Embracing the Highly Improbable

Six Lessons for commodity traders from the tragic events in Japan.

The tsunami-induced nuclear crisis in Japan reinforced a lesson that many organizations first learned from the financial crisis: Risks considered extremely unlikely can, and increasingly do, happen. Many commodity trading organizations discovered themselves on the wrong side of the market when power, natural gas, coal and carbon emission prices suddenly increased by double digits shortly after the events in Japan and government decisions to shut down nuclear plants in Europe. This is likely to result in losses that will have a significant impact on their upcoming quarterly earnings results.

Agricultural commodity prices like corn, wheat, rice, sugar, soybeans and milk rebounded after dropping in reaction to fears of lower Japanese imports. Uranium also tumbled initially more than 20 percent as increasingly divided views about the future of the nuclear industry spread around the world. Some speculative market participants unloaded positions while plant operators and producers stepped in and bought the fuel raw material. Similarly, Australian coal fell more than 5 percent as Japan’s coal infrastructure and generation capacity declared force majeure and new buyers had to be sought for cargos.

The chain of incidents that led to Japan’s nuclear emergency highlights the structural deficits that many commodity trading organizations suffer from in their ability to cope with tail events. Well-established standard practices for preparing for highly improbable events such as nuclear conflicts in the Middle East and widespread power outages have existed for many years. And yet, many organizations do not embrace these practices with a sufficient sense of urgency under normal conditions.

We believe the time has come for trading organizations to incorporate impossible events into their regular risk management routines. To this end, we suggest that every commodity trading organization should embrace the following six broad strategies:

  • Supplement stress tests for risk reporting – Process a static set of stress scenarios consisting of extreme price movements; correlation coupling and decoupling; and liquidity decreases on a recurring basis. Make sure that the associated monitoring of stress test outcomes is a key element of the risk governance framework.
  • Consider market liquidity – Regularly evaluate the market liquidity of each position. Asset-backed traders can hold positions that are more than 100 times the daily transacted volumes. As a result, any quantification of risk can be significantly distorted if the liquidity of a trading position’s market is not taken into account.
  • Apply proven methods – Identify key historical incidents that had a detrimental impact on risk drivers and use them as inputs for standardized stress scenarios that are evaluated on a regular basis. This approach becomes especially relevant once full portfolio diversification benefits have been realized in favor of capital efficiency. Senior executives should also reevaluate whether they are using adequate stress testing tools. False security supported by insufficient models leads to severe financial consequences.
  • Conduct reverse stress tests – Examine the level of loss that would pose a significant threat to the trading organization. Such a critical loss could result from occurrences ranging from missing annual performance targets to traders’ reputations being damaged because they could suddenly trigger a need to hold a higher level of collateral, for example. A breach of a financial covenant requiring immediate refinancing of debt at a significantly higher margin or the failure to fulfill an obligation set forth by a contractual agreement could also jeopardize a trading organization’s survival in the mid to long term.Developing stress scenario and associated thresholds of risk factors and their dependencies fosters a thorough understanding of the firm’s risk environment among all stakeholders. For senior management, reverse stress tests provide an excellent basis for prioritizing risk mitigation measures and allocating resources based on the vulnerabilities and dependencies of the firm’s businesses. Insightful reverse stress cases account for market, credit, liquidity, operational and legal implications as well as the specificities of the underlying physical asset base.
  • Define combined stresses for commodity price developments and correlations – Trading organizations increasingly need to develop stress tests and more sophisticated risk aggregation methodologies that take into account risks related to not only commodity price fluctuations, but also alterations in their correlations. Under extreme market conditions, commodities often become either much more positively or negatively correlated, increasing the basis risk in a hedge portfolio significantly. For instance, the observed change in the spread between South African coal delivered into Europe and coal shipped from Australia may become a standard example of a correlation suddenly decoupling. In terms of credit risk, the correlation between a potential counterparty default and the replacement value of a structured contract may also be suddenly, and dramatically, changed.
  • Incorporate a checkpoint prior to stop-loss close-out procedures – Some commodities’ initial price shocks leveled off in the weeks following the initial tragic events in Japan. For instance, the 12 percent price increase of Dutch natural gas in the first week shrank to less than half of that only a week later. Stop-loss limit procedures should be structured so that commodity traders must explain losses to senior management before hard limits are triggered. Furthermore, they should allow, in exceptional cases, a trader to leave a position open if a convincing case for the persisting fundamental rationale of the trade can be made.

Standard risk metrics or basic stress tests are often overly reliant on simplified model assumptions and historical data that assume a given pertinent set of fundamental risk factors continues to drive risk in an unchanged manner at all times. Under extreme market conditions, however, risk factors behave and interact differently.

The earthquake and tsunami that hit Japan on March 11 and their aftermath highlight how vulnerable modern society is to events that are often inadequately assessed because they may be deemed impossible. For a trading organization, it is critical to maintain an adequate financial buffer to protect the company from a negative impact that is beyond its risk appetite. To achieve this, trading organizations need to reconsider how they are coping with lingering tail risk.

Embracing the Highly Improbable