November 25,2008

Is Goldman Sachs Running a Derivatives Casino?

By CSC staff, Shanghai
State-owned enterprises such as Shenzhen Shennan Circuit Co.(SCC) and Air China have recently suffered big losses in international derivatives trading, focusing investor attention on derivatives market and structural options. The situation is frightening investors by reviving the ghosts from the CAO (China Aviation Oil) incident of 2005.
 
Three years after CAO ran up $550 million in losses in derivatives speculation in oil prices, domestic companies such as SCC have become the target of J. Aron & Company, a wholly owned subsidiary of Goldman Sachs. Now losses from a "small probability event" are spreading and spreading.
 
Let us look at the contract between SCC and J. Aron & Company.
 
The contract is valid is from March 3, 2008, to December 31, 2008. When the floating price of oil is higher than $63.5/barrel, SCC will receive a monthly income of $300,000 (200,000 barrels × $1.5/barrel). When the floating price is lower than the $63.5/barrel but above $62/barrel, SCC will have the proceeds of ( floating price - $62/barrel) × 200,000 barrels per month. When the floating price is below $ 62/barrel, SCC has to pay ($62/barrel - the floating price) × 400,000 barrels.
 
The contract was signed on March 12, 2008, and its code is 165723967102.11. On that day, the futures price index for light crude oil on the New York Mercantile Exchange closed at $106.81/barrel. In light of the situation at that time, the risk of the contract seemed very slim, most insiders believing it was not likely the futures price of crude oil would fall below $62/barrel before Dec. 31.
 
By March this year, the price of oil had risen to over $100/barrel. Forecasting oil prices became the focus of industry insiders. Goldman Sachs, which before had accurately forecast that oil would reach $95/barrel by the end of 2007, predicted that month that the average price of crude oil would continue to rise to $141/barrel in 2008. The oil price hitting $147/barrel in July made Goldman Sachs.
 
Look positively magical in it prescience.
 
At the time SCC signed its contract, insiders said that $100/barrel had opened a new era and that the days of cheap oil were gone forever.
 
And that agreement looked like cash on the barrelhead---as long as by the end of this year oil price didn’t fall below $62/barrel, SSC was set to rake in the cash. At the time, "oil falling below $62/barrel" seemed a microscopically "small probability event."
 
Though really, not so much cash. Regardless of how high oil prices might soar above $63.5/barrel, the maximum monthly earning for SSC is only $300,000. However, if oil prices fall below $62/barrel, losses can mount up quickly and almost without end. It’s a trader’s nightmare-a position with a limited upside and an unlimited downside. Positing that, by the end of this year, oil falls to $40/barrel, SSC will be paying out $8.8 million per month. The total net profit of SSC in 2007 was just over $17 million.
 
This contract is designed to be similar to a game in casino. The market maker pays for losses due to "great probability events," and usually costs are modest; the market player must cover losses due to "small probability events," and these can be massive. When the market maker faces many players, the odds of "great probability events" against "small probability events" and the ratio of compensation will favor the market maker.
 
Moreover, when the market maker has a certain impact on the bet, it is the least conducive to players.
 
In this oil price gamble, Goldman Sachs has played at least three roles------predictor, speculator and gambler. The research center of Goldman Sachs plays the role of predictor, Goldman's fund plays the role of speculator, and J. Aron & Company plays the role of gambler.
 
Since July this year, turning points of commodity prices such as crude oil have occurred. Goldman Sachs issued a forecast, greatly surprising the global market, that oil prices may drop to $40/barrel. Oil is currently trading at over $53/barrel, but it has been below $50/barrel and could well drop to $40 or even less. It should be noted that Goldman Sachs fund has played an important role in the ups and downs of the oil price, and, with companies such as Morgan Stanley, has been referred to as one of the large organizations influencing the futures price of oil.
 
It is reported that the marketing team of J. Aron & Company also contacted a number of domestic companies, which have the same demand for hedging risk as SSC.
 
J. Aron & Company is not always the winner in these gambles, but it can control the risk according to the design of "small probability event and great earnings," and if it plays well only a few times, it can reap great profits. It is clear that with the support of its parent company, which has strong "research ability" and "ability to participate in the market," it is not so difficult for "small probability events" to occur. However, under this "business model," Chinese enterprises, only beginners in international financial markets, are doomed to pay expensive fees to learn the ropes.
 
The designer of derivatives in Goldman Sachs is perhaps a casino master. In this gamble of oil prices, it seems that one Chinese firm hit the tables at Vegas and left without his shirt.
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