Physical Differential Risk Management
In this article Jean-Michel Boehm campaigns for a more systemic and transparent evaluation of differentials in physical commodity trading that accepts an ongoing dialogue and position disclosure environment to benefit all participants in the trading, funding and regulatory chain.
A FEW YEARS back, I asked a senior commodity trade finance banker the following question: “If I buy a 100 metric tonnes of coffee at $1,000 per ton and hedge my future / derivative at $1,010, have I made a profit”? His answer was a straight “yes, I made a $10 profit per ton”. After a full hour of laborious explanations, aimed at convincing him that in commodity trading you cannot mix apples and pears, he walked out of my office convinced that he was right anyway. He has since been promoted! A differential in commodity terms is the spread
between the value of the cash commodity and its related derivative hedge – some call it premium / discount. But all traders reference the value of the physical commodity against the derivative. Traders hope to sell at 10 over the relevant future and aim to cover their sale with a purchase at 10 under. The differential is therefore the speculative segment of a trade. Get your differential right and you will make money. Get your differential wrong you will lose money ... and you could even go bust. Naturally, there are other and more radical
ways to go bust: just take an outright physical or derivative’s position and hope for the best! A differential is variable, which inflates or deflates due to various and quite often concurrent factors such as supply and demand, regional or world political events, climate change, phytosanitary requirements, institutional or regulatory changes. Not least, changes in market structure veering from contango to flat or to backwardation and vice versa have a major impact. Banks (and increasingly others like private equity
etc.) feed their commodity merchant counterparts with transactional cash. But the years of clean lending, are long gone. Nowadays, lenders demand and get securities against their credit lines. Banks have devised a series of protective instruments, which they deem to be sufficiently limitative for their client to avoid a major catastrophe. These protective ‘defensive’ measures range from the unsophisticated line tenor or revolving limits up to the more refined tripartite agreements, repo’s and ownership based finance deals.
I am not criticising all the arduous due diligence
the banks undertake to on-board a customer, nor am I doubtful of the value of a credit or a risk committee’s input. While it is good and proper practice to “know your customer”, I feel that “understanding what your customer does” is essential. How many times have I heard, “we did everything we could have done” from bankers facing a commodity merchant who is going under. What they actually did, was to fund a speculation on differentials, which is their prime undertaking anyway. But where they went amiss is that they failed to understand the life-cycle of a differential and side-stepped its risk management. We have already seen that the triggers for moving
a differential are diverse. We also know that the matching of bought and sold differentials is the key constituent of a merchant’s P&L. The differential is therefore at the heart of physical commodity trading and it should be the trade finance banker’s prime concern.
The differential is at the heart of physical commodity trading ...
Most trade finance lenders satisfy themselves with
the protective qualities of a tripartite agreement. Their security resides in the reconciliation of the purchased physical quantities with the size of the hedge: as long as the two match, credit and risk committees remain comfortable with the agreement. This should be the first point where a banker could question the validity of a purchase: is it in line with the current market and differential trends; what is the expected profit of the trade; does the hedge need refining via a spread or an arbitrage trade; who could buy such a commodity … etc.? The assignment of the deeds of a trade (physicals and hedge) from a merchant to a bank does not constitute perfect protection for the lender as it only transfers the rights and obligations of the transaction. It protects the lender against its counterparty but does not guarantee the lender to be spared from a financial loss. In essence, the lender parts with their cash for a deal, for which
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