Commodity Risk - Curve Construction and Environmental and Social Risk

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In a previous article, I gave an overview of the topic of risk in commodity markets. In that piece, I described the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Three risks that are very important for those trading in the commodity markets are curve construction risk, environmental risk, and social risk.

Curve construction risk occurs when the assumptions involved in the construction, repair or extension of a market curve do not line up with the reality of levels traded during the life of a transaction. Most commodity traders deal with this huge risk on a daily basis. An example of this risk that draws from my own is experience is a pre-export finance deal I did back in the late 1980s with the Russians. I paid upfront for nickel deliveries promised three months in the future. We set a fixed price for the deal on the day I transferred cash. When the ports in Siberia froze, the Russians were unable to perform on their obligation to me. I had hedged the price risk by selling three-month nickel on the London Metal Exchange. By the time I found out that there would be a delay in delivery, nickel went into a huge backwardation. The price of the metal rallied for the date I was short and I would not have the metal to deliver against my position.

I had to cover my short position at a significant economic loss. Therein is the essence of the curve risk, the shift in the forward curve or term structure of nickel resulted in losses. This an example of curve construction risk as well as counterparty performance risk discussed in a previous article.

Environmental risk is the risk of damage to the environment through involvement in a commodity transaction. An example of this type of risk is the Exxon Valdez oil spill, which occurred in Prince William Sound in Alaska on March 24, 1989. An oil tanker bound for Long Beach, California hit a reef spilling 11 to 38 million gallons of crude oil. The oil spill did a huge amount of damage to the environment and businesses in the region suffered. The cleanup and litigation charges for the accident were unprecedented. New regulations resulted from the accident. More recently, the Deepwater Horizon oil spill or the BP oil spill that began on April 20, 2010 in the Gulf of Mexico started with an explosion on an oilrig and a sea floor gusher flowed for 87 days until the oil company capped it on July 15, 2010. The destructive nature of the spill caused problems with beaches, wildlife and businesses all along the coast of the Gulf of Mexico. The costs were enormous and in July 2015, BP agreed to pay $18.7 billion in fines, which was the largest corporate settlement in U.S. history.

Social risk is the risk of damage to social structures through involvement in a commodity transaction. This type of risk can affect the reputation of those involved in these types of transactions as well as the societies affected by them.

I remember back in the mid 1980s the Romanian government decided to sell a significant portion of the nation's gold reserves. I suspect that the gold sales did not benefit the people of Romania but rather the leadership of the nation at that time led by Nicolae Ceausescu. One could argue that another example of social risk, closer to home and not commodity related, was the lending policies of many institutions that led to the U.S. housing crisis in the United States. These easy lending policies encouraged people to assume a great deal of debt. Many could not afford to pay their loans. This eventually led to property foreclosures and volatility in financial markets, which caused hardships, and tremendous social costs in the U.S. in the aftermath of the crisis.