Bunkers, Bob and The Bandit

I was stuck into a particularly fiendish Sudoku puzzle on a flight back to London from Singapore recently when I happened to notice Boring Bob, an old neighbor from my time living in Climax, Georgia. He had his seat reclined as he roared out loud while watching a rerun of ‘Just For Laughs’ on the AVOD. I slipped though the curtain from my bulkhead seat, stepping over my colleague Fat Andy who was snoring loudly with his shoes and socks in the aisle and approached old Bob. After a few minutes of catching up I noticed a tanker report on his table.

So over an airline-style Bloody Mary (warm tomato juice, a splash of Worcester sauce, a pint of vodka and an ice cube) we got talking about what he was up to in tankers these days. It turned out that he was now a tanker FFA trader for an owner, having previously worked at a couple of very big swingers in the tanker market. One was an oil major, the other a Wall Street bank. Bob had the second biggest house in our street in Climax, Georgia until he moved to New York, the biggest being mine.

Population 228 when Boring Bob left for Singapore to trade FFAs.
Population 228 when Boring Bob left for New York to trade FFAs.

I really know less about the tanker market than I do about where to go for fun in Pyongyang, so I thought it was a good chance to ask him a few little teasers to see if it would help me run my dry bulk business. One thing that has always bothered me is the question of bunkers. People in proper companies seem to always call it fuel oil, but it pretty much amounts to the same thing, the stuff you put in a ship’s engine to make it go.

Many years back Bob got poached to go work for this mega-tonne white shoe bank on Wall Street, with a sign on that could have bought the whole of Climax had he so desired. So he was paid well to trade tanker FFAs. Nothing else mind you, just tanker FFAs. His main market was TD3, which I am told is Arabian Gulf/Japan in VLCCs. It trades in Worldscale, which apparently is not measured in feet and inches. I cannot be bothered to explain Worldscale to you here, I suggest a well known search engine can do that for you. What I do know is that it does contain two elements; freight rate and fuel oil cost. So if you trade TD3 then by definition you will be taking on fuel oil exposure.

So I asked Bob what did he do about hedging it? Well he told me that one day at the bank he put on a small trade and decided to hedge the fuel oil exposure. He had to walk across the trading floor, which was the size of a football pitch to find the fuel oil trader to make him a market. Firstly, it was a long walk. Secondly, Bob didn’t know the fuel oil trader. Thirdly, inevitably the fuel oil guy would laugh at the tiny cover Bob needed, tune him up on the bid/offer as Bob couldn’t see his screen and also, most crucially he would now see a small part of Bob’s PnL.

Old Bob did hedge one trade and all of the above happened. The fuel oil trader was known around the desks as ‘The Bandit’, and The Bandit had no problem telling everyone what a horrid trade Bob had done. Cue shame, embarrassment, humiliation and the whiff of violence. So Bob told me that he made a plan. He worked out that in fact the fuel oil risk wasn’t so bad as to make him want to cross the floor and deal with The Bandit. Instead he did what all quality traders would do in the circumstances and decided to hope for the best and leave it unhedged.

Just your regular Fuel Oil Trader.
Just your regular Fuel Oil Trader.

Now Bob is a very straight guy. He vacuums in straight lines. He makes lists of lists that he needs to make. So what he told me really was pretty revealing. Sure enough Bob told me that he decided that some time later, after picking at the edge of the scabs of the market, he needed to make a VaR-busting name for himself at the bank. He put on a trade on the same TD3, which he described to me as chunkier than a Georgian McDonalds worker. He also did it unhedged.

It was a Friday and only the sad, desperate and the criminally insane trade freight swaps after midday on a Friday. Everybody else is drunk by 1pm so no need to worry. Bob took the afternoon off and left early for a weekend fishing trip in Scotland. After the hour-long flight he casually flicked on the Blackberry to glance at his PnL. Now nobody trades freight on a Friday afternoon, but they do trade crude. And crude had tanked. So had the fuel oil, going down with it. The freight element, for which he was paid to trade, was unchanged. The fuel oil had gone down the crapper and to his horror he’d booked in a marked to market loss of $250,000 over that one hour flight!

How could this happen? If Bob had taken some of his VaR cash and bought a consignment of hover boards and lost 250 grand I think it quite likely he would have been fired. Putting it simply he lost $250,000 because he had taken on exposure in a market that somebody else was paid to trade and simply didn’t know what he was doing. His words here, not mine! This is actually a more common theme than one might imagine.

Bob’s dislike of The Bandit was issue one. It is worth, as a manager, investing some time in working out if every person who has to interact as part of the trading and risk management process can walk past each other without thinking about drowning the other one’s kittens. Issue two was that Bob was not allowed to have a live fuel oil price screen on his desktop. Effectively he had no access to control the risk for a large part of his trade. That was The Bandit’s job, and he knew Bob’s predicament so would tune him up on the bid/offer and serve up general abuse as a free gift for loyalty card holders to boot.

The ‘solution’ Bob elected to use was that he was allowed the ICE Brent screen on his desktop. Brent is a decent proxy of fuel oil, but hardly perfect. Recently the Rotterdam and Singapore bunker prices have fallen far faster than the crude price. This relationship I am informed is called the crack spread (even I’m too proud to be making jokes about that one by the way). This is not constant and displays volatility. The east/west spread on bunkers is also variable, and all of these elements can and often are traded as part of sensible arbitrage strategies.

I did think that there were some lessons for my dry bulk business though. Clearly unforeseen internal dynamics can actually cause the business to take on risk that it did not intend to, and also might well be failing to capture, manage or price it correctly. Also, even the simple bunker hedge has many aspects; Brent vs WTI, East vs West, crack spreads, forward curves and so on. When dry bulk businesses operate on margins thinner than Yoda’s hair, it is a crime not to sweat the small stuff. This is in my control, unlike the general market direction. The last part is that it seems imperative that each trader can dissect his product into all of its moving parts and manage them properly.

Should Bob have had access to the fuel oil market? What if Bob was long, then The Bandit went short? The market roofs and Bob is a hero while The Bandit puts down ‘What Porsche’ magazine and starts thumbing the used Ford pages of ‘Auto Trader’. Bob lands a big bonus, The Bandit gets nothing and the company is left with a PnL which took no real market risk while using up VaR, made no net return and yet paid Bob a bonus for his troubles. Bad work all round.

Amazing what you can learn over a strong Bloody Mary.
Amazing what you can learn over a strong Bloody Mary.

So what was the conclusion one might draw overall from this tale? Bob says that he hedged the fuel oil using his Brent on his ICE screen (which for some reason he was allowed) for a while, basically making him hedged a bit in the right general direction. However, in no way could he say for certain that the calls he made on freight would be reflected perfectly in his PnL. After a while he told me that he started to think that actually the oil was the only interesting part of most of his trades, so he just gave up hedging altogether. None of his bosses even noticed.

I asked him what his one take away from this whole tale would be? He finished the last drop of his Bloody Mary, the ice cube that was stuck to the bottom of the cup fell painfully onto the bridge of his nose as he upturned the plastic glass. With tomato juice gently dribbling down his chin he fixed me with a cold brown-eyed stare and said: ‘That’s easy. The Bandit is an asshole’.

Mr.Prospector thinks Capesize purchases

The other day I was sitting in the economy class lounge at East Midlands airport, sipping a non-vintage Cava from a plastic flute while humming the theme tune to ‘Bonanza’ when who should I see across the way, but my old buddy Pippy. Pippy is a high flyin’ dry bulk trader who’s worked for the best of the best out there. I siddled up to him and said ‘Howdy’ and we shot the breeze for an hour or so waiting for our flights.

I asked him why he thought all these rich dudes are buying up Capesize ships at the moment. I told him about my plan to create a floating health club using a Capesize (tennis courts on deck, squash in holds 1 and 9, a weights room in 2 and 8, with spa and sauna plus a bar and changing rooms in the rest). He didn’t take to it well, but he did point out a few interesting facts and figures for me regarding buying a ship right now.

A modern capesize vessel was sold from a listed company into private ‘old money’ of shipping for $19.2m not so long ago. Basically that ship will need to earn about $11,400 per day over its life to break even. One argument is well, that’s darned cheap right? Historically yeah, I guess it does look cheap. But hang on there partner. It’s only cheap if it makes you money, and this one looks like it might not be a money spinner.

Granted, a lot of the buyers of these capesizes are also tanker owners who are choosing to take their chips off the table there while the cards are still running hot in order to place them somewhere where the luck must surely eventually change. Pippy showed me a little graph which I thought I would share with you, which puts prices vs earnings into some kind of historic format.

What Pippy was telling me was that if you take the value of a ship, then divide it by its earnings over the next five years then you come up with a ratio. When a ship costs $20m and it earns $20m then the ratio is 1.0. The higher this ratio gets frankly the better it is to sell a ship rather than buy it. Pippy took the FFA forward curve to model earnings over the next five years, in effect creating an arbitrage window for owners of tonnage or those wishing to buy.

On my way to Airdrie, pondering to buy or not to buy.
On my way to Airdrie, pondering to buy or not to buy.

This graph shows that buying a ship right now isn’t the best deal, but is far from the worst. The ratio for the $19.2m ship comes in at 1.25, kind of better than most ratios, but not at the end of the normal distribution curve either. Now let’s talk bucks here. The average earnings over the next five years of the FFA curve when we were chatting was $8,481 (average of the 4t/c’s, not the 5 t/c’s).

graph1

So the buyer is committing to funding a loss of $5.43m if he bought the ship and hedged the earnings. What Pippy said was that it looks a decent trade if you take the other side of it. The guy who sold his ship could now take some of that cash (once he’s let his bankers off the hook) and buy the long dated FFA curve. It looks a bit like an options trade right? Like a slightly odd shaped covered call, but using the earnings as cover.

What Pippy had to say certainly got my head thinking. My weekly stats round-up will have to give this more context, detail, different ship types and granularity. Pippy jetted off in his flat bed seat, destination Monaco, cursing the penny pinching that dry bulk traders are having to do to survive these days. I headed off into the night, watching the bright lights of Newark twinkle below me while tucking into a bag of Wotsits and a mini Mars Bar that I had unfortunately sat on, looking forward to getting home to my one bed flat in Airdrie.