Extreme price events are the greatest source of risk for commodity-related businesses

In March 2020, oil price collapsed more than 70% from its January peaks, causing severe losses to the industry and beyond: RyanAir lost $325 million on their hedging positions; Vitol allegedly lost $1.6 billion; Hin Leong, one of Asia’s largest oil traders lost $3.8 billion and ABN Amro bank lost $1.4 billion. Similarly, when oil prices fell by 40% in the last quarter of 2018, Trafigura reported losing $254 million and China’s Sinopec lost $690 million. All the losses were attributed to these firms’ hedging transactions.

Indeed, extreme price events such as these are far and away the greatest source of risk facing oil related businesses. An earlier experience gave us an industry-wide case study reaffirming this principle: from mid-2014 through 2015 commodity prices collapsed by over 50%.

The decline was disastrous for the mining industry, which includes oil and gas producers, resulting in a total after-tax loss of $227 billion for 2015, wiping off more than eight years’ worth of industry’s profits.

Extreme price events are unpredictable…

Extreme price events have become more frequent and more severe, but their occurrence cannot be predicted using conventional market analysis: only in January 2019, over 1,000 oil market professionals polled by Reuters predicted that oil price would average between $65 and $70/bbl through 2023. None of them had foreseen the 70% collapse in 2020 that brought oil prices to below $20/bbl.

… but they unfold as trends.

Almost invariably, extreme price events unfold as trends that can span weeks or months. As such, they can be exploited using systematic trend following strategies. In fact, systematic trend following has proven to be the only viable method of navigating such storms reliably and effectively.

This was in fact another important test of I-System’s ability to effectively navigate the turbulence. It has passed the test admirably, generating profits of nearly $35/bbl during the critical weeks of February and March 2020.

After many months of sideways action around the $60/bbl level, crude oil started trending through November and December last year. I-System strategies gradually shifted to the long side and generated moderate gains through early January. However, subsequent reversal caused more losses until it turned into an accelerating down-trend. By February, all 20 strategies switched to the short side (at abt. $58/bbl on average), generating strong profits through the price collapse.

The chart below summarizes I-System performance through Friday, 20th March 2020:

Event A in the above chart represents the largest recorded 1-day oil price jump. On Saturday, 14 Sep. 2019, a missile attack in Saudi Arabia caused substantial damage to Aramco’s Abqaiq oil production facilities. The following Monday, oil price closed $8.42/bbl above previous Friday’s price.

Managing price risk must be a priority

The responsible decisions in organized economic life are price decisions; others can be reduced to routine

Frank Knight, “Risk, Uncertainty and Profit”

Among the first known victims of the 2020 oil price collapse was Ryan Air, having lost $325 million from their oil price hedging. This is yet another reminder that managing price risk may be the single most important determinant of profitability for commodity-related businesses.

In fact, 90% of CEOs and CFOs at such firms believe that managing price risk is key to competitive advantage. Yet only 1/3^rd of them have confidence in solutions they have in place.^[1]

This too may be understandable: for most firms, managing price risk requires a very different set of skills from those needed to manage their core operations. For this reason, many firms find it difficult to develop an effective hedging process. By default, they tend to turn to their bankers for solutions, but experience has shown that such solutions tend to be very costly and largely ineffective.

With the increasing price volatility and greater frequency of severe price events, managing price risk is a high priority challenge. The good news is that with the right tools and methods, firms can create a world-class risk management process as an integral part of their business operation and turn oil price risk into a source of profit and competitive advantage.

Move gradually… but take action today!

Firms seeking to master their commodity price risk can adopt a gradual approach in evaluating the solutions we propose, testing the process at first on a smaller portion of their risk exposure – say, 10% or 20% of their hedging needs – and build up with accumulating experience and know-how.

As Milton Friedman put it, “it is worth discussing radical changes, not in the expectation that they will be adopted promptly but for two other reasons. One is to construct an ideal goal, so that incremental changes can be judged by whether they move the institutional structure toward or away from that ideal. The other reason is… that if a crisis.. does arise, alternatives will be available that have been carefully developed and fully explored.”

We can help!

With more than 20-years of experience in commodity and FX price hedging and trading in global financial and commodity markets, and with the help of I-System Trend Following, we can help your firm turn commodity price risk into a source of profits and competitive advantage. The following brochure provides summarizes I-System SmartHedge approach to managing oil price risk.

The same principles apply to any other of the 200+ markets we cover including metals, agricultural commodities and over 50 different currency pairs. To learn more about the central role of price risk and hedging, please read the following articles:

Hedging and competitive advantage

Best practices in price risk management

For a preliminary discussion, please contact me, Alex Krainer at xela.reniark@gmail.com or by calling me at +33 678 63 90 57.

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Notes:

[1] Tevelson, Robert, Petros Paranikas, Harish Hemmige. “Key Challenges in Managing Commodity Risk.” BCG Perspectives, 11 April 2013.