Energy Trading {unit 06}

Unit- 6 HEDGING STRATEGY Energy price volatility ruled the 1990s. Crude oil prices soared as high as $40/bbl during the Gulf War and dropped as low as single digits in 1998 and 1999. They were at 10 year highs as this book went to press. Natural gas prices experienced as much or even greater volatility as changes in temperatures increased and decreased the size of the “gas bubble”. These wild swings in energy commodity prices wreaked havoc on the bottom lines of many energy producers, refiners, marketers, traders and end-users. One outgrowth of these market developments was sprouting of energy price risk management programs throughout the energy industry. For a few companies, the experience was a highly visible financial disaster owing to the misuse – or misunderstanding – of the use of derivatives in so called “hedging” programs. For the vast majority of companies, success in energy price risk management was mixed. As a result, comprehensive, and enterprise –wide risk management programs are still not widespread throughout the industry. From my experience analyzing energy risk management programs since 1979, there are several key reasons why there are relatively few really successful energy price risk management programs. First and most fundamental is the failure to properly establish an important and sustaining rationale for the hedging program. In every company, there will be wide ranging opinions as to whether the company should be expected. A second critical reason is the Failure to properly analyze and quantity the company’s portfolio risk exposure on a continuous basis. Clearly if the risk is misdiagnosed, like a disease, it can not be properly treated or controlled. A third crucial reason is lack of a systematic strategy properly designed to address the company’s portfolio risk. Few companies have what I consider to be a formal strategy, with decision rules. Many that does have rules based on physical rather then financial events. A fourth major reason is the lack of structure and discipline in the implementation of the risk management process. Often expectations are not set or, again , very widely 167

among executives . Evaluations of result, if they take place at all, are ofteninconsistent with risk reduction objectives.

To hedge or not to hedge

For hedging to gain lasting acceptance in any company , it must be seen as a means by which the company can better attain its corporate strategic or financial goals. Such goal may include meeting or exceeding a budget, protecting against a drop in cash flow that could threaten debt rating or payments , or batter enabling a company to have a competitive cost or price . In short, it must provide a viable alternative to simply accepting the market risk and its impact. It is management’s responsibility to set the proper objectives for risk management and the proper evaluation criteria. In my view, there are at least two valid hedging objectives: •

To achieve the highest risk adjusted return on capital employed

•

To reduce the risk of unacceptably low returns on capital employed

Over the years, I have heard many reasons why executives believe their their companies should not hedge some believe that their companies are being rewarded in the stock market for taking energy market risk. Even for those companies that are oriented toward accepting the market’s energy price exposure, I believe hedging is still logical. Why? Because companies should take the risk that have the highest risk – adjusted expected returns. Why take risks on exposures that are expected to lose money? If an unhedged portfolio has market exposures with negative expected returns, those exposures should be hedged. By hedging those exposures, the company can afford to take additional risk on exposures with positive expected returns. This is simply the most logical method to allocate risk capital. Wheather the outcome of such capital allocation is favorable or not the company would at least be making more rationale risk management decision than exposure with negative expected returns.

168

Backwardation Backwardation is a market condition where spot prices exceed forward prices. Contango is the opposite condition, where forward prices exceed spot prices. The terms are most commonly used in oil markets but are also applied in certain commodities and energies markets. In oil markets, the prevailing condition may reflect immediate supply and demand. If crude oil is contango, it may indicate immediately available supply. Backwardation can indicate an immediate shortage. Anything that threatens the steady flow of oil around the world, such as imminent war, tends to drive the oil market into backwardation. A theory developed in respect to the price of a futures contract and the contract's time to expire. Backwardation says that as the contract approaches expiration, the futures contract will trade at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate.

When backwardation does occur in a futures market it has been suggested that an individual in the short position would benefit the most by delivering as late as possible.Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. This is because he believed that a price movement like the one suggested by backwardation was not random but consistent with the prevailing market conditions. Backwardation is the opposite of contango. Backwardation (sometimes incorrectly referred to as "backwardization") is a futures market term: it means an downward sloping forward curve (as in an inverted yield curve): one says that the forward curve is "in backwardation" (or sometimes: "backwardated").

169

Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is lower than the spot price, or a far future delivery price lower than a nearer future delivery. The opposite market condition to backwardation is known as contango. More generally, the term is sometimes applied to forward prices other than those of futures contracts, when analogous price patterns arise. For example, if it costs more to lease silver for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation. Notable examples of backwardation include,


1.Commodities: Copper circa 1990, apparently arising from market manipulation by Yasuo Hamanaka of Sumitomo Corporation.




2.FX: The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006: the backwardation occurs simply because Australian dollar bonds pay so much more interest at every point in the yield curve than Japanese yen bonds do. Any high-yield foreign currency contract will show backwardation in its pricing.




3.NYMEX traded natural gas currently (May 2007).

Trend The general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend. As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in the opposite direction. A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long-term movement in price or volume.

170

Market trends Market trends reflect the general direction of prices or rates in financial markets.[1] Participants in a given market use price charts to observe these trends, and to identify investment and trading opportunities. That market prices do move in trends is one of the major premises of technical analysis,[2] though the description of market trends is common to Wall Street,[3] the economics profession, and the Federal Reserve. [4] Market trends unfold in periods when bulls (buyers) consistently outnumber bears (sellers), or vice versa. A bull or bear market describes the trend and sentiment driving it, but can also refer to specific securities and sectors ("bullish on IBM", "bullish on technology stocks," or "bearish on gold", etc.)

171

Bull market The Charging Bull in Bowling Green, New York is a symbol of the bull market.

A bull market tends to be associated with increasing investor confidence, motivating investors to buy in anticipation of further capital gains. The longest and most famous bull market was in the 1990s when the U.S. and many other global financial markets grew at their fastest pace ever.[5] In describing financial market behavior, the largest group of market participants is often referred to, metaphorically, as a herd. This is especially relevant to participants in bull markets since bulls are herding animals. A bull market is also described as a

bull run. Dow Theory attempts to describe the character of these market movements. The United States has been in a long-term bull market since about 1983, with brief upsets including the Panic of 1987 and the NASDAQ Crash in 2000.

Bear market A bear market tends to be accompanied by widespread pessimism. Investors anticipating further losses are motivated to sell, with negative sentiment feeding on itself in a vicious circle. The most famous bear market in history was 1930 to 1932, marking the start of the Great Depression.[6] A milder, low-level long-term bear market occurred from about 1967 to 1983, encompassing the stagflation economy, energy crises in the 1970s, and high unemployment in the early 1980s.

172

Prices fluctuate constantly on the open market; a bear market is not a simple decline, but a substantial drop in the prices of a range of issues over a defined period of time. By one common definition, a bear market is marked by a price decline of 20% or more in a key stock market index from a recent peak over a 12month period. However, no consensual definition of a bear market exists to clearly differentiate a primary market trend from a secondary market trend. Investors frequently confuse bear markets with corrections. Corrections are much shorter lived, whereas bear markets occur over a longer period with typically a greater magnitude of loss from top to bottom. A secondary trend is a temporary change in price within a primary trend. These usually last a few weeks to a few months. A temporary decrease during a bull market is called a correction; a temporary increase during a bear market is called a bear market rally. Whether a change is a correction or rally can be determined only with hindsight. When trends begin to appear, market analysts debate whether it is a correction/rally or a new bull/bear market, but it is difficult to tell. A correction sometimes foreshadows a bear market. Correction

A market correction is sometimes defined as a drop of at least 10%, but not more than 20% (25% on intraday trading) over a short period of time. The major difference between a bear market and a correction is magnitude and duration. Bear markets last much longer, and the magnitude of loss is greater. Major disasters or negative geopolitical events can spark a correction. One example is the performance of the stock markets just before and after the September 11, 2001 attacks. On September 7, 2001, the Dow fell 234.99 points to 9,605.85, thoroughly pushing the Dow into a correction. On September 17, 2001, the first day 173

of trading after the attacks, the Dow Jones Industrial Average plunged 684.81 points to 8,920.70. That loss officially pushed the Dow, not just even further into a correction, but into a bear market. (Although unless investors had prior knowledge of the events of September 11, 2001, it would be impossible for the attacks to have had an effect on the markets ahead of time.) How can this be called a, "correction" when on 9.7.01 the Dow fell 2-3% and on 9.17 by 7-8%? Both numbers, eight and three are less than ten, therefor this is not a, "correction" by the definition stated above. Because of depressed prices and valuation, market corrections can be a good opportunity for value-strategy investors. If one buys stocks when everyone else is selling, the prices fall and therefore the P/E ratio goes down. In addition, one is able to purchase undervalued stocks with a highly probable upside potential. Bear market rally

A bear market rally is sometimes defined as an increase of at least 10%, but no more than 20%. Notable bear market rallies occurred in the Dow Jones index after the 1929 stock market crash leading down to the market bottom in 1932, as well as throughout the late 1960s and early 1970s. The Japanese Nikkei stock average has been typified by a number of bear market rallies since the late 1980s while experiencing an overall downward trend. A secular market trend is a long-term trend that usually lasts 5 to 25 years, and consists of sequential primary trends. In a secular bull market the bear markets are smaller than the bull markets. Typically, each bear market does not wipe out the gains of the previous bull market, and the next bull market makes up the losses of the bear market. Conversely, in a secular bear market, the bull markets are smaller than the bear markets and do not wipe out the losses of the previous bear market.

174

An example of a secular bear market was seen in gold over the period between January 1980 to June 1999, over which the nominal gold price fell from a high of $850/oz to a low of $253/oz,[7] which formed part of the Great Commodities Depression. Conversely, the S&P 500 experienced a secular bull market over a similar time period.[8] An example of a secular bull market would be the US Stock market between August 1982 and June 2007. The DJIA, S&P500 and Wilshire 5000 indexes all made new record highs in 2007 with only a single cyclical bear market low in October 2002 after the cyclical bull market high made in March 2000. These secular bull and bear market trends are also termed "super cycles". "Grand supercycles" of 50 to 300 years have also been proposed by Nikolai Kondratiev and Ralph Nelson Elliott. Price risk identification

The best way I have found to identify a company's portfolio risk to commodity prices is to create a model of their earnings. The objective of building the model is to determine how the company's earnings change if "market prices" of related commodities change. Though any number of market prices can be used in building the earnings' model, I often use NYMEX futures contract prices. The futures price curve could be viewed as an unreliable input since it keeps changing all the time. However, the benefit of this approach is that one can "lock-in" projected earnings if they are high enough, or if the downside is perceived to be great. In a sense, the "prediction" can become a self-fulfilling prophecy through hedging, no matter how the price curve changes after the hedge is established.

Earnings models Earnings can be forecast by linking NYMEX futures prices to a company's sales prices and costs. The equations can be developed through multiple regression analysis.

175

By inserting the current forward strip, an earnings forecast for forward months can be generated. As NYMEX prices change, new earnings forecasts can be automatically generated. Stress tests A stress test is a means for assessing the impact of an extreme price movement on future earnings. For example, with an earnings model, crude futures prices could be increased or decreased by $l/bbl to determine the effect such a change would have on future earnings.

176

WHAT IS MONTE CARLO SIMULATION? The drawback of stress testing is that the probability of the scenario being tested is not taken into account. To assess the likely distribution of earnings for any given month, a probability distribution for futures prices is needed. Further, the relationships among futures prices must be maintained for the resulting distribution to be realistic. One analytical method to develop a distribution of earnings is "Monte Carlo simulation." A Monte Carlo simulation is a method by which price scenarios are randomly selected from their distribution according to their frequency in the distribution. The output of the simulation is a distribution showing the frequency of different earnings estimates The standard deviation of an earnings distribution is a generally accepted measure of portfolio risk. A new standard deviation can be computed when hedge positions are included in the portfolio by running the Monte Carlo simulation. If the new standard deviation is lower, the hedge has reduced portfolio risk, and vice versa. What do we mean by "simulation?" When we use the word simulation, we refer to any analytical method meant to imitate a real-life system, especially when other analyses are too mathematically complex or too difficult to reproduce. Without the aid of simulation, a spreadsheet model will only reveal a single outcome, generally the most likely or average scenario. Spreadsheet risk analysis uses both a spreadsheet model and simulation to automatically analyze the effect of varying inputs on outputs of the modeled system. One type of spreadsheet simulation is Monte Carlo simulation, which randomly generates values for uncertain variables over and over to simulate a model.

How did Monte Carlo simulation get its name? Carlo simulation was named for Monte Carlo, Monaco, where the primary attractions are casinos containing games of chance. Games of chance such as roulette wheels, dice, and slot machines, exhibit random behavior. The random behavior in games of chance is similar to how Monte Carlo simulation selects variable

177

values at random to simulate a model. When you roll a die, you know that either a 1, 2, 3, 4, 5, or 6 will come up, but you don't know which for any particular roll. It's the same with the variables that have a known range of values but an uncertain value for any particular time or event (e.g. interest rates, staffing needs, stock prices, inventory, phone calls per minute). What do you do with uncertain variables in your spreadsheet? For each uncertain variable (one that has a range of possible values), you define the possible values with a probability distribution. The type of distribution you select is based on the conditions surrounding that variable. Distribution types include:

. To add this sort of function to an Excel spreadsheet, you would need to know the equation that represents this distribution. With Crystal Ball, these equations are automatically calculated for you. Crystal Ball can even fit a distribution to any historical data that you might have. What happens during a simulation? A simulation calculates multiple scenarios of a model by repeatedly sampling values from the probability distributions for the uncertain variables and using those values for the cell. Crystal Ball simulations can consist of as many trials (or scenarios) as you want - hundreds or even thousands in just a few seconds. During a single trial, Crystal Ball randomly selects a value from the defined possibilities (the range and shape of the distribution) for each uncertain variable and then recalculates the spreadsheet

178

Portfolio Risk Theory Before addressing the questions of what to hedge, when to hedge or how much to hedge , the company needs to know the nature the magnitude of its price risk . The lessons learned about its price risk are often as valuable in making other business decisions as they are in making the determination of whether to hedge- e.g. refinery optimization and inventory management. The application of portfolio theory to business and not just stock portfolios, began to take hold in the latter part of the 1990s. Many financial firms , and even some industrial firms , embraced the concept of managing the “ enterprise” or “global” risk of their business portfolio. A business portfolio is a group of assets-such as a company's oil reserves, refineries, or inventories. A financial portfolio may be a group of oil futures contracts, swaps, and/or derivatives. Each has its own set of risk/return characteristics, depending on what a portfolio includes. When a financial portfolio is combined with the firm's business portfolio, the combination (or total portfolio) will have new risk-return characteristics, or market exposure, than either one separately. Diversification of risk enables the total portfolio to have lower risk than either the business portfolio or financial portfolio has separately. Controlling the risk of the financial portfolio separately is inconsistent with managing the risk of the total portfolio. It is this portfolio framework that one must apply in the construction of hedges. Otherwise, determining the proper portfolio is just guesswork that may lead to a result the opposite of what is expected. The Financial Accounting Standards Board (FASB) has defined commodity price risk as the sensitivity of a firm's income to changes in prices. Many large oil companies are exposed to changes in literally thousands of prices, 1 and so the problem of price risk identification and quantification is analytically challenging. As a result, many firms do not conduct a comprehensive, portfolio risk assessment to identify their risk exposure. The most common mistake is that someone identifies one risk within the portfolio and the company hedges that risk.

179

However, a risk analysis that addresses only part of a company's portfolio (i.e., a partial risk analysis) is inherently flawed. Correlations among all risk factors need to be quantified. The result of considering only part of a company's portfolio risk exposure can in fact lead to a hedging strategy that actually increases, rather than reduces, risk. If you were to craft the perfect investment, you would probably want its attributes to include high returns coupled with little risk. The reality, of course, is that this kind of investment is next to impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the "perfect investment". But none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the management of your portfolio.

The Theory One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk".

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains 180

both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest eggs.

Two Kinds of Risk Modern portfolio theory states that the risk for individual stock returns has two components:

Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.

Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock's return that is not correlated with general market moves.

For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference - or covariance between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.

181

Figure 1

The Efficient Frontier Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enter the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the efficient frontier for just two stocks - a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola).

182

Figure 2

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose.

What MPT Means for You Modern portfolio theory has had a marked impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts.

That being said, MPT has some shortcomings in the real world. For starters, it often requires investors to rethink notions of risk. Sometimes it demands that the investor 183

take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter. Government-backed bonds are presumed to be risk free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification. How many is enough? Mutual funds can contain dozens and dozens of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.

Conclusion The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take above-average risk. It is also implied that these risk takers will get their comeuppance when markets turn down. Price Risk and Derivatives Diversification and insurance are the major tools for managing exploration risk and protecting firms from property loss and liability. Firms manage volume risk—not having adequate supplies—by maintaining inventories or acquiring productive assets.

184

Derivatives are particularly appropriate for managing the price risk that arises as a result of highly volatile prices in the petroleum and natural gas industries.

Petroleum and Natural Gas Price Risks and Risk Management Strategies

Participants

Price Risks

Risk Management Strategies and Derivative Instruments Employed

Oil Producers

Low crude oil price

Sell crude oil future or buy put option

Petroleum Refiners

High crude oil price

Buy crude oil future or call option

Low product price

Sell product future or swap contract, buy put option

Thin profit margin

Buy crack spread

Storage Operators

High purchase price or low Buy or sell calendar spread sale price

Large Consumers Local Distribution Companies (Natural Gas)

Unstable prices, wholesale Buy future or call option, buy prices higher than retail basis contract

Power Plants (Natural Gas)

Thin profit margin

Buy spark spread

Airlines and Shippers

High fuel price

Buy swap contract

Source: Energy Information Administration.

The typical price risks faced by market participants and the standard derivative contracts used to manage those risks are shown in table. Price risk in the petroleum and natural gas industries is naturally associated with each participant’s stage of production. Some companies integrate their operations from exploration through final sales to eliminate the price risks that arise at the intermediate stages of processing. For example, for an integrated producer, an increase in the cost of crude oil purchased at its refinery will be offset by revenue gains from its sales of crude oil. Other, smaller 185

companies usually do not have integrated operations. Independent producers want protection from low crude oil prices, and they sell to refiners who want protection from high prices. Refiners want protection from low product prices, and they sell to storage facilities and customers who are concerned about high prices. At each stage, suppliers and purchasers can split the risk in order to allay their concerns. They typically supplement exchange-traded futures and options with over-the-counter (OTC) products to manage their price risks. Risk managers in the petroleum and natural gas industries commonly use derivatives to achieve certainty about the prices they pay or receive. Depending on their circumstance, they may be concerned with the price paid per se, with price spreads (differences between prices), with ceilings and floors, and/or with price changes over time. In addition, volumetric production payment contracts—a variant of a standard swap—may be used to reduce uncertainty about cash flows and credit. Some of the instruments particular to the oil and gas industries are described below. The principal difficulty in using exchange-traded products is they often do not exactly correspond to what the trader is attempting to hedge or to speculate in. For examples, price movements in premium gasoline are not identical to those in unleaded gasoline. Similarly, the price of natural gas at Henry Hub is not identical to that at Chicago. The distinction between what exchange products can hedge and what the user wants to hedge is the source of basis risk. Basis risk is the risk that the price difference between the exchange contract and the commodity being hedged will widen (or narrow) unexpectedly. To a large extent, the OTC market exists to bridge the gap between exchange-traded products and the needs of individual traders, so that the two markets in effect have a symbiotic relationship. Basis Contracts Price certainty in a unified market can be bought with forward sales, futures contracts, or swaps (contracts for differences). When one or both parties face a spot market price that differs from the price in reference market, however, other derivative contract

186

instruments may be needed to manage the resulting basis risk. For example, a local distribution company (LDC) in Tennessee could enter into a swap contract with a natural gas producer, using the Henry Hub price as the reference price; however, the LDC would lose price certainty if the local spot market price differed from the Henry Hub price. In this example, when the Henry Hub price is higher than the Tennessee price by more than it was at the initiation of the swap contract, the LDC gains, because its payment from the producer will exceed the amount it pays to buy gas in its local market. Effectively, the LDC will pay less per thousand cubic feet than the fixed amount the LDC pays the producer. Conversely, if the Tennessee price is lower, the producer’s payment will not cover the LDC’s gas bill in its local market. A variety of basis contracts are available in OTC markets to hedge locational, product, and even temporal differences between exchange-traded standard contracts and the particular circumstances of contract users. The simplest is a basis swap. In the example above, the OTC trader would pay the LDC the difference between the Tennessee price and the Henry Hub price (for the nominal amount of gas) in exchange for a fixed payment. The variety of contractual provisions is unlimited. For example, the flexible payment could be defined as a daily or monthly average (weighted or unweighted) price difference; it could be capped; or it could require the LDC to share the costs when the contract’s ceiling price is exceeded. What this OTC contract does is to close the gap between the Henry Hub price and the price on the LDC’s local spot market, allowing the LDC to achieve price certainty. The traders supplying basis contracts can survive only if the basis difference they pay— averaged over time and adjusted for both financing charges and the time value of money—is less than the fixed payment from the LDC. Competition among OTC traders can only reduce the premium for supplying basis protection. Reducing the underlying causes of volatile price differences would require more pipeline capacity, more storage capacity, cost-based transmission pricing, and other physical and economic changes to the delivery system itself.

187

Risk limits Creating risk limits is one of management's most important steps in the process of controlling risks and the effects of risk management activities. Unfortunately, the risk limits we have seen relate to the risk associated with the hedge positions instead of the corporation's total risk exposure. This is backwards, because the purpose of risk management positions should be to reduce the corporation's total risk exposure. Instead, the risk associated with those positions is treated as a new risk to the corporation, consistent with the view some have that hedging is speculation. An overall limit to portfolio risk for a given time-period (month, quarter, or year) should be set for the corporation and approved by the board. The company's portfolio risk needs to be assessed on an on-going basis and reported. All proposed hedge transactions should be input to the corporation's portfolio risk model to ensure that it would reduce the portfolio's risk exposure. All positions actually taken need to be input when taken, and removed when closed to the portfolio risk model for all future calculations. Testing proposed transactions With an earnings model, proposed hedge or speculative transactions can be tested to determine their impact on portfolio risk. If the proposed transaction reduces portfolio risk, it is a hedge transaction. If it increases risk, it is a speculative transaction. Ideally, the expected risk/return of all proposed transactions should be evaluated before they are entered, and they should meet the pre-determined risk/return "hurdle rates" established by management. DETERMINING IDEAL HEDGE PORTFOLIO The risk-minimizing portfolio of hedge contracts can be mathematically derived with an earnings model. The hedge portfolio that is effective in eliminating market risk is the ideal hedge portfolio, or risk-minimizing hedge portfolio. The hedge ratio is the relationship between the size of the hedge and the size of the position being hedged. For example, if one million barrels of crude were being hedged by 1,000 NYMEX crude contracts, the hedge ratio would be 1.0 (i.e., 1,000,000 barrels divided by 1,000 contract times = 1,000 barrels per contract).

188

Optimal hedge ratios are rarely 1.0 in the real world. They must be determined by correlations and volatilities such as running Monte Carlo simulations within an earnings model.

Hedge index concept The size of the hedge should be proportional to the size of the risk. Therefore, as the size of the risk changes, so should the size of the hedge. Determining the relationship between hedge sizes and risk can be determined objectively or subjectively. Further, the hedge index can be customized to reflect management's appetite for risk. By characterizing management's "risk preferences" at various earnings levels, it is possible to create a hedging strategy using the hedge index concept. The hedge index concept simply defines in advance the level of hedging that will take place depending on what level of earnings is forecast. Formal corporate risk preference assessments are highly beneficial for several reasons. They: •

translate management's views to actionable decision rules

•

provide the guidance needed for implementation

•

reduce the time required by senior management

•

ensure greater consistency in program implementation

Hedge strategy development A hedging strategy is a set of decision rules that define when to enter the hedge, how and when to adjust its size, and when to exit a hedge. An efficient hedge strategy specifies all key position inputs in advance, i.e., the effect risk exposure will have, and the effect predicted income would have on determining the percent hedged. Positioning programs translate the strategy to daily decisions. There is no need to reinvent the wheel everyday. Consistency, not emotion, is the key. Simulating the actual effect of a hedging strategy is both informative in the process of developing the strategy and essential in the process of obtaining management buy-in. 189

Institutionalizing risk analysis, hedging strategy, and evaluation To integrate the development of a risk management program with its implementation, it is important to develop and/or revise the company's risk management policies and procedures to reflect the company's objectives, strategy, and structure. The goal should be to provide the necessary means to enable management to successfully control the corporation's risk exposures and guide all risk management activities. All major participants should review drafts of the policies and procedures for their input, understanding, and commitment to their success. The creation of a risk management committee (RMC) to steer the management of a company's risks is a good idea that works. Generally, there are issues that require input from numerous corporate departments, and so the timely and recurring input of each is useful. Therefore, it makes sense to keep key executives and departments informed on a regular basis. Because risk management is a financial function, the chief financial officer or treasurer should normally chair the RMC. The person acting as risk manager should be a knowledgeable manager of traders, supply or purchasing, depending on the business. More specifically, some key elements the policies and procedures should include: •

Define an evaluation criterion that specifically measures how well the company is meeting its objectives for risk management.

•

Define the methodologies that shall be used to measure portfolio risk exposures. Relate to the company's overall price risk exposures, and not be limited to controlling risks of derivatives only. Create an earnings model and risk manager's model to project portfolio risk and return.

•

Require the development and implementation of a formal risk management strategy with decision rules for hedge entry, hedge size, and hedge exit.

•

Identify the risk management instruments that can be used.

•

Define management's responsibilities in monitoring and controlling risk measurement and management.

190

•

Specify levels of authority, risk limits, and "red flags" -such risk limits not simply being a maximum derivative loss.

•

Specify the process for quickly and effectively addressing any development that has been "flagged."

•

Provide the necessary level of reporting to those responsible for managing, implementing, and monitoring risk management activities.

•

Define management reports that management can understand.

•

Provide clear separation between those implementing the risk management activities and those controlling the activities.

•

Specify hedge criteria and establish the infrastructure for hedge accounting.

Evaluating hedging effects Typically, most companies do not determine in advance how they will judge their hedging performance. Of course, this causes unpleasant surprises after the fact. Most companies measure results only in terms of hedge gains or losses-the same way they would measure the success of a speculative trading program. We recommend the use of both risk and return measures. Over time, a successful hedging program will outperform both the "blind hedge" (i.e., 100% hedge) and the "unhedged" case, in risk-adjusted return. Energy price risks are out there. You can manage them or hope for the best.

191

Hedging techniques with help of Example. Example 1 Crude Oil Producer's Short Hedge (Short Hedge) One of the most common commercial applications of futures is the short hedge, or seller's hedge, which is used for the protection of inventory value. Once title to a shipment of a commodity is taken anywhere along the supply chain, from wellhead, barge, or refinery to consumer, its value is subject to price risk until it is sold or used. Because the value of commodity in storage or transit is known, a short hedge can be used to essentially lock in the inventory value. A general decline in prices generates profits in the futures market, which are offset by decline in the value of the physical inventory. The opposite applies when prices rise. A crude oil producer agrees to sell 30,000 barrels a month for each of six months at the posted prices prevailing at delivery. When he agrees to the deal, posted prices are $70.50 barrel, but as market conditions appear to be weakening, he wants to protect his revenues against a decline, and executes a short hedge. The example shows how the producer's revenue is protected from the full brunt of a declining market.In this example, the oil producer establishes hedges for the second, third, fourth, fifth, sixth, and seventh contract months against his production during the first, second, third, fourth, fifth, and sixth months ahead. Near-month futures positions are liquidated after a price posting is established (normally on the first day of the calendar month). In a surplus crude market, spot prices generally fall faster than postings, regardless of whether prices decline more slowly, as in Case 1, or more rapidly, as in Case 2. Date Cash Market

Dec1

Commits to sell 30,000 barrels in each month for January, February, March, April, May, June crude at the posted price

Futures Market

Futures Results

Net Price Rece

Sells 30 crude contracts in each month for: February, $70.00; March, $69.75; April, $69.50; May, $69.50; June $69.25; July, $69.00

Case 1: Slowly Declining Prices

Jan. Posted price for January crude: Buys back February contracts ($0.50) $70.50 1 $71.00/bbl. at $70.50

Feb. Posted price for February crude: Buys back March contracts at 0 1 $70.50/bbl. $69.75

192

$70.50

Mar. Posted price for March crude: Buys back April contracts at $0.50 $70.50 1 $70.00/bbl. $69.00

Apr. Posted price 1 $69.50/bbl.

for

April

crude: Buys back May contracts at $1.00 $70.50 $68.50

May Posted price 1 $69.50/bbl.

for

May

crude: Buys back June contracts at $0.50 $70.00 $68.75

Jun. Posted price for June crude: Buys back July contracts at ($0.50) $69.50 1 $70.00/bbl. $69.50

Case 2: Rapidly Declining Prices Jan. Posted price 1 crude:$70.00/bbl.

for

January Buys back February contracts $0.50 $70.50 at $69.50

Feb. Posted price for February crude: Buys back March contracts at $1.00 $70.50 1 $69.50 $68.75 Mar. Posted price for March crude: Buys back April contracts at $1.50 $70.50 1 $69.00 $68.00 Apr. Posted 1 $68.50

price

for

April

crude: Buys back May contracts at $2.00 $70.50 $67.50

May Posted 1 $68.50

price

for

May

crude: Buys back June contracts at $1.50 $70.00 $67.75

Jun. Posted price 1 crude:$69.00/bbl.

for

June Buys back July contracts at $0.50 $69.50 $68.50

Selling Prices ($/bbl.) Unhedged Month

Hedged

Case 1

Case 2

January

$70.50

$71.00

$70.00

February

$70.50

$70.50

$69.50

March

$70.50

$70.00

$69.00

April

$70.50

$69.50

$68.50

May

$70.00

$69.50

$68.50

193

June

Average

$69.50

$70.25

$70.00

$69.00

$70.08

$69.08

Increased cash flow Case 1 Case 2

$70.25 - $70.08 = $0.17 x 180,000 barrels = $30,600 $70.25 - $69.08 = $1.17 x 180,000 barrels = $210,600

If the producer could not lock in revenue, he could be faced with shutting in all or part of the production. The example shows two possible outcomes. Case 1, with relatively high posted and futures prices, and Case 2, with relatively low posted and futures prices. Short hedges for February, March, April, May, June, and July (against January, February, March, April, May, and June production) are initially established on December 1. Assuming the futures hedge is placed on December 1, the near-month contract is January and the second month out is February. Because the January crude futures contract expires three business days prior to December 24, and the posted prices for January are not finally established until January 2, the example attempts to have the liquidation of the futures coincide with the setting of the posted price. In summary, the nearby contract is used to hedge current production. For example, the February futures contract is utilized to hedge January production because the timing is better matched

Example 2 Petroleum Marketer's in Rising and Falling Markets. (Long Hedge) A long hedge is the purchase of a futures contract by someone who has a commitment to buy (is short) in the cash market. It is used to protect against price increases in the future. An end-user with a fixed budget, such as a manufacturing company that uses natural Gas, can use a long hedge to establish a fixed cost. A fuel marketer may offer customers fixed-price contracts for a number of reasons: to Avoid the loss of market share to other marketers or alternative fuels, to expand market Share; or to bid on municipal contracts requiring a fixed price. On September 7, the New York Harbor price (Future price) for heating oil is 55 cents and the cash market price at the fuel dealer's location is 54 cents a gallon, a 1 cent differential, or basis, between New York Harbor and the retailer's location. The dealer agrees to deliver 168,000 gallons to a commercial customer in December at 70 cents per gallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at 57 cents; the price quoted that day on the Exchange's NYMEX Division. Total cost: $95,760 (42,000 x 4 x $0.57).

194

Case 1 - Rising Prices On November 25, the fuel dealer buys 168,000 gallons in the cash market at the prevailing price of 59 cents a gallon, a 1 cent differential to the New York Harbor cash quotation of 60 cents, Cost: $99,120 (168000 x0 .59) .He sells his four December futures contracts (initially purchased for 57 cents) at 60 cents a gallon, the current price on the Exchange, realizing $100,800 on the sale, for a futures market profit of $5,040 (3 cents a gallon). His cash margin is 11 cents (the difference between his agreed-upon sales price of 70 cents and his cash market acquisition cost of 59 cents for a total of $18,480 ($0.11 per gallon x 168,000 gallons).

Cash Market

Futures Market

Sept 7

Buys 4 December futures contracts for 57¢ per gallon

Nov. 25 Buys 168,000 gallons at 59¢ per gallon

Sells 4 December heating oil futures for 60¢ per gallon

A cash $18,480 or margin 11¢/gallon plus of: $5,040 or A futures 3¢/gallon profit of: equals A total $23,520 or margin 14¢/gallon of: Case 2 - Falling Prices On November 25, the dealer buys 168,000 gallons at his local truck loading rack for 49 cents a gallon, the prevailing price on that day, based on the New York Harbor cash quotation of 50 cents a gallon. He sells his four December futures contracts for 50 cents a gallon, the futures price that day, realizing $84,000 on the sale, and experiencing a futures loss of $11,760 (7 cents a gallon).

Cash Market

Futures Market Buy 4 December heating oil futures at per gallon

Sept 7 Nov. 25

Buys 168,000 gallons for 49¢ per gallon

A cash margin of:

$35,280 minus

57¢

Sells 4 December heating oil futures for per 50¢ per gallon

195

A futures ($11,760) (7¢/gallon) equals loss of: A total margin of:

$23,520 or 14¢/gallon

In summary, the fuel retailer guarantees himself a margin of 14 cents a gallon regardless of price moves upwards or down in the market. With the differential between cash and futures stable, as in Cases 1 and 2, spot-price changes in either direction are the same for both New York and the marketer's location. As a result, a decline in the futures price, which causes a loss in the futures market, is offset cent-for-cent by the increase in the cash margin. Example 3 Fixing Refiner Margins through Crack Spreads In January, a refiner reviews his crude oil acquisition strategy and his potential distillate margins for the spring. In January, he sees that distillate prices are strong, and plans a two-month crude-to-distillate spread strategy that will allow him to lock in his refinery margins. On January 22, the spread between April crude ($70 per barrel) and May heating oil ($1.2564 per gallon or $52.77 per barrel) presents what he believes to be a favorable $17.23 per barrel. The refiner sells the April/May crude-to-heating oil spread, thereby locking in the $17.23 margin. In March, he purchases the crude for refining into products. Crude oil futures are $71 per barrel in March, $1 higher than the original crude futures position ( $70 ). Heating oil is trading at $1.2588 per gallon ($52.87 per barrel), which equals a margin of $18.13 Had the refiner been unhedged, his margin would have totaled only the $18.13. Instead, the net margin from the combination of the futures position and the cash position is the $17.23 he originally sought.

Date Cash

Financial Effect Futures

Jan.

Sell crack spread:

--

Buy crude Sell heating $1.2564/gal.

Financial Cash --

oil

at

($70.00) $52.77

Net Mar.

Effect Futures ($/bbl)

$17.23

Buy crude at $71

($71.00)

Sell heating oil at $1.2588/gal.

$52.87

Net

$18.13 Buy crack spread: Sell crude Buy heating $1.2588/gal

$71.00 oil

at

($52.87)

Net

($18.13)

Futures gain (loss)

$0.90

196

Cash refining without hedge

margin

(loss)

$18.13

Final net margin with hedge

$17.23

Example 4 Trucking Company Hedges Diesel Purchases On September 7, the cash market price of diesel fuel is 60 cents a gallon, exclusive of taxes, a five-cent differential, or basis, to the prevailing New York Harbor heating oil futures price of 55 cents. The trucking company intends to buy 168,000 gallons of diesel fuel in December at the prevailing futures price at that time plus 5 cents per gallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at 57 cents, the December price quoted that day on the Exchange's NYMEX Division. Total cost: $95,760. If futures prices are unchanged by the time he has to take delivery, his fuel cost will be 62 cents a gallon. Case 1 - Rising Prices On November 25, the trucker buys his December fuel allotment of 168,000 gallons in the cash market for 65 cents a gallon, 5 cents over the spot New York Harbor heating oil futures quotation of 60 cents. Cost: $109,200. He sells his four December futures contracts (initially purchased for 57 cents) at 60 cents a gallon, the then current price on the Exchange, realizing $100,800 on the sale, for a futures market profit of $5,040 (3 cents a gallon). His effective cost of diesel fuel is 62 cents per gallon or $104,160 (the cash price of the fuel, less his 3 cents gain on the futures, when the contracts rose in price from 57 cents to 60 cents). Cash Market

Futures Market

Sept. 7

Buy 4 December heating oil futures at 57¢

Nov. Buys 168,000 gallons of diesel fuel at 65¢/gal. 25

Sells 4 December futures at 60¢/gal.

Case 2 - Falling Prices On November 25, the trucker buys 168,000 gallons at 54 cents a gallon for a cost of $90,720, the prevailing heating oil futures price of 49 cents plus 5 cents a gallon. He sells his four December futures contracts for 49 cents a gallon, realizing $82,320 on the sale, and experiencing a futures loss of $13,440 (8 cents a gallon). His fuel cost, however, is only 54 cents a gallon, 8 cents less than the 62 cents that he would have paid had futures prices been unchanged when he entered the hedge. The loss on his futures position is offset by his gain in the physical market.

197

Cash Market

Sept. 7 Nov. 25

Futures Market Buy 4 December heating oil futures at 57¢

Buys 168,000 gallons of diesel fuel at 54¢/gal. Sells 4 December futures at 49¢/gal

Example 5 Trading application of the crack spread Options
A purchaser of put can protect acquisition costs for crude oil relative to market demand for refined products. A long crack put consists of being short the products and long the crude oil. Refiners as hedgers are natural crack spread longs as they are continually buying crude and selling products.If crack spreads rise or widen , only the premium is at risk, meanwhile ,the refiner is protected if refining margin should narrow.
A purchase of a call can offset contract and forwars term sales of gasoline and heating oil to bulk marketers. A purchaser of crack calls is long product and short crude ,If spread fall, or narrow .only the premium is at risk.
Selling a call is also refiners strategy. It enhances returns on refining margins as the premium income is used to offset the risk of product market declines outpacing crude declines whivh will squeeze his margin in the cash market. A writer of crack calls incurs a short product futures position and a long crude oil position. Refiners are natural writers of calls. If the crack spread widens, a refiner is at risk because his position could be exercised against him. However , he will likely be able to mitigate the riskby turning out additional products and recouping the higher margins in the cash markets.
A writer of the puts is long the product and short the crude. The seller of the put incurs the risk that the spread will narrow , and his position could be assigned against him. Example 6 The following example shows a refiner locking in a margin between crude oil and heating oil. Refiner with a Diversified Slate, 3:2:1 Crack Spread An independent refiner who is exposed to the risk of increasing crude oil costs and falling refined product prices runs the risk that his refining margin will be less than anticipated. The refiner initiates a long hedge in crude and short hedges in heating oil and gasoline to fix a substantial portion of his refining margin. On September 15, the refiner incurs a Future obligation to buy 6,000 barrels of crude oil on Oct 16 at prevailing cash prices. He is also obliged to sell 84,000 gallons (2,000 barrels) of heating oil and 168,000 gallons (4,000 barrels) of gasoline on November 28 at prevailing spot prices. The crack spread has ensured that refining crude oil will be at least as profitable in November as it was in September, regardless of whether the actual cash margin narrows or widens. A decline in the cash margin is offset by a gain in the futures market; conversely, any gain in the cash market is offset by a loss in the futures market. The example assumes a crack spread of three crude, two gasoline, one heating oil.

198

Date

Prices

Action

Futures Market

Sept 15. Sweet crude: Agrees to buy at Buys 6 Nov sweet Cushing - $18.90 prevailing contracts at $18.45/bbl. prices: 6,000 bbl. sweet crude on Oct 16

crude

Heating Oil: Gulf $0.4875/gal, $20.47/bbl

Coast, Commits to sell at Sells 2 Dec. heating oil contracts, prevailing prices: $0.5255/gal, 84,000 gal. heating oil $22.07/bbl on Nov 28

N.Y. Harbor, $0.5125/gal, $21.52/bbl Gasoline: Commits to sell at Sells 4 Dec. New York Harbor gasoline prevailing prices: contracts, 168,000 gal. gasoline $0.5275/gal, $22.15/bbl on Nov. 28 Gasoline Gulf Coast, $0.5450/gal, $22.89/bbl Gasoline N.Y. Harbor, $0.5850/gal, $24.57/bbl Gulf Coast cash margin: (6 x $18.90)-[(2 x $20.47)+(4 x $22.89)]/6 = $3.18/bbl. Cushing / NY Harbor cash margin: {[(2 x $21.52)+(4 x $24.57)]-(6 x $18.90)}/6 = $4.65/bbl. Crack spread: {[(2 x $22.07)+(4 x $22.15)]-(6 x $18.45)}/6 = $3.67 Cash basis

- $1.47/bbl $4.65)

Expected $2.20/bbl margin $1.47)

($3.18-

Futures Crack Spread: $3.67/bbl

($3.67-

.

Case A: Rising Crude, Falling Product Prices, Stable Basis

Oct Crude: 16

Buys 6,000/bbl crude at $19

Sells 6 Nov sweet crude contracts at $19/bbl.

NYMEX Div. crude oil futures,$19/bbl.

Nov Heating Oil: 28 Gulf

Sells 84,000 $0.4850/gal.

heating

oil Buys 2 Dec heating oil contracts at $0.4942/gal

Coast,

199

$0.46/gal, $19.32/bbl. N.Y. Harbor, $0.4850/gal, $20.37/bbl

Gasoline: Gulf $0.4625/gal,

Coast, Sells 168,000 $0.4875/gal.

gasoline

at Buys 4 Dec N.Y. Harbor gasoline contracts at $0.4936/gal.

$19.42/bbl N.Y. Harbor, $0.4875/gal, $20.47/bbl.

Results Cash margin

$1.44

{[(2 x $20.37) + (4 x $20.47)] - (6 x $19)} / 6

Futures profit

$1.94

($3.68 - $1.74)

Crack spread:

Realized $3.38 margin

$1.74/bbl.

Case B: Falling Crude, Rising Product Prices, Stable Basis

Oct Crude: 16

Buys 6,000/bbl $17.50

crude

at

Sells 6 Nov sweet crude contracts at $17.50

NYMEX Div. crude oil futures, $17.50/bbl.

Nov Heating Oil: 28 Gulf 0.50/gal,

Coast,

Sells 84,000/gal. heating

Buys 2 Dec heating oil

oil at $0.5250/gal.

contracts at $0.52/gal.

$21/bbl. N.Y. Harbor, $0.5250/gal, $22.05/bbl.

200

Buys 4 Dec N.Y. Harbor Sells 168,000/gal. gasoline at gasoline contracts at $0.60/gal. $0.5950/gal

Gasoline: Gulf $0.56/gal,

Coast,

$23.52/bbl N.Y. $0.60/gal,

Harbor,

$25.20

Results Cash margin

$6.65

Futures ($2.66) profit

{[(2 x $22.05) + (4 x $25.20)] - (6 x $17.50)} / 6 ($3.68 - $6.34)

Crack spread:

Realized $3.99/bbl. margin

$6.34/bbl.

Timing risk and basis risk can be quantified and are usually less than the absolute price risk to which the refiner is subjected. The example assumes fixed points in time of obligation to buy and sell in the cash market. In practice, these may not be entirely known or fixed.

201