Risk Management Workshop:

The Middle Distillate Case

Mr Antonio Juliano
Manager Risk Data Services-EMEA
antonio.juliano@platts.com
September 03, 2013

2013 Platts, McGraw Hill Financial. All rights reserved.

Objectives
How to use financial instruments for cargo hedging and risk
management purposes
How Platts Forward Curves help in cargo hedging and risk
management activities
How a trading company manages market risk using swaps
Use of options in hedging
Hedging Case Study
Trading company manages market risk exposure of a middle distillate
cargo (JET A1, ULSD 10ppm) using a mix of futures and swaps
2

Volatile Nature of Commodity Markets

3-year Historical Implied Annualized Volatility

3-year Historical Implied Annualized Volatility

120%

50%

100%

40%

80%

Volatility

Volatility

60%

30%

60%

40%
20%

20%
10%

0%
Nov-08

May-09

Nov-09

May-10

Nov-10

May-11

0%
WTI

S&P 500

Gold

Nat Gas

API4

Brent

CL1 Comdty

SPX Index

NG1 Comdty

CO1 Comdty

Effective risk management measures are crucial in sectors that experience

high volatility, especially in environments where uncertainties reign

Source: Bloomberg
3

Oil Market Overview

Uncertainties about the global economy still reigns as the EU is
mired in low growth
Supply uncertainties still exist in the market
Iran embargo/sanctions
Major disruption in supply from volatile Libya and Nigeria

Demand is slated to increase

Refinery startups in Asia and direct burn by the power sector in the Middle East

Source: IEA Platts 6th Annual Crude Oil Summit

Hedging Definition and Objectives

Hedging is taking an equal and opposite financial position
on a futures, forward or other derivatives market to that on
the physical market to protect against major adverse price
changes

To prevent or limit losses

To keep within budget
To maintain profit margins
Fix prices ahead
To reduce investment risk

Imperfect Hedging/Basis Risk

Hedging to cancel/mitigate absolute price risk,
introducing basis risk
Grade/commodity difference
Jet versus ICE gasoil

Location difference
Amsterdam versus Rotterdam

Timing (calendar) difference

January versus February

Risk in Trading
Price Risk
Counterparty risk: Clients might not want to have a large OTC derivatives
exposure with a single counterparty.

Once a transaction is entered it can be given up to the exchange for

clearing and hence eliminates counterparty risk, i.e. the client will end up
facing the exchange.

Basis/Liquidity risk: physical contracts might be linked to an illiquid

instrument other than the major and/or more commonly used/traded
ones.
Correlation and other statistical analysis can be applied to decide whether it
is feasible to use an instrument as a proxy hedge, i.e. to see how well
correlated each instrument is to each other.
7

Rolling Hedges to Overcome Liquidity

This strategy works by hedging further dated exposure using the more liquid Brent
crude and then rolling this into jet fuel by buying the crack spread on a closer tenor

On a short term basis the paper hedge is an improved match to the physical fuel that
the airline has to purchase

Hence the short term hedges match underlying physical exposure while the longer
dated ones act as a hedge against general market movements
Buy Brent

3-4 years Swap = Long

Brent

2 years

Buy Gasoil Crack

(+ GO Brent)

1 years

Buy Jet Diff

( + Jet GO)

Hedging Instrument-Swap
An airline is exposed to increases in jet fuel prices and can choose a variety of tools to
hedge depending on its risk philosophy.

The most vanilla product that an airline could utilise is a fixed for floating swap, where
the airline pays a fixed price in return for receiving the floating price.
Hedging Tools

Description

Benefits

Enables the client to eliminate their price exposure,

protecting themselves from a rise in commodity prices.

Fixed for
Floating Swap

To do this the client would buy a swap from a Bank and

receives the floating market rate in return for paying a
fixed price.

Swap Mechanics:
Airline receives the
floating price from
Bank Platts Jet CIF
NWE 1-30 Sept

Potential Costs

No upfront premium
By receiving the floating
market price the client now
has greater control over their
cost base

Forgone benefit from

falling prices

Airline pays supplier floating

price for fuel- Platts Jet CIF
NWE 1-30 Sept 13

Airline

Airline receives fuel from supplier

Supplier

Airline pays a fixed

price to Bank

Bank
9

Hedging Instruments: Option Structures

Examples of Producer Hedging Strategies
Most
conservative

Buy put
options

Defined, upfront
cost, analogous
to buying
insurance

Worse case
future sales
revenue known
at outset

Upside price
participation
unlimited

Most
aggressive

Collars

No, or limited
cost

Upside price
participation
limited (strike
of call)

Downside
price
participation
limited (strike
of put)

Sell swaps

No upfront cost
Fixed price for
future sites

Selling call
options

Maximum
benefit is
upfront premium

Full protection
from lower
prices
CONSIDERATION

No upside
participation

10

Case Study : Complete Futures and Swaps

Purchase from:
Date of
transaction:

Antonio Limited

Type:

Spot purchase

Quantity:

30,000 MT +/-10 pct vol, buyer's option

ULSD 10PPM French summer specs,
c&b, bio-free
Platts ULSD 10PPM High CIF MED
22 May-12th June 2013

Quality:
Pricing formula:
Price:
Freight
Estimate:

8th March, 2013

2.00basis 0.8450

Payment terms:

4 working days after

B/L

Laytime & Demurrage:

36H +6NOR\ CP

Load/Discharge laycan:

FOB FOS, 20-30th June, buyer to

nominate 3 days (5 days in advance)

Shipping condition(s):
Credit
information:

FOB

SBLC

GTC:
Law:

Sale to:
Date of
transaction:

Juliano Limited

09th April, 2013

Spot
sale
Type:
Quantity:
30,000MT+/-10pct,
seller's option
USLD 10PPM French summer
specs, c&b
Quality:
Platts ULSD 10PPM High CIF
Pricing formula: MED 1-3rd July 2013

Price:
Freight
Estimate:

-3.75 basis0.8450
5.38 basis 27kt

Payment terms: 3/5 COD/NOR

Laytime &
Demurrage:
36H +6NOR\ CP
Load/Discharge
laycan:
Shipping
condition(s):
Credit
information:

CIF Barcelona, 2-5th July, 2013

DES
open
credit

GTC:
English

Law:

Broker (if any):

Broker (if any):

Deal done by:

Deal done by:

English

11

Risk in the Deal

Price risk

Volume risk
Outturn quantity risk (FOB-DES)
Payment terms risk
Demurrage risk
Credit risk (SBLC-Open)
12

Hedging and Exposure

Exposure is to 10ppm CIFMED High quote

10ppm CIFMED= ICE GO+ premium/discount ( differential)
ICE GO flat price hedged using futures and differential hedged using basis swaps
10ppm CIFMED = 1020$/mt
i.e. ICEGO=990$/mt+40$mt
Risk Manager will agree exposure and will control that traders buy and sell futures to hedge flat
price in a proper manner
Purchase
22-May
25-May
26-May
27-May
28-May
29-May
01-Jun
02-Jun
03-Jun
04-Jun
05-Jun
08-Jun
09-Jun
10-Jun
11-Jun
12-Jun

Physical
30,000
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875

19
19
19
18
19
19
18
19
19
19
19
18
19
19
18
19

Futures
300 lots
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun
sell Jun

Sale
01-Jul
02-Jul
03-Jul

Physical
30,000
10,000
10,000
10,000

Futures
300 lots
100 buy Jul
100 buy Jul
100 buy Jul

13

Hedging and Exposure

Buy Physical

Sell Physical

22May-12 June

1-3 July

Buy 300 lots ICE GO Jul futures

1-3 July

Sell 300 ICE GO lots Jun futures

22May-12 June

Physical Flat price 22May-12Jun 1020$

Futures ICE GO June long 22May-12 June

1020$

Physical Flat price 1-3 July 1000$

Futures ICE GO short July 1-3 July 1000$

-20$

+20$

Buy 300 lots spread Jun/Jul

11.25$/mt
Buy Jun futures

Sell Jul futures

14

Hedging and Exposure

Spread 300 lots Jun/Jul is essential because it defines the
contango gain, in this case spread Jun Jul was bought at
11.25$/mt giving a gain of 337,500$ (11.25*300lots)
This shows how important is for a trading decision to monitor
the forward curve of the spread Jun/Jul
In case of a market averse condition (backwardation) the Risk
Manager will monitor the spread and at a critical level put
pressure on the trading desk

15

Hedging and Exposure

Quote 10ppm CIF Med =1020$/m

ICEGO futures+40$/mt differential swaps

Hedging flat price is done through

futures

Hedging differential 10ppm CIF MedICE GO is done through swaps

16

Hedging and Exposure

What happens if when you buy a cargo the differential is X and when you sell
your cargo the differential goes down?

LOSE MONEY
To control differential volatility oil trading companies use swaps or basis swaps
Hedging tool

Description

Benefits

Potential Costs

Fixed for Floating Swap

Enables trading desk to

eliminate their price
exposure, protecting
themselves from a rise
in commodity prices

No upfront premium

Forgone benefit from

falling prices

By receiving the floating

market price, the trader
now has greater control
over his/her cost base
17

Hedging and Exposure

Physical BUY
10ppm ULSD CIF
MED-ICE GO
22 May-12 June13

Purchase swap
Buy 40$/mt
SELL 10ppm ULSD CIF
MED-ICE GO 22 May12 June13

Long
40$/mt
fixed
purchase no
fluctuation

Physical SALE
10ppm ULSD CIF
MED ICE GO
1-3 July

Sale swap
BUY 10ppm ULSD CIF
MED - ICE GO 1-3 July
Sell ICEGO +43

Short
43$/mt
fixed sale
no
fluctuation

18

Conclusion
Physical= ICE GO + Differential
Flat price hedge with ICEGO futures
If you buy physical, you sell futures and vice versa

Swaps will fix the differential

Forward Curves
Look at them and make the decision on when to fix
the sale and purchase

Use them to report PL and MTM

Advantages
With futures we locked 355,000$ contango; without
having forward curves was not possible to make
this profit

With swaps we locked purchase at 40$/mt and sale

at 43 $/mt making 3*30,000=90k

19

Appendix
Risk Management Workshop: The Middle Distillate Case

Credit Risk

Trade Date

17-June-13

Buyer
Seller
Commodity / Product
Price Count Period
Price / Spread
Quantity
Broker
Notes
Reference to cargo

Antonio Limited
Juliano Limited
10PPM fob barges basis ARA less 1st line ICE GO
July - September
7.00
10kt/month
Tullet Prebon
Speculative Position

With this contract, Antonio buys fixed price 7.00$ and sells 10PPM fob barges basis

ARA-ICE GO 1st line.

If differential goes for Q3 to 12 $/mt and Juliano credit limit is 100K then you would ask
him to pay 50K (5$*30kt =150,000$) into your account without valid forward curves
you cannot control your credit risk

21

Case Study: (Producers) Hedge Using

Futures
We are a Gas Oil producer and are currently seeking Gas

Scenario

Prices

Hedge Action

Oil customers for April. It is currently 20th January 2013.

We have very limited storage capacity but potential
customers need to agree April price today. We agree to
sell them 2.000 tonnes at todays April price (plus
operating profit)

Gas Oil Physical Market

$ 140 per tonne

April Gas Oil Futures

$ 141 per tonne

Gas Oil Producer: Buy 20 April Gas Oil Futures

contracts at $ 141

22

Hedge - Results

25th March
Prices:

Cash Market $ 165

Futures (April) $ 165

Futures (April)

Physicals

Jan

Bought

141

Sold

141 (+ operating profit)

Mar

Sold

165

Bought

165 (+ operating profit)

Profit

+24

Loss

-24

23

Risk Manager
Creation of risk reports: P&L report , Risk Position Report,
Credit Risk report, Mark-to-Market report and VaR, Et cetera
Monitoring hedging of physical business
Communicate and agree upon exposure and limits with
trading team
Monitor trading limits using market data and forward curves
and report breaches to book owner and management

Reliable Data

Unbiased
Data

Platts Assessments

24

Marking to Market
It allows an approximate P&L for the year to date
to be calculated
It assists in the day-to-day control of open positions
PROBLEMS
Bid/offer spreads
Long-term positions
Embedded options
Price and volume
Cash flow implications
25

Instruments for Price Risk Management

Exchange
Futures

Over the Counter (OTC)

Forwards
Swaps
Options

Several futures, swaps and options-based strategies

can be used by end-users to manage specific needs
Hedging periods and protection levels can be
customized to fit any maturity and price level
26

Exposure
Where does the exposure to price risk lie???

Is there a credit risk?

How are market data used?
How forward curves are used to manage oil price
volatility
What do you look at to lock contango and to eventually
fix loss in a market that is in backwardation
27

Hedging and Exposure

When is the right time to buy or sell a swap and lock the profit?
What triggers the decision to hedge the whole cargo?
Purchase
22-May
25-May
26-May
27-May
28-May
29-May
01-Jun
02-Jun
03-Jun
04-Jun
05-Jun
08-Jun
09-Jun
10-Jun
11-Jun
12-Jun

Physical
30,000
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875
1,875

Futures
Physical
300 lots Sale
30,000
19 sell Jun
01-Jul 10,000
19 sell Jun
02-Jul 10,000
19 sell Jun
03-Jul 10,000
18 sell Jun
19 sell Jun
19 sell Jun
18 sell Jun
19 sell Jun
19 sell Jun
19 sell Jun
19 sell Jun
18 sell Jun
19 sell Jun
19 sell Jun
18 sell Jun
19 sell Jun

Futures
300 lots
100 buy Jul
100 buy Jul
100 buy Jul

28