The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders by Kate Kelly Page A
Authors: Kate Kelly
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The only problem was that was exactly the scenario Emirates encountered.
Because the jet-fuel derivative market was relatively small, making it tough at times to get in and out of trades, airline fuel hedges typically employed a basket of contracts tied to various liquid energy commodities—usually crude, but also other contracts that were related to it, like heating oil and diesel. Bourlot’s trade involved using various options to set the expectation that crude oil would trade within a certain price band at a certain dollar amount above and below where Emirates management expected crude prices to actually be. If prices stayed in the range—which,statistically speaking, they almost certainly would—Emirates would achieve significant cost savings on crude.
But the trade also had some other features. Emirates had layered an additional batch of commodity contracts to widen that original range. So, instead of only being price-protected in a price range that was $30 wide, a second set of options contracts locked in oil prices at a range about $50 wide (the exact prices would change every year based on the market price of crude oil, but the size of the price range remained about the same). Emirates sold put options, which represented the right to sell oil, and calls, the right to buy it, to Morgan Stanley, which in turn sold other instruments back to Emirates.
It was a relatively simple concept with a complex execution, and it had a Seussian name to describe it: a “cap-swap double-down extendable.” There were layers upon layers of different trades between the parties, and no one bothered to track the amount of money one party had paid to the other overall. For Morgan Stanley, however, the “extendable” part was key. If the trade went well for the client—and it did for a number of years—it was simply rolled into the new year and reinstated at new price targets.
“For years and years, they were happy, and the firm was happy,” says a onetime Morgan official who was involved with the trade. Oil prices rose within the ranges expected, and Emirates effectively locked in cheaper fuel prices at just the right time. The carrier had recently initiated nonstop flights from Dubai to New York, and was planning to add a route from Dubai to San Francisco as well. The airline’s executives, led by Sheikh Ahmed bin Saeed Al Maktoum, whose nephew was the ruler of Dubai, were happy to remove some of the uncertainty from their biggest liability. Over time, the program saved the carrier at least a billion dollars on fuel; for the fiscalyear that ended in March 2008, Emirates reached a record profit of $1.4 billion.
Then things changed. In early May, West Texas Intermediate crude contracts—the standard oil contract in the U.S. at the time and the one Morgan had used to structure the Emirates hedge—soared past the $120 upper limit Emirates had imposed. That meant not only that Emirates was paying sky-high prices for jet fuel as cash prices moved higher, but that it was no longer protected by the hedges it had paid to create.
Oil’s $147 peak in July 2008 was an expensive miscalculation for Emirates, but its reverse was far worse. In five short months, West Texas contract prices collapsed from their height of nearly $150 to less than $70 and kept going. The floor of the Emirates trading range had now been pierced, and although the cost of West Texas crude was by now impossibly low—ranging in the $50s by November—the cost of the “swap” portion of the trade the airline had arranged with Morgan Stanley, which was repriced every day based on the latest market movements, was exploding.
At that point, Morgan made a massive “margin call,” or demand for additional cash as a down payment on the ongoing swap trade, to Emirates of more than $4 billion. The put options, or rights to sell crude, that the carrier had sold to Morgan were by now well below their “strike,” or target price. While the details of the paper
Because the jet-fuel derivative market was relatively small, making it tough at times to get in and out of trades, airline fuel hedges typically employed a basket of contracts tied to various liquid energy commodities—usually crude, but also other contracts that were related to it, like heating oil and diesel. Bourlot’s trade involved using various options to set the expectation that crude oil would trade within a certain price band at a certain dollar amount above and below where Emirates management expected crude prices to actually be. If prices stayed in the range—which,statistically speaking, they almost certainly would—Emirates would achieve significant cost savings on crude.
But the trade also had some other features. Emirates had layered an additional batch of commodity contracts to widen that original range. So, instead of only being price-protected in a price range that was $30 wide, a second set of options contracts locked in oil prices at a range about $50 wide (the exact prices would change every year based on the market price of crude oil, but the size of the price range remained about the same). Emirates sold put options, which represented the right to sell oil, and calls, the right to buy it, to Morgan Stanley, which in turn sold other instruments back to Emirates.
It was a relatively simple concept with a complex execution, and it had a Seussian name to describe it: a “cap-swap double-down extendable.” There were layers upon layers of different trades between the parties, and no one bothered to track the amount of money one party had paid to the other overall. For Morgan Stanley, however, the “extendable” part was key. If the trade went well for the client—and it did for a number of years—it was simply rolled into the new year and reinstated at new price targets.
“For years and years, they were happy, and the firm was happy,” says a onetime Morgan official who was involved with the trade. Oil prices rose within the ranges expected, and Emirates effectively locked in cheaper fuel prices at just the right time. The carrier had recently initiated nonstop flights from Dubai to New York, and was planning to add a route from Dubai to San Francisco as well. The airline’s executives, led by Sheikh Ahmed bin Saeed Al Maktoum, whose nephew was the ruler of Dubai, were happy to remove some of the uncertainty from their biggest liability. Over time, the program saved the carrier at least a billion dollars on fuel; for the fiscalyear that ended in March 2008, Emirates reached a record profit of $1.4 billion.
Then things changed. In early May, West Texas Intermediate crude contracts—the standard oil contract in the U.S. at the time and the one Morgan had used to structure the Emirates hedge—soared past the $120 upper limit Emirates had imposed. That meant not only that Emirates was paying sky-high prices for jet fuel as cash prices moved higher, but that it was no longer protected by the hedges it had paid to create.
Oil’s $147 peak in July 2008 was an expensive miscalculation for Emirates, but its reverse was far worse. In five short months, West Texas contract prices collapsed from their height of nearly $150 to less than $70 and kept going. The floor of the Emirates trading range had now been pierced, and although the cost of West Texas crude was by now impossibly low—ranging in the $50s by November—the cost of the “swap” portion of the trade the airline had arranged with Morgan Stanley, which was repriced every day based on the latest market movements, was exploding.
At that point, Morgan made a massive “margin call,” or demand for additional cash as a down payment on the ongoing swap trade, to Emirates of more than $4 billion. The put options, or rights to sell crude, that the carrier had sold to Morgan were by now well below their “strike,” or target price. While the details of the paper
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