China Aviation Oil - Derivative Losses

China Aviation Oil (Singapore) Corporation Ltd ("CAO") is the largest physical jet fuel trader in the Asia Pacific region and the key supplier of imported jet fuel to the PRC civil aviation industry. CAO's key businesses include jet fuel supply and trading, trading of other oil products and investments in oil-related assets. Incorporated in Singapore on 26 May 1993, CAO was listed on the mainboard of the Singapore Exchange Securities Trading Limited since 6 December 2001. Their parent company, China National Aviation Fuel Group Corporation (CNAF) is a large State-owned enterprise in the PRC. It is the largest aviation transportation logistics service provider in the PRC, with a diverse portfolio of businesses, comprising aviation fuel distribution, storage and refuelling services at more than 160 PRC airports. CNAF holds about 51% of the total issued shares of CAO. BP Investments Asia Limited, a subsidiary of oil major, BP, is a strategic investor of CAO, holding 20% of the total issued shares of CAO.

In 2005, CAO had losses of USD 550 million. This lead to it collapsing, until it was revived by CNA. How could CAO with monopoly in its area of business get into this position? It did this by speculation in fuel options. What started out by trading in derivatives to control volatility moved onto speculative trading in fuel options for profit, which eventually went very bad.

In the beginning CAO traded in over-the-counter (OTC) swaps and exchange-traded futures as hedging instruments to manage the risk in its business of procuring oil. The company traded in relatively riskless back-to-back option positions on behalf of client airline companies. This earned fee income for CAO from the bid/ask spread on these trades without exposing it to any volatility in oil markets.

At the end of the third quarter in 2003, CAO started conducting speculative option trades to profit from favourable market movements in oil-related commodities. It traded them on the basis that oil prices would move upwards. The trading strategy involved simultaneous purchase of call options and sale of put options. This effectively created a synthetic long position in oil without the need to purchase the commodity outright. As oil prices increased, the calls that were purchased were exercised at a profit. The puts that were sold were not exercised and CAO profited from the premiums that had been collected when these options were sold. These trading strategies had however not been reviewed/approved by the Board of Directors before trading began, and there was no risk committee in place to review these transactions on an ongoing basis.

This strategy worked well for CAO till the fourth quarter, when they estimated prices would go southward. Its CEO Chen Jiulin, began initiating trades with numerous counterparties that created a short position which would profit if oil prices  moved below USD 38.00/bbl.  This was accomplished by selling calls and buying puts with the result that CAO was in a short position at the end of 2003. In 2004 the prices exceeded USD38.00, resulting in CAO having to fund margin calls on its open short positions. The accumulated losses from these closed positions amounted to approximately USD 390 million. In addition, the company had unrealized losses of about USD 160 million, bringing the total derivative losses to USD 550 million. CAO concealed these losses. The international standard for accounting for derivatives IAS 39 required that these transactions be market to market with gains and losses reflected in current earnings.  As in most of the world, Singapore companies were required to adopt FRS 39 (the IAS 39 equivalent) as of 1 January 2005.

A review was then conducted by Price Water House Coopers. They opined that since specific methods to value derivatives trading were not present in FRS 39, CAO should have adopted the Industry standards, rather than saying that there were no clear norms. The key problem PwC noted was that the valuation of the derivatives was wrong in that it treated the intrinsic value as the fair value of its options. It should have instead taken into account the intrinsic value and the time value. This would mean that the length of the time to maturity of the option, the volatility in the spot price of the underlying commodity, interest rates and other factors would have been taken into account.

PwC represented CAO’s valuation against its own to show the variation:

Q1Q2Q3First 9 months
CAO EBT19.0 19.311.349.6
PwC adjusted EBT-6.4-58.0-314.6-379.0

The oil prices had been steadily rising in 2004. If CAO had used its intrinsic approach, it still would have shown losses. To cover its losses the company adopted a risky strategy to sell long-term options to generate premiums that would cover the cost of closing out the loss-making option contracts. CAO was trying to compensate for their existing losses by collecting premiums on options that had the potential to generate further losses in the future.

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