1. Dr Abdelatif Abada BP - Structured Products
NOT AN OFFICIAL UNCTAD RECORD
Algeria Africa Oil & Gas Trade & Finance Algiers - April 2006
Price Risk Management
Dr Abdelatif Abada BP - Structured Products
Mr Chairman, Ladies and Gentlemen, good afternoon. I am honored and humbled at the same time to stand in front of you and sharing with you BP’s approach to Price Risk Management. It is also an immense pleasure for me to be back to Algiers, which happens to be my home town.
Mention:
My name
Based in Singapore – heading the bpriskmanager team
One of the 3 offices of bpriskmanager; the other ones being in Chicago and London.

2. Disclaimer
This presentation and any services described in it are intended only for Market Counterparties or Intermediate Customers as those terms are defined by the UK Financial Services & Markets Act 2000 and the FSA Handbook, or only for Eligible Contract Participants as that term is defined in the U.S. Commodity Exchange Act.
This presentation and its contents have been provided to you for informational purposes only. This information is not advice on or a recommendation of any of the matters described herein, whether they consist of financing structures (including, but not limited to senior debt, subordinated debt and equity, production payments and producer loans), investments, financial instruments, hedging strategies or any combination of such matters and no information contained herein constitutes an offer or solicitation by or on behalf of BP p.l.c. or any of its subsidiaries (collectively "BP") to enter into any contractual arrangement relating to such matters. BP makes no representations or warranties, express or implied, regarding the accuracy, adequacy, reasonableness or completeness of the information, assumptions or analysis contained herein or in any supplemental materials, and BP accepts no liability in connection therewith. The actual terms and conditions of any contract or specific arrangement that may be entered into between you and BP may differ from the arrangements described in this presentation. BP deals and trades in energy related products and may have positions consistent with or different from those discussed herein.
There is no assurance that the structure described herein will hedge risks the recipient may incur in the operation of its business. Prior to dealing in any investment or financial instrument or entering into any risk management product arrangement, you should obtain your own tax, legal and other advice as they may expose you to inappropriate financial risk.
First of all, and purely for regulatory reasons, I must show you this somehow lengthy slide, which, in essence says that this presentation is given for informational purposes only and does not constitute a recommendation or an investment advice to enter into a financial transaction.

3. Content Context & Back to Basics What is Price Risk Management
Various type of Solutions
Tools and derivative instruments
Structures & hedging strategies
Summary
My presentation today is structured along three main pieces.
I will first set the scene for Risk Management within the context of the Energy business
After this I will share with you our approach to Risk Management and what we really mean by all this business of Hedging
I will end by sharing with you 3 real examples where the use of appropriate Risk Management tools can bring solutions to business problems.
I also want to point out that Price Risk Management is a technical subject and require certain expertise to comprehend its application in the trading environment. I hope and will do my best to make it simple for you during this short presentation. I will make myself available for offline discussions afterwards for those who want to know more.
If I have time towards the end of this talk (I doubt it!) I have a couple of slides to show you how bpriskmanager fits within the trading arm of BP.

4. Context: Energy Risk
World events and growth have thrown a spotlight on security of energy supply, energy costs and price volatility
Energy costs & revenues are a significant source of uncertainty for budgeting purposes
They feed directly through to a company’s bottom line
The need to understand energy market risk has never been greater
I believe we live now in a world where companies involved in buying or selling a type of Energy cannot afford to ignore Risk Management.
Current world events together with the rapid growth seen in many part of the Globe, have thrown a spotlight on security of energy supply, on energy costs and price volatility
Energy costs & revenues are with no doubt a significant source of uncertainty for budgeting purposes – and cause major headaches to CFO’s, Planners and Finance controllers.
They feed directly through to a company’s bottom line
The need to understand energy market risk has never been greater

5. Who are the players? Types of energy traders
Producers
Oil and gas producers
Renewable power generators
Transformers
Power generators
Oil refiners
Chemical refiners
Resellers
End Users
Air, land and sea transport companies
Commercial and industrial users
Domestic users
Governments
First, let’s go back to basics and try to understand who are the stakeholders around this business of Risk Managment hedging.
At some point all of these energy users will need to buy or sell energy – and to be delivered in the future
Since markets are volatile, there is uncertainty in the energy costs or revenue streams of these users
Where traded markets exist, - and I mean by that: Liquid Forward markets (Def: Market where a commodity can be sold or bought for delivery at an agreed date and place in the future, but at an agreed and transparent fixed price NOW); there is the potential for risk management products to assist these energy users
It is worthwhile noting that most of these energy users will also be impacted by foreign exchange rate fluctuations – and probably debt management too (interest rate exposure)

6. Types of trading
Speculation: taking risky positions in a market with the intention of exploiting market price movements.
Frequent In & out of the Market looking for potential gain opportunities
View driven
Take a bet on the future direction of a market
Want price volatility (uncertainty) to increase
Will enter into deals and set limits when to exit
Hedging: trading activity intended to reduce the riskiness of a portfolio.
Reduce/eliminate the risk faced from potential future price movements
In & out of the Market only when there is a (strategic) business
Business objective driven
Reduce/”hate” exposure to volatility of the business
Want certainty at the cost of sacrificing away potential upside
No surprise approach
Arbitrage: trading activity resulting in a riskless profit, usually arising from participants exploiting inefficiencies in a market or mis-pricing of derivatives. The forces of supply and demand usually ensure these price mismatches subsequently disappear as a result of the trade being executed.
Trading activity in energy markets may be grouped under 3 headings:

7. Some Definitions: What is risk?
Most dictionary definitions of risk relate to hazard, exposure to misfortune, or other quite negative meanings
Definition for our purposes: Risk: Exposure to an uncertainty
Risk Management or Hedging: is about transforming an “unknown” (uncertain) future cash flow to a “known” (certain) one
As you’ve seen in the previous slide the word RISK was used several time.
So let’s look at some definitions.
Talk through the slides.
If we go back to the daily life of an Energy trading company, that is to sell and/or buy a type of energy,:
A do-nothing approach is equivalent to speculating with shareholders money. It is similar to a trader who is buying/selling a commodity based on a view he/she may have on future prices. This may result in good performance for the trader if the market goes his/her way. But it could also turn out to be disastrous.
Either way, a do-nothing approach will have a huge impact on profit margins, whether negatively or positively.
The second approach is adopting Risk Management solutions to hedge some (or all) price exposure is another approach. It stabilises future cash flows.
In any case, given the current volatility we are experiencing in the market, it has never been a greater need for energy risk management. And any Energy player should learn about hedging tools so that he can apply them when needed.

8. Risk management objectives
Use of Price Risk Managment Tools to meet the following objectives:
Costs and revenues stabilisation
Secure positive margins
Elimination of price risk to ensure budget predictability
Competitive advantage
Strategic hedged-based finance
First, one need to have a business objective.
The true objectives sought by using Price Risk Management policy are mainly to:
Stabilise and protect future Revenues
Secure positive margins
Protect from rising or falling prices
Predict one’s Budget
Meet Loan commitments

9. Types of markets Exchange Futures Standardised options
Volumes are regulated
Indices are restricted (Brent, WTI, etc)
Delivery and settlement dates are regulated
“Clearing houses”
IPE, NYMEX, ICE, CBOT, SFE…
Over The Counter
Swaps
Exotic options
Packages and structured
Products
No restriction on volumes
All indices/products are traded
Delivery/Settlement dates are agreed upon
Hedging structures are designed to meet exact exposure
There are two type of Market Places where to trade Energy Derivatives.
Talk through the slides.
Both speculators and risk managers will use the same Markets as well as the same tools – which I will take you through some of them in a minute.
OTC markets offer fit-for-purposes solutions to mitigate business exposures.

10. Types of risk management tools
Linear instruments
Fixes the future price at a level agreed today (forwards, futures, swaps)
Non-linear instruments
Right of achieving a maximum or a minimum protection price (options and derivatives)
Structured products
Tailored package (combination of above)
Interaction between different risk factors (physical commodities, FX, interest rates, freight, etc)
Hedging tools can be split in 3 categories..

11. Swap contracts
A purely financial (paper) transaction between two parties who agree to make regular payments to each other in the future
Allows the exchange of a variable or floating price for a schedule of fixed price payments
Swaps can pay out on the basis of differing notional volumes month-by-month
Need to agree:
Floating price index
volume
time period
fixed price
No premium outlay
So, let’s start by the most basic OTC derivative: A Swap. And let’s see its application in a simple but real business example.
‘Read through the slide’

12. Swap: Application Refinery Seller
Fuel Oil
Fuel Oil
Refinery
Seller
Customer
V (tons)
V (tons)
FOn($)
Fixed($)
0.7*V (tons)
P0($)
FOn($)
Buy a Swap on FO:
Monthly cash settled;
pay a fixed price P0($);
receive the floating price FOn($)
for the next 12 months;
Volumes (tons) per month = 0.7*V
Decision made to:
fix the price of Fuel Oil;
for the next 1 year;
in US$ or other (e.g., €)
bpriskmanager
Consider the business case where a seller is negotiating to enter into a fixed price 1 year term supply contract to sell a product (say, Fuel Oil) to a shipping company. The seller will in fact be buying the product (fuel oil in this case) from a refinery at a transfer price based on the monthly average as reported, let’s say, by Platt’s. This will obviously create an exposure to Fuel Oil prices.
So the business case here is: How can the seller secure the Term supply Contract but still secure known and certain margin.
One way to address this case and mitigate such exposure is for the seller to buy a Financial Swap. Maybe the seller doesn’t want to give up all potential upside in the case where the Fuel Oil prices falls during the term of the contract – and therefore he makes a business decision to hedge 70% of his exposure for the term of the contract (1 year) and leave the other 30% unhedged.
‘Talk through the slides’.
Net Margin for Seller on a given month:
30% × (Fixed – FOn) + 70% (Fixed – P0)

13. Option instruments
Options are derivative instruments that provide the holder with the right, but not the obligation, to pay or receive some quantity of cash or commodity, at an agreed strike price
Options come in many different flavours, and have a whole language associated with them
A call option provides the holder with the right, but not the obligation, to receive the underlying at some agreed strike price, an operation known as exercising
A put option provides the holder with the right, but not the obligation, to exercise by selling the underlying at the strike price
Options are asymmetric, they guarantee their holder needs never exercise unless market prices are in their favour
Since there is no such thing as a free lunch, the option purchaser needs to pay an option premium for this “insurance”
The next type of hedging instruments which are extensively used in some Markets is the “Option” tool.
‘Read through the slide’

14. Option: Application Gas Supplier Buyer
K= $40
Supplier
bpriskmanager
Buyer
V×a (bbls)
V (tons)
$$-premium
Brentn($)
Buy a Put Option on Brent:
Monthly cash settled;
pay a premium p upfront, or
as part of settlement;
receive: Max (0, $40 – Brentn) per bbl;
for the next 10 years;
Volumes (bbls) per month = a×V
Decision made to:
protect against prices ≤ $40/bbl;
for the next 10 years;
on 100% of the volumes
Let us consider another example where a supplier is receiving for his gas a monthly price based on Brent (or this could also be Henry Hub gas index for instance). And suppose that the supply contract is for 10 years.
Again, the supplier will have some business objectives to meet. This is the starting point on deciding whether to hedge or not. If it’s the former, the second step is to chose the appropriate hedging instrument.
Suppose the seller is worried about protecting his return on investments. In order to achieve such return, prices need to stay above a threshold level of $40/bbl over the next 10 years.
Let’s suppose he was able to secure a Floor in the LNG contract of $20/bbl.
At the same time he doesn’t want to give up all potential upside in the case where the Brent price settles above $40.
He makes a business decision to hedge 100% of his exposure for the next 10 years.
One way to achieve such objective is to:
Sell to the market the existing Floor in the LNG contract (sell a Put option at a strike of $20/bbl). This will generate a premium to the seller.
Buy from the Financial market a Put Option that strike at $40/bbl;
‘Talk through the slides’.
Net price to receive for LNG for next 10 years: Pn($) = [a × Max(40, Brentn) + b] - p

15. Option: Application
a = 0.1; b = 0 premium = $5/bbl

16. Option prices Option premiums are impacted by:
Current market price (Forward prices)
Strike price
Time to expiry
Risk-free interest rates
Volatility of the underlying market
Volatility is the most important “unobservable” market data.
It is a measure of the uncertainty/instability of future prices
Option premiums will depend on Market data as well as the specifics of the sought protection.
...‘talk through the slide’
It is worthwhile noting that the greater the time to expiry, the more chance there is for the option to move ITM, or deeper ITM, and therefore the higher is the premium.
Similarly, the greater the volatility of the underlying market, the more chance there is for the option to move ITM, or deeper ITM and hence the higher is the premium.

17. Hedging Refinery Crack Margin
Consider a refinery of 55kbd
Consider that the refiner needs to meet some fixed payments during next 2 years to service a $120MM loan. I.e. $5MM per month*
Consider the Jet Fuel yield is 30% (i.e. 16.5kbd)
Market Forward price for Crude and Jet Fuel are such as the margin for next two years is: $10/bbl
Let me now consider a third and last example applicable to the Refinery business
*Ignore interest effect

18. Hedging Crack Spread: Example
Solution to secure repayments:
Refiner Sells a Swap
Underlying: Refining margin Jet/Crude
Volume: 16.5kbd (i.e. ~500kbbls/month)
Period: 2 Years
Starts: July-06
Ends: June-08
Settlement: end of each Calendar month
Fixed price: $10/bbl
*Ignore interest effect

19. Hedge and Physical Transactions
bpriskmanager
Fixed = $10/bbl
Floating: Monthly average of Margin
Refinery
Physical crude and product
Floating: Monthly average of Margin
Physical market
Settlement Amount = Monthly Volume * ($10 – Margin)
Settled by either party on, say, 5 business days after end of each month

20. Hedging Crack Spread: Example What happens at each settlement?
Crude Price ($/bbl)
Jet price ($/bbl)
Physical Transaction
Crack Spread Swap outcome to Refinery: $ Margin
Net Effect: Achieved Margin = $10.0
Secure Payment of $5MM / month

21. Another Mitigation Solution: Indexation
Refinery can buy Crude on a price linked, e.g., to gasoil price:
Crude Oil price ($/bbl) = a* Gas Oil price + b
a & b two constant parameters
Or,
Refinery enter into a “reference swap” (i.e. financial hedge) where Crude oil price is swapped to a Gas Oil price (formula as above)

22. Summary An ENERGY player can add value to its business through:
Understanding the Risk Management solutions that exist to manage price exposure;
Being able to enter into the most appropriate solution when needed, after defining the business model of the company (how much exposure to hedge? How far in time? And other corporate considerations); and
Transact when a decision is made to hedge.
Once it executes the appropriate hedge, one becomes indifferent to prices movements during the hedged period.
Ladies and Gentlemen I will finish by stating that with current uncertainty and volatility, it has never been a greater need for Energy Risk Management.
One has to understand the existing technology and be ready to use it when there is a business need.
Ignoring hedging is not an option in nowadays business.

23. Something to remember... Price Risk Management is not Speculation
It is about reducing risk to future market movement
It is about Margin & Return On Investment stabilisation/Protection
It is about seeking certainty in an uncertain world
And at last but not least, if there is something to remember from this presentation, it is that hedging in its proper sense, is not Speculating.
Talk through the slide.
Mr Chairman, Ladies & Gentlemen, Thank you very much for listening.

24. THANK YOU

25. bpriskmanager Services
bpriskmanager is a core part of BP’s Integrated Supply and Trading Organisation
We offer cross-commodity and cross-currency hedging service to BP and to external counterparties
Our activities comprise derivatives marketing, commodity options trading, financial FX, Money Market & Metals trading, and structured products
bpriskmanager works with its partners to help them understand their risk exposures, and explains the range of hedging tools available to them, including in-house financially-engineered structures. It then prices and transacts the hedge selected by the customer
We offer cross-commodity and cross-currency hedging service to BP and to external counterparties
Our activities comprise derivatives marketing, commodity options trading, financial FX, Money Market & Metals trading, and structured products
We work with our partners to help them understand their risk exposures, and explain the range of hedging tools available to them, including in-house financially-engineered structures.
We then price and transact the hedge selected by the customer

26. London, Chicago and Singapore
Context within BP Trading
BP’s Customers
OTC
Oil
Market
Analysis
Options
Marketing (bpriskmanager):
London, Chicago and Singapore
Structured
Financing
Quantitative
Analysis
BP’s Trading Books
Crude Oil
Products
Gasoil
Jet
Gasoline
Naphtha
Fuel Oil
Gas &
Power &
Emissions
Shipping
Freight
Metals
Non/precious
Forex & Money
Markets
Structured
Products