, was the volume of contracts being traded since they were "loading-up" on closer month contracts. Add to that the fact that they would not get paid for the product sales for years out, and you begin to have a cash flow problem where margin calls are concerned. Their position in the Fall of 1993 was estimated to be between 160 to 180 million barrels stretched-out over the following (10) years.

In 1993, prices fell as the market received a "bearish" signal from OPEC on production quotas. This lowered futures prices and reversed the market from "backwardated" to "contango," whereby each successive month's price is higher than the prior one (Lesson 3). Faced with this position, MG management was changed and the new team was directed to close all positions. This resulted in losses on the futures purchases totalling almost ($1.5) billion USD. The had to seek bailout funds from one of their banks, and in return, had to sell-off several divisions.Today, the German industrial giant no longer exists having been bought-out by a competitor.

Mini-Lecture: Risk Control

Key Lessons Learned by Examining the Case Studies

There were some common themes that ran through each of these cases.

  • Single, or small groups, of “rogue” Traders (little supervision over the decision-making process).
  • The use of risky financial derivatives.
  • Lack of real accounting/auditing oversight and/or Trader(s) controlled these.
  • No trading policies, controls, etc., in-place.
  • “Hidden” trade losses.
  • Lack of executive knowledge and understanding of the inherent risks in trading.
  • Trading positions increased to lessen impact of losses led to increased exposure (so-called, “doubling-down”).

These events, along with others, prompted the financial industry to institute ways to monitor, track and stay on top of, financial derivative trading. These same methods would later have to be adopted by publicly traded energy companies in the US.

Key Learning Points for the Mini-Lecture: Risk Control

  • Severe losses by “rogue” Traders led to the establishment of controls for financial derivative trading in the banking and finance businesses.
  • These “risk measures” were later made mandatory for the energy industry.
  • Companies face more than just financial risk, such as legal, operational, credit.
  • Necessary risk controls, measures, reports and organizational structure.
    • “mark-to-market”
    • “Value at Risk”
    • “P&L”
    • Volumetric
    • Risk Control Group/Chief Risk Officer/Risk Oversight Committee
EBF 301 Risk Controls
John A. Dutton e-Education Institute

Lesson Activity

Baring's Bank Case Study Activity

Using the information presented in this Lesson, evaluate the Baring's Bank case to determined where the flaws were in the risk controls.

  • What controls were lacking in the Singapore office?
  • What were Nick Gleeson's biggest mistakes?
  • What should London have done to prevent this?
  • What controls/guidelines do you think should have been in place?
  • Using the "Recommendations" presented in the lesson, which of these would you recommend in this instance?

Grading Criteria

This activity is worth up to 20 points on the EBF 301 grading scale. Each question is worth up to 4 possible points.

Fundamental Factors

The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [4] for additional information and grading rubric.

Submitting Your Work

Case Study Activity: Submit your findings to the Lesson 12 Case Study Activity in Canvas.

Fundamental Factors: Submit your work as a single word processed document Lesson 12 Fundamental Factors Activity in Canvas.

Summary and Final Tasks

Key Learning Points: Lesson 12

  1. Catastrophic losses in the financial industry were caused by trading in risky financial derivatives.
  2. Similar themes and events existed among them all.
  3. A system of risk controls was established within the financial community to better monitor and quantify this trading activity.
  4. “mark-to-market” gives the current value of all “open” trading positions based on daily market prices.
  5. “P&L” is the estimated profit and/or loss determined by the mark-to-market calculations.
  6. “Value @ Risk” (VaR) is a theoretical measure of the maximum potential loss for a trading book.
  7. Corporations face various risk exposures. Among them are:
    • Financial
    • Market
    • Counterparty
    • Operation
    • Credit
    • Legal
  8. Publicly-traded energy companies engaged in trading financial derivatives were required to implement risk controls by FY2000.
  9. Companies need to have a defined risk control structure in-place including:
    • Standard risk metrics
    • Daily reporting requirements
    • Risk Policies and Procedures
    • Violations reporting
    • Independent Risk Control Staff headed by a Chief Risk Officer
    • Risk Oversight Committees comprised of top executives

Activities and Quiz

  1. Trade Justifications - on-going
  2. Quiz Log onto Canvas and complete the Lesson 12 Quiz

Reminder - Complete all of the lesson tasks!

You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities.


Source URL: https://www.e-education.psu.edu/ebf301/node/565

Links
[1] https://www.e-education.psu.edu/ebf301/569
[2] https://www.e-education.psu.edu/ebf301/570
[3] https://www.e-education.psu.edu/ebf301/571
[4] https://www.e-education.psu.edu/ebf301/680