escape cruise lines: fuel risk management strategies james buckner brigid lenahan meghan michaels...

Escape Cruise Lines: Fuel Risk Management Strategies James Buckner Brigid Lenahan Meghan Michaels Charles Mohn Derivatives and Financial Markets Concepts Prof. James Bodurtha December 15, 2012

Escape Cruise Lines is finishing its first full year of operation. As employees and founders of the company, we seek to tackle the task of hedging against the risk associated with our fuel costs for the upcoming quarter. Since there is insufficient historical data for the company, we will use the Royal Caribbean cruise line as a benchmark in our hedging process. We are short the underlying. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Cruise ships commonly run on a type of fuel called bunker fuel, which is very similar to crude oil and a byproduct of the crude oil refining process. Because there is no real market for this underlying, we believe it would be best to proxy our study to crude oil because of the close connections between the two. We would like to forecast our projections out to March of 2013, or simply to look into 3 month contracts that have maturities of March 2013. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Escape Cruise Lines sources fuel from its home port in Miami. The company pays to have fuel delivered to the Port of Miami. The company incurs an additional storage cost to keep fuel on site until the time when the two cruise ships come in to the port. Escape Cruise Lines understands that fuel expenses have a significant impact on the cost of operating cruise ships. According to the Royal Caribbean 2011 10K: Expenditures for fuel represent a significant cost of operating our business. If fuel prices rise significantly in a short period of time, we may be unable to increase fares or other fees sufficiently to offset fully our increased fuel costs. We routinely hedge a portion of our future fuel requirements to protect against rising fuel costs. Further volatility in fuel prices or disruptions in fuel supplies could have a material adverse effect on our results of operations, financial condition and liquidity. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Factors: 1) Supply 2) Demand 3) Crude Oil and the US Dollar 4) Speculators Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

There is no definitive trend in prices Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

1) Supply The supply of crude oil is at a historical high, pushing the price down. Forecasters say that in the fourth quarter, global oil output will top demand by more than 630,000 barrels a day, the largest surplus in four years. Currently, U.S. crude oil inventories are the highest since 1982. Horizontal drilling and hydraulic fracturing has unlocked oil trapped in shale formations in North Dakota, Texas and Oklahoma. As of October, U.S. crude production is at the highest level in over 15 years, at 6.52 million barrels per week. The International Energy Agency earlier this month forecast supplies from countries outside OPEC will rise to 53.6 million barrels a day in the fourth quarter, up 600,000 barrels a day from the third quarter. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

2) Demand The American Petroleum Institute last month reported U.S. oil demand in October fell to 18.4 million barrels a day, which was the lowest October demand seen in 17 years. During the first 10 months of the year, demand was 2.1% below the comparable period in 2011. Seasonal changes in weather affect the price of oil, with heating oil used heavily in the winter. With above average temperatures this year, however, demand for this oil will likely decrease. According to The Hill, Hurricane Sandy lowered gas prices due to decreased demand or demand destruction. The storm hit gas consumers, not producers, and will take an enormous amount of gasoline consumption offline. Given the above analyses, therefore, we believe supply will exceed demand and lower prices. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

3) Crude Oil and the US dollar Oil is traded and sold internationally in US dollars. Crude Oil prices and the value of the dollar have an inverse relationship: depreciation of the dollar tends to increase oil demand and therefore the price of oil. Currently many analysts predict the value of the US dollar will rise. If the dollar strengthens, reducing real income in countries that purchase oil, there will be less demand and oil prices will go down. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

4) Speculators Speculative purchasing creates a variation in the cost of oil-based products, as speculators buy and sell futures in the open market. Historically, speculators have been accused of bidding up oil prices to unstable levels. President Obama launched an plan to curb oil speculation in April of this year that may decrease the affect of speculation. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

1) OPEC and Global Oil Prices 2) Historic Trends 3) U.S. Fiscal Cliff Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

1) OPEC and Global Oil Prices OPEC (a consortium of 13 countries) is the largest entity that impacts world oil supplies. OPEC is responsible for 40% of the worlds oil production, and sets policies to meet global consumption. The consortium affects the price of oil by regulating production among member countries. Decreases in OPEC allocations have historically led to higher oil prices. We foresee continued violence in the Middle East- particularly in Egypt and Syria-a region which accounts for 66% of OPEC production. When the financial markets are uneasy and there is political unrest, OPEC will protect its member states and lower production. This will contribute, therefore, to high volatility Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Recently, volatility has been relatively high Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

2) Historic Trends Oil prices have been especially volatile this year: increasing more than 10% in February, before falling by nearly 30% during the summer, before rising again and falling back to todays price. There has been a large increase in oil volatility ever since electronic trading proliferated in 2004. In 2008, the price of WTI tripled over 12 months to $150 per barrel, before falling all the way down to $33 the next year. Analysts expect oil prices to remain volatile for the next year amid worries that Saudi Arabia no longer has the capacity to help fix large disruptions in supply. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

3) U.S. Fiscal Cliff Government policies are a major determinant of oil prices along with supply, consumption, and financial markets There is currently a high level of uncertainty regarding the looming Fiscal Cliff If a deal IS made increase confidence businesses need to have to invest, grow and hire If a deal IS NOT made continued negative impact on investment and economic health This uncertainty translates to high volatility in consumer spending, investment, hiring, and commodity prices Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

According to Royal Caribbeans 2011 10K, their estimated fuel costs for the first quarter of 2012 are $228,821,918. Using this estimate, our exposure value is $10,400,996 $228,821,918/22. Royal Caribbean has 22 ships in its fleetby dividing by 22 we aim to isolate the cost for a single ship. Escape Cruise Lines will not accept more than a 1% risk of its fuel expense exceeding $10,921,046 (+5% or +$520,050) for the period extending from December to March. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Historical Volatility: 29.3% Risk Premium: NRPO=RP from 1959-2004: 20.67% 1 PS=43.45 (12/31/2004) PE=98.83 (12/30/2011)as we do not have data for 12/31/2012 NO=8 RPH = (PE/PS-1)/NO RP = (NRPO*NH+RPH*NO)/(NH+NO) RP=20.35% R: 0.31% (3 month LIBOR Rate) Futures Contract=87.51 (as of 12/6/2012) T=0.25 1 https://msb040.msb.edu/faculty/bodurthj/unrestricted/teaching/Project/Distributions%20of%20 individual%20commodity%20futures%20returns.htm See attached excel documents S t market = 0 F t * 1+ (r+RP) * t = 87.51 * 1+(.0031+.0134)* 0.25 = $91.96 1+r * t 1+.0031*0.25 Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Underlying - SS = MaturityDec '12March '13June '13Sep '13 Now-Current (11/13/12) Settlement Prices ($)85.3887.1788.8289.53 Actual Maturity Date 16-Nov- 12 20-Feb- 13 21-May- 13 20-Aug- 13 SymbolSPZ9SPH9SPM9SPU9 Subsequent (11/20/12) Settlement Prices86.6788.5589.3889.90 A subsequent date mark-to-market ("now-current" settlement - subsequent prices due to short exposure) -1.29-1.38-0.56-0.37 **NOTE: 1000 barrels of underlying is equal to one futures contract Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

S M *e +#(sqrt(T)) = (91.96)*e (2.33*.293*.25) Critical Price: $129.30 Associated Loss: (87.51-129.37)/(87.51) = - 47.83% Keep=Target Loss/Actual Loss =5%/47.83% =10.45% Hedge 90% (1-.1045) Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

1 Futures contract = 1,000 barrels of oil Contracts equivalent to exposure = 119 Number of contracts to sell=107 Number of contracts to leave unhedged=12 Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Futures Price (12/6/12)=87.51 Call ATM: 8750 Premium: 4.41 Call OTM: 9000* Premium: 3.24 Call ITM: 8500* Premium: 5.83 Put ATM: 8750 Premium: 4.40 Put OTM: 8500 Premium: 3.33 Put ITM: 9000 Premium: 5.73 *Used a 3% range (87508750*.03)=9012.5; 8487.5 Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

By going +107 F rather than +106F suggested by the @ Risk Program, we meet our risk limit. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Level of Confidence Vol vs. marketUnsure-Vol=MarketSure-StableVol vs. market Direction vs. market view View = Vol up (options cheap) View = Vol Stable (options prices fair) View = Vol Down (options expensive) Direction vs. market view Up-Unsure (forward cheap) Up-Sure (forward cheap) No direction - ? (forward price fair) *(I) * (II) No direction Sure (forward price fair) Down-Unsure (forward expensive) X *(III) Down-Sure (forward expensive) Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

StrategyCombinationNotationPurposeMarket ViewName Market ViewLong Put-F+CInsurance (Trading)Down and unsureSynthetic Long Put Alternative Market View Long Put ITM-F +C OTM Insurance (Trading)Down and unsureSynthetic P ITM Alternate View 1 (Neutral Direction, Volatile) Short Forward, Long 2 Calls -F+2CTrade vol (Insurance)Volatile (neutral direction) Synthetic Long Straddle Alternate View 2 (Neutral Direction, Volatility Stable) Short Forward, Long 2 Puts -F,-2PTrade vol (Income)Stable (neutral on direction) Short Straddle Alternate View 3 (Down, Volatility Stable) Short Forward-F+COTM-POTMTrading (Insurance and Income) Limited Down, Concern about a big up Synthetic Bear Spread Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

At Escape Cruise Lines, we are speculative in our assessment that the price of crude will go down in the next three months. In this the case, we would choose Alternative 1, which is a Long Straddle. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

Rationale: If one characteristic of our underlying is more certain than others, it is that volatility will be a continuing factor in the near future If we are more uncertain about where exactly the price would move, we would chose this strategy because it allows us to gain from the volatility without having to pick a direction Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

If we were certain that the price of oil would go down, we would choose a synthetic long put. As shown in the following slides, the synthetic long put does better in the down- side, but is costly on the up-side. Therefore, this position is only recommended if we are sure the prices will decline. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

o Between the prices of 82.51 and 87.51 the hedged position provides a greater return. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

o However, on the down-side, the risk management performs better (a price roughly halfway between 128.76 and 137.01). At these prices, the hedged position is quite expensive. Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend

http://online.wsj.com/article/SB10000872396390444734804578066730415856020.html http://www.bloomberg.com/news/2012-10-03/oil-declines-after-u-s-supplies-gain-a-fourth-week.html http://online.wsj.com/article/SB10001424052970203937004578076892015038554.html http://www.bloomberg.com/news/2012-12-10/gasoline-gains-on-budget-talks-optimism-stronger- brentprices.html http://finance.yahoo.com/news/record-production-rates-decade-low132000065.html http://thehill.com/blogs/e2-wire/e2-wire/265411-sandy-to-drive-gas-prices-lower-through-end-of-year http://www.bloomberg.com/news/2012-10-09/most-accurate-forecasters-say-dollar-beats-qe3.html http://www.theatlantic.com/business/archive/2012/04/would-obamas-war-on-speculators-really-reduce- the-price-of-oil/256076/# http://www.royalcaribbean.com/customersupport/faq/details.do?pagename=frequently_asked_questions&pnav =5&pnav=2&faqSubjectName=Ships&faqId=2668&faqSubjectId=319&faqType=faq http://www.cbsnews.com/8301-505123_162-51337483/why-oil-prices-are-so-volatile/ http://professional.wsj.com/article/SB10001424127887324296604578177680511658970.html?mod=WSJ_fc_L EFTTopStories&mg=reno64-wsj Business Overview View on Direction and Volatility Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies What We Recommend