Hedging & Price Management March 31, 2017 Oil Futures Market Good morning everyone. Today, I intend to give you a background on the oil futures market, its financial instruments and the various objectives behind using those instruments.  Hedging & Price Management March 31, 2017

Outline Types of Financial Instruments Jargons Usages of Financial Instruments Trading Failures  First I will go through the different financial instruments that have been utilized in the oil future markets. Then, and before we go any further, I will guide you through some financial jargons and terminologies that my come up at one point or another during the presentation. We will take a look at each of the purposes behind using those instruments. Some in more details than others mainly hedging and price management. Finally, we will discuss some of the causes that have contributed to many trading failures in this volatile and, to a certain degree, unforgiving market.

Types of Financial Instruments Forward Contract Futures Contract Derivatives Options Calls Puts Swaps The first type of financial instrument and probably the simplest, is the forward contract.  The second instrument is the future contract.  Then you have two types of financial derivatives, options and swaps.  And finally, Swaps are A custom-tailored, individually negotiated paper exchange transaction of a fixed price for a floating price designed to manage price risk, usually over a period of one to 12 years. Swaps can be conducted directly by two counterparties, or through a third party such as a bank or brokerage house. The writer of the swap, such as a bank or brokerage house, may elect to assume the risk itself, or manage its own market exposure on an exchange. Settlements are usually made in cash. In a typical commodity or price swap, parties exchange payments based on changes in the price of a commodity or a market index, while fixing the price they effectively pay for the physical commodity. I’m not going to go into further details with regard to derivatives since it is a very rich and complicated topic that requires a dedicated session. 

Forward Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price on a specified future date. Payment in full is due at the time of, or following, delivery.” A forward contract as defined by the NYMEX is “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price on a specified future date. Payment in full is due at the time of, or following, delivery.” An oil forward contract, more specifically, specifies a cargo size quantity. It is not price transparent since it is usually between two parties with a longstanding and trusted relationship. For example, Shell may have a forward contract with Aramco to buy fuel oil. 

Future Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price at a specified location.” A future contract also as defined by the NYMEX is a supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price at a specified location. Futures differ from forward contracts in their standardization, exchange trading, margin requirements, and daily settling, where all contract are marked to market at the end of each trading day. 

Futures Contracts - Characteristics Regulated Small lots Monthly quote Price transparent Clearing house Margin money required Not always physical Also, unlike the forward market, the futures market is highly regulated where contracts are traded in small lots at monthly quotes with very transparent prices through clearing houses that requires margin money. One more important aspect about the Futures contracts, they hardly become physical. 

Options “a right – but not an obligation- to buy or sell an underlying asset at a fixed price during a specified time period in exchange for a one-time premium payment.” Call : the option to buy Put : the option to sell An Option give you the right – but not the obligation- to buy or sell an underlying asset at a fixed price during a specified time period in exchange for a one-time premium payment. The option contract also obligates the writer, the one who receives the premium, to meet these obligations. A Call Option gives the buyer ( or the holder) the right, but not the obligation, to buy a futures contract and It obligates the seller or the writer of an option to sell the underlying futures contract. Where: A Put Option gives the buyer, or holder, the right, but not the obligation, to sell a futures contract. It obligates the seller, or writer, of the option to buy the underlying futures contract at the designated price, should an option be exercised at that price. Again,…. 

Where are They Traded ? NYMEX (US) IPE (London) Light sweet crude (WTI) Brent Heating oil (No 2) Gasoil Gasoline Natural Gas SIMEX (Singapore) Fuel Oil There are three main futures markets, the NYMEX (New York Mercantile Exchange), the IPE ( International Petroleum Exchange in London), and the SIMEX ( Singapore International Monetary Exchange). Those are examples of the different commodities that are being traded in each of the three markets. 

Jargons Contango vs. Backwardation Long vs. Short Bull vs. Bear  Before we go any further, we need to go over some of the terminologies that are commonly used in the oil futures market. First, contango vs. backwardation.  A long position and a short position.  Also, you have a bullish outlook if you think that prices are rising, and vies versa, you are a bear if you have a negative outlook on the market and predict that prices will be falling. 

Contango If at any point in time… Market prices RISE through future months… Then the market is in CONTANGO What is a contango market? A contango Market is a market condition in which prices are higher in the succeeding delivery months than in the nearest delivery month. I.e. if market prices RISE through future months…then we say the market is in contango 

Backwardation If at any point in time….. Market prices FALL through future months… Then the market is in BACKWARDATION On the other hand, If at any point in time futures prices are lower in each succeeding delivery month …then the market is in backwardation Also known as an inverted market. 

IPE Gasoil Curve In this example, Both curves represents IPE gasoil prices but at two different periods. The red line illustrate a time when the gas oil market was in contango where the front month futures price is less than the price of subsequent months. On the other hand, the blue line shows the state of the gas oil market this past summer when it was in backwardation. The market continued to be in backwardation until now due to the bearish sentiment presiding over the market. US and European inventories are at historical low levels as most refiners choose not to hold inventories at today’s high prices as they anticipate a retraction in crude prices and soon after product prices. The perception out in the market is that crude prices will not continuo to be in the $32 to $35 price range. So, if it curving up, then the market is in contango, and if it is curving down then the market is in backwardation. 

Pay Out Diagram – Long Position Profits $ Long is the market position of a futures contract buyer whose purchase obligates him to accept delivery unless he liquidates his contract with an offsetting sale. Hence, the holder of the contract will profits as the market rises as shown here in the green.  Profits as Market rises 27 28 29 $/bbl Losses as Market falls Losses $

Pay Out Diagram – Short Position Profits $ And to the contrary, Short is the market position of a futures contract seller whose sale obligates him to deliver the commodity unless he liquidates his contract by an offsetting purchase and the seller will loss if the market rises as he will be covering his position by buying at a higher price.  Short Selling Selling a contract with the idea of delivering or of buying to offset it at a later date. Profits as Market falls 31 32 33 $/bbl Losses as Market rises Losses $

Use of Financial Instruments Speculation Hedging Price Management Now, let’s shift our attention to the three main different motives behind using those financial instruments; First, a lot of traders use the futures market for speculative purposes,  The second usage of the futures market and probably the most legitimist one is hedging  The futures market can also be used for Price Management. Which is a bit different than hedging.

Speculation Outright position taking Pure paper traders Directional price movement Speculation means outright position taking.  Speculators simply do it to profit on paper barrels. Many of the participants in the oil futures market are pure paper traders who have absolutely nothing to do with the physical. Those speculators hope to profit from the specific directional price move of a futures or options contract. And there are many speculators in this market as the number of paper barrels that are traded far exceed the number of physical barrels at any given day. To illustrate this point,

A Speculative Market The average daily volume of worldwide consumed crude is between 75 – 78 million barrels. On the other hand, the average daily volume of traded Brent crude futures contracts at the IPE is around 90 thousands contracts or 90 million barrels as each single contract represent 1000 barrels. By the same token, the average daily volume of traded WTI crude futures contracts at the NYMEX is around 140 thousands contracts or 140 million barrels. 

Hedging Definition: Taking an opposite position on futures to that on physical to remain… “PRICE NEUTRAL” Objective: “TO REDUCE RISK” Hedging  is Taking an opposite position on futures to that on physical not to make money, but mainly to remain PRICE NEUTRAL A central point in finance is that risk is undesirable. And, a company hedges primarily to offset or reduce risk. I.e. a Hedger is a trader who enters the market with the specific intent of protecting an existing or anticipated physical market exposure from unexpected or adverse price fluctuations.

Hedging - Example It is October 29th. A trader loads a gasoil cargo ex-Yanbu. The FOB price is $270/ton. His freight cost is $15/ton. He also has agreed to sell it CIF to a buyer in Rotterdam at Platts 0.2%S CIF on arrival. Vessel is due Rotterdam November 9th. Today, Platts 0.2%S CIF price is $293/ton IPE December Futures price for gasoil is $291/ton. The trader intend to make $8/ton in profits. Let us go through an example of a hedging exercise. Read example setting from the big screen.          So what do we have here, But, The vessel is is not due in Rotterdam until November 9th. During this period the trader is long and if market prices fall, he will lose money since his buying pricing window is not as his selling pricing window. 

Hedging – Example (continue) Hedging plan (Part I) When the physical is priced in, he should sell futures (October 29th) Action: 1. Buy physical @ $270/ton 2. Sell Futures @ $291/ton To reduce this unwanted risk, the trader decide to hedge via the futures market. On the day the physical is priced where he becomes long the physical barrels, he should sell futures to become neutral.  So, on October 29th, he will buy the physical @ $270/ton and thus he should sell Futures @ 291/ton.

Hedging – Example (continue) Hedging plan (Part II) When the physical is priced out, he should buy futures (November 9th) On November 9th, Platts CIF Cargoes price is $280/ton IPE December Futures price is $278/ton Action: 1. Sell physical @ $280 2. Buy Futures @ $278  On November 9th, the physical is priced out where i.e. the trader will become short the physical barrels, he should buy futures to offset his paper position. So, if we assume that on November 9th, the market continue to be in backwardation as the Platts CIF Cargoes quotation for 0.2%s gasoil was $280/ton and the IPE November Futures price was $278/ton. Hence, the trader will Sell the physical @ $280/ton to the Rotterdam buyer and he will buy Futures @ $278/ton to offset his paper position.

Hedging – Example (continue) Accounting Physical $/ton Futures FOB Purchase -270 Sell on Oct. 29th +291 Fright -15 Buy on Nov. 9th -278 CIF Sale 280 Net -5 13 So, how all this selling and buying add up? Go through the physical then through the futures calculations. The over all net profit is a +$8/ton Any question? OVERALL NET = +$8/TON

Price Management Definition: Using futures and forward markets as a vehicle to… “CATCH THE MARKET” Objective: “LOCKING IN A PRICE” The third use of the oil futures market is price management.  It is defined as using futures and forward markets as a vehicle to CATCH THE MARKET, thus choosing when to price And the Objective: a very simple one is to LOCK IN A PRICE. (Explain difference to hedging) Let us go through an example.

Price Management - Example It is November 1st A Japanese refinery is due to load Dubai crude on December 15th As usual, price will be determined 5 days around B/L Buyer fear that crude prices are increasing next month and would like to lock current price Action: 1. Buy Dubai futures now 2. Sell Dubai futures at time physical is priced Read example setup.      The difference between this example and the previous one is that the buyer as of November 1st has no position.Yet, because he likes the price today and fears that prices may go up next month since he has a bullish outlook on the market, he decide to become long by buying the Dubai futures. Thus, the refiner is no longer neutral. He is in fact long paper until the physical is priced on December 15th. At that point in time after he would have sold the Dubai futures contracts, as stated in action number 2, he will become long the physical. And then he can go neutral again if he wish by hedging as we saw in our previous example. 

Why Do You See Trading Failures? Failure to understand risk & exposure Poor organizational structure Excessive speculation No position tracking Absence of controls Extreme market volatility Now that we have covered the tools and why are they used whether that is speculation, hedging, or price management, we turn our attention to the question of were does it go wrong? There are six main reasons for trading failures companies usually experience trading loses because they fail to understand their risk and their exposure to the market.  They also sometime suffer dire consequences due to poor organizational structure where various inter related organization with in the company go in different directions.  The third cause of failure is pure greed. Some companies over do it to the point where their trading activities become excessive speculation.  Also, any company that trades in the oil futures market and neglect to closely track its positions is bound to fail.  5. many companies also suffer huge losses in the oil futures market due to the lack of control with in the organization where there is no accountability.  6. And finally, many failures are blamed on the extreme volatile nature of the crude oil market. 

Crude Oil Prices If we look at the historical prices for the three main crude markers, we can easily spot the volatility and sensitivity of of Crude oil prices. And the causes ranges from war in the Middle East to the adaptation of net back pricing to the gulf war to over production, to extremely cold winter in the US and Europe. And, the volatility of crude prices can be witnessed also in the short term.

Crude Oil Price Volatility OPEC Meeting (Vienna) Here is an example that illustrate volatility of the crude market in the short-term. During the early part of 1999, in less than six weeks WTI crude price increased by $4/BBL or 35% from around $11.5 a barrel to almost $15.5 a barrel Why?

Summary Many financial instruments Three motives to use financial instruments. There is a distinct difference between hedging and speculation Hedge to reduce risk Trading Failures To summarize,  We started by looking at the various financial instruments that are being utilized in the oil futures markets such as the forward contracts, future contract, and derivatives. We also covered the three main trading objective which were speculation, hedging and price management. We differentiated between hedging and speculation. Also, as we saw in our hedging example, the main purpose of hedging is to reduce risk and not to profit from the futures market. And finally, we examined the six main causes for trading failures. Thank you very much.