CAO used “incorrect mark-to-market methodology”

China Aviation Oil (CAO) has published a report into the circumstances surrounding $550 million in oil derivatives losses, which the Singapore-listed firm – supplier of virtually all China’s jet fuel imports – revealed in late November.

The investigation, conducted by PricewaterhouseCoopers and published on March 29, highlights catastrophic failures in risk management policies and procedures at CAO, including the use of an incorrect valuation methodology for the mark-to-market calculation of its options portfolio.

The firm regarded the mark-to-market (MTM) value of an option as the intrinsic value – the difference between the strike price and the forward price of the underlying commodity – and ignored the time value of the option in its calculation, PwC said.

“We find [CAO’s] adherence in 2004 to this incorrect MTM valuation methodology difficult to comprehend as its own MTM valuation of its various options contracts differed significantly from the valuation of [the] same contracts by the counterparties,” PwC said in the report.

The oil firm had taken a bearish view of oil price movements in the fourth quarter of 2003, engaging in a strategy to sell calls and buy puts, leading to its short position with a negative MTM value of S$2.1 million ($1.2 million). CAO reported this at S$138,000 based on the intrinsic value method and overstated its 2003 profit-before-tax by S$0.6 million.

Following a surge in oil prices in 2004, CAO restructured its options books in January, June and September by closing out near-dated call options and replacing them with longer-dated call options.

As oil price continued to rise, margin calls by counterparties also increased, which “increased in magnitude after the June 2004 restructuring”, PwC said. CAO exhausted its financial resources by October 2004, with PwC estimating its MTM losses to be $367 million on October 8.

The firm had no established risk management policies in place for the speculative trading of options, which it began in March 2003. While an attempt to introduce trading limits was made in January 2004, the mark-to-market of the firm’s options book was already well beyond those limits. While the firm had generic stop-loss limits in place for trading, “having adequate risk management rules and tools requires not just that these are in place but that they are also adequately implemented and policed”, PwC said.

PwC states that CAO should have closed out its positions in January 2004 when faced with a negative MTM value on its options portfolio, rather than attempt to restructure its options portfolio. “Given the effects of the restructuring, namely that the company in fact took on higher risk as a result, it would appear that the company’s stated objective of managing its risk was not in fact achieved. This was perhaps influenced by the company taking the approach (in our view mistakenly) that, as a consequence of the restructuring, it would not have to record losses on the options that were maturing in Q1 2004,” the report says.