Posted on: March 10, 2020

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After the Crash…

There are events throughout our lives and careers which stand out for their suddenness, unexpectedness and the magnitude of their consequences.  Their causes are varied – political, economic or natural phenomena.  Often the consequences in the markets depend as much on people’s perceptions and reactions as the natural implications of the events themselves.

But all those events which cause the greatest market shocks do so because they are just that – shocks.  Yes, some are presaged – many claimed they saw the financial crisis coming – but many turn expectation on its head.

Comparison has been made in the last 24 hours with the impact of the first Iraq war and that the dramatic fall in the oil market yesterday was the largest since January 1991.  That of itself was, at the time, seen by many as a contrarian reaction to a widely anticipated repeat of the leap in prices that followed the Iraqi invasion of Kuwait just five months earlier – perhaps one of the biggest misreads of the “buy the rumour, sell the fact” dictum ever.  But in terms of parallels, I see more similarities with the market slump and the flirtation with single digit oil at the end of 1998 and early 1999.

The respected American energy economist Ed Morse said yesterday that he considered this year’s crash to be the first time that a major demand slump had coincided with a splurge in supply, but I would look at 1998 in a similar vein.  At the time, OPEC were as disunited as at any time, and quota-busting among members was rife.  So, when, in the middle of the Asian crisis with demand spluttering, OPEC met in apparent denial of what was obvious to everyone else and agreed a 1.5mmbd increase in quotas from January 1999, the writing was on the wall.

Back in 1998, the effect might not have been quite as dramatic as the 25% collapse yesterday, but it was just as immediate.  Oil markets set off on a one-way slide, Brent breaching the psychological $10 in December, and leading the doom-mongers to forecast $5 oil forever.

While the Asian crisis didn’t come out of the blue and many had feared OPEC might make the nonsensical decision to increase quotas, what followed took all by surprise: and arguably there were three “will never happen” events that took place.  First, nobody believed that Hugo Chavez would win power in Venezuela and, even if he did, once behind the leather-bound desk that he would ever actually deliver on his promise to stop Venezuela’s rampant quota-busting; secondly, by the same school of thought, nobody imagined that other members of OPEC quietly exceeding quotas in Venezuela’s shadow would be cowed into following suit; and thirdly, nobody would have dreamed that a triumvirate of non-OPEC countries – Russia, Norway and Mexico – would agree to OPEC-matching cuts of their own.  Yet those three steps, all necessary together, completely turned the world on its head and paved the way for what then became an inexorable rise to $140 oil some eight years later.

There are clearly many differences between the current crisis and 1999, and a kiss-and-make-up resolution between Saudi Arabia and Russia really would be the stuff of fairy-tales.  Coronavirus and its panic-driven impact on markets was a complete surprise, even if a Russian-Saudi fallout was always a risk, but either way, just as in 1999 when $10 oil wouldn’t be countenanced, today $30 oil is not sustainable.  Precipitating a further hiatus in investment in the industry will only exacerbate the scramble to catch up when demand normalises again.  And before the environmentalists leap for joy, one of the most poorly communicated needs of environmental transition is the huge dependence on our legacy fossil-based industries to deliver the clean future we all crave.  Low oil prices will inevitably starve the economic incentives to go green as well as depriving us of the resources to build the green infrastructure that we desperately need.  Even if we achieve the daunting target of the Paris Accord by 2040, we will still need to be consuming, by BP’s esteemed estimation, 80mmbd – a level of consumption we only first reached in 2004.  And to do that, we still need to be making huge investments in new production – now!

But while we fret over our tomorrows, we also have a more urgent issue with dealing with our todays.  The market collapse has put enormous pressure on our industry.  Many businesses will be reeling from the effects of the last few days and for the weeks to come.  Shock events like this week’s are as difficult to protect against as they are to predict, but they do focus the mind on how or what might have been done.  Yes, this horse has bolted, but it serves as a reminder of how fragile our businesses can be and how important understanding and managing our risks are.

Fortunately, in my career in risk management I’ve been spared the analyst’s poisoned chalice of being expected to forecast prices.  But in helping clients escape the siren-like lure of tracking markets and to focus on their own businesses, I have had the constant challenge of getting clients to understand first the threats that markets pose to their businesses and objectives and only then, once they really understand them, devise the strategies to mitigate those risks.  Hedging, however well devised, might not be able to give ultimate protection in shocks like we have just experienced, but such events can at least wake us up to the need to understand our risks and design the most appropriate and effective strategies that do genuinely protect our businesses.

There are those who remain sceptical; those who point out that all the companies who went bust in 2015 to 2017 were the ones who hedged.  But it was leverage, not hedging, that broke companies. The hedging that was employed failed because the companies – and banks that insisted on the hedging – didn’t properly understand how price risk threatened the ability to service debt, and therefore how to design fit-for-purpose hedging that would actually protect it.

It all comes back to the fundamentals: you need to understand how your business is affected by market risk before you can design and implement an effective risk management strategy.  And the best way to build that understanding is by taking as objective an approach as possible to what may happen, and how prices may evolve.  Ignore the forecasts – this week has proved again that we don’t know what’s around the corner – and don’t let the market colour your analysis.  Review all possibilities, good and bad, dispassionately and understand how the key objectives of your business are threatened.

Extreme events like this week’s may fall outside the range of possibilities you consider, but the fact that you pass a wide lens over your risks will give you much more detailed insight into the behaviour of your business.  And when you have that, then you can build effective strategies to protect it.

If this discussion has made you think about whether you are doing the right thing, or you would like to know more about my thoughts on risk management accumulated over nearly thirty years in the market, please feel free to contact me at [email protected].

 


 

Andy is a highly experienced industry professional and market risk management expert with a background in oil refining. He is a trained Chemical Engineer with hands-on experience of the physical demands and logistics of the entire process of turning crude oil into an end product. Andy joined Lloyds Bank at the start of 2011, becoming their Head of Commodity Market Solutions. Similar to his previous role, with RBS, he was tasked with building their commodity derivatives business, focusing on the corporate client base, extending from FTSE100 companies to SMEs. He was also a Director of Energy Sales at BNP Paribas Fortis, specialising in structured debt/derivative products, enhancing client debt capacity and risk management. Andy’s career started at Shell, where he had roles as chemical engineer, refinery scheduler and trader, trading oil products both physically and on derivatives, as well as providing in-house risk management training. Andy has developed significant IT skills, most notably building enhanced debt models for upstream clients for managing debt capacity and hedging while optimising investor objectives. Andy holds an MA, MEng in Chemical Engineering from the University of Cambridge.

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