CHINA AVIATION OILs

COLLAPSE

Group Members
Himanshu Dhoot 11BSP0282 Tushar Supriya Anurag -

ABOUT CAO
Incorporated in Singapore on 26 May 1993, CAO was listed on the mainboard of the Singapore Exchange on 6 December 2001. Is the largest purchaser of jet fuel in the Asia Pacific region and the key supplier of imported jet fuel. The largest single shareholder of CAO is China National Aviation Fuel Group Corporation ("CNAF"), which holds about 51% of the total issued shares of CAO.

China
Civil Aviation Administration

Singapore
Ministry of Finance Lee Kwan Yew

CAOHC

Temasek

24%

75%

25% public shareholders (including Temasek)

CAO

Case Background
17th Nov 2004 SAs Standard Bank threatened legal action.

Timeline of events
March 2003 CAO enters into speculative option trades on oil prices with a bullish view Q4 2003 CAO changed its strategy and started trading speculative option trades taking a bearish view. October 2004 international oil prices rose steeply, leaving CAO facing significant margin calls on its open (short) derivative positions. 30 November 2004 in a press release CAO states it was unable to meet some of the margin calls arising from its speculative derivative trades, resulting in the companys being forced to close the positions with some of its counter parties. The accumulated losses from these closed positions amounted to approximately US$390 million. In addition, the company had unrealized losses of about US$160 million, bringing the total derivative losses to $550 million.

Option Scam
From PwCs report it is possible to summarize the CAO options trading strategy as follows: Starting Q3 2003, CAO took a bearish view on oil markets (they were expecting oil prices to go down) Consistent with this view, CAO sold call options and purchased put options on Jet Fuel These options were valued in their profit & loss accounts based on the Intrinsic Value only (i.e. not taking into account the Time Value) With the market moving against their position, CAO restructured their books at 3 different times by repurchasing the call options sold earlier and selling call options with a longer maturity With oil prices continuing to rise, CAO could not satisfy the resulting cash (margin) calls from the call option buyers and had no choice but to go public with their results

Simplification of the actions undertaken by an entity X will be as follows5: Action 1: On 1st October 2003 X sells 100 OTM call option with expiry 1st April 2004; Action 2: On 1st March 2004 X repurchases the April 04 option and sells an OTM call option with expiry 1st July 2004; Action 3: On 1st June 2004 X repurchases the July 04 option and sells an OTM call option with expiry 1st November 2004; Action 4: On 1st October 2004 X repurchases the November 04 option and sells an OTM call option with expiry 1st January 2005. Note that X sells only OTM options, i.e. options with no intrinsic value and only time value.

INTERNAL CORPORATE GOVERNANCE FAILURE

Singapore has long been widely recognized as a jurisdiction with strong investor protection. Before the debacle, CAO was not only honoured for having outstanding risk-management structure and procedures by the Chinese, but named Singapores most transparent company by the local securities investors association. Months before the bankruptcy filing, Chen was praised by a Singaporean newspaper for exceeding entrepreneurship The meltdown of the elite firm was a blow to the Singapore Stock Exchange (SGX) which had been actively courting listings by mainland Chinese companies as well as intending to press the world by one of the best financial regulation and corporate governance standards in Asia.

 There was a Risk Management Manual (RMM) in place within the Company to govern and provide guidance for its derivative business. There was however, no specific provision for options trading in the manual. On 20th March 2002, the Company conducted its first options trade. According to the management, options trading was conducted in view of the potential gains that could benefit the Company despite the fact that option trading was never part of its business and expertise. there were no margin calls in place to stop the Company from further trading when losses were made No disclosure guidelines were available to address what should be included in the financial statements to account for these options and the profit or loss arising from them. There was no active independent third party involvement in verifying the financial statements and probing into the Companys business despite there being three independent directors as required by the Code.

 Information of the Companys losses was deliberately withheld by the management and not communicated to its shareholders and independent directors. there had been a formal corporate multi-layer risk control system designed by Ernst & Young in 2002, composed of numerous safeguards to ensure that nothing goes wrong: senior traders, division heads, independent risk-control committee, internal audit division, audit committee and the board. while the internal audit division failed to periodically and correctly report to the audit committee the possible checking deficiencies. Both its directors and controlling shareholders lacked the capacity to closely monitor the actions taking place overseas.

External Corporate Governance Failure.

As per the notice by state council on 1st august 1998Enterprises with overseas futures permit can only be allowed to engage in hedge transactions and they are not allowed to engage in speculative transaction. Futures transactions must be only made inside the futures exchanges and over-the-counter futures transactions are not allowed. State-run enterprises can only do hedge business in futures transactions and the total volume should be in line with the total volume of all spot trading in the same period.

 Assesment of Financial Statements was not done properly and was named as the most transparent listed firm. Regulatory authorities failed in identifying flaws. Limited disclosure and lack of transparency in dealings. Media Reports-The corporate Chinese companies listed in Singapore was worse than those listed in other countries.

Lessons to be learnt
The strategic objectives and risk management policy of the company must be determined at the highest level in the organisation. Senior management must be responsible for the policies to be incorporated into daily operations and to dedicate the necessary resources to achieve this. Internal and external reporting (financial statements) must follow best practice with frequent and detailed disclosures.

 There should be regular stress testing on strategy. Prior to trading in new products, a formal analysis must be conducted.