Commodity Risk - Force Majeure Risk and Funding Liquidity Risk

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In a prior 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. Two risks that are very important for those trading in the commodity markets are force majeure and funding liquidity risk.

Force majeure risk is the risk of an unforeseen event beyond the reasonable control of either counterparty to a transaction. This term comes from the Latin, vis major or casus fortuitus or the French cas fortuit, which means superior force. A force majeure is often an act of god. An example of this type of risk would be a weather event that hampers the ability of one party to a commodity transaction to perform. If a storm, flood or drought were to decimate a sugar, corn or any other crop sold to another party the weather event would constitute an act of god that prevented performance or delivery of the commodity promised. Sometimes commodity traders take out special insurance policies to cover these types of risks. In 2011, an earthquake and tsunami wrecked havoc in Japan. As a major consumer and importer of many commodities, including corn, companies in Japan maintain stockpiles and inventories in order to meet the requirements of the Japanese citizenry.

The earthquake made many of these inventories unusable, destroyed them or washed them out to sea. While these inventories were the property of certain parties, sold to others or financed by yet others, the act of nature that destroyed the corn or other commodities was not the fault of any one of the contract parties.

The force majeure situation caused massive economic losses. Many, if not most contracts, deal with the potential for a force majeure situation and that is why contract parties often go to insurance companies to buy protection for these unforeseen events.

Funding liquidity risk is the risk that a party to a transaction is unable to meet interim payment requirements. These types of payments can be for margin calls, or in some cases, a rating downgrade can trigger an increased collateral demand in excess of the mark-to-market for a transaction. The bottom line on this type of risk is that one party cannot come up with the necessary funds to meet obligations. On futures exchanges, margin is a daily responsibility for any party holding a long or short futures position. If a party cannot meet a margin call on their position, the exchange or its agent (and FCM or broker) may liquidate that position immediately. A dramatic example of funding liquidity risk took place in the financial markets in 2008. Two companies, Bear Stearns and Lehman Brothers held enormous long positions in mortgage-backed securities. In August 2007, a credit crisis erupted as two Bear Stearns hedge funds that held these securities failed.

The value of the collateral (home values) declined dramatically. Therefore, the paper securities held by both institutions moved lower as the collateral was worth less.

The problem, that caused both firms to disappear (Bear Stearns was taken over by JP Morgan and Lehman went bankrupt), was leverage. Each firm had a high ratio of total assets to shareholder equity and their huge mortgage portfolios, or positions, made each vulnerable to deteriorating market conditions. When the value of the securities dropped, each firm could not pay the market differences required to maintain their positions. At the same time, the market for those securities moved lower so fast that they became illiquid -- there were no buyers available to sell those positions to in order to stop the bleeding. Both Bear Stearns and Lehman Brothers, two leading investment banks, went out of business as they did not have enough cash to fund their positions.

Both failed due to funding liquidity risk. There are many other examples of this type of financial risk in all asset classes. In commodities, funding liquidity is always a risk for parties to a transaction and the larger a transaction, the bigger the risk becomes.