When it rains, it pours. The phone calls in the middle of the night from Head Office. The flurry of emails from regulators. The pressure from the CEO on what is actually going on in their books, who in turn is being pressured by the board.
That could very well have been the fate which befell Oil bankers based in Singapore, the major oil financing hub east of the Suez canal, as HSBC disclosed that had grave concerns over $48.9M of oil financing transactions it had entered into with Zenrock Commodities. HSBC believes that the cargoes of oil it financed where it either (a) on-sold to a (third party who either remitted the funds to another bank account and/or (b) on-sold the same cargo to another party. In b) there could be competing claims for the same cargo, but strong is the position of the one who has title to the original set of Bills of Lading.
This matter will most likely end up in front of the courts so we focus our post on exploring several themes, namely what preventive measures could a bank take in order to protect themselves from the case of financing an oil cargo.
Some background is required in order to fully comprehend this. Around 10 years ago, oil was trading at above $100. A VLCC cargo of oil is 2 million barrels. The financing amount is $200M. Banks can tack on a whole lot of fees if they are able to intermediate this transaction, where 0.10%, or 10 bps on $200M amounts to $200,000. And the best thing is that this consumes only a small part of the overall bank’s risk asset base, settles quickly, and can be done over and over again using this instrument called a Standby Letter of Credit (SBLC). A SBLC is basically a promise made by the bank to pay the seller in sales and purchase transaction. This facilitates global trade as the seller need not worry if they are dealing with a fly-by-night trader as the bank stands in between to ensure payment, so long as the seller can provide documentary evidence that it has fulfilled its responsibility.
Case in point, consider that JP Morgan had SBLC’s of $33.9B as of end Dec 2019, but only counted $618M as part of its risk assets. This happens because this form of transaction is considered as “low risk” (ahem, ahem) by the banking overlords at Basel, Switzerland and thus banks only need consider a fraction of their exposure as part of their risk assets.
So how did this entire oil financing structures through SBLCs, which were supposed to be low risk end up being the Mother of All Nightmares (MOAN) for affected bankers?
To that, as mother always says, one should not be involved in something one does not fully comprehend. This so called low-risk oil financing through SBLCs have two major risk components that need to be fully understood
- A) The risks associated with the financing structure
- B) Energy price risk
Banks that have experienced risk analysts who understand both A) and B) are able to superior risk adjusted profits to banks that do not. Banks that do not understand A) and B) and undertake oil financing can be subject to extremely long tailed losses, which means, that they can be on the hook for huge losses.
There are 2 definitions of Risk Management, which applies depending on the management of a bank. Banks that values skillful risk managers, see risk management is defined as being able to earn profits from risky endeavors by constantly identifying and reacting to problems which may arise. To Banks that treat risk managers as a cost center, risk management means what you should have known prior to stuff hitting the roof.
Today we will explore a bit more in depth item B) which is Energy price risk management when financing a shipment of oil. There are 4 components to cover namely
- A) Flat Price Risk : Risk of change in the price level of the commodity.
- B) Basis Risk: Spread between the price of the physical commodity and the financial contract used to hedge the physical commodity price
- C) Spread Risk: The price risk between two related commodities. Example could be High Sulfur Crude Oil from Iran versus Low Sulfur Crude Oil from Saudi Arabia
- D) Delivery Risk: Call it the 5 D’s and the 4 I’s. 5Ds: Date range, delay, demurrage, dues and dead freight and the 4 I’s: In transit loss, insurance, inspection and interest.
Our proposition is that banks which engage in Oil Financing without adequately understanding and controlling the risks associated with the financing structure as well as the energy price risk management are doomed to sustain those massive losses.
To make this treatment somewhat concrete, lets assume the following:
A Fly-By-Night trader, we call them Vagabond Incorporated, decides on February 15, 2020 to by a VLCC shipment of Nigerian Oil (called Bonny Lite), loading from Bonny Terminal, Nigeria between March 01 – March 08th 2020. The seller is Chevron, and the price agreed the 5 day average of Dated Brent + $0.50 per barrel around the Bill of Lading. A bank called Muppet Bank, agrees to issue an SBLC to Chevron for the purchase price.
Ok, lets explain several terms here:
Dated Brent: Those who watch financial news shows may see two numbers for the price of oil, the first being WTI and the second being Brent. Both these numbers refer to the settlement of financial future contracts and are not directly one to one related to this beast called Dated Brent. Quite simply put, Dated Brent is a daily price assessed/determined by that Price Reporting Agency called Platts which is based on actual cargoes loading 10 days to 1 month using North Sea blend of crude oils from the date of publication. (The job of a Price Reporting Agency or PRA is to report prices. Sounds simple, but its not).
Bill of Lading date: The date when the crude loads into the ship
So now, lets assume that this is observed
- Vagabond Traders agreed to buy 2 million barrels of Bonny Lite from Chevron (perhaps Shell Trading would be a better choice since it’s loading from Bonny Terminal) loading between March 01 to March 07th 2020.
- The price is the 5 day average of Dated Brent around the Bill of Lading, i.e. the document that confirms the oil has been transferred to a ship nominated by Vagabond Traders.
- The ship arrives on March 05th, is directed to Bonny Terminal, loads the oil on the same day and departs. The Bill of Lading is dated March 05th, 2020.
- The 5 day average of Dated Brent around the date of the Bill of Lading (i.e. March 05th, 2020) is $30.34. Vagabond Traders has to pay an additional $0.50 for Nigerian oil relative to North Sea oil, so the final price is $30.84 per barrel.
- As there are 2 million barrels loaded, Vagabond Traders needs to pay Chevron $61.68M. Vagabond Traders has no money, so it asks a bank, lets call it Muppet Bank to issue a Letter of Credit in favour of Chevron and pay Chevron the $61.68M.
In undertaking the transaction, Vagabond Traders experienced 4 types of pricing risk, which is simultaneously also assumed by Muppet Bank. We shall examine a bit about the Flat Price risk as an introductory coverage of the topic.
Flat Price Risk: This is a change in the general price level of the commodity, in this case the Nigerian Oil was priced based on that beast called Dated Brent. This is an interesting type of risk because prior to the loading, which means between Feb 15th to Mar 01st, Vagabond Traders would really like the price of Dated Brent to be as low as possible. So we say that Vagabond Traders was short Dated Brent.
Once the crude has loaded, which in our case was March 05th, this exposure changes from the trader hoping for Dated Brent to be as low as possible, to hoping that this physical cargo of Nigerian oil will fetch the highest price. We say that the Trader is Long Crude Physical.
Here is where things get ‘icky’. Vagabond Traders picked this period in March 2020 because from its point of view looking out in February 2020, it bet that the upcoming OPEC meeting in March will lead to a historic cuts and its crude physical price will jump by $2 to $3 a barrel. That meant a gain of $4 to $6M. Vagabond wanted risk exposure to crude oil over this period. So early March came along and OPEC came and met. There was some discussion with the Russians. Some folk said that OPEC was going to cut 10 million barrels per day. Even worse, unbeknownst to Muppet bank, other traders in Vagabond Traders had actually gone around all the banks in town to get as much financing as they could muster so that they could have as much crude oil as they could get their hands on over this period. The Vagabond CEO sees this as the opportunity of a lifetime to do that George Soros like deal and make $40 to $50M over this period. Things looked promising. Vagabond Traders retires for the weekend beginning March 07th 2020, based on hope and expectation.
As things usually turn out, disaster happens over the weekend.
On Sunday afternoon March 08th, Bloomberg has reported that Saudi Arabia announces a “total price war.” Brent Futures is closed and on Monday morning, 08.00 AM Singapore Time, it opens at $10 lower or around $25.00 per barrel. All that cargoes of oil is now worth significantly less than a couple of days ago. Instead of a $40 to $50M pay day, Vagabond Traders is effectively a “gone case.”
Ok, here is where the bank’s risk management skill comes in. The bank will in no way participate in any of the upside of Vagabond Traders. If Vagabond Traders made a $100M, the bank will still only get its same fees and not a penny more. But if Vagabond Traders lost a $100M and became insolvent, the bank can no longer look to Vagabond Traders to pay for the crude it helped to finance is now left holding title to some crude oil which is suddenly worth much less.
Of course a bank with proper risk management would have had all the structures in place. Using a combination of financial instruments, namely Cash BFOE, Brent CFDs, the entire price risk of this transaction could have been eliminated in February itself. Of course, a bank which insisted that all the traders were fully hedged will be less appealing to Vagabond Traders who wanted to profit from prices going up in March. If the price was hedged, then the effective price was basically stuck to a particular point and the trader could not make that price gain he had hoped for.
There are 2 definitions of Risk Management, which applies depending on the management of a bank. Banks that values skillful risk managers, see risk management is defined as being able to earn profits from risky endeavors by constantly identifying and reacting to problems which may arise. To Banks that treat risk managers as a cost center, risk management means what you should have known prior to stuff hitting the roof and they deserve their losses. They are so dysfunctional, they would probably blame the risk manager whom they did not value in the first place.
Bad for the trader, but good for the bank. The question is whether the Oil Bankers involved in Muppet Bank had insisted on a fully hedged price exposure and closely monitored what Vagabond Traders was up to?
This will be the question that will be revealed in due time because all vagabond traders who were long crude oil in sufficient quantities were effectively destroyed on the weekend of March 08th, 2020 if they did not engage in effective energy price risk management. Over the next several weeks, we will witness whether the banks which financed these oil trades will end up taking a loss as well.