Month in 93

Spot

3-month
Futures

January
March
June
September
December

$19.30
$19.25
$19.16
$14.20
$14.50

$19.10
$19.00
$18.50
$18.60
$18.50

Price change
Volatility

-24.87%
$2.68

-3.14%
$0.29

Long Futures
Profit / Loss
per contract

on
100,000

$0.15
$0.16
($4.30)
($4.10)

$15,000
$16,000
($430,000)
($410,000)

Backwardation
Backwardation
Backwardation
Contango
Contango

5% of futures price
Previous Margin + Profit / Loss
Initial margin
Cash Position (required deposit)
100,000 barrels of oil
$95,500
$95,000
$110,500
$92,500
$111,000
$93,000
($337,500)
$92,500
($317,000)
not much difference
volatility in spot price produces
futures price not volatile large gains and losses for futures

Oil has a convenience yield

Difference between spot and futures price is not driven entirely by interest rate
OPEC decides not to cut production in September- greater expected supply causes spot price to decline
However, convenience yield also declined (less supply concerns), which lowered the decline in the futures price

Rollover

excess margin
excess margin
margin call
margin call

$0.10
$0.50
($0.10)
$0.10

$10,000
Sell March Expiry Buy June Expiry
$50,000
Sell June Expiry
Buy Sept Expiry
($10,000) Sell Sept Expiry
Buy Dec Expiry
$10,000
Sell Dec Expiry
Buy next Expiry
not large
futures price not volatile
Would a sustained increase in oil prices reduce hedge effectiveness? Need more contracts!

MG has contracts to sell oil at a fixed price (of $20) - MG is short oil!
These contracts are similar to a short position in long-maturity forward contracts
Fall in the spot price makes these contracts more valuable (from MG's perspective)
However, futures contracts are producing a large loss (long oil while contracts are short oil) and require funding
RISKS

1) Counter-party Risk

Will customers buy oil at the agreed upon contractual price if the spot price is lower?

2) Funding Risk

MG cannot fund short-term losses in futures contracts with gains on their supply contracts

Recall that convenience yield lowers the futures price relative to the spot price.

If oil prices stay low, the MG will eventually reap a large reward on its contracts to supply oil.
Speculation

Suppose MG purchased another 100,000 of futures in June (maturing in September) after making a profit

Initial margin
$92,500 This use of cash would be detected in June
Profit / Loss
($430,000) This "potential" loss would NOT be detected in June
Cash required to fund losses can quickly exceed initial margin
However, this potential liability is not recorded!

Margin Call

Losses occurred when market went into Contago

This should not have been unexpected!

Information

1) Supervisory board needs information on historical sequences of prolonged contango in the oil market.

Empirically, persistence in contango is not uncommon

2) Supervisory board needs information on future delivery schedule

Suppose MG has contracts for delivery in March, June, and September at $20 for 100,000 barrels

Using Futures
Month in 93
Expiration
March
June
September
December

Futures

Sale Price

$19.10
$19.00
$18.50
$18.60

$20.00
$20.00
$20.00
$20.00

Profit / Loss from Contract

$90,000
$100,000
$150,000
$140,000

Using long futures to supply oil for long-term contracts

MG overhedged!
Too many long futures
Profits and losses are more stable using futures market as futures prices are less volatile

Gains are insufficient to offset cash required for margin calls. When spot price is low, don't need to use long futures - overhedged

Using spot
Month in 93

Spot

March
June
September

$19.25
$19.16
$14.20

Sale Price
$20.00
$20.00
$20.00

Profit / Loss from Contract

$75,000
$84,000
$580,000

Profits and losses are more volatile using spot market

Losses on long futures in September are greater than gains, even if German accounting conventions allowed them to be offset.
Numbers in red should offset each other!

As long maturity contracts are unavailble, MG rolls over short maturity contracts
Rollover strategy

Sells closest maturity contract

Buys next closest maturity

F(t, t+M)
-F(t+M, t+2M)
F(t, t+M) - F(t+M, t+2M)

Consequently, the rollover strategy produces intermediate cash flows that are

Both sell and buy trades are done before the expiration of the closest maturity contract

positive when the futures price is

negative

The term-structure of futures prices determines the intermediate cash flows from the rollover strategy

decreasing F(t, t+M) > F(t+M, t+2M)

increasing F(t, t+M) < F(t+M, t+2M)

This is NOT contango

This is NOT backwardation