hedging derivatives

8/8/2019 Hedging Derivatives

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Lecture Note

Petroleum Economics: T. Boonpramote

1

Derivatives and Risk ManagementIn the Petroleum and Energy Industries

(Extracted from eia.doe.gov and NYMEX)

Derivatives are financial instruments (contracts) that do not represent

ownership rights in any asset but, rather, derive their value from the value ofsome other underlying commodity or other asset. When used prudently,derivatives are efficient and effective tools for isolating financial risk and

hedgingto reduce exposure to risk.

Although derivatives have been used in American agriculture since the mid-1800sand are a mainstay of international currency and interest rate markets, their use

in the U.S. energy industries has come about only in the past 20 years withenergy price deregulation. Deregulation revealed that energy prices are amongthe most volatile of all commodities. Widely varying prices encouraged consumersto find ways to protect their budgets; producers looked for ways to stabilize cash

flow.

Derivative contracts transfer risk, especially price risk, to those who are able

and willing to bear it. The past 25 years have seen a revolution in academic

understanding and practical management of risk in economic affairs. Normally,both parties to a derivative contract are better off as a result. For example, alocal distribution company that sells natural gas to end users may be concerned

in the spring that the wholesale price of natural gas in the following winter will betoo high to allow for a reasonable profit on retail sales to customers. Thecompany may therefore hedge against the possibility of high winter prices byentering into a forward or futures contract for wholesale gas purchases at a

guaranteed fixed price. The seller of the contract would profit if the distributioncompanys fears were not realized. Both parties would be better off, because eachwould accept only those risks that it was willing and able to bear.

Nothing is new in using derivative contracts to manage particular risks. What isnew is that global competition, flexible exchange rates, price deregulation, and

the growth of spot (cash) markets have exposed more market participants tolarge financial risks. Simultaneously, advances in information technology andcomputation have allowed traders to assign a value (price) to risk by using

formulas developed by academics starting in the 1960s. Starting from the late1960s, the business of isolating, packaging, and selling specific risks has becomea multi-trillion dollar industry.

Derivatives, properly used, are generally found to be beneficial. They can allow afirm to invest in worthwhile projects that it otherwise would forgo. In addition,they neither increase volatility in spot markets nor have been shown historically

in oil markets to be a major tool for market manipulation.

Derivatives and Risk

The general types of risk faced by all businesses can be grouped into five broadcategories: m a r k e t r i sk (unexpected changes in interest rates, exchange rates,stock prices, or commodity prices); c r ed i t / d e fau l t r i sk ; opera t iona l r i sk

(equipment failure, fraud); l i q u i d i t y r i s k (inability to pay bills, inability to buy orsell commodities at quoted prices); and po l i t i ca l r i sk (new regulations,expropriation).

In addition, the financial future of a business enterprise can be dramaticallyaltered by unpredictable eventssuch as depression, war, or technological


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breakthroughswhose probability of occurrence cannot be reasonably quantifiedfrom historical data.

Businesses operating in the petroleum, natural gas, and electricity industries areparticularly susceptible to market riskor more specifically, pr ice r i sk as aconsequence of the extreme volatility of energy commodity prices. To a largeextent, energy company managers and investors can make accurate estimates of

the likely success of exploration ventures, the likelihood of refinery failures, orthe performance of electricity generators. Diversification, long-term contracts,inventory maintenance, and insurance are effective tools for managing thoserisks. Such traditional approaches do not work well, however, for managing pricerisk. Derivatives are particularly useful for managing price risk.

Risk Managem en t W i t hou t De r iva t i ves

When investors, managers, and/or a firms owners are averse to risk, there is an

incentive to take actions to reduce it. Diversificationinvesting in a variety ofunrelated businesses, often in different locationscan be an effective way ofreducing a firms dependence on the performance of a particular industry or

project. In theory it is possible to diversify away all the risks of a particular

project; in practice, however, diversification is expensive and often fails becauseof the complexity of managing diverse businesses. More fundamentally, the

success of most projects is strongly tied to the state of the general economy, sothat the fortunes of various businesses and projects are not independent butmove together. In the real world, therefore, diversification is often not a viable

response to risk.

Another method of managing the risk created by fluctuating prices is to use long-

term fixed-price contracts: the owner of a firm that invests in a natural gascombined-cycle plant could simply sign a long-term contract with a gas supplier.

For example, in January 2002 it would have been possible to lock in gas prices of$2.59 per thousand British thermal units (Btu), $2.92 for 2003, and so on.However, such a hedging strategy still would leave some risk. If the spot marketprice for natural gas in 2003 turned out to be only $2.70 as opposed to $2.92,

power from the firms plant might not be competitive, because other plant ownerscould purchase natural gas at $2.70 and undercut the price of power from theplant with a higher fuel cost of $2.92. Conversely, if natural gas prices in 2003

rose to $4.00, the seller might choose to default on the plants gas supplycontract.

Insurance contracts can also be used to manage risk. For example, there is

some probability that the natural gas plant in the previous example mightmalfunction and be taken out of service. The owner of the plant could purchasean insurance contract that would provide compensation for lost revenue (andperhaps for repair costs) in the event of an unplanned outage. The insurance

would essentially shift the risks from the owner of the plant to the counterpartyof the contract (in this case, the insurance provider). The counterparty would

accept the risk if it had greater ability to pool risks and/or were less averse to riskthan was the owner of the plant.

The plant owner could also reduce the risk of adverse movements in futurenatural gas prices by purchasing the fuel in the current period and storing it as

inventory. If prices fell, the firm could buy the fuel on the open market; if theyincreased, it could draw down the inventory. This could be an expensive way tomanage risk, because storage costs could be considerable.


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Manag ing R isk W i th De r iva t i ve Con t r ac ts

Derivatives are contracts, financial instruments, which derive their value from

that of an underlying asset. Unlike a stock or securitized asset, a derivativecontract does not represent an ownership right in the underlying asset.

The asset that underlies a derivative can be a physical commodity (e.g., crude oil

or wheat), foreign or domestic currencies, treasury bonds, company stock, indicesrepresenting the value of groups of securities or commodities, a service, or evenan intangible commodity such as a weather-related index (e.g., rainfall, heatingdegree days, or cooling degree days). What is critical is that the value of theunderlying commodity or asset be unambiguous; otherwise, the value of the

derivative becomes ill-defined.

The following sections describe various derivative instruments and how theycan be used to isolate and transfer risk. Most of the discussion is in terms of price

risk, but derivatives have also been developed with other non-price risks, such asweather or credit. When used prudently, derivatives are efficient and effectivetools for reducing certain risks through hedging.

Forward Contracts

Forward contracts are a simple extension ofcash or cash-and-carrytransactions. Whereas in a standard cash transaction the transfer of ownershipand possession of the commodity occur in the present, delivery under a forward

contract is delayed to the future. For example, farmers often enter into forwardcontracts to guarantee the sale of crops they are planting. Forward contracts aresometimes used to secure loans for the farming operation. In energy markets, anoil refiner may enter into forward contracts to secure crude oil for futureoperations, thereby avoiding both volatility in spot oil prices and the need to store

oil for extended periods.

Forward contracts are as varied as the parties using them, but they all tend todeal with the same aspects of a forward sale. All forward contracts specify the

type, quality, and quantity of commodity to be delivered as well as when andwhere delivery will take place. In addition, forward contracts set a price or pricingformula. The simplest forward contract sets a fixed (firm) price. More elaborate

price-setting mechanisms include floors, ceilings, and inflation escalators. Bysetting such a price, the buyer and seller are able to reduce or eliminateuncertainty with respect to the sale price of the commodity in the future. Knowingsuch prices with certainty may allow forward contract users to better plan their

commercial activity. Finally, the contract may contain miscellaneous terms orconditions, such as establishing the responsibilities of the parties undercircumstances where one party fails to perform in an acceptable manner (lack ofdelivery, late delivery, poor quality, etc.). Overall, forward contracts are designed

to be flexible so as to match the commercial merchandising needs of the partiesentering into them.

A direct result of the forward pricing and delivery features of forward contractsare default and credit risks. In the case of long-term forward contracts, theexposure to default and credit risks may be substantial. Parties to forwardcontracts must be concerned about the other partys performance, particularlywhen the value of the contract moves in ones favor.

For example, if an oil refiner has contracted to purchase oil at $19 per barrel, itslevel of concern that the other party will perform by delivering oil risesprogressively as the price of oil rises above $19 per barrel and the incentive for


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the counterparty to walk away from the contract increases. To deal with the riskof default, parties scrutinize the creditworthiness of counterparties and deal onlywith parties that maintain good credit ratings. They may also limit how much they

will buy from or sell to a particular trader based on his credit rating. In somecircumstances parties may also ask counterparties to post collateral or good faithdeposits to assure performance. Ultimately, how parties deal with default andcredit risk in a forward contract is up to them.

Futures Contracts

Futures trading in the United States evolved from the trading of forward contractsin the mid-1800s at the Chicago Board of Trade (CBOT). By the 1850s, the

practice of forward contracting had become established as farmers and grainmerchants in the Midwest sought to reduce their exposure to changes in the priceof grain they were producing or storing. After the CBOT standardized forwardcontracts, speculators began to purchase and sell the contracts in an effort to

profit from the change in the value of the contracts. Actual delivery of thecommodity became of secondary importance. Eventually this practice becameinstitutionalized on the CBOT, and the modern futures contract was born. Today

futures contracts are traded on a number of exchanges in the United States

and abroad (Table 1).

Table 1. Major U.S. and Foreign Futures Exchanges

Exchange Country Primary Commodities

Chicago Board of Trade (CBOT) USA Grains, US Treasury notes and bonds,

other interest rates, stock indexes

Chicago Mercantile Exchange(CME)

USA Livestock, dairy products, stockindexes, Eurodollars and other interest

rates, currencies

Kansas City Board of Trade(KCBT)

USA Wheat and stock indexes

Minneapolis Grain Exchange(MGE)

USA Spring wheat

New York Board of Trade

(NYBOT)

USA Sugar, coffee, cocoa, cotton, currencies

New York MercantileExchange (NYMEX)

USA Metals, crude oil, heating oil, naturalgas, gasoline

Philadelphia Board of Trade(PBOT)

USA Currencies

Bolsa de Mercadorias & Futuros(BMF)

Brazil Gold, stock indexes, interest rates,exchange rates, anhydrous fuel alcohol,coffee, corn, cotton, cattle, soybeans,

sugarEUREX Germany/

Switzerland

Interest rates, bonds, stock indexes

Hong Kong Futures Exchange

(HKFE)

Hong Kong Stock indexes, interest rates,

currencies

International PetroleumExchange (IP E)

England Crude oil, gas oil, natural gas,

electricity

London International FinancialFutures Exchange (LIFFE)

England Interest rates, stock indexes, bonds,coffee, sugar, cocoa, grain


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London Metals Exchange

(LME)

England Copper, aluminum, lead, zinc, nickel,

tin, silver

Marche Terme International deFrance (MATIF)

France Bonds, notes, interest rates, rapeseed,wheat, corn, sunflower seeds,stock indexes

MEEF Renta Fija Spain Bonds, interest rates, stock indexes

Singapore Futures Exchange Singapore Interest rates, stock indexes, crude oil

Sydney Futures Exchange Australia Interest rates, stocks, stock indexes,

currencies, electricity, wool, grains

Tokyo Grain Exchange (TGE) Japan Corn, soybeans, red beans, coffee,sugar

Tokyo International FinancialFutures Exchange (TIFFE)

Japan Interest rates, currencies

Source: Commodity Futures Trading Commission (CFTC).

Forward contracts have problems that can be serious at times. First, buyers and

sellers (counterparties) have to find each other and settle on a price. Findingsuitable counterparties can be difficult. Discovering the market price for a deliveryat a specific place far into the future is also daunting. Second, when the agreed-upon price is far different from the market price, one of the parties may default(non-perform). Third, one or the other partys circumstances might change. The

only way for a party to back out of a forward contract is to renegotiate it and facepenalties.

Futures contracts solve these problems but introduce some of their own. Like a

forward contract, a futures contract obligates each party to buy or sell a specificamount of a commodity at a specified price. Unlike a forward contract, buyersand sellers of futures contracts deal with an exchange, not with each other.

Futures contracts are firm commitments to make or accept delivery of a specifiedquantity and quality of a commodity during a specific month in the future at aprice agreed upon at the time the commitment is made. The buyer, known asthe long, agrees to take delivery of the underlying commodity. The seller,known as the short, agrees to make delivery. Only a small number of contractstraded each year result in delivery of the underlying commodity. Instead, tradersgenerally offset their futures positions before their contracts mature (a buyer

will liquidate by selling the contract, the seller will liquidate by buying back thecontract). The difference between the initial purchase or sale price and the priceof the offsetting transaction represents the realized profit or loss. Futures

contracts trade in standardized units in a highly visible, extremely competitive,continuous open auction. In this way, futures lend themselves to widely diverseparticipation and efficient price discovery, giving an accurate picture of themarket.

To do this effectively, the underlying market must meet three broad criteria: Theprices of the underlying commodities must be volatile, there must be a diverse,large number of buyers and sellers, and the underlying physical products must befungible, that is, products are interchangeable for purposes of shipment or

storage. All market participants must work with a common denominator. Eachunderstands that futures prices are quoted for products with precise specificationsdelivered to a specified point during a specified period of time.


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Actually, deliveries of most futures contracts represent only a minuscule shareof the trading volume; less than 1% in the case of energy. Precisely because theExchange's physical commodity contracts allow actual delivery, they ensure that

any market participant who desires will be able to transfer physical supply, andthat the futures prices will be truly representative of cash market values.

Most market participants choose to buy or sell their physical supplies through

existing channels, using futures or options to manage price risk and liquidatingtheir positions before delivery.

For example, a producer wanting to sell crude oilin December 2002 can sell afutures contract for 1,000 barrels of West Texas Intermediate (WTI) to the New

York Mercantile Exchange (NYMEX), and a refinery can buy a December 2002 oilfuture from the exchange. The December futures price is the one that causesoffers to sell to equal bids to buyi.e., the demand for futures equals the supply.The December futures price is public, as is the volume of trade. If the buyer of a

December futures finds later that he does not need the oil, he can get out of thecontract by selling a December oil future at the prevailing price. Since he hasboth bought and sold a December oil future, he has met his obligations to the

exchange by netting them out.

Table 2. Example of an Oil Futures Contract

Prices per Barrel

Date WTI Spot December Future Contract Activity Cash In (Out)

January $26 $28 Refiner buys 10contracts for 1,000barrels each and pays the

initial margin.

($22,000)

May $20 $26 Mark to market:(26 - 28) x 10,000 ($20,000)

September $20 $29 Mark to market:(29 - 26) x 10,000 $30,000

October $27 $35 Mark to market:

(35 - 29) x 10,000 $60,000

November

(end)

$35 $35 Refiner either:

(a) buys oil, or(b) sells the contracts.Initial margin is refunded.

($350,000)

$22,000

Source: Energy Information Administration.

Table 2 illustrates how futures contracts can be used both to fix a price inadvance and to guarantee performance. Suppose in January a refiner can make asure profit by acquiring 10,000 barrels of WTI crude oil in December at the

current December futures price of $28 per barrel. One way he could guaranteethe December price would be to buy 10 WTI December contracts. The refinerpays nothing for the futures contracts but has to make a good-faith deposit(initial margin) with his broker. NYMEX currently requires an initial margin of

$2,200 per contract. During the year the December futures price will change inresponse to new information about the demand and supply of crude oil.


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In the example, the December price remains constant until May, when it falls to$26 per barrel. At that point the exchange pays those who sold December futurescontracts and collects from those who bought them. The money comes from the

margin accounts of the refiner and other buyers. The broker then issues amargin call,requiring the refiner to restore his margin account by adding$20,000 to it.

This marking to market is done every day and may be done several timesduring a single day. Brokers close out parties unable to pay (make their margincalls) by selling their clients futures contracts. Usually, the initial margin isenough to cover a defaulting partys losses. If not, the broker covers the loss. Ifthe broker cannot, the exchange does. Following settlement after the first change

in the December futures price, the process is started anew, but with the currentprice of the December future used as the basis for calculating gains and losses.

In September, the December futures price increases to $29 per barrel, the

refiners contract is marked to market, and he receives $30,000 from theexchange. In October, the price increases again to $35 per barrel, and the refinerreceives an additional $60,000. By the end of November, the WTI spot price and

the December futures price are necessarily the same, for the reasons given

below. The refiner can either demand delivery and buy the oil at the spot price orsell his contract. In either event his initial margin is refunded, sometimes with

interest. If he buys oil he pays $35 per barrel or $350,000, but his trading profitis $70,000 ($30,000 + $60,000 - $20,000. Effectively, he ends up paying $28 perbarrel [($350,000 - $70,000)/ 10,000], which is precisely the January price for

December futures. If he sells his contract he keeps the trading profit of$70,000.

Several features of futures are worth emphasizing. First, a party who elects tohold the contract until maturity is guaranteed the price he paid when he

initially bought the contract. The buyer of the futures contract can alwaysdemand delivery; the seller can always insist on delivering. As a result, atmaturity the December futures price for WTI and the spot market price willbe the same. If the WTI price were lower, people would sell futures contracts and

deliver oil for a guaranteed profit. If the WTI price were higher, people would buyfutures and demand delivery, again for a guaranteed profit. Only when theDecember futures price and the December spot price are the same is the

opportunity for a sure profit eliminated.

Second, a party can sell oil futures even though he has no access to oil. Likewisea party can buy oil even though he has no use for it. Speculators routinely buy

and sell futures contracts in anticipation of price changes. Instead of delivering oraccepting oil, they close out their positions before the contracts mature.Speculators perform the useful function of taking on the price risk that producersand refiners do not wish to bear.

Third, futures allow a party to make a commitment to buy or sell large amounts

of oil (or other commodities) for a very small initial commitment, the initialmargin. An investment of $22,000 is enough to commit a party to buy (sell)$280,000 of oil when the futures price is $28 per barrel. Consequently, traderscan make large profits or suffer huge losses from small changes in the futuresprice. This leverage has been the source of spectacular failures in the past.

Futures contracts are not by themselves useful for all those who want to manageprice risk. Futures contracts are available for only a few commodities and a fewdelivery locations. Nor are they available for deliveries a decade or more into thefuture. There is a robust business conducted outside exchanges, in the over-the-


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counter (OTC) market, in selling contracts to supplement futures contracts andbetter meet the needs of individual companies.

Cash vs. Futures Price Relationships

Cash prices are the prices for which the commodity is sold at the various marketlocations. The futures price represents the current market opinion of what the

commodity will be worth at some time in the future. Under normal circumstancesof adequate supply, the price of the physical commodity for future delivery will beapproximately equal to the present cash price, plus the amount it costs to carry

or store the commodity from the present to the month of delivery. These costs,known as carrying charges, determine the normal premium of futures overcash.

As a result, one would ordinarily expect to see an upward trend to the prices ofdistant contract months. Such a market condition is known as contango and is

typical of many futures markets. In most physical markets, the crucialdeterminant of the price differential between two contract months is the cost ofstoring the commodity over that particular length of time. As a result, markets

which compensate an individual fully for carry charges interest rates, insurance,

and storage - are known as full contango markets, or full carrying chargemarkets.

Under normal market conditions, when supplies are adequate, the price of acommodity for future delivery should be equal to the present spot price plus

carrying charges. The contango structure of the futures market is kept intact bythe ability of dealers and financial institutions to bring carrying charges back intoline through arbitrage.

Futures markets are typically contango markets, although seasonal factors in

energy markets play an important role in market relationships. For example,during the summer, heating oil futures are often in contango as the industrybegins to build inventory for the approaching cold weather. On any given day,prices in the forward contract months are progressively higher through the fall,

reflecting the costs of storage, interest rates, and the assumption of increaseddemand.

The opposite of contango is backwardation, a market condition where thenearby month trades at a higher price relative to the outer months. Such a pricerelationship usually indicates a tightness of supply; a market can also be inbackwardation when seasonal factors predominate.

As a futures contract approaches its last day of trading, there is little differencebetween it and the cash price. The futures and cash prices will get closer andcloser, a process known as convergence, as any premium the futures have had

has disappeared over time. A futures contract nearing expiration becomes, ineffect, a spot contract.

Hedging reduces exposure to price risk by shifting that risk to those with oppositerisk profiles or to investors who are willing to accept the risk in exchange forprofit opportunity. Hedging with futures eliminates the risk of fluctuating prices,but also means limiting the opportunity for future profits should prices move

favorably.

A hedge involves establishing a position in the futures or options marketthat is equal and opposite to a position at risk in the physical market.


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For instance, a crude oil producer who holds (is "long") 1,000 barrels of crude canhedge by selling (going "short") one crude oil futures contract. The principlebehind establishing equal and opposite positions in the cash and futures or

options markets is that a loss in one market should be offset by a gain in theother market.

Hedges work because cash prices and futures prices tend to move in tandem,

converging as each delivery month contract reaches expiration. Even though thedifference between the cash and futures prices (calledbasis) may widenor narrow as cash and futures prices fluctuate independently, the risk of anadverse change in this relationship (known as basis risk) is generally much lessthan the risk of going unhedged and the larger a group of participants in the

market, the greater the likelihood that the futures price will reflect widely heldindustry consensus on the value of the commodity.

Because futures are traded on exchanges that are anonymous publicauctions with prices displayed for all to see, the markets perform the importantfunction of price discovery. The prices displayed on the trading floor of theExchange, and disseminated to information vendors and news services worldwide,

reflect the marketplace's collective valuation of how much buyers are willing to

pay and how much sellers are willing to accept.

The purpose of a hedge is to avoid the risk of adverse market moves resulting inmajor losses. Because the cash and futures markets do not have a perfectrelationship, there is no such thing as a perfect hedge so there will almost always

be some profit or loss. However, an imperfect hedge can be a much betteralternative than no hedge at all in a potentially volatile market.

Short Hedges

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 titleto 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 itis sold or used. Because the value of commodity in storage or transit is known, ashort hedge can be used to essentially lock in the inventory value.

A general decline in prices generates profits in the futures market, which areoffset by decline in the value of the physical inventory. The opposite applies whenprices rise.

Example 1 - Crude Oil Producer's Short Hedge

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, postedprices are $20.50 barrel, but as market conditions appear to be weakening, he

wants to protect his revenues against a decline, and executes a short hedge. Theexample shows how the producer's revenue is protected from the full brunt of adeclining 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 futurespositions are liquidated after a price posting is established (normally on the firstday of the calendar month).


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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.

DateCash Market Futures MarketFuturesResults$/bbl.

Net PriceReceived$/bbl

Dec.1

Commits to sell 30,000 barrels ineach month for January, February,March, April, May, June crude at theposted price

Sells 30 crude contracts in eachmonth for February, $20.00;March, $19.75; April, $19.50; May,$19.50; June, $19.25; July,$19.00

Case 1: Slowly Declining Prices

Jan.1

Posted price for January crude:$21.00/bbl.

Buys back February contracts at$20.50

($0.50) $20.50

Feb.1

Posted price for February crude:$20.50/bbl.

Buys back March contracts at$19.75

0 $20.50

Mar.1

Posted price for March crude:$20.00/bbl.

Buys back April contracts at$19.00

$0.50 $20.50

Apr.1

Posted price for April crude:$19.50/bbl.

Buys back May contracts at$18.50

$1.00 $20.50

May1

Posted price for May crude:$19.50/bbl.

Buys back June contracts at$18.75

$0.50 $20.00

Jun.1

Posted price for June crude:$20.00/bbl.

Buys back July contracts at$19.50

($0.50) $19.50

Case 2: Rapidly Declining Prices

Jan.1

Posted price for Januarycrude:$20.00/bbl.

Buys back February contracts at$19.50

$0.50 $20.50

Feb.1

Posted price for February crude:$19.50

Buys back March contracts at$18.75

$1.00 $20.50

Mar.1

Posted price for March crude: $19.00Buys back April contracts at$18.00

$1.50 $20.50

Apr.1 Posted price for April crude: $18.50 Buys back May contracts at$17.50 $2.00 $20.50

May1

Posted price for May crude: $18.50Buys back June contracts at$17.75

$1.50 $20.00

Jun.1

Posted price for Junecrude:$19.00/bbl.

Buys back July contracts at$18.50

$0.50 $19.50

Selling Prices ($/bbl.)

Unhedged

Month Hedged Case 1 Case 2

January $20.50 $21.00 $20.00

February $20.50 $20.50 $19.50

March $20.50 $20.00 $19.00

April $20.50 $19.50 $18.50

May $20.00 $19.50 $18.50

June $19.50 $20.00 $19.00

Average $20.25 $20.08 $19.08

Increased cash flow

Case 1 $20.25 - $20.08 = $0.17 x 180,000 barrels = $30,600

Case 2 $20.25 - $19.08 = $1.17 x 180,000 barrels = $210,600


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If the producer could not lock in revenue, he could be faced with shutting in all orpart of the production.

The example shows two possible outcomes. Case 1, with relatively high postedand 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 isJanuary and the second month out is February. Because the January crudefutures contract expires three business days prior to December 24, and the

posted prices for January are not finally established until January 2, the exampleattempts to have the liquidation of the futures coincide with the setting of theposted price.

In summary, the nearby contract is used to hedge current production. Forexample, the February futures contract is utilized to hedge January productionbecause the timing is better matched.

Example 2 - 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 YorkHarbor heating oil futures price of 55 cents.

The trucking company agrees to buy 168,000 gallons of diesel fuel in Decemberat the prevailing futures price plus 5 cents per gallon. On September 7, he buysfour December heating oil contracts (42,000 gallons each) at 57 cents, theDecember 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, hisfuel cost will be 62 cents a gallon.

Case 1 - Rising Prices

On November 25, the trucker buys his December fuel allotment of 168,000gallons 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) at60 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 priceof 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 MarketSept. 7 Buy 4 December heating oil futures at 57

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


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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 agallon).

His fuel cost, however, is only 54 cents a gallon, 8 cents less than the 62 centsthat he would have paid had futures prices been unchanged when he entered thehedge. The loss on his futures position is offset by his gain in the physical

market.

Cash Market Futures Market

Sept. 7 Buy 4 December heating oil futures at 57

Nov. 25 Buys 168,000 gallons of diesel fuel at 54/gal. Sells 4 December futures at 49/gal.

Hedging Strategies I nvolving Multiple Contracts

Strip Trades

Strip trading is a flexible strategy that energy futures market participants use

when hedging positions for several consecutive months forward. A marketparticipant can lock in an average price for several months at a time bysimultaneously opening a futures position in each of the months to be hedgedthrough a single Exchange transaction. The average of the futures contracts overthe period is the price level of the hedge. A six-month strip, for example, consists

of an equal number of futures contracts for each of six consecutive contractmonths.

Strip trades in the NYMEX Division futures contracts for crude oil; heating oil;gasoline and natural gas are executed as a single transaction during the openoutcry trading session, after being bid and offered at an agreed-upon differentialto the previous day's settlement price. The strip and the differential is calculated

based on the average value of those months currently versus the average of theprevious day's settlement prices for those months.

The ability to obtain an average price for multiple months enables a hedger toaverage his cash flow over a period of time. Positions can be hedged for as littleas two consecutive months, or can go forward for up to 12 months in gasoline;18 months in heating oil, 30 months in light, sweet crude oil; and 72 months in

Henry Hub natural gas.

The futures positions assumed in a strip trade are like any other futures position.Any single month's position can be liquidated by an offsetting futures trade, anexchange of futures for physicals (EFP), or, if desired, physical delivery

through the Exchange clearing-house. Strips let a hedger retain the flexibility tochange a strategy by buying or selling additional futures contracts in any month,or liquidating the position of any month of the strip, something that cannot be

done easily with over-the-counter instruments.

Regular margin requirements apply to strip trades. The participant will berequired to post and maintain margin levels for each month in the strip as if itwere a separate position.

Example 3 - Petroleum Refiner's Use of a Strip Trade

A refiner anticipates the purchase of 60,000 barrels of crude oil, the volumedistributed evenly over a six-month period beginning in October. The use of the


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strip allows the company to hedge its expenditures for crude oil evenlythroughout the period.

The refiner's risk management committee is comfortable with locking in thisstrip's price level over the period of their purchases, and, considering theirfundamental view of the crude oil market, is even willing to pay a higher price, ifnecessary.

The risk manager determines that those months are currently trading at anaverage that is 10 cents over the average of the previous day's settlement price,or $18.35. Assuming he wishes to hedge 100% of his physical requirements, hebuys 10 contracts for each of the six months, or 60 contracts representing 60,000

barrels since each futures contract is for 1,000 barrels.

The refiner's hedge, which has locked in a price of $18.35 for a total of 60,000barrels over the period, looks like this:

Month Transaction Price Market PositionOCT $18.54 Long 10 contracts

NOV $18.42 Long 10 contracts

DEC $18.35 Long 10 contractsJAN $18.29 Long 10 contracts

FEB $18.26 Long 10 contractsMAR $18.24 Long 10 contracts

Average $18.35

Assuming the refiner takes delivery from its traditional suppliers, it will liquidatethe futures positions in the relevant months, offsetting its physical markettransactions. If the refiner chooses, however, it can take delivery through the

Exchange for any, or all, of the months involved in the strategy.

As with any other hedge, there may be a loss in the futures market for aparticular month that is compensated for by a gain in the cash market, conversely

a gain in the futures market will offset a loss in the cash market.

Regular margin requirements apply to strip trades. The participant will be

required to post and maintain margin levels for each month in the strip as if itwere a separate position.

Example 7 - Petroleum Marketer's Long Hedge; Guaranteeing RetailPrices by Purchasing a " Strip" of Futures

By allowing market participants to lock in an average price over a period of time,strip trading strategies can be used by vendors of refined products to offer their

customers seasonal price stability through fixed-price programs. These programshave become increasingly popular with heating oil retailers who are faced with

increasingly competitive market conditions, and their customers, who desirestable pricing, thus avoiding the price spikes that can wreak havoc withhousehold budgets.

Retailers are able to offer seasonal fixed pricing with minimal risk to their

operating margins by locking-in ahead of time during the off-season the pricerequired to service those customers during the winter. This can be accomplishedwith strips of NYMEX Division heating oil futures contracts.


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A retailer who wants to offer a fixed price program would in the spring andsummer solicit as many customers as possible whose consumption averages1,000 gallons each over the period from October to the beginning of April, with

the bulk of consumption occurring during December, January, and February.

A large dealer typically sells about 10 million gallons in a season. Assume 20% ofhis customers choose to take advantage of the fixed price program, representing

2 million gallons, during the summer, he would buy a portfolio of futurescontracts:

Customer Delivery Month Futures Contract Month Heating Oil Futures Price /gallon

October November 50.02

November December 50.77

December January 51.17

January February 50.92

February March 49.87

March April 48.92

Weighted average price: 50.28 per gallon

During the period, he will need 50 futures contracts (representing 2.1 million

gallons). However, he has to weight the volume toward the contract months ofDecember, January, and February, which represent, say, 60% of the volume.

He would buy five contracts per month for October, November, March, and April,and 10 per month for December, January, and February.

As the distributor sells his product to his customers, he liquidates his futurescontracts, one contract for each 42,000 gallons of product purchased.

May 25

Commitment to offer fixed price for heating oil in October through March

Contracted Price

Oct 50.02

Nov 50.77

Dec 51.17

Jan 50.92

Feb 49.87

Mar 48.92

Avg Price 50.27

Physical (Cash) Futures Profit (loss)

Sept. 15 Buy Oct. 48.00 Sell Oct. 48.00 2.02

Oct. 15 Buy Nov. 48.50 Sell Nov. 48.50 2.27

Nov. 15 Buy Dec. 50.00 Sell Dec. 50.00 1.17

Dec. 15 Buy Jan. 50.00 Sell Jan. 50.00 0.92Jan 15 Buy Feb. 50.08 Sell Feb. 50.08 (0.21)

Feb 15 Buy Mar. 48.76 Sell Mar. 48.76 0.16

Avg price 49.22 Avg profit 1.05

Physical P&L Net Price 50.27


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Several other factors must be taken into account in constructing a guaranteedprice offering: transaction costs, the relationship between rack and futures prices,volume risk, and the dealer's operating costs and profit broken down to a cents-

per-gallon figure.

The retailers will hedge, that is, purchase their physical supply from theirtraditional suppliers while liquidating their futures positions. The difference

between the rack price and the futures price is the basis. (In the New York area,for example, rack prices might be 2 per gallon over the futures price).

The distributor must compare his own historical rack prices to futures prices.There are two important pieces to this analysis: The average difference, which

represents the basis, and the standard deviation, a statistical measure of thevariation of the basis around the average, which represents basis risk.

Components of Guaranteed Price

Weighted Average Futures Price $0.5028

+ Operating Costs (insurance, permits, $0.45

mortgage/rent, salaries, taxes, profit)

+ Basis (rack over futures) $0.02+ Transaction costs $0.002*

Minimum guaranteed price offer $0.9748 per gallon

* For illustration purposes only. Fees arenegotiable

Spread Trades

Spread positions offer another way of using futures. There are many types ofspreads, but they all have two things in common. First, a spread always involvesat least two futures positions, which are maintained simultaneously. For example,a trader may be long 10 June coal contracts and short 10 September coal

contracts. Second, the price changes in the two or more legs of the position areexpected to have a reasonably predictable relationship, and the potential

profitability of the spread lies in that relationship or expected changes to thatrelationship. For example, the trader who is long 10 June contracts (the near-term contract) and short 10 September contracts (the distant contract) willbenefit if market forces cause the near-term contract to make a larger advancethan the more distant contract - or if market forces cause the distant contract to

drop more sharply than the near-term contract.

Crack Spreads

A petroleum refiner, like most manufacturers, is caught between two markets:the raw materials he has to purchase and the finished products he offers for sale.It is the nature of these markets for prices to be independently subject to

variables of supply, demand, transportation, and other factors. This can put

refiners at enormous risk when crude oil prices rise while refined product pricesstay static or even decline, thus narrowing the spread.

The Exchange facilitates crack spread trading in its futures trading rings bytreating them as a single transaction for the purpose of determining a marketparticipant's margin requirement.

To calculate the theoretical refining margin, first calculate the combined value ofgasoline and heating oil, then compare the combined value to the price of crude.Since crude oil is quoted in dollars per barrel and the products are quoted in


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cents per gallon, heating oil and gasoline prices must be converted to dollars perbarrel by multiplying the cents per gallon price by 42 (there are 42 gallons in abarrel). If the combined value of the products is higher than the price of the

crude, the gross cracking margin is positive. Conversely, if the combined value ofthe products is less than that of crude, then the cracking margin is negative.

Using a ratio of two crude to one gasoline plus one heating oil, the gross cracking

margin is calculated as follows:

(Assume heating oil is $0.5450 per gallon, gasoline is $0.5750 per gallon and crude is $18.50 perbarrel.)

$0.5450 per gallon x 42 = $22.89 per barrel of heating oil

$0.5750 per gallon x 42 = $24.15 per barrel of gasoline

The sum of the products is: $47.04

Two barrels of crude ($18.50 x 2) = $37.00

Therefore, $47.04 - $37.00= $10.04

$10.04/2 = $5.02 (margin)

A refiner expects crude prices to hold steady, or rise somewhat, while products

will fall. In this case, the refiner would "sell the crack"; that is, he would buycrude futures and sell gasoline and heating oil futures.

Conversely, buying the crack means buying gasoline and heating oil and sellingcrude.

Whether a hedger is selling the crack or buying the crack reflects what is done on

the product side of the spread.

Once the hedge is in place, the refiner need not worry about movements in

absolute futures prices. He need be concerned only with how the combined valueof products moves in relation to the price of crude.

The following example shows a refiner locking in a margin between crude oil and

heating oil.

Example 8 - Fixing Refiner Margins Through Crack Spreads

In January, a refiner reviews his crude oil acquisition strategy and his potentialdistillate margins for the spring.

In January, he sees that distillate prices are strong, and plans a two-monthcrude-to-distillate spread strategy that will allow him to lock in his refinery

margins.

On January 22, the spread between April crude ($18 per barrel) and May heatingoil ($0.4925 per gallon or $20.69 per barrel) presents what he believes to be a

favorable $2.69 per barrel.

The refiner sells the April/May crude-to-heating oil spread, thereby locking in the

$2.69 margin.

In March, he purchases the crude for refining into products.

Crude oil futures are $19 per barrel in March, $1 higher than the original crudefutures position. Heating oil is trading at $0.4950 per gallon ($20.79 per barrel),which equals a margin of $1.79.


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Had the refiner been unhedged, his margin would have totaled only the $1.79.Instead, the net margin from the combination of the futures position and the cashposition is the $2.69 he originally sought.

DateCash Financial Effect FuturesFinancial Effect

CashFutures($/bbl)

Jan. -- Sell crack spread:

Buy crude -- ($18.00)Sell heating oil at$0.4925/gal.

$20.69

Net $2.69

Mar. Buy crude at $19 ($19.00)

Sell heating oil at $0.4950/gal. $20.79

Net $1.79

Buy crack spread:

Sell crude $19.00

Buy heating oil at$0.4925/gal

($20.79)

Net ($1.79)

Futures gain (loss) $0.09

Cash refining margin (loss) withouthedge

$1.79

Final net margin with hedge $2.69

Basis

As noted earlier, futures contracts are standardized instruments that stipulate thequantity, quality, and delivery points for a wide cross section of the underlying

industry. Basis is the differential that exists between the cash price of a givencommodity and the price of the nearest futures contract for the same, or arelated commodity.

The predictability and size of the basis can involve three price relationships: The difference between the futures contract and the spot price of the

underlying commodity.

The difference between the price at the futures contract delivery point andthe price at a different location.

The price at the futures contract delivery point and the price of a similar,

but not identical, quality commodity at the same location.

The cash/futures basis can be effectively minimized if delivery is made or

accepted at the same time that the trading of a futures contract nears expiration.Because of price convergence, a futures contract nearing expiration becomes, ineffect, a spot contract.

Locational basis is a consideration for firms that desire to hedge but do not make

deliveries at the futures contract location. In theory, the price relationship

between two different markets will be based on the cost of transportationbetween them. Sudden local shifts in supply or demand, however, can distort thisprice relationship.

The extent to which these changes in relative market conditions are predictablewill determine the hedged firms' exposure to locational basis risk.

The product basis concerns those firms that desire to hedge the purchase or saleof a specific commodity not offered as a liquid futures contract. Firms base their


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hedge on the historical relationship of the commodity underlying the contract tothe commodity to be hedged.

For example, the NYMEX Division heating oil futures contract is widely used as ahedging proxy for jet fuel, as the products are chemically similar and oftentrade within a narrow price range in relation to each other.

The NYMEX Division light, sweet crude oil futures contract, likewise, is used tohedge crudes not specified for delivery by the contract, but which neverthelesstrade at a high correlation to the futures contract.

For the futures trader, the critical period for assessing basis is between the time

that the futures transaction is entered into and the time it is closed, or liquidated.

If a short hedger (a seller of futures) experiences a widening in the basis duringthe time the hedge is held, a basis loss may result. This narrowing means that

cash prices have declined relative to futures prices. That is, they have fallen moreor risen less than futures prices.

The short hedger's cash loss in a declining market would exceed the gain on the

short futures transaction. Or, conversely, the cash gain in a rising market wouldbe exceeded by the loss on the futures transaction.

On the other hand, a basis gain would occur in the case of a long hedge and awidening basis because the futures price would rise relative to the cash price.

Thus, a narrowing basis yields gains for the short hedger and losses for the longhedger.

Potential Basis Changes:

RISING MARKET FALLING MARKET

Cash/FuturesPosition

Cash RisesLess ThanFutures

Cash RisesMore ThanFutures

Cash FallsLess ThanFutures

Cash FallsMore ThanFutures

Bought the cash/sold the futures Loss Gain Gain Loss

Sold the cash/bought the futures Gain Loss Loss Gain

Exchange of Futures for Physicals (EFPs)

The Exchange estimates that more than 95% of all energy futures contracts donot directly result in physical delivery. Nevertheless, significant volumes of crude

oil, heating gasoline, natural gas, coal, and propane are delivered, and companiesusing energy futures for delivery have several options. They can choose standarddelivery, attempt too arrange an Alternative Delivery Procedure (ADP) or effectan Exchange of Futures for Physicals (EFPs).

Options

An option is a contract that gives the buyer of the contract the right to buy (acall option) or sell (a put option) at a specified price (thestrike price) overa specified period of time. American options allow the buyer to exercise hisright either to buy or sell at any time until the option expires. European optionscan be exercised only at maturity. Whether the option is sold on an exchange or


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on the OTC market, the buyer pays for it up front. For example, the option to buya thousand cubic feet of natural gas at a price of $3.40 in December 2002 maycost $0.14. If the price in December exceeds $3.40, the buyer can exercise his

option and buy the gas for $3.40. More commonly, the option writer pays thebuyer the difference between the market price and the strike price. If the naturalgas price is less than $3.40, the buyer lets the option expire and loses $0.14.Options are used successfully to put floors and ceilings on prices; however, they

tend to be expensive.

Options on futures offer additional flexibility in managing price risk. There are twotypes of options, calls and puts. A call gives the holder, or buyer, of the optionthe right, but not the obligation to buy the underlying futures contract up to a

specific price and time. A put gives the holder the right, but not the obligation tosell the underlying futures contract up to a specific price and time. A call ispurchased when the expectation is for rising prices; a put is bought when theexpectation is for neutral or falling prices.

The target price at which a buyer or seller purchases the right to buy or sell theoption is the exercise price or strike price. The buyer pays a premium, or the

price of the option, to the seller for the right to hold the option at that strike.

An options seller, or writer, incurs an obligation to perform should the option be

exercised by the purchaser. The writer of a call incurs an obligation to sell afutures contract and the writer of a put has an obligation to buy a futurescontract.

An option is a wasting asset. The premium declines as time passes. Dependingupon the movement of an option's price, the buyer will choose one of threealternatives to terminate an options position: Exercise the option; liquidate it byselling, or buying, it back on the Exchange; or let it expire without value.

Options give hedgers the ability to protect themselves from adverse price moveswhile participating in favorable price moves. If the option expires worthless, theonly cost is the premium. Many people think of buying options like buying

insurance.

By using options alone, or in combination with futures contracts, strategies can

be devised to cover virtually any risk profile, time horizon, or cost consideration.

Options Rights and ObligationsCall Buyer

Has the right to buy a futures contract at a predetermined price on or

before a defined date.

Expectation: Rising prices

Seller

Grants right to buyer, so has obligation to sell futures at predeter-mined

price at buyer's discretion.

Expectation: Neutral or falling pricesPut Buyer

Has right to sell futures contract at a predetermined price on or before

a defined date.

Expectation: Falling prices

Seller

Grants right to buyer, so has obligation to buy futures at a predetermined

price at buyer's discretion.

Expectation: Neutral or rising prices


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Determinants of an Options Premium

In return for the rights they are granted, options buyers pay options sellers a

premium.

The four major factors affecting the price are: Futures price relative to options strike price

Time remaining before options expiration Volatility of underlying futures price Interest rates

As in the futures market, options trading takes place in an open outcry auctionmarket on the floor of the Exchange. While the value of futures is tied to the

underlying cash commodity through the delivery process, the value of an optionis related to the underlying futures contract through the ability to exercise theoption.

Strike P rice vs. Futures Price

Strike prices are listed in various increments, depending upon the contract.

The most important influence on an option's price is the relationship between theunderlying futures price and the option's strike price.

Depending upon futures prices relative to a given strike price, an option is said tobe at-the-money, in-the-money, or out-of-the-money. An option is at-the-

money when the strike price equals the price of the underlying futures contract.

An option is considered in-the-money when the price of the futures contract isabove call's strike price, or when the futures price is below a put's strike price. Anin-the-money option has intrinsic value.

A call is out-of-the-money when the futures price is less than the options strikeprice. For example, when the December crude oil futures price is $22 per barrel,the December $23 call grants the holder of the option the right to buy a

December futures contract at $23 even though the market is at $22.

A put is out-of-the-money when the underlying futures price is higher than the

put's strike price.

An option's premium will usually equal or exceed whatever intrinsic value theoption has, if any. Intrinsic value is the amount by which an option is in-the-

money.

Premium - Intrinsic Value = Time Value

Call Premium = Time Value + Intrinsic Value

Put Premium = Time Value + Intrinsic Value

Time Value

An options time value is the amount buyers are willing to pay for the optionabove its intrinsic value. Out-of-the-money options carry all time premium sincetheir intrinsic value is zero, as do at-the-money options. As an option becomesdeeply in- or out-of-the-money, the time premium shrinks. As an optionapproaches expiration, or volatility decreases, time value decreases. It is


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important to note that time value is equal for the same strike and sameexpiration for both calls and puts.

The time value of an option shrinks as the expiration date approaches, all otherfactors being equal. The reason is that there is less and less time for a majorchange in market behavior, and a decreasing likelihood that the option willchange in value.

Call/ Put P arity

Options prices are linked to futures prices through the exercise feature. If at the

call option's expiration, crude oil futures are trading at $27, a $26 call is worth$1, intrinsically the difference between the futures price and the strike price. Thisis because the holder of a $26 call can exercise his option, receive a long futuresposition at $26, immediately turn around and sell the futures contract for $27,

and make $1. This is known as trading at parity. If the call is only trading at, say,30, then a trader can buy $26 calls, exercise them into long futures at $26, sellthem for $27 and make a risk-free 70, exclusive of transaction costs. Market

forces ensure that an opportunity like this cannot last long.

The option cannot have a negative value, so if the risk does not occur, that is, if

futures prices do not exceed the strike price, the option will be worth zero. Anoption will not be exercised to buy futures at $26 when the futures can bepurchased at $23.

For a put option, the risk is the possibility that the futures price will be below thestrike price. When this occurs, the option will be worth precisely the differencebetween the strike price and the futures price. Since a put gives its holder theright to sell futures, if futures are at $23, the holder of a $26 put could exercise

the put into a short futures position at $26 and immediately buy it back for $23,making $3, exclusive of transaction costs. At expiration, the put will be worth $3.

If futures prices are not below the strike price, the option be worth zero. No one

would exercise the right to sell futures at $23 when they can sell them in thefutures market for $26.

Volatility

Volatility is a measure of the amount by which an underlying futures contract isexpected to fluctuate in a given period time. Markets which move up or down

very quickly are highly volatile: markets which move up or down only slowly arenon-volatile which is why volatility is an important factor in the pricing of options.As prices fluctuate more widely and frequently, the premiums for options onfutures increase, since the probability of the option attaining intrinsic value or

moving deeper into the money increases. If market volatility declines, premiumsfor puts and calls decline correspondingly.

Historical volatility will be calculated from the past movement of prices over aspecified time period. Technically, historical volatility is the annual standarddeviation of the log of the changes in the futures price, expressed in percentageterms. Or, to put it another way, 50% volatility, for example, means that there is

a 68.3% chance (one standard deviation) that, a year from now, prices will be50% higher or lower.


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Swaps

Swaps (also called contracts for differences) are the most recent innovation infinance. Swaps were created in part to give price certainty at a cost that is lowerthan the cost of options. A swap contract is an agreement between two parties toexchange a series of cash flows generated by underlying assets. No physical

commodity is actually transferred between the buyer and seller. The contracts areentered into between the two counterparties, or principals, outside anycentralized trading facility or exchange and are therefore characterized as OTCderivatives.

Because swaps do not involve the actual transfer of any assets or principalamounts, a base must be established in order to determine the amounts that willperiodically be swapped. This principal base is known as the notional amount ofthe contract. For example, one person might want to swap the variable earnings

on a million dollar stock portfolio for the fixed interest earned on a treasury bondof the same market value. The notional amount of this swap is $1 million.Swapping avoids the expense of selling the portfolio and buying the bond. It also

permits the investor to retain any capital gains that his portfolio might realize.

Figure 1 illustrates an example of a standard crude oil swap. In the example, arefiner and an oil producer agree to enter into a 10-year crude oil swap with amonthly exchange of payments. The refiner (Party A) agrees to pay the producer(Party B) a fixed price of $25 per barrel, and the producer agrees to pay the

refiner the settlement price of a futures contract for NYMEX light, sweet crude oilon the final day of trading for the contract. The notional amount of the contract is10,000 barrels. Under this contract the payments are netted, so that the party


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owing the larger payment for the month makes a net payment to the party owingthe lesser amount. If the NYMEX settlement price on the final day of trading is$23 per barrel, Party A will make a payment of $2 per barrel times 10,000, or

$20,000, to Party B. If the NYMEX price is $28 per barrel, Party B will make apayment of $30,000 to Party A. The 10-year swap effectively creates a packageof 120 cash-settled forward contracts, one maturing each month for 10 years.

So long as both parties in the example are able to buy and sell crude oil at thevariable NYMEX settlement price, the swap guarantees a fixed price of $25 perbarrel, because the producer and the refiner can combine their financial swapwith physical sales and purchases in the spot market in quantities that match thenominal contract size. All that remains after the purchases and sales shown in the

inner loop cancel each other out are the fixed payment of money to the producerand the refiners purchase of crude oil. The producer never actually delivers crudeoil to the refiner, nor does the refiner directly buy crude oil from the producer. Alltheir physical purchases and sales are in the spot market, at the NYMEX price.

Figure 2 shows the acquisition costs with and without a swap contract.

Many of the benefits associated with swap contracts are similar to thoseassociated with futures or options contracts. That is, they allow users to manageprice exposure risk without having to take possession of the commodity. They

differ from exchange-traded futures and options in that, because they areindividually negotiated instruments, users can customize them to suit their riskmanagement activities to a greater degree than is easily accomplished with more

standardized futures contracts or exchange-traded options.11 So, for instance, inthe example above the floating price reference for crude oil might be switchedfrom the NYMEX contract, which calls for delivery at Cushing, Oklahoma, to an


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Alaskan North Slope oil price for delivery at Long Beach, California. Such a swapcontract might be more useful for a refiner located in the Los Angeles area.

Although swaps can be highly customized, the counterparties are exposed tohigher credit risk because the contracts generally are not guaranteed by aclearinghouse as are exchange-traded derivatives.12 In addition, customizedswaps generally are less liquid instruments, usually requiring parties to

renegotiate terms before prematurely terminating or offsetting a contract.

Crude Oil and Petroleum Products

Much of the nearly 79 million barrels per day of crude oil produced worldwide in

2000 was sold into international markets. World oil traders use several locationsand types of crude oil as pricing benchmarks. The price ofWest Texas

Intermediate (WTI), a light, sweet (low-sulfur) crude oil sold at Cushing,Oklahoma, is used as a principal pricing benchmark for spot trading in the United

States. Brent crude, a light, sweet North Sea oil, serves as an internationalpricing benchmark. Brent is shipped from Sullom Voe in the Shetland Islands,United Kingdom, and is traded actively on a free-on-board (FOB) basis. There are

many other types of crude oil, and their pricing is frequently expressed as a

differential to Brent or WTI, depending on quality differences and location. Crudeoil and petroleum product prices vary with world economic growth, weather and

seasonal patterns, and regional refining and transportation capability. Crude oilprices have also been sensitive to international political events and to theproduction policies of the Organization of Petroleum Exporting Countries (OPEC).

Tankers move most crude oil from producing areas to major markets in theUnited States, Northwest Europe, and Japan for refining. The three major tradingareas for refined products are New York Harbor, Northwest Europe (Antwerp,Amsterdam, and Rotterdam), and Singapore. There are also dozens of other

trading areas for refined products, including Japan and the U.S. Gulf Coast, WestCoast, and Midwest. The physical trading of refined products tends to be regional,with surpluses also being traded internationally.

Although more than 50 percent of the petroleum consumed in the United Statesoriginates from foreign sources, domestic crude oil production is still a majorextractive industry. Turning the crude oil into useful products involves huge

capital investments at many stages of processing (Figure 7), and the risks facingfirms at each stage of processing differ. Historically one way firms haveattempted to limit price risk is to integrate their operations from crude oil throughfinal product delivery; however, that strategy is available only to a few very large

companies. The rest must turn to other means of managing risk.


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There are dozens of domestic spot markets for petroleum products, but in generalthey tend to be closely linked, because traders quickly take advantage of price

differences that do not reflect the marginal cost of transportation. If pipelines arenot available to move product, barges and trucks usually are. Consequently,location arbitrage generally causes crude oil and petroleum product prices to

move together across all the spot markets.

Price Risk and Derivatives in Petroleum Markets

Diversification and insurance are the major tools for managing exploration risk

and protecting firms from property loss and liability. Firms manage volume risknot having adequate suppliesby maintaining inventories or acquiring productiveassets. Derivatives are particularly appropriate for managing the price risk thatarises as a result of highly volatile prices in the petroleum and natural gas

industries.

The typical price risks faced by market participants and the standard derivativecontracts used to manage those risks are shown in Table 7.


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Table 7. Petroleum and Natural Gas Price Risks and Risk ManagementStrategies

Participants Price Risks

Risk Management Strategies

and Derivative InstrumentsEmployed

Oil Producers Low crude oil price Sell crude oil future or buy putoption

Petroleum Refiners High crude oil price Buy crude oil future or call

option

Low product price Sell product future or swapcontract,

buy put option

Thin profit margin Buy crack spread

Storage Operators High purchase price or lowsale price

Buy or sell calendar spread

Large Consumers

Local Distribution Companies(Natural Gas)

Unstable prices, wholesaleprices higher than retail

Buy future or call option, buybasis contract

Power Plants (Natural Gas) Thin profit margin Buy spark spread

Airlines and Shippers High fuel price Buy swap contract

Source: Energy Information Administration.

Price risk in the petroleum and natural gas industries is naturally associated witheach participants stage of production. Some companies integrate their operationsfrom exploration through final sales to eliminate the price risks that arise at the

intermediate stages of processing. For example, for an integrated producer, anincrease in the cost of crude oil purchased at its refinery will be offset by revenue

gains from its sales of crude oil. Other, smaller companies usually do not haveintegrated operations. Independent producers want protection from low crude oil

prices, and they sell to refiners who want protection from high prices. Refinerswant protection from low product prices, and they sell to storage facilities andcustomers who are concerned about high prices. At each stage, suppliers and

purchasers can split the risk in order to allay their concerns. They typicallysupplement exchange-traded futures and options with over-the-counter (OTC)products to manage their price risks.


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Lecture Note


27

Table 10. NYMEX Light Sweet Crude Oil Contract Specifications

Trading Unit 1,000 U.S. Barrels (42,000 gallons).

Trading Hours Open outcry trading conducted between 10 am till 2:30 pm.NYMEX ACCESS@ on Mon-Thu begins at 3:15 pm and concludes 9am the following day. Sunday ACCESS begins at 7 pm (all times

are New York).

Trading Months 30 consecutive months plus long-dated futures initially listed 36,48, 60, 72, and 84 months prior to delivery. Additionally, calendarstrips can be executed (during open outcry trading hours) at an

average differential to the previous day's settlement prices forperiods of 2 to 30 consecutive months in a single transaction.

Price Quotation Dollars and cents per barrel.

Minimum Price Fluctuation $0.01 per barrel (i.e., $10 per contract).

Maximum Daily Price

Fluctuation

Initially $3.00 per barrel for all but the first two months, rising to

$6.00 per barrel if the previous settlement price of any backmonth is at the $3.00 limit. If $7.50 per barrel movement in eitherof the two front months, then the limit for all months becomes$7.50 per barrel in the direction of the price movement.

Last Trading Day Trading stops at close of business on the 3rd business day prior tothe 25th calendar day of the month preceding the delivery month.If 25th is a non-business, then trading stops on 3rd business day

prior to last business day preceding the 25th.

Delivery FOB seller's facility, Cushing, OK, at any pipeline or storage facility

with access to pipeline, by in-tank transfer, in-line transfer, book-out, inter-facility transfer.

Delivery Period Deliveries are rateable over the course of the month and must beinitiated on or after the first calendar day and completed by thelast calendar day of the delivery month.

Alternative DeliveryProcedure

Available to buyers and sellers matched by the Exchange aftertermination of spot month contract. If buyer and seller agree to

the contract specifications, they may proceed and must notify theExchange.

Exchange of Futures forPhysicals (EFP)

Commercial buyer or seller may exchange a futures position for aphysical position by notifying the Exchange. EFPs may be used toinitiate or liquidate a futures position.

Deliverable Grades Specific domestic crudes with 0.42% sulfur or less, and not lessthat 37 degree API gravity nor more than 42 degree API gravity;

including WTI, Low Sweet Mix, NM Sweet, North TX Sweet, OKSweet, South TX Sweet. Specific foreign crudes not less than 34degree API nor more than 42 degree API; including Brent, Forties,and Osenberg Blend for which the seller will receive a 30 cent per

barrel discount; Bonny Light and Cusiana (a 15 cent premium);and Qua Iboe (a 5 cent premium).

Inspection Will be conducted according to pipeline practices. Buyer or sellermay appoint an inspector and the requesting party will cover thecost and notify the other party.

Position Limits 20,000 contracts for all months combined, but not to exceed 1,000in the last 3 days of trading in the spot month or 10,000 in anyone month.

Margin Requirements Margins are required for open futures positions.

Source: New York Mercantile Exchange (NYMEX), web site www.nymex.com.


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Lecture Note


28

Price Risk Management Glossary (From Platts.com)

Glossary Futures and options terminology Category

American option An option that may be exercised on anyday ahead of expiry. These trade on thefutures exchanges.

options

Arbitrage The simultaneous purchase and sale ofan instrument in two separate markets,when the price is out of line.

futures/options/swaps

Asian option An option that is exercised against an

average over a period.

options

At the moneyoption (ATM)

An option with an exercise price at thecurrent market level of the underlying.

options

Basis The gap between the active futures priceand the implied forward price of the

underlying commodity.

futures

Basis swap Basis swaps are used to hedge exposure

to basis risks, such as locational risk or

time exposure risk. For example, anatural gas basis swap could be used tohedge a locational price risk: the sellerreceives from the buyer a Nymex

settlement value (usually the average ofthe last three days closing prices) plus anegotiated fixed basis, and pays thebuyer the published index value of gas

sold at a specified location (Source: RiskPublications)

swaps

Black-Scholes Options pricing theory derived by FisherBlack and Myron Scholes, based on thetheory that price volatility is random

around a given trend.

options

Call The right, but not the obligation, to buysomething, for instance, a future.

options

Combination

hedging

A risk management strategy that uses a

combination of hedges using differentderivative instruments (Source: RiskPublications)


Contracts fordifference

This term is used as an alternative to theterm swap. The term is often applied tohedging instruments used in the UK

electricity market, and in the Brent 'CFD'

market. (Source: Risk Publications)

swaps

Covered option An option written against an underlyingposition

options

Curve-lock

swap

Swap which "locks" the counterparty into

an existing price relationship in theforward curve, with the aim of benefitingfrom any shifts in the forward curve e.g.between backwardation and contango

(Source: Risk Publications)

swaps


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Lecture Note


29

Delta The rate of change of the value of anoption with respect to changes in theprice of the underlying commodity

options

Diff swaps Contract to exchange the difference

between 1) the differential between theprice of two products (fixed), and 2) the

actual differential over time (floating)(Source: Risk Publications)

swaps

Double-up swap This instrument grants the swap provideran option to double the swap volume

before the pricing period starts; grantingthis option, swap users can achieve aswap price which is better than the actualmarket price. The mechanism by which

this is achieved involves consumers0,vho are buying fixed) selling a putswaption, or producers (who are sellingfixed) selling a call swaption; in either

case, the premium earned from the sale

is used to subsidize the swap price.(Source: Risk Publications)

swaps

Europeanoption

Option that can only be exercised on thedate of expiry. These typically trade inthe OTC markets. For metals, expiry isthe third to last day of the month since

settlement. In crude oil, options expireOTC six days prior to the 25th of themonth or three days before the

underlying future expires.

options

Exchange-

traded

Futures or options that are traded on an

exchange such as NYMEX or IPE, withstandard contracts and rules.

futures/options

Exercise The conversion of the option into theunderlying commodity

options

Extendableswap

The extendable swap is constructed onthe same principle as the double-up swap, except that instead of doubling the

swap, the provider has the right toextend the swap, at the end of theagreed period, for a furtherpredetermined period (Source: Risk

Publications)

swaps

Futures A forward contract that trades on anorganized exchange allowing traders to

take position in the market at a futuredate

futures

Gamma The rate of change in delta per unitchange in the underlying instrument.

options

Historicvolatility

The change in the absolute value of acommodity or instrument over a certain

period, expressed as a percentage of theLOWEST price recorded in that period.



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Lecture Note


30

Impliedvolatility

The volatility implied by a certain optionprice.

options

In the moneyoption (ITM)

An option with an exercise price higherthan the current value of the underlying

commodity.

options

Index swap Iin the natural gas market in North

America, index swaps are often used tohedge against location price risk (a formof basis risk). The seller receives a fixed,or otherwise determined, price and pays

the buyer the published index value fornatural gas from a specified location(Source: Risk Publications)

swaps

Inter-monthspread

Simultaneous purchase and sale of afuture in two separate trading periods


Long position A trader buys something, in the hopethat its value will go up


Long-liquidation Selling of a long position futures/options/swapsMargin swap Refining margin swaps (Source: Risk

Publications)swaps

Margins A deposit paid on a futures transaction.Initial margin is paid, followed by top-upsas the position develops. Margins arepaid to the exchange.

futures

Naked option A short option position in which thewriter does not have the underlyingcommodity

options

Off-marketswap

In this type of swap, a premium is builtinto the swap price to fund the purchase

of options or to allow for therestructuring of a hedge portfolio. Off-

market swaps are generally used torestructure or cancel old swap/hedgedeals: essentially, they simulate a

refinancing pack-age (Source: RiskPublications)

swaps

Options A system of trading under which thewriter of the option gives someone the

right but not the obligation to buy or sellan underlying commodity, for instance, afutures contract. Options can be over-the-counter or exchange-traded. Because

the writer of the option faces more riskthan the buyer, he charges a premiumfor his services.

options

Out of themoney option

(OTM)

An option with an exercise prices lowerthan the current market level of the

underlying instrument. Such an optionhas no intrinsic value, but has got timevalue, as price changes in the underlyingmight bring it back into the money.

Options


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Lecture Note


31

Over thecounter (OTC)

Bilateral markets in which contracts forfutures, options and swaps are written ona tailor-made basis.


Participationswap Similar to a regular swap in that the fixedprice payer is fully protected when pricesrise above the agreed (fixed) price, withthe difference that the client -

participates" in any price decrease. Forexample, a participation swap agreed ata level of $80/mt for high sulfur fuel oil,with a 50% participation, would offer full

protection against prices above $80/mt.But tile buyer would retain 50% of thesavings generated when prices fell below$80/mt. (Source: Risk Publications)

swaps

Premium The price of an option, as determined by

an options pricing model.

options

Pre-paid swap By means of a pre-paid swap, the fixed

payments that form one side of the cash-flows generated by a standard swap, andwhich are normally paid over the life ofthe swap, arc discounted hack to their

net pre-sent value and paid as animmediate cash sum to one of the swapcounterparties. That counterparty will

then make floating price pay-merits overthe life of the swap, just as in a standardswap. Pre-paid swaps are often used as asource of project finance or pre-export

financing. (Source: Risk Publications)

swaps

Profit-taking Long liquidation or short-covering set offby the desire to realize the profits in aposition.


Put The right, but no the obligation, to sellsomething, for instance, a future.

options

Refining marginswaps

Swaps that simultaneously hedge theprice of the products (or output) of arefinery, and the price of the crude oil

feedstock (or input). That is, theproducts are sold, and the crude isbought, for equivalent for-ward periods.Refinery margin swaps effectively "lock-

in" the profitability of a refinery. (Source:Risk Publications)

swaps

Rho The rate of change of the value of an

option with respect to the risk-free rateof interest.

options

Short position A trader sells something he doesn't have,with a view to buying it cheaper at a

later date.



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Lecture Note 32

Short-covering Buying back of short sell positions. futures/options/swaps

Spread The difference between two futurescontract months (or contracts fordifferent commodities).

Stop-lossorders

Buy or sell orders put in through abroker, which are automatically triggered

if the price moves above or below acertain level.

futures

Straddle (long) Simultaneous purchase of a put and a

call option with different maturities. Thisis

hedging derivatives

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