Derivatives and Commodity Hedging

Derivatives and Commodity Hedging
OECD-MENA Senior Budget Officials Network Randy Ewell, World Bank, Banking and Debt Management Department The World Bank Treasury 1818 H Street, N.W. Washington, DC, 20433, USA treasury.worldbank.org

The world has changed … Commodity prices have fallen sharply, beginning in July 2008 with the sharpest falls over the past month Falls have been most severe in oil and metals Agricultural commodity prices have also fallen, but by less Price falls have been both large and fast Many intermediaries in the commodity chain, who are naturally long, will have lost considerable money unless they were hedged and will may experience financing difficulties in the coming months Un-hedged northern hemisphere farmers may experience large losses since the price falls have come just as crops are brought to market Decreasing prices create an opportunity for importers (of food/oil) to lock in lower prices

The aggregate picture Commodity prices rose steadily from 2003 until the summer of 2008 This is the longest and most general commodity boom since the 1920s Not all prices shared in the boom, and some started to fall in 2007 IMF commodity price indices, normalized at 2000 = 100 deflated by US PPI. The 2008 figure is the January-July average

Crude Oil Most least developed countries are oil importers but a significant minority are major exporters Crude oil prices rose more or less steadily from 2001 to early July 2008 reaching over $140/bl They have now halved to $70/bl Average, Brent and WTI first positions, deflated by US PPI. Source: IMF

Non-Ferrous Metals Along with oil, metals prices have fallen furthest and fastest – particularly over the past month Al, Ni & Zn are lower now than at the start of 2006 Cu, Pb & Sn are around the same level as Jan 2006 Source: LME

Maize Chicago (CBOT) corn prices jumped sharply in 2006 to peak in June 2008 at $7/bl. They have now fallen to $4/bl. South African (SAFEX) white maize prices also rose but this reflected local factors. Although they have now fallen sharply in dollar terms, this is almost all due to the downward fall of the Rand CBOT first position and SAFEX spot prices (converted into dollars), deflated by US PPI. Sources: CBOT, SAFEX and IMF

Rice Rice is the principal food of many poor people. An increase in the rice price has a negative impact on poverty levels worldwide Bangkok rice export price. Source: World Bank

Cotton Cotton prices have been very stable since 2005, albeit at a low level They have dropped sharply over the past month to 60c/lb, lower in real terms than in 2004 This price fall will have caused serious problems for any unhedged ginner Cotlook A Index deflated by US PPI, and converted into F.CFA/kg and deflated by Burkina Faso CPI. Source: ICAC and IMF.

Policy Responses The food price crisis led many countries to revert to the food policies of the 1970s Export bans Costly strategic grain reserves Reversal of diversification policies Price stabilization/subsidy programs These policies carry risks Can be destructive to market / trade Total financing needed for these interventions are unknown / unpredictable

Dealing with Risk 10

Increased Interest in Risk Management
Governments need to.. Plan for & budget responses Raise financing for responses & ensure rapid implementation Ensure that they are protected against future shocks Donors & International community should.. Maximize value & impact of assistance Ensure resources are not diverted from longer term programs Both have led to renewed interest in ex ante solutions Since ex post reactions are costly, inefficient, and difficult to finance & implement when countries are already in crisis

Significant Factors for a Nation
No Shareholders – only Voters Not necessarily driven by returns on Capital or Equity Risk appetite virtually zero Unfortunately, short term Horizons Affected by Politics Not necessarily Commercial decisions, therefore the solution is not necessarily a commercially driven one Cannot ignore the ‘Power of One’ – the VETO All solutions have to pass the ‘Monday Morning Quarterback’ test

Why Would a Nation Hedge ?
Reduce Volatility of the Budget in favor of stability Strengthen the probability of meeting the Budget ‘Targeted’ Hedging of Key Elements in Budget Education Health Infrastructure Inflation Imports where there is inelastic demand and no substitution To address security of supply & security of energy and food Investment of Government Funds Commodity Indices, Bonds, Notes where inversely Correlated to Budget Event’ Hedging

Hedging Products A commercial contract which limits the impact of adverse price movements which might take place between buying (or incurring production costs) and selling Why? Traditional (unhedged) price stabilization programs can’t survive without high levels of subsidy / bailout Market intermediaries (co-ops, exporters) can’t survive repeated years of trading losses Banks A) Can’t survive repeated years of default when borrowers mismanage price exposures and have financial losses as a result B) Will have to charge high interest rates to maintain lending in high risk agricultural sectors -the high cost of finance erodes margins for all

Oil Price Volatility Hedging Introduction
Why Hedge? Oil prices are volatile and hard to predict Exposure to oil price may harm fiscal policy Uncertain fiscal revenues linked to oil exports may lead to shelving of planned projects or wasteful use of ‘windfall’ revenues Hedging stabilizes cash flows Allows to lock in prices in advance or specify their range Substantially reduces volatility of revenues Reduces the risk of sudden financial loss due to adverse market movements

No Hedge Current Price USD/BBL
Selling on a spot basis exposes producer to rising and falling commodity prices Current Price USD/BBL

Oil Price Volatility Hedging Introduction
There are two ways to pursue stabilization Self Insurance: Oil revenues in excess of a predefined average level are saved. Savings are used to complement oil revenues when they fall below average. Hedging with markets Oil revenues can be fixed or floored for future dates using market instruments. The second method is usually more efficient

Oil Price Volatility Hedging Hedging with Markets
There are generic instruments Futures/Forwards Swaps No cost. Lock in future price. Do not permit upside gains Put options Upfront cost (to buy puts). Place a floor on future price. Permit upside gains.

Derivatives Introduction
Growth in Derivatives Use Derivatives are used for either Hedging, or Speculation Hedging Hedgers use derivatives to manage risk and protect themselves against the possibility that the market might go “against them” Speculation Speculators use derivatives to produce a return They “take a view”, i.e. bet on where the market is going and try to make a profit Cocoa Example You may think there are thousands of different reasons for using derivatives and there are, but if you really look closely it turns out derivatives are mostly used for just one of two basis functions: hedging and speculation. Hedgers use derivatives to manage uncertainly, and speculators use derivatives to wager on it. Hedgers use derivatives to reduce financial risk or the prospect that the price of things might “move against them”. They may use derivatives to match assets to liabilities to reduce exposure or brings things that are less certain to certainly when you don’t have an appetite for uncertainty. Consider a chocolate manufacturer who knew 6 months ago they would need to buy cocoa beans today. They face the prospect of a hurricane damaging the cocoa crop and drastically reducing the available supply of cocoa beans on the market leading cocoa bean rising significantly. If this uncertainty is not desirable, you may use a forward contract to mitigate that risk. By contrast speculators use derivatives not to reduce financial risk but to potentially profit from it. Doing so is often called “taking a view” on future prices because that term sounds more legitimate than “gambling.” But speculating really is little more than gambling on an uncertain outcome. If one has the view that IBM’s stock price will be higher in 6 months than it is today, he or she can buy options to buy IBM stock in 6 months at today’s price. If their prediction comes true they can profit handsomely. If not, they lose whatever they paid for that option – or 100% of their investment. That’s speculating. Our purpose in discussing derivatives here is not to tout “technical trading” or other purported surefire miracles for making money. Rather, you will find our presentations geared toward the use of derivatives as a means of hedging and managing risk such as exposure to currency, interest rates or commodity price fluctuation and not on speculation. Scope of the Presentation For our purposes, the use of derivatives is a risk management tool 19

Who Hedges and Why? End users: “SHORT” energy – concerned about rising prices Eg. Airline, Industrial, Shipper, Road Transport, Railway: all active hedgers Producers: “LONG” energy – concerned about falling prices Eg. Energy Majors and Independents, State Oil Companies Refiners and Power-Generators: MARGIN exposed – concerned about relative prices Oil Refiner: Crude oil versus oil products (called “cracks”) Power-generator: Coal / Oil / Gas versus Electricity (“Dark / Spark spreads”) Traders and Distributors: TIMING and / or BASIS RISK Mismatch between purchase price and sale price window Mismatch between purchase price INDEX sale price INDEX Eg. buy LNG on Brent Index, Selling on UK Gas NBP

Forward Contract vs Futures
An over-the-counter (OTC) contract determining the price of the underlying to be paid or received on an obligation beginning at a future start date Essentially forwards contracts lock-in the price of the underlying Forward Contract vs Futures Instrument is similar to that of a future The payment under the contract is equivalent to a margin payment but… …Payment at maturity only: Higher credit risk OTC Contract Forward contracts are not standardized Maturity dates agreed by the parties Nominal amount can be adjusted Nominal amounts in any currency Day count convention applicable in the reference rate and currency chosen

The role of clearing houses Credit Risk Mitigation
Futures Futures Futures: obligation to buy or sell an underlying instrument at a certain price and date A futures is a method to lock in a price Physical delivery of the underlying asset Cash settlement: difference between the spot and the futures price Exchange traded and standardized contract: specified quantity and quality of the instrument, price per unit, date and method of delivery (if any) The role of clearing houses Futures counterparties interact with the exchange’s clearinghouse (CH). Clients do not know whom they have traded with A futures trade is really two trades The agreement will be honored by the CH To protect itself the CH demands that An initial collateral amount is deposited to cover future losses A futures account is marked to market daily. Daily margin increase to cover unrealized losses from daily market movements No party will incur a big loss at maturity Party A Clearing house Party B Credit Risk Mitigation 22

Characteristics of Swaps
What is a Swap? A contract between two counterparties to exchange streams of cash flows Characteristics of Swaps Defined period of time and can be customized Contracts are traded over-the-counter (OTC) Cash flows are calculated over a notional principal amount Interest Rate Swaps Exchange of fixed payments against floating interest payments Maturities vary by market; in major currencies, 3 months to 30 years Used to alter interest rate exposure and align asset and liabilities Currency Swaps Exchange payments in one currency for another Maturities vary by market; in major currencies, 3 months to 30 years Used to alter the currency exposure of an asset or liability Commodity Swaps Exchange payments linked to the price of a commodity Used to reduce volatility in income/expenditures due to fluctuations 23

Forward and Futures: A Summary
Similarities Both futures and forwards represent agreements to buy or sell some underlying asset in the future Both allow for physical or cash settlement depending on the underlying instruments (interest rates, commodities, etc) Both entail market risk and can be used for hedging purposes Differences Futures Forwards Exchange Exchange traded Over the counter Counterparty Clearinghouse Counterparty in the forward agreement Transaction Timing Marked-to-market every day Transact when purchased and on the settlement date Customization Standardized: Amount, currency, dates are fixed Non-standardized: Amount, currency, maturity dates can be adjusted Credit Risk Minimal: essentially eliminated through margining process Counterparty credit risk Regulation Highly regulated Private, unregulated transactions Liquidity Highly liquid Illiquid Bid-Ask Spread Low High

Endogenous Term-Structure of Futures Prices
For low oil prices the market is in contango, i.e. the term structure is upward-sloping. For medium oil prices the term structure of futures prices can be slightly humped For high oil prices the market is in backwardation. Backwardation occurs when the oil price expected for the expiration date declines with the maturity of the futures contracts. Oil futures prices exhibit “mean-reversion,” i.e., prices in contracts for delivery many months in the future converge to the long-term expected price.

Hedging with Futures or Forward Contracts
Firm commitment that provide for the futures sale/delivery of crude oil at a specified price Gains or losses realized daily (Futures) P/L from the agreed upon price vs. the actual market price on the delivery date is usually settled on the delivery date Profit to seller = initial futures price - ultimate market price Profit to buyer = ultimate market price - initial futures price

Using Futures for Hedging
Oil Futures A country with a long position in commodities (i.e. an oil producer) loses out if the price of the commodity drops and gains if the commodity price rises. To hedge that position, it can sell exchange-traded futures to lock in the price. Therefore, no matter if the price moves up or down, the producer is not exposed to the volatility because the gain/loss on the futures contract will offset the gain/loss on the commodity.

Hedging through OTC Options - Price Floor (Insurance)
Price Floors Alternatively, if the producer wants to participate in the upside gains, it may choose to enter into a series of put options to create a price floor, which means that the producer is guaranteed a minimum price for its commodities. However, an upfront premium must be paid to purchase this series of put options

Consumer: Buying a Call Option – Cap
Key considerations Illustrative example Objective To cap forward price. Description It is the right, but not the obligation, to buy specific volumes of diesel at a specified price (the strike price) during a specified period of time. In purchasing a call option, the party is effectively buying insurance against higher products prices. The buyer pays an upfront premium for protection from prices above the specified cap strike price. The average monthly settlement price is compared to the strike If settlement price is lower than the strike price, the client does not receive anything If settlement price is higher than the strike, the client receives the difference between the strike and the settlement price Advantages Locks in a cap over a time period and is protected from any price appreciation above the strike Price rises in the physical market are compensated by hedging gains Benefit from potential upside, should diesel prices drop. Disadvantages The buyer has to pay an upfront premium to buy a call option. Price USD/mt The client receives the difference between the floating and fixed price 1500 Swap No exchange Time Strike Potential gains Market Price Potential costs Indicative Levels - Jet Cargos CIF NWE Aug Jul 2009 Strike Premium USD 1500 / mt USD 85 /mt

Hedging Instruments - Summary Fixed for Floating Swap
The below table illustrates the tools available to hedge against a fall in commodity prices Hedging Instruments Description Benefits Potential Costs Fixed for Floating Swap Enables the party to eliminate their price exposure, protecting themselves from a fall in oil prices. To do this the party sells a swap to bank and receive a fixed rate in return for paying the floating market rate. No upfront premium By receiving a fixed market price there is greater control over their revenue base. Forgone benefit from rising oil prices Floor In purchasing a put option, The buyer is effectively buying insurance against lower prices. The party pays an upfront premium for protection from prices below the specified floor strike price Able to retain 100% of the upside if market prices rise (minus the premium paid for floor). Must pay an upfront premium for upside protection. Zero Cost Collar Collars involve buying a put and offsetting the premium by selling a call option struck above the market. The party receives the same protection as a put option provides, however, the group has sold away some of its upside in order to finance the purchase of the put. No upfront premium is paid. Floored on the downside, but is allowed to ride the market up to the call strike that it sells. Party loses the benefit of rising prices above the cap option strike price.

Case Study – Outright Exposure - Airline
An airline is exposed increase in jet fuel prices and can choose a variety of tool to hedge depending on their risk philosophy. The most vanilla product that an airline could utilise is a swap. Here the airline would enter a swap and pay a fixed price in return for the floating price. Hedging Tools Description Benefits Potential Costs Fixed for Floating Swap Enables the airline to eliminate their price exposure, protecting themselves from a rise in fuel prices. To do this the airline would enter a swap and receive the floating market rate in return for paying a fixed price. 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 jet fuel Airline Supplier Airline receives jet fuel from supplier Airline receives the floating price from Bank Airline pays a fixed price to Bank Bank

Case Study – Outright Exposure - Airline
An airline can also hedge their exposure using options. The below table outlines the different hedging options available: Hedging Tools Description Benefits Potential Costs Cap In purchasing a call option, The airline is effectively buying insurance against higher prices. The airline pays an upfront premium for protection from prices above the specified cap strike price. The client is able to retain 100% of the downside if market prices decline (minus premium paid for cap) The client must pay an upfront premium for upside protection. Zero Cost Collar Collars involve buying a call and offsetting the premium by selling a put option struck below the market. The airline receives the same protection as a cap option provides, however, the group has sold away some of its downside in order to finance the purchase of the call. No upfront premium is paid. The client is capped on The upside, but is allowed to ride the market down to the put strike that it sells. The client loses the benefit of falling prices below the floor option strike price. Three way Similar ides to a Zero Cost Coupon, yet the Airline would sell an additional call with a strike above the existing collar to fund a lower collar No upfront premium is paid Market levels are capped at a lower level than a Zero Cost Coupon The client is exposed to prices above the upper call level and loses the benefit of price below the floor

Hedging through OTC Swaps (Fixed Price Swap)
Fixed Price Swaps Swaps are basically a series of futures or forward contracts. Swaps can be used when a commodity producer wants to hedge at a several points in time. In this case, the producer enters into a fixed price swap, which guarantees a set selling price no matter how much the commodity price moves in the future.

Hedging through OTC Swaps (Fixed Price Swap)
Producer receives floating price from off taker supplier Producer Off taker Producer delivers oil to off taker Producer pays the floating price throughout period Producer receives a fixed price throughout the period Bank

Consumer: Buying a Fixed Price Swap
Key considerations Illustrative example Objective To lock in forward price. Description The buyer locks in the price for a fixed volume of diesel over a predetermined period by buying a fixed price swap The average monthly settlement price is compared to the swap price If settlement price is lower than the swap price, the buyer pays the difference between the settlement price and the swap price If settlement price is higher than the swap price, the buyer receives the difference between the swap price and the settlement price Advantages Locks in a fixed price over a time period and is protected from any price appreciation above the swap price Price rises in the physical market are compensated by hedging gains No upfront premium required Disadvantages Loose all the potential gain from downside price moves below the swap price Price decreases in the physical market are offset by hedging losses Price USD/mt The client receives the difference between the floating and fixed price 1325 The client pays the difference between the fixed and floating price Time Hedged Potential gains Market Price Potential costs Indicative Levels – Jet Cargos CIF NWE Aug Jul 2009 Fixed Level USD / mt12

Using Put Options for Hedging
Oil Put Options Alternatively, the commodity producer may want to participate on the upside movement of the commodity price, which is not possible if futures contracts are used. Buying put options allows the producer to gain when the price of the commodity drops, which offsets the loss in the commodity position. On the other hand, when the price of the commodity rises, the producer will gain from the commodity position, and at the same time do not face a marked-to-market loss in the hedging instrument as in the case of the future. The cost is the price of the option, which can be very high in volatile markets

Hedging through OTC Options - Zero Cost Collars (Price Bands)
Since buying options can be expensive, the producer may choose to forgo some upside by selling call options at a higher strike price and at the same time, lower its price protection by buying a put option at a lower striker price, which is basically a collar strategy. Collars can be structured so that it costs the producer nothing, but a trade-off must be made with a lower floor when compare with a normal floor strategy.

Consumer: Zero Cost Collar
Key considerations Illustrative example Objective To hedge at zero cost whilst benefiting from the part of the downside Description The party buys a call option and finances it by selling a put for the same time period and quantities at zero upfront cost. There are multiple possible combinations of call and put strikes so that the collar is zero-cost A non-zero-cost collar can also obviously be envisaged (i.e. the client paying a reduced premium compared to the standalone call) The monthly average settlement price is compared to the strike levels of the monthly put and call If the settlement price is lower than put strike, the client pays the difference between the average and the put strike If the settlement price is higher than call strike, the client receives the difference between the call strike and the average If the monthly average is between the two strikes, nothing happens. Advantages Hedging method against upward price moves while maintaining some downside participation Zero-cost structure Disadvantages If the market price drops below the put strike , the client will be buying at the put strike. The client has upward price exposure comparing the current swap level vs. the put strike Price USD/mt The client receives the difference between the call strike and fixed price 1500 No exchange Swap 1200 The client pays the difference between the put strike and floating price Time Strike - Put Potential gains Strike - Call Potential costs Market Price Indicative Levels - Jet Cargos CIF NWE Aug Jul 2009 The client buy Call Strike USD 1500 / mt The client sell Put Strike USD 1200 / mt

Rules for Sovereign Hedging
Understand all aspects of ones current exposures and the contemplated Hedge Strong procedures with checks and balances Remember…….. ……..This is NOT speculation! Create a regulatory environment for Industry to hedge in order to…… Encourage Investment Reduce Volatility of Earnings Encourage Consumers to take ownership of Hedging Regulatory & Tax Environment Reward ‘Right Way Exposure’ Do NOT remove totally the fundamental price movement This is needed in order that supply and demand can balance out

Questions to Consider In light of the recent financial crisis, to what extent are governments still concerned about commodity price volatility? The recent fall in food/energy prices has created some relief for governments who are importing these commodity classes. Are they able to take advantage of the price decreases and lock in supplies/prices at these lower levels? If not, why not? Should governments be involved in commodity risk management? If so, how? If not, why not? Are there other examples of countries using macro level commodity risk management strategies? What should the World Bank Group be doing to support governments in this area?

Disclaimer ©2008 The International Bank for Reconstruction and Development / The World Bank1818 H Street NW Washington DC 20433 Telephone: Internet: All rights reserved The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: ; fax: ; Internet: All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: ;

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