In a quietly released, densely worded statement to the Hong Kong stock exchange, Air China took a brave step late Friday night and warned its shareholders that it was sitting on a paper loss of almost half a billion dollars because oil prices are falling dramatically. Anyone holding shares in companies like these is entitled to ask: what is going on here? After years of pain from high oil prices, the balance sheets of these kinds of companies should be getting better now that oil has fallen by 65%. But they are not, and in some cases they are only going to go disastrously wrong from here.
Investors picking over the revelation will quickly note that the massive loss has not yet been realized -- instead it will likely be painfully fed into financial results for years to come, unless the airline takes the hit and unwinds the position before then.
More announcements like those are sure to follow in the coming weeks from other airlines, shipping companies, and other companies exposed to the price of oil.
But they're not, and the main reason is the seductive -- and clearly dangerous -- nature of so-called "zero-cost" trading in oil derivatives. Zero-cost options are at best misleadingly labelled. At worst, they can be a poison pill that quickly send your business hurtling towards disaster, as Sri Lanka's Ceypetco also found out this month.
Air China is just the latest company to fall into the zero-cost honey trap. Banks and other financial institutions offer to sell call options to companies like Air China, which are exposed to a surge in their costs if oil prices go up.
Those options give the companies the right to buy oil at preset prices -- which is good if prices go even higher. But they don't have any obligation to buy the oil, which is great if the price of oil goes down.
So far, so good. But an option like that costs money -- what's called a "premium" that must be paid to the bank that is giving you the protection. There the deal can start to break down, and there is where the zero-cost fantasy begins.
Don't want to pay the premium? OK, any bank will tell you -- why don't you grant someone else an option, charge them a premium, and use it to offset what you spent on your call option?
The bank will arrange the whole thing, and it sounds pretty tempting. A lot of companies fall into the trap.
The problem with this structure, and what Air China's shareholders will wake up to read in newspapers on Monday, is that when you sell someone else an option, you take on an obligation in return for the money they pay you. In the case of Air China, you take on an obligation to buy oil from someone else if the price collapses.
The fuse was lit in July on a bomb that eventually blew a half-billion dollar hole into Air China's book, when it signed up for masses of zero-cost options, extending out as far as 2011 in some cases. Oil was trading at $147/barrel and it was on a five year bull run.
Someone, somewhere, obviously thought it was no big issue to take on the risk of guaranteeing someone else the right to sell oil at a lower price.
That decision could cost the company a half a billion dollars and counting. In reality, airlines have no reason to be out there selling put options, and do it only for the short-term revenues earned from the premiums they receive. Generally speaking, they don't have the skills required to manage a short option position. It is simply a position they should not put themselves in.
If the oil market turns, Air China might be able to look back on this as a lesson learned. But the signs are not good: it looks like the global recession will run for several years, and oil futures have fallen by another 24% since Air China marked the half-billion dollar loss onto its books on October 31.
Watch out for more blood in the water.
Commodities trading continues to burn people on the way down.