CORPORATE AFTERSHOCK 2 PHẦN 3 pps

We begin by ex-plaining the distinctions between traditional and prepaid energy forwards and swaps, and we remind readers that even plain vanilla forward purchase contracts are economica

the project being financed (as opposed to the other assets of the firm bor-rowing the commodity) So useful are prepaids for project finance, in fact, that the World Bank relied on them extensively in the 1980s for many of its development and project finance loans

The dearth of publicly disclosed information about what Enron actu-ally did prevents us from fully addressing the Enron transactions here, but we instead provide a number of more general conclusions that can be drawn even without a detailed Enron-specif ic analysis We begin by ex-plaining the distinctions between traditional and prepaid energy forwards and swaps, and we remind readers that even plain vanilla forward purchase contracts are economically equivalent to a money loan plus physical

stor-age of the underlying commodity We further explain why traditional for-wards can be used to extend money credit, but prepaid forfor-wards involve no

money credit and, instead, are economically equivalent to borrowing and lending the underlying commodity We then explain how prepaids and commodity loans play an important role in project finance, using an early program from Enron itself as an example Next, we explain why Enron’s more recent uses of prepaids have generated so much controversy We out-line the circumstances under which the more recent prepaid structures can be legitimately used for commodity finance, as well as when they can potentially be abused to disguise traditional debt A brief conclusion ends with a cautionary note about the recent public and political scrutiny of prepaids

TH E ECONOM ICS OF COM MODI T Y FORWA R D A ND

SWA P CON T R AC T S

Dating back to at least to the 12th century, forward contracts are among the oldest and most established forms of commodity derivatives—con-tracts whose values are based on underlying physical commodities such as

natural gas or oil A forward contract requires the long to purchase a fixed

amount of the underlying commodity on some future date at a fixed price that is negotiated at the inception of the contract The basic difference between traditional and prepaid forwards, as we explore in the following sections, simply concerns the timing of the payment by the long to the commodity seller

Tradit ional For ward and Swap Cont racts

In a traditional forward agreement, the payment of cash by the long and

the transfer of the asset by the short both occur at the end of the life

of the transaction (i.e., on its settlement date) Consider, for example, a

three-month forward contract negotiated on September 15 that requires the long to purchase 1,000 barrels of West Texas Intermediate crude oil

on December 15 The fixed price paid by the long (denoted $K /bbl) is fixed on September 15, although the payment by the long occurs on De-cember 15 Figure 9.1 illustrates from the perspective of the short (i.e., the oil seller), where up arrows denote cash or asset inf lows and down arrows denote outf lows

Instead of requiring the physical transfer of title for oil on the

settle-ment date, some forwards are cash-settled The long still makes a fixed cash

payment to the short at maturity, but now the short also makes a cash pay-ment to the long.1The cash payment by the short is equal to 1,000 bbls

times the spot price of oil on the contract’s settlement date The values of

the physical and cash-settled forwards are identical.2

One myth that has surfaced in the wake of the Enron failure is that

cash-settled forwards do not serve legitimate commercial purposes An

ex-ample immediately illustrates why this is wrong Consider a petrochemi-cal f irm that purchases oil every three months as an input to chemipetrochemi-cal production As oil prices rise, its profit margin shrinks The firm could,

of course, lock in its oil purchase price using a traditional forward Equally plausible, however, is that the f irm prefers to buy oil competi-tively on the spot market to spread its business around and retain some de-gree of purchasing f lexibility In this case, the firm might use cash-settled forwards to lock in its f ixed purchase price for oil indirectly—the for-wards would generate cash income at the same time that oil price in-creases erode margins This use of a cash-settled forward is clearly a legitimate part of the chemical firm’s primary business activities, despite the absence of physical delivery

Close cousins to forwards, swaps are essentially multiple forward

con-tracts with different maturity dates bundled and sold as a single package

FIGURE 9.1 Inflows and Outflows from the Perspective of the Short

Time

$K/bbl × 1,000 bbls

Short Oil Forward

1,000 bbls of Oil Three Months

A swap involves not just a single exchange of cash for an asset but several

such exchanges Consider, for example, a nine-month oil swap with quar-terly settlement dates If the swap is negotiated on September 15 and spec-ifies a fixed purchase price of $K /bbl, on December 15, March 15, and June 15, the long pays $K /bbl × 1,000 bbls to the short in exchange for 1,000 bbls of oil Exactly the same result could have been achieved had the short entered into three forward contracts, each with f ixed purchase price $K /bbl and based on 1,000 bbls of oil and with maturities of three, six, and nine months Like forwards, swaps can be cash-settled

Prepaid For wards and Swaps

The sole difference between traditional commodity forwards/swaps and prepaid forwards and swaps is the timing of the cash and asset f lows In-stead of making a cash payment to the short at the same time the short de-livers the asset as in a traditional forward, the long in a prepaid makes a

cash payment to the short at the inception of the transaction Figure 9.2

il-lustrates, using an otherwise identical oil forward as in Figure 9.1 Notice in Figure 9.2 that the fixed price received by the short when the prepaid deal is struck on September 15 is now denoted $M/bbl to indicate

a different price than the $K /bbl received by the short in the traditional forward shown in Figure 9.1 We explore what this price difference is in the next section

Like traditional forwards, prepaids may also be cash-settled Similarly,

prepaid swaps are just bundles of prepaid forwards, or contracts in which

a single fixed payment is made at the beginning of the transaction in

ex-change for the subsequent delivery of a commodity on several future dates.

At face value, there is nothing particularly controversial about pre-payment features in derivatives Consider the most prevalent example

FIGURE 9.2 Prepaid Forwards and Swaps

Time

Short Prepaid

1,000 bbls of Oil

$M/bbl ×

1,000 bbls.

of prepaid derivatives: options, or contracts in which the buyer pays an upfront premium to the seller for the subsequent right to buy or sell the underlying asset at a specified price Even the most ardent critics of de-rivatives generally admit that options can serve a legitimate purpose So, too, can prepaid forwards and swaps

For wards ve rsus Physical St orage

Like all derivatives contracts, the usefulness of commodity derivatives comes from the tight linkage between derivatives and the underlying mar-kets on which the derivatives are based The ability to “replicate” and “ar-bitrage” the payoffs of derivatives with positions in the underlying asset market, for example, keeps the prices of derivatives in line and makes them reliable tools for hedging

The economic distinctions between traditional and prepaid forwards

can be better understood by examining the differences in the replicating strategies for these two derivative products—that is, strategies that involve

no outlay at time t and produce the same payoff at time T for the

tradi-tional and prepaid forwards, respectively

T R A DI T IONA L FORWA R D CON T R AC T

R E PL IC AT I NG S T R ATEGY

As Culp and Hanke explain in Chapter 1, going long a forward contract

is economically equivalent to borrowing money and using the proceeds

to finance the immediate (spot) purchase of oil and then storing that oil over time.3 Table 9.1 shows the equivalence of a long forward with this borrow, buy, and store replicating strategy

Table 9.1 A Traditional Long Forward and Its Replicating Strategy

Borrow, Buy, and Store Oil from t to T

Long Oil Forward Maturing at T

where S(t) (S(T )) denotes the spot price of oil at time t(T ), r denotes the money interest rate, K denotes the fixed purchase price for oil in the for-ward, and z denotes the cost of physically storing oil, net of any benefits

to holders of actual oil inventories, and where both r and z are expressed

as continuously compounded annualized rates

Because both strategies involve no initial outlay and have identical risks, their values must be the same.4Table 9.1 thus tells us that the

equi-librium fixed purchase price K in the forward must be the same as the

cost of borrowing money plus storing oil, or

The term r + z is called the net cost of carry, where r represents the cap-ital cost of carry (i.e., storage) and z represents the net physical cost of

carry The economical equivalence of the two strategies has led many to

refer to a position in long forward contract as synthetic storage (Culp and

Miller, 1995b)

Because the replicating strategy for a traditional forward requires the long to borrow, buy oil, and store oil, the long cannot escape the capital cost of storage (i.e., the interest due on the loan required to fund the physical oil purchase) by going long a forward contract.5True, in the tra-ditional forward, the long no longer has to borrow to finance its oil

pur-chase at time t, but the seller knows this and thus can raise the forward

purchase price by exactly the capital cost of oil storage that the long avoided by using the forward contract

In other words, there are no free lunches, and the long bears the

cap-ital cost of storage in both physical and synthetic storage strategies In the

physical strategy, those costs are paid explicitly to a lender to finance the initial purchase of oil In the forward, the short is essentially extending money credit to the long by allowing the long to delay its cash payment, and the interest charges on that de facto loan are ref lected in the price paid by the long to the short at the contract’s maturity

Prepaid For ward Replicat ing St rateg y

If a traditional oil forward is economically equivalent to borrowing money plus buying and storing oil, then to what is a prepaid oil forward equiva-lent? Table 9.1 shows that borrowing, buying oil, and storing it is a

zero-cost strategy Now, the prepaid forward requires an initial outlay of M, where M is the fixed price paid by the long to the short at time t for de-livery of oil at time T The prepaid is not a zero-cost strategy To invoke the

traditional no-arbitrage valuation arguments of financial economics, we need to compare apples to apples and thus either need to convert the

replicating strategy into a strategy with an initial cost of M or to convert

the prepaid into a zero-cost strategy We adopt the latter approach with-out any loss of generality

As Table 9.2 shows, the original replicating strategy of borrowing, purchasing oil, and storing it is now economically equivalent to going long

a prepaid forward plus borrowing M to fund the cash prepayment In the absence of arbitrage, the fixed price M paid by the long in the prepaid

thus is

As in the case of the traditional forward, the long yet again bears the capital carrying costs of the commodity in both the physical replicating strategy and the prepaid In the former case, the capital carrying cost is paid explicitly to a moneylender in the form of the money interest on the loan required to finance a spot market purchase of oil In the latter case, the capital carrying cost is again paid to a lender, this time to finance the

upfront payment in the forward In both cases, it need not be the case that the long has borrowed any funds from the short.

Unlike the traditional forward, the long now bears the capital carry-ing cost explicitly when a prepaid is used in lieu of physical storage The short is no longer extending credit to the long by allowing the long to delay its payment for the commodity Accordingly, the short can no longer charge the long a higher price to ref lect the foregone capital carrying cost As a result, the fixed price paid by the long in the prepaid is exactly

Table 9.2 A Prepaid Long Forward and Its Replicating Strategy

Borrow, Buy, and Store Oil from t to T

Long Oil Prepaid Maturing at T and borrow

equal to the present value of the fixed price paid by the long in the

tradi-tional forward—that is:

I M PL IC AT IONS

A major implication of the foregoing discussion is one of the oldest and most basic tenets of commodity derivatives As the great economist Sir John Hicks recognized in 1939, any forward transaction (prepaid or oth-erwise) can always be “naturally thought of as reducible to a money loan

plus a spot transaction or forward transaction In fact any loan

transac-tion can be reduced in that way” (Hicks, 1939/1957, p 141)

In that context, it should also now be clear that the oil purchaser al-ways bears the capital cost of storage In a physical storage program or a

pre-paid forward, the capital storage cost is pre-paid in the form of the funding cost borne by the long to finance its initial cash outlay, whereas the long bears the capital carrying cost in a traditional forward contract through

a higher forward purchase price for oil This immediately implies that ab-solutely all commodity derivatives have a funding component and that the

cost of this lending is always borne by the purchaser of the asset

Another implication of the analysis in the previous sections is that the only extension of money credit from one counter party in a forward to

the other occurs when the short agrees to let the long delay payment in a traditional forward In that case, the simultaneous exchange of cash for the

asset at maturity allows the long to avoid the cost of funding the purchase over time, but that savings is offset by a higher forward price In the case

of prepaids, the long must fund its initial outlay until it receives the un-derlying asset Although the cash f low consequence of this is to put cash

in the hands of the short earlier, this is not an extension of credit by the

long to the short On the contrary, this is an extension of credit by a third

party to the long, and the long in turn uses this credit to finance a com-modity loan to the short.

To see why the prepaid is equivalent to a commodity loan despite the obvious cash transfer from the long to the short, we need only recognize the fundamental difference between an asset purchased for immediate delivery and one purchased for future delivery In a normal spot transac-tion, funds are exchanged for an asset that is delivered within a day or two of the funds transfer In a forward transaction, the two parties

mu-tually agree that funds will be exchanged later for an asset that will be de-livered later In this case, both counter parties bear some credit risk—the

M =Ke−r T t( − )=[S t e( ) (r+z) (T t− )]e−r T t( − )=S t e( ) z T t( − )

long has allowed the short to “borrow” the commodity by agreeing to

delay delivery, and the short has allowed the long to “borrow” the funds

by agreeing to take payment

A prepaid represents the middle ground, where the short does not

agree to extend credit to the long, but the long does agree to delay de-livery The long thus has bought and paid for a commodity on which it voluntarily delays taking delivery The prepaid is thus equivalent to a

pur-chase of the commodity for immediate delivery plus the simultaneous

de-cision of the long to loan the commodity back to the short

ECONOM ICS OF COM MODI T Y L ENDI NG

Why might a firm agree through a prepaid to lend a commodity back to the short that it has already paid for? There are two possibilities—either

the short needs the commodity, or the short does not yet have the commodity.

The latter, in particular, lies at the core of understanding prepaids as they

are used in commodity finance.

The Economics of Commodit y Lending

Commodity finance is essentially the lending of commodities to a producer

that does not yet have the commodity in deliverable form By paying for the commodity in advance, the producer can use the funds to acquire the com-modity or transform it into a deliverable form In markets such as gold, commodity lending occurs explicitly, whereas in markets such as oil and gas, commodity borrowing and lending are accomplished with prepaids

In a money loan, the borrower either accepts cash on an unsecured basis and merely promises to repay it or posts collateral with the lender to guarantee performance on the loan In a commodity loan, by contrast,

the borrower commits to repaying the commodity itself over time A cash-settled commodity loan involves the purchase of the cash equivalent of a

commodity by the long on the trade date and the subsequent payment by the short to the long of cash amounts determined by the prevailing future spot price of the underlying commodity

To see how a cash-settled commodity loan works, consider, for exam-ple, a U.S bank that advances the Mexican government $1 million to fund the completion of a government-owned oil drilling operation The loan is

to be repaid over f ive years, with quarterly installment payments com-mencing one year after the initial advance of funds The cash payment due

on each installment date is explicitly linked to a fixed amount of oil and

a f loating reference oil price The loan is thus equivalent to a prepaid, cash-settled oil swap

From the perspective of the U.S bank, a payment has been made for the cash equivalent of a fixed amount of oil, and the bank has then agreed

to delay its collections of those oil price-based payments over time From the bank’s perspective, its credit exposure to the Mexican government is substantially reduced relative to an extension of money credit by the bank that would require fixed interest payments in return If oil prices rise sub-stantially, the Mexican government will have relatively little trouble ser-vicing the commodity loan Interest payments on the commodity loan are higher, but so are revenues from the oil rig Similarly, the debt burden for Mexico falls at precisely the same time that its revenues fall—that is, when the spot price of oil declines

Commodity-based loans of this kind date back to the fourteenth cen-tury where they were used by the Medici Bank to promote trade finance (See Cochrane and Culp, 2003b; de Roover, 1963.) Similar commodity-index loans resurfaced in the early 1980s as a source of development f i-nance The World Bank, for example, frequently used commodity-based debt to provide funds to countries that relied heavily on commodity ex-ports to service their borrowings

Another common use of commodity loans is project finance By pre-purchasing the production from an as -yet uncompleted oil field or pro-duction platform, the upfront cash can provide the commodity borrower with enough cash to complete the underlying project This does not mean

that the lender has made a cash loan to the borrower Instead, the lender has made a loan of the commodity to the borrower, and the completion of

the project acts as economic collateral to ensure that the commodity can

be repaid as the underlying project begins producing and the commod-ity becomes available

Does all of this mean that prepaids are “bank debt in disguise”? Ab-solutely not On the contrary, prepaids are commodity loans that are not dis-guised at all To use a forward contract to extend a money loan, the short would extend credit to the long by allowing the long to delay payment A prepaid, by contrast, involves the long lending the commodity to the short.

The commodity purchaser bears the interest costs of funding the com-modity purchase regardless of the timing of the cash payment, as we have seen

Enron’s Volumet r ic Product ion Payments Prog ram

To illustrate the actual mechanics and benef its of commodity lending through prepaids, we need look no further than Enron itself As explained

in Chapters 1 and 4, one of the great success stories of Enron was Jeffrey Skilling’s GasBank, in which Enron provided long-term price protection

and project financing to its natural gas customers A pivotal component of the GasBank was Enron’s Volumetric Production Payments (VPP) program, begun in 1990 These transactions were prepaid natural gas forwards in which Enron was the long—that is, Enron paid cash upfront to a customer

in exchange for oil and gas production from the customer in the future

As Kavanagh explains in Chapter 8, an important application of struc-tured f inance has always been the area of project f inance, in which a lender agrees to help finance the completion of a project using the fu-ture revenues from that project as collateral for the loan This was pre-cisely the intent behind the VPP program To keep the credit risk of the transactions limited to production fields, Enron’s VPPs were set up in the form of SPEs that operated as legitimate aff iliates of the oil and gas pro-ducers The producers ringfenced their oil production f ields in these SPEs, thereby enabling Enron to limit its credit exposure to the SPEs themselves In other words, by prepurchasing the production from the fields set apart in the VPPs, Enron was essentially extending a loan to its customers whose interest payments in the form of gas and oil deliveries de-pended solely on the performance of the field underlying the VPP

As we alluded earlier, commodity financing is an attractive alterna-tive for would-be lenders to firms that may be questionable credit risks

but for their involvement in or development of a commodity-related

proj-ect that can serve as economic collateral for commodity financing Not surprisingly, then, Enron set up VPPs primarily with producers that either were struggling and needed short-term liquidity to keep a gas or oil field producing or that were in need of project financing for a field As an ex-ample of the former, Enron’s first VPP was done in 1990 with Forest Oil,

a cash-strained gas producer Enron entered into a prepaid natural gas swap in which Enron paid $44.8 million upfront in exchange for 32 billion cubic feet of natural gas to be delivered over five years through the VPP

An example of the latter was the 1991 VPP Enron helped set up with Zilkha Energy Under that agreement, Enron paid $24 million upfront to assist in covering the high upfront costs of Zilkha’s planned Gulf of Mex-ico expansion in return for a portion of the subsequent production from those properties (Fox, 2002)

Enron’s use of prepaids is a type of structured commodity finance for

two reasons The first is Enron’s use of SPEs to house the VPPs In addition,

Enron looked to the structured finance market to fund the project finance

credits extended through its VPP prepaids Starting in 1991, Enron pooled

its VPPs into a series of limited partnerships called the Cactus Funds The

terms of each individual VPP called for gas deliveries at varying frequen-cies and across differing maturities, but combining the VPPs into a single

vehicle created a net position that looked like one giant prepaid gas swap