China threatens to default on oil derivatives trades

About one year after the Lehman bankruptcy, we are getting rumors of more impending bankruptcies, this time from China.

The problem started last year when the price of oil dropped from $147 to $32 per barrel. Many companies use the futures markets to hedge their buying of oil. When prices skyrocket, they get scared and buy futures contracts for future delivery to lock in a price and to be assured of getting the product. So, some companies were buying oil at the height of the market last year. Companies that place hedges usually leave them on until delivery. What happened was that when the price of oil collapsed, these companies were still holding high-priced contracts. They saw the price plummet and took horrendous losses.

Usually such deals are struck in Hong Kong or Singapore. Apparently these deals were not made on listed exchanges. When commodities are traded on a listed exchange, all margin monies must be paid by noon the next day, usually via bank wires. If the margin is not met, the house automatically sells out the account. This keeps losses from growing too large.

If banks had been forced to use clearinghouses, these same rules would have been in effect, and chances are we would not have had the financial meltdown that occurred last year.

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