September 08,2009

Government Involves Itself in SOE Fuel Derivative Defaults

By CSC staff, Shanghai

Last year's commodity price plunge caught a number of Chinese state-owned enterprises (SOEs) flat-footed and they suffered huge losses in fuel hedging derivative trading with international investment banks. Both the SOEs and regulators are straining to explain the debacle, and there are even indications they are inclined to blame fraud and/or conspiracy by foreign investment banks.


The State-owned Assets Supervision and Administration Commission(SASAC) has acknowledged that "central enterprises engaged in oil structural option trading have sent letters to their counterparties to safeguard legal rights." It went on to say it would pay a high degree of attention to the issue, and was requiring that "relevant counterparties should provide assistance."


The news, released a week ago, has triggered strong response from international commodity markets and exchanges, which are afraid Chinese companies may up and walk away or default.


There has been no news in response from counterparties. It is reported that at least six international investment banks may be involved in the case. Goldman Sachs is the largest "banker" for oil derivative trading.

SASAC said: "To defend the security of state-owned assets, SASAC is undertaking investigation of oil structural option transactions, and it supports enterprises to resort to legal means, minimize losses and protect their interests through negotiations, consultations, and position management, and retain the rights to take further legal action."


The "structural option" is a derivative product packaged through trading strategies out of simple option products and other derivative products. Last year, many SOEs under SASAC "stumbled" in oil derivatives, including Air China and China Eastern Airlines. Air China was trading in structural hedging products.


SASAC has not disclosed which central enterprises have sent the letters, and it is believed that only a few have. Air China, China Eastern Airlines and COSCO say they don't know which companies have written to counterparties.


The specific content of the letters is to require an investigation of the pricing policies and trading rules of previous financial derivative transactions. Before the investigation is complete, enterprises will not provide additional margin on the transaction to limit their risk.


A Singapore investment banker quoted by Reuters says, "If these central enterprises declare bankruptcy, then the situation will be handled differently, but if these companies are still running but walk away due to the losses, it is unacceptable."


A legal adviser and attorney engaged in derivative trading told Reuters that details of the contract will determine whether these Chinese central enterprises can walk away from derivative transactions after huge losses. He disclosed that contracts signed by central enterprises and foreign investment banks have followed the form issued by the International Swaps and Derivatives Association (ISDA), but the ISDA sample contract allows the investment banks to choose where and what kind of law they should obey. Therefore, investment banks can choose to litigate outside of China.


Huang Bin, General Board Secretary with Air China, revealed that for the fuel hedge contracts signed earlier, the company will take the initiative to stop losses and adjust its position based on market fluctuations, and will do modifications to payment limits, but it will not make risk overlay.


While SOEs are undertaking their own investigations, SASAC is also looking into the situation, but there seem to be no direct links between them. As those directly involved, enterprises have the right to examine their trades, while SASAC's work is to strengthen supervision over central enterprises who carry on derivative business.


In February, SASAC issued a circular requiring central enterprises to file a written report before March 15 on straightening out their derivative business. At the end of March, it issued a "Notice on Further Strengthening Supervision of Central Enterprises' Financial Derivative Business." But SASAC has not declared its attitude toward accountability identification or reasons for losses that have occurred.


SASAC requires that the position of central enterprises shall not exceed 90% of the spot of the hedge during the same period. For firms with huge derivative losses in previous years or for newly-established enterprises, in the next two years positions may not exceed 50% of the spot of the hedge during the same period.


China Eastern chairman Liu Shaoyong says his firm hasn't signed any new fuel hedging contracts, though he says engaging in such business is conventional. "I hope that airlines can achieve a legitimate qualification for OTC trading, but they have not got it yet."


As for central enterprises trading in structured option transactions, Liu Shaoyong suggests that laws and regulations need to improve and enterprises must better manage risks. Documents from SASAC have not totally prohibited SOEs from signing new hedging contracts.


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