THE CHINA DERIVATIVES THREAT…… UPDATED AND REAL
Monday, September 7, 2009
This is a follow up piece to my initial report titled CHINA AND THE BUZZ OF A PENDING BANK DEFAULT. I want to thank everyone for the tremendous response that piece received.
First and foremost, today’s latest news on this topic reiterates the views by many that China is not fooling around with regards to their threats to walk away from the derivatives contracts. Here is the latest courtesy of Reuters. (September 7, 2009 LINK)
Beijing has publicly put its weight behind some state-owned firms struggling with oil derivatives losses, saying it will back them in any legal action against the foreign banks that sold the products.
In a statement on Monday, the State-owned Assets Supervision and Administration Commission said that some state-owned enterprises had sent letters to their trading partners about oil structured options trades, confirming a report in Caijing magazine last week that had sent shudders through the banking community.
"(SASAC) will support companies to minimise losses and protect rights through negotiations and holdings management. We also reserve the right to launch legal suits," the agency said.
I did a little more digging and would like to expand upon my first essay. Let’s follow this story via the Chinese State owned Nanshan Power story.
Flashback to 2008:
* Goldman Sachs Group Inc. analysts led by Arjun N. Murti call for $150.00 to $200.00 oil within two years. (The link is HERE) “The possibility of $150-$200 per barrel seems increasingly likely over the next six-24 months” was the statement.
* Deutche Bank calls for $200 barrel oil but admittedly their analyst Adam Sieminski acknowledges that while oil may surpass that target it would lead to global recession.
The Bloomberg piece read:
China Consumption
China, the world's fastest-growing major economy, has more than doubled oil use since New York crude oil dropped to this decade's low of $16.70 a barrel on Nov. 19, 2001. Record prices have failed to stem rising consumption in developing nations, with demand led by China, India and the Middle East.
Price forecasts for spot U.S. benchmark West Texas Intermediate crude oil for 2008 to 2011 were revised higher by Goldman. The 2008 price estimate was raised to $108 a barrel from $96, the 2009 forecast to $110 from $105, and 2010 to 2011 estimates are projected at $120 from $110, the analysts including Murti and Brian Singer said, citing slowing supply growth in Mexico and Russia, and low spare production capacity in OPEC.
Deutsche Bank AG Chief Energy Economist Adam Sieminski, who forecasts oil averaging $102.50 next year, today said Asian demand and limited extra supply will keep pushing oil to record levels. There's a ``huge risk' that prices will rise to a level, perhaps $200, ``when demand finally collapses because ordinary people can no longer afford to burn as much energy as they are burning now,' Sieminski said in an April 25 report.
If I’m a major oil consumer, reading these types of forecasts from the biggest institutions in the world might lead me to want to start protecting myself against the upside especially if those forecasts called for prices to escalate by as much as 90%.
Let’s recap how the rest of 2008 played out.
* In May 2008 oil was at $110.00 per barrel and rising. It would spike even further in the following months;
* By the end of October of that year oil was at $70.00 and falling;
* By December of 2008 it was below $50.00 a barrel;
* December 12, 2008 – Goldman Sachs calls for $30.00 oil
* By January 2009 Bloomberg is publishing an article on the losses incurred by many international corporations on oil hedges. (read here)
THE FIRST REAL SHOT
The first call for a Chinese Corporation to terminate derivatives contracts with Goldman Sachs came in October of 2008 when Shenzhen Nanshan Power brought the legality and the legitimacy of the derivatives contracts they entered into with Goldman Sachs into question. Nanashan Nanshan Power refused to pay for losses on contracts signed when oil prices were surging. This story was reported by Reuters HERE.
Shenzhen Nanshan Power warned that company officials had signed oil derivatives contracts without the firm's approval, intensifying fears about internal risk management at Chinese companies.
Shenzhen-listed Nanshan Power said on Wednesday its officials had signed two option-related contracts with a subsidiary of Goldman Sachs to bet on crude oil prices, although analysts said the contracts were still in the money.
Nanshan Power said the first contract, from March 2008 to December 2008, bet that oil prices would stay at $62 per barrel or above, for a maximum profit of $300,000 per month.
The second contract, from Jan 1 2009 to October 2010, bets that oil prices stay at $64.50 per barrel or above and the maximum return will be $340,000 per month.
Analysts said the contracts are still in the money but warn that risks increase as international oil prices fall.
Follow me in reviewing the news related to this story because the story stayed pretty quiet until the December 12, 2008 Goldman Sachs oil price revision cited above. We then get an acceleration of news on this story.
Reuters reported on December 15, 2008: (LINK)
BEIJING/SHANGHAI, Dec 16 (Reuters) - Chinese newspapers available in Beijing and Shanghai carried the following stories on Tuesday….
Shares in Shenzhen Nanshan Power Co jumped their 10 percent daily limit on Monday after the company disclosed, one month after the event, that it had terminated a financial agreement with Goldman Sachs. [my emphasis]
On December 19, 2008 we got this from Bloomberg:
Dec. 19 (Bloomberg) -- Shenzhen Nanshan Power Co., a Chinese power producer based in the southern city, and Goldman Sachs Group Inc. are in talks to resolve a dispute over oil- hedging contracts that caused losses for the utility.
The parties may take legal action if the talks fail, Nanshan Power said in a statement to the Shenzhen Stock Exchange late yesterday. The Chinese producer is refusing to pay for losses on contracts signed in March based on oil prices ranging from $62 to $66.50 a barrel.
Connie Ling, Goldman Sachs' Hong Kong-based spokeswoman, declined to comment when reached by phone. The New York-based investment bank earlier this month cut its forecast oil prices in the first quarter by half to $30 a barrel. [my emphasis]
My opinion? I can not accept any argument that the talks were centered on trying to have Nanshan remain as a party to the contracts. Remember, once matters proceed to litigation they become public record. What Goldman Sachs or any other investment bank might say or what might be disclosed in the proceedings would become public record. Is it possible that Goldman shushed this issue and let Nanshan walk? Remember, Reuters cited headlines from China that inferred the contracts were dead. Also, the Shanghai Daily on December 20, 2008 (LINK) quoted a blunt statement from a spokesperson for Nanshan Power. "The contracts have been terminated" was the comment. What did Goldman Sach’s substantially lowered forecast have to do with this? I don’t have the answers. We can only speculate on them.
These contracts were earning Nanshan Power money so long as oil remained above their contract price, income that amounted to over $300,000 per month. These contracts became questionable when oil dropped to a level that would require Nansham to start paying … you guessed it…. Goldman Sachs.
Bloomberg, citing a Wall Street Journal piece (LINK) said on December 19, 2008:
The Chinese company has argued the derivatives trades, on which Goldman was a counterparty, were “unauthorized” and it is refusing to pay the U.S. bank for the losses incurred, the WSJ said. The losses run into tens of millions of dollars, the newspaper
I have been unable to find follow up reports to this story nor have I been been able to find any stories about pending litigation in regards to this matter. Please feel free to email me one if you can find it.
Has Goldman settled? Did they let Nanshan walk? Have particulars of the settlement not been reported in the media because (and again I am speculating) the precedent has been set? If this case has indeed set a precedent, that is, if Nanshan Power was able to walk with no penalty, legal ramifications or additional cost to them, then I submit that China has it’s precedent. This makes the wording of the piece that brought my attention to this matter more important.
The August 31, 2009 Reuters report (LINK) that sparked my concern over this issue provided in part: (Pay special attention to the wording)
Chinese state-owned companies will be allowed [my emphasis] to default on commodity derivative contracts. The report provoked anger and dismay among investment banks that feared a damaging precedent.
Did you catch that? “Will be allowed”, not “might” or “thinking about” …. WILL!
Today’s news (September 7, 2009 linked above) reinforces that stance.
Personally, I feel that the “damaging precedent” for the investment banks involved may have been set with Nanshan Power. China may have tested the legalities and waters with these smaller valued contracts by throwing a small firm with small absorbable losses against the wall to see if it’s allegations “stick”. Could Nansham Power served as the test drive?
FORCE MAJEURE
This is where things get much more intriguing in my view. (And while I hate to ramble, it is important in this context to familiarize oneself with the legal term of Force Majeure. From the Yale library:
Force Majeure literally means "greater force". These clauses excuse a party from liability if some unforseen event beyond the control of that party prevents it from performing its obligations under the contract. Typically, force majeure clauses cover natural disasters or other "Acts of God", war, or the failure of third parties--such as suppliers and subcontractors--to perform their obligations to the contracting party. It is important to remember that force majeure clauses are intended to excuse a party only if the failure to perform could not be avoided by the exercise of due care by that party.
My research into this matter brought me to various outlets but one in particular that caught my attention to help make my point was a Supreme Court of Canada decision and commentary related thereto that discusses Force Majeure. A great discussion about that case and Force Majeure in economics can be found HERE. As stated;
The requirements to establish such an event were enunciated by the Supreme Court of Canada in Atlantic Paper Stock Ltd. v. Anne-Nackawic Pulp & Paper Company Limited (Atlantic Paper):
* one of the events referenced in the force majeure clause has occurred;
* the force majeure event was beyond the control of either party, it was "unexpected" and "beyond reasonable foresight and skill";
* the event prevented, hindered, or delayed the party seeking to rely upon the clause from performing its contractual obligations; and
* there were no reasonable steps that could have been taken to avoid or mitigate the event or its consequences.
An excerpt from the analysis in the above noted link provides: [my emphasis is in bold]
“This case defined Unforeseeable as a situation in which the party claiming Force Majeure must demonstrate that conditions have radically changed from what they were at the time the contract was entered into. This speaks not only to the magnitude of the force majeure event itself but also to its foreseeability. The Atcor case provides some guidance on "reasonable" expectations in this regard. Here the court suggested that the event need not be a catastrophe or "act of God", but just something not present in sound business calculations, which amounted, in the court’s determination, to a list of events for which insurance is not available at a reasonable cost. As such, the force majeure economic event must be shown to be beyond the general volatility of the market and to be such an unprecedented, sudden and extreme loss or impediment that it could not be seen to be a normal (case- and industry-specific) risk that would be allocated through the contract.”
Could the dramatic forecast reduction in the price of oil, ($30.00 in December of 2008 versus $200.00 when the contract was entered into) be considered a “radical change” in conditions from when the contract was entered into? Can China invoke Fore Majeure?
LAYMAN’S TERMS
Let me put my layman hat on for a minute and see if I get this correct.
In the spring of 2008 when oil was being run up, Goldman Sachs and other banks made price forecasts on oil. These price forecasts provided that $150-$200 oil was likely. At the time oil was clipping along at $100.00+ a barrel and had some legs underneath it. If I’m Nanshan Power or any other huge shipper, airliner etc who relies on oil I surely would have wanted to protect myself against the upside rise in oil prices. Nanshan entered into Derivatives contracts with Goldman Sachs to get this protection. Who better than Goldman Sachs to purchase the upside protection from given they were the firm that was making the case for $200.00 oil. This is exactly what Nanshan would have wanted to protect itself against.
In my view, Goldman Sachs had to offer calculations, models and particulars in those instruments in order for Nanshan to want to purchase the upside protection and none the least of which was it’s forecast model for $200 oil. As we read above in the Reuters press releases discussing the Nanshan Power case, these contracts provided that as long as Oil stayed above $62.50 in their first scenario and $64.50 in their second scenario (covering 2009-2010) then Nanshan was going to make money on the protection. Given the information that Goldman Sachs (the seller of the instrument) gave to them, this surely must have seemed a great bet. It would have seemed a slam dunk!
Here’s where things get real dicey.
In December of 2008 Goldman Sachs slashes it’s forecast on oil prices to $30.00 per barrel. (LINK)
Wait a minute!! If I’m Nanshan Power I’m SURELY biting my finger nails at this point. Imagine the hypothetical exchange on the telephone that day…
Nashnan: “Hey! You told me that you were expecting oil to reach $200 per barrel…you sold me this stuff that was supposed to protect me!”
Goldman Sachs: “Uhhh……..sorry?”
Using the legal example I referred to above, could this significant downside revision be considered “an event” that could be construed as an event “beyond the general volatility of the market”? Remember only 7 months before their $30.00 revision they were calling for $200.00 a barrel while at the same time they were packaging and selling these exotic products. In my uneducated view, such a downward revision would not appear to be consistent with “generally accepted market volatility conditions”. That was significant downward revision and in my view would be material to the overall performance of the instruments the investment bank sold based on it’s earlier forecast.
The Chinese will claim that these SOEs were not authorized or licensed to enter into these contracts. I would offer up for consideration that whether or not they were licensed may not be the point. The mere fact that a company sold a product to protect against an upside move of an asset they were forecasting to go significantly higher and then drastically slashes that revision after these contracts or locked up smells might fishy to me. I imagine that Lawyers would have a field day with this.
Doesn’t this eerily remind us of the the lenders and investment banks “packaged promises” of huge real estate gains as they were dumping their very intricate instruments on unsuspecting customers just before the real estate market blew up?
It is ever apparent that in 2008 Goldman Sachs and other investment banks were talking one way while acting completely another way.
THE IMPACT
In July of 2009, Reuters (link) printed a factbox on the growing issue with the derivatives. Look at some of these losses:
October 2008
* CITIC Pacific announced potential losses of up to $2 billion from unauthorised bets on volatile forex markets
* China Railway Group reported a 1.9 billion yuan ($278 million) foreign exchange loss for the first nine months of the year due to the stronger yuan
* China Railway Construction Corp also revealed foreign exchange losses for the third quarter 2008 of 320 million yuan ($47 million).
December 2008
* COSCO, the country's largest shipping group, said potential freight rates hedging losses jumped to nearly 4 billion yuan ($585 million) due to a plunge in rates.
January 2009
* Three airlines -- Air China, Shanghai Airlines and China Eastern -- reported book losses totalling 13.17 billion yuan ($1.94 billion) as of the end of January on aviation fuel hedging contracts
The Financial Times ALSO did a piece on this story. (LINK)
My question: Can all these companies have been so wrong in their analysis of the market? Or, did they “trust” the bank(s) they were doing business with? I am stunned that so many institutions have been so wrong on their analysis of the particular asset price they were interested in purchasing protection for. Whether it be oil, metals or currency…can so many of these companies have been so wrong? Who was giving them the advice? Who was giving them the sales pitch? The same companies selling the “protection” instruments?
I speculated in my piece titled China and the Buzz of a Pending Bank Default that this development has the potential to take down major Wall Street Institutions if the Chinese are serious with their threat. I'm more convinced today that this isn’t a threat. Instead, I am almost sure that the wording contained in my readings says they are going to do this. In my view, the threat and warnings came as early as the Nanshan Power case and that China ramped it up this past March when China ordered it’s state owned firms to review their derivatives. (See the March Reuters article here). They merely reiterated their stance today in an effort to ensure that they are taken seriously on their threat.
Do they have their wild card? Do they have something now that has accelerated their belief that they can default without penalty? Has the Nanshan Power case revealed particulars and information that raises issues and facts that they can now exploit?
As for the potential scope of this, should China go ahead, we look no further than the August 29, 2009 Reuter’s article HERE:
“Chinese state-owned enterprises (SOEs) may unilaterally terminate derivative contracts with six foreign banks that provide over-the-counter commodity hedging services, a leading financial magazine said.
It also cited a SASAC official as saying that almost every SOE involved in foreign exchange or trade had some exposure to derivatives such as crude oil, non-ferrous metals, agricultural commodities, iron ore and coal, although only 31 SOEs were licensed to do so.” [my emphasis]
This may be speculation on my part but I feel that the precedent was set. I think the Nanshan Power case simultaneously served as both the WARNING and the test case. The Chinese may very well have used the The Nanshan case as their precedent. It is highly conceivable that the Chinese Government may have found their loophole…their “out” so to speak. That “out” may have as much to do with proper disclosure, breach of trust and markedly revised price forecasts after the products were sold and after the market tanked. (Not unlike the manner in which the toxic mortgages were packaged in the preceding years).
The argument that the firms that entered into these deals were not licensed to do may be a “fall back” argument. My initial read on the matter is that the Chinese are walking away as a result of two key points;
1. The absence of proper disclosure of risk and;
2. The fundamental change in the underlying asset value and the forecasts related thereto made by the issuing banks .
This is the inference I draw from the September 1, 2009 update from Reuters (HERE):
“The move is not meant to cover a comprehensive range of businesses and companies. It's mainly to deal with some problematic contracts that were signed before, especially those that might have insufficient information disclosure [my emphasis] or two parties have disputes over certain details,"
The stories seem to indicate that oil and metals are bearing the brunt of these derivatives reviews in China. Today’s story from Reuters reiterates the oil relationship. What does this bode for the price of oil? Is it still overvalued and being artificially propped at today’s levels? Why are the Chinese now so anxious to walk from their oil derivatives? Remember Nanshan Power’s price protection for 2009-2010 was at $64.50. They walked. With oil above that price today, and at the time of these most recent threats, what are the Chinese telling us about what they feel the real price of oil should be?
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