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Traders have been seeking profits and making fortunes at the Chicago Mercantile Exchange since 1919, when investors mostly went long in butter and shouted out for mass egg buys.
Now, an entire tower of the exchange is devoted to just one asset: fossil fuels.
There’s no better classroom for a commodity economics lesson, and no better teacher than Greg Williamson, a former prop trader and BP’s chief investment officer. We’re in a 10th floor boardroom in the 40-story tower that BP took over when computers began to replace burly men jostling in the pits. Just down the hall from Williamson and me, traders phone and focus—no garish jackets in sight—but are still pursuing the same goal as a century ago: seeking big returns on volatile assets.
Williamson’s investing goals for the $8 billion defined benefit pension fund may have more in common with these traders’ than most of his asset owning peers’—or they did, up until a few years ago. Williamson was—and to a great extent still is—in an exclusive clutch of corporate CIOs who chose not to pursue liability-driven investing (LDI).
Up until the mid-2000s, the fund was roughly 80% equities at any given point. While this may seem stock-heavy—and it certainly is compared with traditional bond-based LDI portfolios—equities provided a robust hedge against commodity prices. “Commodity prices are typically negatively correlated with the rest of the economy,” Williamson explains, wearing a Chicago-perfect suit: doubled-breasted with pinstripes.
“When oil prices rise, everything else being equal, the rest of the economy weakens, stocks fall, and oil companies make a lot of money,” he says. “I’m always thinking about the company’s ability to continue funding its pension obligations, and equities are the most diversifying asset that the investment portfolio can hold relative to the source of the company’s cash flow. Returns aside, investing in the stock market means we’re already hedging.”
BP and similar corporations’ ability to offset occasional large investment portfolio losses means CIOs like Williamson can pursue riskier strategies with higher upside potential, thereby reducing the company’s need to make contributions overall—which is exactly what the CFO of such a firm is looking for.
Williamson recognizes that by the nature of the commodities business, a hefty cash flow comes with vast demands for capital investment. “Anything we can do meet our fiduciary obligation while minimizing company funding of the pension is what we want. They have to spend enormous amounts on production, exploration, and taxes to keep the company viable.”
“About 75% of American plans have extended duration to some degree,” says Marty Jaugietis, director of LDI solutions for Russell Investments. He notes that almost all of his clients have taken that fundamental first step onto the LDI path. “But,” he points out, “there are a handful of companies out there—and some of the large energy companies may be examples—where their pension liabilities are small relative to their market capitalization. They also generate so much cash that they don’t need to worry much about the impact of interest-rate or market volatility on their plans. They can potentially afford to fund it even in a bad market scenario.”
“One of the main questions that leads and has led funds to de-risk through LDI is ‘Can I handle the downside of my current exposures?’ With someone like an energy company or a healthcare company, yeah, there is a potential you can, but those situations are relatively rare,” Jaugietis says.
There are two widely agreed upon qualities of successful LDI holdouts: a market cap that dwarfs the company’s pension obligations, and the cash flow to absorb volatility and investment losses through extra contributions. Expectations of rising interest rates, at least according to some leading consultants and Williamson, is not one of those qualities.
“I had one prospective client, a $1 billion corporate fund in the US, come to us in rough shape,” recalls Jaugietis. “Two years before we first met, they’d begun shorting Treasury futures. With the Fed’s quantitative easing program, they thought ‘surely rates will rise.’ Well, interest rates fell, and they had to sell assets to mark their futures position to market. This was an example of a client that thought they could handle their interest rate risk, but couldn’t, so they came to us with their portfolio.”
Jaugietis has a small number of clients who meet the structural criteria required to consider abstaining from LDI, but he advises these clients to tread carefully. “With these clients, I consider three main aspects in helping to design a portfolio: One, how big is their pension compared to the company as a whole? Two, funded status. Is it closed or open? How much return seeking do we need to get to the finish line versus the ability to put in contributions? And three, flavor of the LDI portfolio. How much interest rate risk are they willing to adopt, and what sort of fixed income exposures best achieve their goals—in particular, looking closely at the corporate/credit exposure versus liabilities and the quality of that exposure. What’s their appetite for swaps and leverage? That sort of thing.”
Like any consultant worth his spot on aiCIO’s Knowledge Brokers List (and a very respectable #13, at that), the broad-shouldered Aussie isn’t naming his clients’ names. However, in addition major oil companies, he says potential LDI naysayers could include technology companies, pharmaceutical giants, and consumer staples.
It is safe to say that BP is not on Russell’s client list, although Williamson is certainly on Jaugietis’ radar.
“I’m sure Greg is doing really interesting things at BP. He’s a highly technical guy,” Jaugietis enthuses, letting his investment-geek flag fly. “What do I think you should ask him? What his portfolio looks like!”
“Not going to happen,” says Williamson with a smile when I relay Jaugietis’ interview advice.
BP’s pension portfolio looks a lot different now than it did—not that Williamson gave a guided tour of his hand-selected equities, bonds, swaps, and puts.
Three things have changed since the 80%-equities days, says Williamson, who has worked at BP (formerly Amoco) since 1991.
Firstly, the rise of exchange-traded funds over the last decade or so has increasingly brought commodities prices in step with the wider economy. Equities are just not the hedge they used to be for big oil.
Secondly, on August 17, 2006, former President George W. Bush signed the Pension Protection Act (PPA) into law and upended everything.
“Fifteen years ago, LDI hadn’t made much of an impact here in the US,” says Nick Davies, Mercer Investment’s segment leader for DB plans in the United States. “The EU [European Union] had been much more at the forefront of the liability driven pension investment strategy. Then the PPA came in and fundamentally changed the way US corporate pension plan sponsors think about their liabilities.”
While Williamson is no cheerleader for the legislation, it did indeed contribute to his later decision to begin implementing a very mild LDI strategy. “The PPA was not geared toward BP,” he says. “It is for companies that don’t make regular contributions to their pensions, and to fund the PBGC [Pension Benefit Guaranty Corporation] safety net for those that fail.” Unless a clean and bountiful energy source to replace fossil fuels is discovered, it is very unlikely that BP’s pension plan will collect on its PBGC contributions anytime soon.
“The PPA penalizes corporations for increases in pension plans’ solvency volatility. The accounting doesn’t take into account a company’s ability to fund its pension obligations,” he says. And BP, along with most of big oil and other high-cash flow corporations, has almost always had a terrific ability to pay.
Well, any year of cash flow except one—which brings us to the third and final factor that will likely thrust BP onto the mildest of LDI paths.
On the evening of April 19, 2010, high-pressure methane gas rose from the ocean bed through drilling pipes to the Deepwater Horizon oil rig and exploded in the darkness.
Flames engulfed the drilling project. Two days later, as BP’s rig sunk and disappeared into the Gulf of Mexico, an oil slick blossomed in its place. Nearly a mile below the surface, more than 100,000 gallons of oil per hour were surging into the sea, according to a federal commission’s estimates.
“BP had something like seven levels of protection and backups that all failed,” remarks one petroleum engineer, who works in unconventional drilling for another major oil company. “Considering the number of offshore rigs in the Gulf and around the world, it’s almost amazing something like this hasn’t happened before. It’s just really shitty luck for them.”
BP seems to agree. In a speech this past May, Executive Vice President Dev Sanyal likened the oil spill to a Black Swan experience—Nassim Taleb’s term for an extremely unlikely event that nevertheless comes to pass. Based on Sanyal’s account, the spill doubtlessly changed things for the man at the helm of DB’s open $8 billion pension plan.
“The operational crisis soon developed into a financial crisis,” Sanyal said. “This was best epitomized by our credit default spreads—or CDSs—which is the cost of insuring against bankruptcy. Before the accident, they stood at around 40 basis points—which made us a safer investment than most sovereign nations. But at the height of the crisis they soared to over 1100 points—and anything over 400 points is considered sub-investment grade—or in popular parlance, a ‘junk’ bond,” Sanyal said. “This was a very big, very serious event.“
As the oil was flowing for those 86 days in 2010, the Deepwater Horizon disaster was an unknown—though enormous—liability for BP. To date, the company has spent $38 billion on cleanup and compensation, and litigation is still ongoing. Where Williamson once enjoyed a bountiful cushion to mitigate volatility, BP’s cash flow fell by more than 50% for the 2010 fiscal year, and hasn’t recovered to its pre-spill level. Quite simply, BP may not meet that second criteria for passing on LDI: the solvency to handle high downside risk. In response, Williamson is scaling back the pension fund’s equities exposure through financial instruments and reducing the overall allocation. A former prop trader, he is fluent in the esoteric reaches of derivatives. The BP pension fund can use swaps, swaptions, calls, and puts to limit the fund’s downside exposure while adding alpha on top of the fixed-income portfolio, which is gradually increasing in size and duration.
The equities allocation, in contrast, has dropped from 80% to 70%, and Williamson gives 60% as the current goal. “LDI is something to be done over time, and we’re not in a hurry. At 60%, we’ll revisit the plan and take a look at the path we’re on,” he said.
BP is in line with much of what Russell’s Marty Jaugietis sees as the direction and future of LDI. Since the financial crisis, he has seen clients become increasingly engaged with the use of financial instruments like Treasury strips, which are key implements in many LDI strategies for hedging interest rate risk. “Some clients still don’t feel comfortable with derivatives. But the majority either consider them in the toolkit, or have decided they don’t have the resources, and hand off that side of investing to a firm like ours.” But Williamson has been using derivatives since his trading days, and as he put it, BP’s pension is “a very late adopter of LDI.” Perhaps what the oil company most exemplifies is how the definition of liability-driven investing is itself changing. A 70% equity portfolio would not qualify as LDI under any traditional conception of the strategy, whereas for BP it represents a real commitment.
Even as BP cut contributions and shelled out $38 billion in compensation and cleanup costs for Deepwater Horizon, most of the nation’s corporate and state pensions would have gladly switched funding statuses. Decades of volatility-embracing, alpha-seeking investing strategy—the style of a true commodity trader—paid off for the oil giant. But for most pensions, what is the takeaway from BP’s tale of the anti-LDI path? Don’t try this at home.