These two stories may make one wonder who runs trading – A good thing or ?

My Hedging Story

When I traded, I was especially concerned about my authority limits, and whether the board we reported to understood our business. I started attending the board meetings with the division president to do nothing more than listen. Did I have this complete warm and fuzzy feeling they did understand when it came to our business and trading strategies?

Did they understand the great benefits of hedging programs for the other internal entities we provided?

No, I didn’t have that great feeling. I had felt uneasiness, and always worked to improve that over time.

And, since, as I stated, I made money five years in a row, I built a great reputation. But, in the second year I knew that one accounting leader questioned what we were doing, which is fair and you should expect it. I prefer someone asking questions than not. That questioning, though curious, ultimately provided us credibility.

Why?

When I joined that energy company and the group I worked for, the division, to my surprise, had just lost $10 million in a few months. I just left a great company, a company I still admire to this very day like no other, Koch Industries, to join something about to go under, an experiment gone awry and, like any company, I thought we are about to shut down.  Fast forward about two years, and this accounting leader was questioning our business so much that that it became an ethics issue.

An ethics issue?

I had met this leader, a long-time employee, and one of the best dressers I have ever seen. Some people do think it is a fashion show, a runway of sorts – sorry, I just came from Koch, and when Koch was 1/10^th of the size it is today, impressing me could no longer happen in that manner, as you will soon learn, too.

Back to the big oil company accounting leader. The U.S. division of this large oil company audited us and found nothing, case closed.

Well, not so much.

The Fashion Guru kept the stir brewing.

Suddenly, two top trading experts out of London were sent for a week to speak to each one of us in our group of eighteen. In those two years, I already knew, because I went from a new hire to having 90% of the authority to transact for this group’s entire command, which was no small amount.

We had worked hard, and our President worked hard, like no other, to communicate our story, not only in the U.S., but worldwide, right to the mothership in The Hague, Netherlands, that we were good. That leader had already made a trip to the U.S. and had literally stopped by our division to speak with us about the fascinating auto-regressive, risk, physical optimization, all energy product trading, were building internally for our company, and of course my trading book!

At the end of that week, however, those two proper Englishmen told us in no uncertain terms that there was an issue. Yikes.

The issue they stated was that this Fashion Guru, behind the scenes, we discovered, was asking or suggesting our business model was questionable.  The Fashion Guru was making ethics assertions that were determined to be without any merit and that the report would reflect this fact.

Since I had been the portfolio leader for five years running, and since I was paid a bonus five years in a row, I think the credibility also began to speak for the hard work we had put into not only building complex hedging programs, with very complex math, which is not absolute, but clearly helpful, but that we had developed a disciplined process for maximizing risk. Again, perception drives the world and we should work hard to remove it and place facts in front of others.

It was unfortunate that someone had made ethics assertions without fact, but in a political move, which I understood the unique dynamics this rather large oil company had, and subsequently had, but for us, staying calm, presenting the facts and our approach, and judgment by others subsided.

 

Fertilizer Company

The client I was called by, new to me, and in a city I had never been, asked me to visit for a period to solve some issues around this hurricane driven issue. Or, was it the hurricane that drove I ask you to discern for yourself.

When I arrived, I asked how can I help. Their reply was that they had this FASB 133 hedging issue they wanted me to resolve and prove to their external auditors that they were hedging.

Ok, fine. I am a CPA too, and I was at the inception of implementing FASB 133 in the 1990’s.

As we debriefed, the client said what their outside auditors had determined, to the best of their ability, was that they had to report $8 million worth of profit.  That may seem counterintuitive to the overall losses they reported, but specifically with some of the hedges, they certainly had a profit to report that they didn’t want to report.

What I determined quickly, was a very liberal application of the FASB 133 rules by the outside auditors. And, with the natural gas hedges they possessed, though only two-thirds of what they needed to be fully hedged per their policy, per their hedging program, resulted in what hedges they did have incurring an $8 million worth of profit that they had to report via the income statement and pay taxes on.

They had losses overall, and didn’t want to reduce the losses for other tax related reasons.  A little complicated yes, but that is not going to be the point here.

However, these hedges, as I said, were still not enough natural gas to cover the volume needed to hedge their fertilizer fixed price sales. Why?

Overall, and for clarity, they had lost $50 million for the natural gas they hadn’t bought, but still had this netting of $8 million for hedges, or rather simply deemed as speculative trading profits by the accounting firm.

So, I was brought in to do some correlation analysis, and leave the spreadsheet tool for future use so they could support their FASB 133 hedge assertions back to the accounting firm.

After a few weeks, I was unable to solve the problem.

What? As I have said, some problems cannot be fixed, or can they?

The client asked, “You can’t correlate the natural gas hedges we do have, to the forward sales of fertilizer we have sold?”

“No, I cannot.”

The reason was that FASB 133 had specific guidelines and, to my amazement, their accounting firm had bent the rules so much already that the hedges the accounting firm did support were executed at least two plus weeks in timing differences between the forward fixed fertilizer sales, and when the hedges, the natural gas purchases, were executed.

Said another way, the fertilizer company was speculating on natural gas, in both being short and being long at times in their portfolio.  Yes, they would bet natural gas direction throughout the year.

Since they had absolutely no policy to speculate, and their public financial statements said they didn’t speculate, this may seem like a train wreck in progress.

Ouch, you are thinking this is not going to end well, is it?

When I suggested to the accounting group that their accounting firm did all they could for them, I asked if I could visit with the trading group, so to speak, which was nothing more than the chief operating officer and a trader deciding when to buy the natural gas, irrespective of the fixed priced sales.

After losing $50 million in the prior year due to Katrina, I merely inquired about how can we shore-up this accounting issue by matching, i.e. buying natural gas timely, being that day or the next business day for the forward fertilizer sales, (as the worst-case scenario), so that we could solve the accounting issue from re-occurring?

The COO shared the current position report, and guess what, by choice, they were short natural gas that day, too. I inquired why, as delicately as possible. “We believe natural gas prices in the next few days or week are going down based on the industry pundits we use.”

What was my response?

Was it: “You are out of control, speculating wildly?”

No, it was rather simple to solve. Taking this complexity in appearance, which it was for their accounting group, auditors and especially for those SEC filings and public reporting, in terms of human nature for both internal and external reasons, how could we make this simple and solve the issue for all involved?

I simply crafted a program that separated their business into a hedging book and a trading book.

I first asked before presenting this solution, “Can we amend your policy to remove the statement that we speculate, to one that says we optimize our risk/reward profile through our hedging programs.”

That resonated quickly.  And, it then opened the avenue to suggest we then create two separate books, using two different entities, for tax and other reasons, to solve your accounting issue.

The answer was clearly yes.

We bifurcated the books, and all was resolved, and all was good.

That simple.

Solutions don’t have to be complicated.

Many untold companies have proprietary trading books, and so I suggested that we could solve the hedge accounting problem by always keeping the hedge book/entity flat by hedging it each day and transferring the risk to the proprietary trading books.

The proprietary trading and hedging books solved both the hedge accounting and allowed for the proprietary trading – a great solution that fit what the client’s risk/reward profile, solved an accounting issue and allowed for them to move forward in making risk/reward decisions as they desired.

I didn’t agree with how it was done, but I was not there to decide, or care, about how they chose their risk/reward profile.  I was there to provide a solution for accounting, and it was solved via trading book setup.

Sometimes solutions can be achieved for all involved without throwing anyone under the bus.

Another reason for Front-2-Back Energy Trading Consulting – we don’t have the pressure to keep the illusion alive for billing reasons, to be honest. We can simply focus on client benefits.

That company, by the way, was bought a year later, and for a very hefty stock price far from where they had been, like most fertilizer companies were when farming pre-21^st century, which was one of the worst industries to be employed, skyrocketed with commodity prices.

For nostalgia, do you recall Farm-Aid – Willie Nelson and John Cougar Mellencamp raising money for farmers?

Things have changed dramatically for farmers, a great thing!

Therefore, hedging and trading can co-exist and the point of the story is that it can co-exist for the right reasons.

The right reason is simply because that company’s culture and risk/reward profile just needed a little discipline in the process to eliminate any perceptions of any misgivings. This new framework for the company, its leaders, and board, regarding how to run a successful hedging and risk management program, while optimizing their assets, in a way that was transparent and disciplined worked perfectly.