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RISKS IN TRADING
ENERGY In an efficient market, the magnitude of the change in price is influenced
by the size of the demand-supply imbalance to be corrected.
COMMODITIES This applies to both the short term and long term.
MG676 Increasing volatility and complexity of the energy commodities have made
it an attractive market for financial players including hedge funds.
For example, take the Arab Spring, which caused crude output to fall
There has been high volatility in the energy industry over the past few quickly and significantly.
years especially with regard to commodity prices. Oil prices rose from $92 per barrel in January, 2011 just prior to unrest in
The key factors that drive energy price volatility are structural and are Tunisia, to $120 per barrel in April after violence erupted in Libya.
likely to have a long-term impact. Irans threats to close the Strait of Hormuz, through which one third of the
Furthermore, significant events such as natural disasters, political worlds traded oil passes, energy analysts predict oil prices could rise 50
uncertainty, and corporate misconduct have spurred instability in the percent or more within days.
energy markets. Speculation about the closure alone has been known to keep oil prices
above $100 a barrel.
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Interest Rate Risk: Risk due to increased funding costs etc. The term "RBOB" shall mean Reformulated Regular Gasoline Blendstock
for blending with 10% Denatured Fuel Ethanol (92% Purity) as defined in
Weather Risk: Fluctuations in volume and hence profitability, due to the American Society for Testing Materials (ASTM) D-4806
weather events such as flooding and hurricanes.
HEDGING STRATEGIES
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This is a very simple example to show how hedging strategies can work.
Sell (short) NYMEX RBOB futures for current market value$125.00 per While the example shows how to lock in a margin, we can also participate
bbl in upward price movements and protect ourselves from decrease in
prices.
Buy (long) the physical gasoline barrel at market value$120.00 per bb
We will focus on price and basis risks and demonstrate how hedging
strategies can be effectively employed to mitigate these risks.
PRICE RISK
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One key factor driving price that is monitored closely is the inverse
relationship of commodity price to the value of the U.S. dollar.
One of the main reasons for the impact of the dollar on commodity prices
is that commodities are priced in dollars.
When the value of the dollar drops, it will take more dollars to buy
commodities.
The relationship between crude futures and the U.S. dollar index is a
good example to illustrate this.
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The major fluctuations in the oil market, at least in the short term, seem to
However, there exist long lead and lag times in this relationship, and be totally divorced from actual supply-and-demand fundamentals.
hence it takes some time for the inflation factor to start trickling down. Therefore, it is imperative to cap the total value of speculative positions in
A weakening dollar for example has served to mask a larger systemic any commodity market.
weakness in the market. This would help regulate the number of pure speculators in the market
against businesses who buy futures to hedge their risk.
BASIS RISK
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Supply and demand factors determine the shape of the futures curve.
Factors such as cost of carry, interest rates, and so on affect demand and
supply.
Hedging helps to reduce the exposure to basis risk but does not eliminate
it completely. The futures curve also moves up or down as market participants keep
changing their view of the future expected spot price.
Quite often, people trade on the spread between the underlying asset in
the spot market and futures contract and this is known as basis trading. Ultimately, futures converge to spot, and basis converges to zero upon
maturity of the futures contract.
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The futures price will therefore decrease with time to converge to the
expected spot price and benefit speculators who are net short.
Oil futures contracts are delivered every month. The back months are
A negative basis indicates that the futures price is lower than the
expected future spot price and hence a negative basis; this implies that usually priced slightly higher reflecting the cost of carry, indicating a
markets are in backwardation. contango market.
However, this market can also be in backwardation.
Backwardation is essentially the opposite. It occurs when the delivery
price of a futures contract must converge upwards to meet the futures Contango is a situation where the futures price (or forward price) of a
price. It occurs in an "inverted futures curve" environment. Essentially, commodity is higher than the expected spot price.
on the maturity date, the futures price will converge higher to the spot
Normal backwardation, also sometimes called backwardation, is the
rate. This means that a commodity is worth more right now than it is in
market condition wherein the price of a forward or futures contract is
the future.
trading below the expected spot price at contract maturity.
Speculators who are net long prefer this market, as they want prices to
increase.
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FORWARD CURVES
The figure above shows the forward curves for West Texas Intermediate
Buyers who need natural gas immediately would be willing to pay the high (WTI) crude and Brent crude respectively.
price, but for investors in the futures market this is good news.
WTI as the name suggests is Texas crude traded on the CME while Brent
They make profits by rolling the futures (sell and buy new contracts) at a is North Sea crude traded on ICE.
discount as the expiring contracts trade at a premium to the back-dated
contracts being purchased. WTI is in contango while Brent is in backwardation.
What ultimately profit or hurts the speculator is any unexpected change in This means a trader/hedger would get a premium by rolling forward
the basis! month to month short WTI futures or long Brent futures.
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however, since the autumn of 2010 Brent has been priced much higher The depletion of the North Sea oil fields is one explanation for the
than WTI, reaching a difference of more than $11 a barrel by the end of divergence in forward prices.
February 2011 (WTI: 104 USD/bbl, LCO: 116 USD/bbl).
In February 2011 the divergence reached $16 during a supply glut, The US Energy Information Administration attributes the price spread
record stockpiles, at Cushing, Oklahoma before peaking at above $23 between WTI and Brent to an oversupply of crude oil in the interior of
in August 2012. North America (WTI price is set at Cushing, Oklahoma) caused by
It has since (September 2012) decreased significantly to around $18 rapidly increasing oil production from Canadian oil sands and tight oil
after refinery maintenance settled down and supply issues eased formations such as the Bakken Formation, Niobrara Formation, and
slightly. Eagle Ford Formation.
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ARBITRAGE
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One of the key factors for arbitrage economics is transportation cost. The key factors to be considered in this case are:
An arbitrage is considered open only if the price differentials are wide Transportation costs from the North Sea to U.S. Gulf Coast.
enough to offset the transportation costs.
Seaway Pipeline tariffs.
For example, refiners choose between competing crudes from across the
globe on a daily basis.
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A storage arb exists if the cash price plus storage and associated costs
are less than the futures price; then we can get paid to store the If at the time of delivery, the spot market is trading above the NYMEX, we
commodity and sell it out in the future. can buy the futures and sell the product in the spot market.
The solid lines in Exhibit 17.4 show the forward curve minus the cash On the other hand, if the spot is trading below the NYMEX, we need to
price at a given point in time. deliver the product to NYMEX to realize the full potential of the trade.
The larger shaded area is the storage cost and gray area is the cost of Consider moving gasoline from northwest Europe to New York Harbor
money over time. (NYH).
If for example, we had purchased spot distillates in August, stored till This would involve availability of ships, docking space, offloading
February and simultaneously sold February futures, we could have made capacity, and more.
$0.15 per gallon.
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This arb averaged around 14.50 cents/gal in 2011 with a range of 825
The presence of an arbitrage situation can be determined by examining cents/gal.
three components:
In October 2011, certain refinery-related announcements caused a rally in
1. Price of gasoline in Europe the NYMEX RBOB prices.
2. Price of gasoline in New York This created an arbitrage opportunity for European exports of gasoline,
3. Freight cost from Europe to New York and other costs despite low consumption levels in the United States.
A positive arb number indicates open arb while a negative arb numbers
indicates closed arb.
European gasoline is quoted in metric tons while NYH gasoline is quoted Other costs, such as port charges, cost of spill insurance, product loss
in gallons. cost, and so forth, are also used in determining whether an arb is open or
closed, as they add a few cents per barrel to the product cost.
Converting to equivalent units (1 metric ton = 358 gallons), we have
This cost is however very minimal and therefore not usually considered in
arb calculations.
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An oil refiner has entered into a contract to sell 420,000 gallons of regular
unleaded gasoline to be delivered in December 2011.
Companies or businesses can hedge themselves from the extremely The parties agreed to use the futures settlement price on the delivery day
volatile energy markets by taking a short/long position in the futures as the sale price.
market.
The contract was entered into in September 2011; the spot price at that
Futures hedging is of two typesshort hedges and long hedges time was $3.55/gallon and the futures price for delivery in 3 months was
depending on whether you are a net consumer (i.e., use a long hedge $3.58/gallon.
position) or producer (i.e., use a short hedge position).
Based on historical seasonality trends, the refiner feels that gasoline
prices will dip in the winter months and so she enters into a short position
for 10 contracts (1 contract = 42,000 gallons) at $3.58/gallon.
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LONG HEDGES
As expected, gasoline prices fell to $3.00/gal on the delivery date, and the
refiner has to sell the gasoline at this price according to the sales A long hedge protects the commodity consumer/buyer from the risk of
contract. increasing prices.
The refiner also buys back the future contract at $3.00/gal to close her The long hedger therefore buys futures to hedge his position as he
short position. benefits from a decline in basis (increase in spot price).
Assume that the transaction involves no commissions.
The proceeds from this sale can be summarized as follows:
Gain on the futures (3.58 3.00) * 420,000 $243,600 A power company has to buy 500,000 MMBtu of natural gas in three
months.
Net Gain $1,503,600 The spot price of natural gas in March 2011 was $3.95/MMBtu, and the
futures price for delivery in three months was $3.98/MMBtu.
This is equivalent to selling 10 contracts at The company wanted to hedge against an increase in natural gas prices
and decided to take a long position at $3.98/MMBtu for 50 contracts (1
$3.5800/gallon. contract = 10,000 MMBtu)
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Three months later, natural gas prices rose almost 11 percent, and the Option hedges are analogous to insurance policies; we pay a premium to
spot price on the delivery day was $4.38/MMBtu. mitigate the risk and execute the option when prices move against us.
Since the company entered into the long hedge position at $3.98/MMBtu, Options provide you the right but not the obligation to take a particular
they had a futures gain. position on the underlying futures.
The transaction details are recorded here: There are two types of optionsput and call
PUT OPTION
Gain on the futures (4.38 3.98) * $200,000 A put option sets the floor price for the commodity.
500,000 This gives the option holder the right but not the obligation to take a short
position in the futures at a certain strike price for a premium.
Net Payable $1,990,000 The difference between the strike price and the premium is the profit for
the option holder.
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A call option sets the ceiling price for the commodity. The risk management function has progressed to become a core
business area mainly driven by investors and the board, not just to hedge
This gives the option holder the right but not the obligation to take a long
against losses but also to gain a competitive advantage.
position in the futures at a certain strike price for a premium.
The hedging process in most corporations is usually a five-pronged
The difference between the strike price and the premium is the maximum
approach as shown in the figure below.
price paid by the option holder for the commodity.
HEDGING PROCESS
The option holder has the right to exercise the option or let it expire or
offset it by transferring the rights to a third party.
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COMMON PITFALLS
The key task of the risk management infrastructure is to monitor price risk,
basis risk, and any kind of operational risk across the different business
Some of the conventional risk-management techniques taught in
units.
classrooms are not applicable in the real world.
Price risk exposure for example can be mitigated by purchasing hedging
In fact, no forecasting model predicted the impact of the 2008 economic
instruments such as options or swaps or by structuring contracts that cap
crisis.
the companys exposure to increasing prices.
This is a perfect example of a Black Swan eventevents with a low-
Most of the companies maintain a book structure that helps identify,
probability and high-impact that are almost impossible to forecast.
measure, and monitor risk-return of individual activities as well as for
providing information across business units. The complex environment in which we live increases the incidence of
such events and makes forecasting them even more difficult.
The risk assessment and mitigation functions are integrated with
performance review mechanisms such as bonus metrics.
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All this in turn can be attributed to the lack of clarity in governance. The choice of KPIs is critical and should be closely linked to the
objectives of the hedging strategy.
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