Fire Hydrants and Other Random Events

About three seconds before my son ran head first into a fire hydrant on Monday night, I was talking to a friend who was asking exactly what JP Morgan had […]

About three seconds before my son ran head first into a fire hydrant on Monday night, I was talking to a friend who was asking exactly what JP Morgan had done to lose $2 billion.

Both this event and the escalating farce in Greece have been dictating both the mood and movement in financial markets in this past week, so let’s look at how the misgivings of a European country and a large US bank filter their way back to Energyland™.

Greece

To sum up the Greek debt crisis, it seems prudent to assess its crash course, from steps 1 – 10:

1 ) Greece joins the euro in 2001, bypassing the stringent debt conditions of the EU through a secret loan from Goldman Sachs (no, seriously). The bank basically lends Greece 2.8 billion euros so its balance sheet would pass the requirements to join the euro currency. By 2005, Greece owes Goldman Sachs 5.1 billion euros.

2 ) Once in the euro, Greece is able to borrow more money through issuing government debt – and at a preferentially low interest rate as it is considered as reliable as its euro-buddy Germany.

3 ) 2001 – 2009: Greece goes nuts, throwing money at infrastructure projects, services, and public sector wages, all the while selling more debt to fund this spending spree.

4) October 2009: Then uh oh. The extent of Greece’s vast debt is realized by the EU. Realization also dawns, however,  as to who has the most exposure to this debt…German and French banks ( ah ha! and the penny drops as to why the Eurozone doesn’t want Greece to default on their debt…).

5 ) And by the way – as an aside – Greece isn’t the only country in this predicament – the rest of the PIIGS have vast debts too (Portugal, Ireland, Italy, Spain).

6 ) March 2010: Greece comes up with a plan (under pressure from an angry Eurozone) to pay down its debt through austerity measures – slashing spending in the country. It also receives a ‘bailout’ from the Eurozone leaders (its in their best interest to save them, after all), which it also needs to pay back.

7 ) October 2011: It becomes clear that Greece is not meeting its austerity measures, while the initial bailout is not enough to stave off default fears. The only answer from the Eurozone is to give them another, larger, bailout (?!) and to implement further austerity measures (which may or may not be adhered to). Owners of Greek debt agree to take a haircut (= a 50% loss on the debt).

8 ) Late October 2011:  The Greek Prime Minister then puts everything in doubt as he tries to call the bluff of the Eurozone by announcing the country will vote on whether or not to accept a second bailout. He is strongly criticized, and promptly resigns. The country continues to scramble to make each next debt repayment.

9 ) This brings us to the present. Greece continues to face an increasing risk of default as it struggles to service its debt, while its economy is in a downward spiral, in part due to austerity measures (but mostly due to its reckless spending – no.3). Recent elections have seen Greek voters rebelling against austerity, meaning another election is required (on June 17).

10 ) Given the deterioration in financial conditions this month, the prospect of Greece leaving the euro is now openly being discussed by central bankers.

This tale will not have a happy ending.

…and onto JP Morgan…..

JP Morgan reported a $2 billion loss last week, after a single trader (nicknamed the ‘London Whale’) took a number of large positions in credit default swaps, which then moved against him. It turns out ‘the Whale’ was called ‘the Caveman’ last year (due to the overly aggressive nature of his trading), as he bet $1 billion on the expectation of certain companies going bankrupt. When bankruptcy hit the parent companies of American Airlines and Dynergy, he hit a jackpot of $450 million.

His history of large gains meant the risks he was taking were largely ignored because of the large profits he was generating (that ole risk / reward thing). Until he struck out. The CEO of JP Morgan, Jamie Dimon, described the Whale’s final trade as ‘flawed, complex, poorly reviewed, poorly executed, and poorly monitored’.

So what is my point?

These two events have been key drivers in the movements in Energyland™ recently, despite their seemingly unrelated or tenuous link back to energy.
The ongoing situation in Greece is weighing on crude for a number of reasons. The prospect of contagion spreading across the Eurozone – and its negative impact on economic growth (ergo, oil demand) – is a key fear, while the simple lack of confidence in the euro is causing a move into the dollar, and weighing on crude (dollar / oil tend to have an inverse relationship).

The worst thing, however, is that no option is favorable. The cost of Greece exiting the euro is estimated at $1,000,000,000,000, while the cost of them staying in is borne by the other Eurozone economies; a lose / lose situation.

As for JPMorgan, the revelation that such a large position taken by a bank could go largely  unmonitored or largely ignored will likely lead to the spotlight of scrutiny being shone on financial trading in the oil markets. This will likely try to manifest itself in tighter regulation. Although some view this as the remedy to stop higher volatility and speculation in the market, the reality is that the presence of speculators is a natural counterparty for those hedging to manage their risk, and for keeping the market efficient and less contrived.

But the ultimate takeaway from the JP Morgan saga is the need for risk management. Which loops us nicely back to what we do here at Summit Energy, and back to my son running head-first into a fire hydrant. Although Greece looks to be beyond smelling salts, JP Morgan – much like my son – will likely be scarred in the near-term, but eventually unscathed by this drama. And both have hopefully learned a lesson – to be more alert.

Matt Smith is a Commodity Analyst for Summit Energy International. A subsidiary of Schneider-Electric.

Find Matt’s Energy Risk Management blog at www.energyburrito.com

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