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Super contango in crude oil

Super contango in crude oil

A black swan situation and its repercussions

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Super Contango

Black Swan Events

The most recent events concerning the raging Corona pandemic have kept the global markets breathless. The preventive measures against the spread of this new virus have inflicted economic repercussions on the gastronomy and hotel business, retailers, automobile producers and airlines. But they are not alone. Commodities traders are also affected, especially those with businesses closely linked to the price of crude oil because it has suffered its worst plunge since the beginning of futures trading. The reason for this is the failed OPEC negotiations on output, a reduced purchase volume because of economic limitations and a lack of storage capacities for crude oil if output is kept up. Traders and speculators are desperately trying to benefit from the falling prices for crude by getting rid of expensive crude oil contracts. This brought about a further crumbling of prices for crude oil, thus causing a so-called super contango in the oil market. On 20 April 2020, this caused the oil price for West Texas Intermediate (WTI) to drop for the very first time in the history of crude oil futures to USD -37.63 per barrel for May contracts. This black swan event1 (partly caused by a technical effect) may have taken some market participants completely by surprise. 

Black swans are highly unlikely events which are practically impossible to predict, but if they occur, will have a massive economic impact. Such events demonstrate the limits in predictive abilities of even the most complex forecasting models. 

Super Contango

Figure: Super contango before May 20 Futures expired (Source: CME, 21 April 2020)

A question of risk management

Just because black swan events cannot be foreseen, they should never be dismissed. The current market situation has raised concerns among Treasury department heads regarding their risk management strategies, methods and processes used so far and made them question the design of their risk cycle and its capacity to mitigate such uncertainties in the long term. Black swan events may be included as extreme stress scenarios. The specific triggering event is in fact irrelevant but what is important is assessing the impact of such an event on the company’s KPIs. Pandemics, natural catastrophes, political upheaval and regulations, financial market crashes, technical disruption, reputational damages and other events have been sufficiently frequent over the past years to be able to assess the possible consequences of a severe slump in sales or the explosion of costs on the company’s financial and profitability situation.

The following questions (which should be part of an effective risk management in any case) are crucial:

  • Risk strategy and risk KPIs
    Be sure to check whether your current risk strategy matches your corporate targets and whether the significance of relevant risks (market, credit and liquidity risks) are known to your company. Can you confirm that the current risk KPIs used to manage the company are truly meaningful as far as their impact on corporate performance KPIs (EBIT, cash, equity ratio) is concerned? It is best to define a clear risk management strategy. 
  • Collect data on your exposure
    Do you know the level and time of occurrence of your commodities risk? Get an overview of which transaction types should be included in your exposure and/or your hedges (physical stocks, physical delivery contracts, financial contracts, time buckets, delivery places, etc.). In doing so, it is also a good idea to consider to what extent and with what delay the risks can be passed on, for instance, because a risk is overestimated if only a commodity’s purchasing price is looked at without considering how sales prices react to changes in the commodity markets. 
  • Risk capacity
    Define which risks you are ready to bear in this strategic area. Be sure to choose an appropriate methodology to measure and report risk. Decide on which risks you may enter into with the help of a risk/reward profile. In doing so, you may want to differentiate between a threshold for times of normal business activity and a different threshold in case of an extreme scenario.
  • Hedging strategies
    Hedging strategies should be formulated in consideration of your goals when purchasing commodities. Is there a possibility to trade for own account or to enter into positions using a market-timing strategy? Define the methodology used to measure the success of your hedging strategy (e.g. benchmarking) and perform it regularly. Make sure the hedge’s effectiveness remains intact from both an economic and an accounting point of view, in consideration of the current market situation (e.g. effectiveness of proxy hedges).
  • Framework conditions for commodity trading
    It is important to create a clear governance structure, which enables the definition of framework conditions for commodity trading and clearly governs responsibilities. For this, identify who is entitled to change the existing framework conditions and whether it is possible to override the adherence to these rules. Define which products/instruments are admitted for trading.

Short-term and mid-term consequences of the super contango

The massive slump in crude oil prices has far-reaching consequences for industries along the value chain. If looking at the trade in crude oil, companies (and their treasury departments) acting in this sector will be confronted with the following problems: 

  • Delays or defaults in payment by private and large customers (gas stations, shipping lines, airlines, truck fleets, etc.) will reduce the liquidity of trading companies. The delays (or even defaults) in payment will affect continuing expenditures that still require payment (storage fees, logistics/operations, margining, salaries).
  • Fewer sales to clients will cause discrepancies in volume and forecasts and thus to costs for the unwinding/settlement of positions if amounts cannot be accepted physically due to limited storage. In the medium-term, clients may default, causing further discrepancies between amounts and forecasts.
  • Short and medium-term market price fluctuations could cause additional liquidity needs in the procurement portfolio due to margin calls triggered by a market slump. Re-sale risks are also continue to increase due to the market slump.
  • Absent cash flows and a looming recession could lower the company’s credit rating, which will worsen the availability and conditions of financing from banks and on the capital market.

What needs to be done – gathering strength during the crisis

Companies should use the crisis to harden themselves against further crises. Indeed, a next super contango may be just around the corner – e.g. when June 20 futures expire. The following could be decisive:

  • Enriching risk management with stress tests
    Risk management should not only contain all of the aspects mentioned above but should be expanded to include stress tests. These help to understand what kinds of repercussions extreme situations could have on your company and how you can prepare for them (e.g. with a liquidity reserve, equity reserve). For this, you will need integrated calculation models that include all major influencing factors. Such comprehensive modeling tools for risk effects allow the derivation of early warning indicators that allow you to recognize threats at an early stage. Companies that only start collecting data on their liquidity drivers and their effects or as well as on the structure of their cash flows only once a critical situation arises, waste valuable response time. 
  • Creating transparency
    In order to get a quick, comprehensive and understandable picture of market upheavals and other uncertainties and in order to be able to communicate these, you will require a holistic view of your risk exposure. Apart from that you should also have an established solution to present the repercussions on your company’s relevant KPIs. A good help is using a powerful ETL tool (such as Alteryx) as well as forecasting models and simulation tools, connected to a BI-supported dashboard reporting. This also allows you to provide senior management with information (if need be, in real time) on an emerging critical situation.
  • Using hedge accounting in accordance with IFRS 9 could be worthwhile
    The publication of IFRS 9 has expanded the possibilities for the recognition of underlying and hedging transactions in the hedge accounting of commodities traders considerably. Hedge accounting stabilizes your results (FVOCI2) also in times of volatile markets.
  • Reviewing the issue of accounting for inventories under IAS 2
    According to IAS 2, company inventories are to be recognized at the lower of acquisition/production cost or net realizable value. However, companies subject to a broker/trader exemption may value their inventories at fair value. In the current market situation, this could cause massive changes in value, which would have to be recognized as expenses in the profit and loss statement for the reporting period. 
  • Using the contango to your benefit
    The current crude oil market situation also offers many opportunities. The spot price for ICE Gasoil Futures currently stands at a price that is USD 100 lower than the price for delivery as at December 2020. This could be to your benefit, provided the difference covers all of the costs (storage fees, logistics, settlement costs) and the target margin. Obtaining physical deliveries of oil is no problem at all in view of the current oil glut, provided you have somewhere to store it. In doing so, you should observe all of the classical risks for a physical transaction (supplier default risk, premiums/discounts depending on quality, etc.). 

In the end, such events may be to the benefit of the treasury because they help demonstrate to Management and to cost controlling the advantages of an effective and comprehensive risk management for risks related to market price, liquidity and default risks thus enabling you to receive the budget required for this. On the other hand, the next time such a crisis arises, treasurers that are not sufficiently prepared may be reproached as not having learned from the past and being mere fair-weather treasurers.

Source: KPMG Corporate Treasury News, Edition 100, April 2020

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1 The term was coined by Nassim Taleb and his book, The Black Swan: The Impact Of The Highly Improbable (Penguin, 2008)
2 Fair Value through Other Comprehensive Income

 

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