Commodity Trading Study Guide PDF

Commodity Trading Study Guide Lecture 1 – Introduction & Market Prices Introduction Commodities – What is it? Stuff other stuff is made from – fundamental raw materials o Created by natural forces o Every shipment/batch is unique Produced or extracted by proc...

Commodity Trading Study Guide Lecture 1 – Introduction & Market Prices Introduction Commodities – What is it? Stuff other stuff is made from – fundamental raw materials o Created by natural forces o Every shipment/batch is unique Produced or extracted by process production o Big complex project with relatively long lead times, economies of scale o Production means turning them into useable (homogeneous) form Usually consumed some distance from where they are extracted and produced through trade and transport Fairly inelastic supply and demand o Demand is ultimately local and constant Commodities are physical – this affects price dynamics Commodities – Characteristics Traded and delivered globally o By sea and usually in bulk o In grids networks (gas, power) Size matters! – Economies of scale favour bulk delivery Commodities with similar characteristics are exchangeable o Quality and location determine price o MWh = MWh (in whatever commodity you trade) No such think as a branded commodity Can be stored to balance supply and demand over time o Cost of storage and the forward curve o Some commodities are more storable than others e.g. ags, gasoline, power Primary vs. secondary commodities Primary o Direct outputs of the production process o Produced on farms, from mines or wells o Non-standard: every cow, stone is different Secondary o Produced from primary commodities o Crude oil is refined into diesel, gasoline, kerosene etc o Ores are turned into concentrates are turned into metals There can be several transformations along the value chain o Ores are usually homogenized and concentrated at the production site o Then further concentrated and blended in storage facilities/ports o They are then turned into metal bars of a specific quality (“pigs”) o Different metals are blended to create allows (such as steel Commodity value chain Value chain describes the flow of commodities from: o Upstream: Extraction/sourcing o Midstream: Processing/manufacturing o Downstream: Distribution/retail Alon value chain, we are transforming commodities in time, form (quality), and space (geography) Integrated value chains o Own oil goes to your own refineries and into your own retail network o Refineries/chemical plants can be seen as an integrated part of the value chain o Oil example: ▪ Extraction → Refine → Transport oil and products → Source feedstock & sell excess product → Distribute Producers (upstream) and trading Upstream producer has production of specific quality and specific locations Exposed to prices → want high prices o Think that’s a good thing (independents) or they just have it (sovereigns) o Price exposure is long term Financial needs o Investments/corporate finance, small vs big producers o Government budgets, infrastructure Governments have other goals o Balance domestic supply and demand → energy independence (US, Europe) o Geopolitics (Russia, Iran) o Environmental impact (Chile) o Development and diversification (Middle East) Producers need to market their product and maximize revenue o They will be sellers, not traders Consumers (downstream) and trading Exposed to prices → Want low prices o They (we) are always short o Longer term prices can be passed through or substitutes can be found Financial needs o Manufacturers need to manage costs, working capital o Government want to ensure price stability for a stable economy (Gas in EU) o Government revenue (taxes) and subsidies Security of supply o Minimum quantity, quality, at the right time – no short term substitutes Consumers need to secure supply and minimize cost o Will always be buyers, not traders Midstream and trading Distil, crack, crush, melt, spin, blend, and turn one primary commodity into another secondary commodity Interested in buying low, selling high o Exposed to spread Financial needs o Investment, working capital o Operating based on a margin (spread), need to mitigate price exposure Security of supply o Oil refineries need to operate continuously, need to ensure constant supply o Also need to continuously sell product as storage is limited Value chain optimization Refinery in US Gulf Coast → Buy oil that comes via pipeline from the Permian basin → Neighboring refinery is importing oil from nigeria with a tanker to arrive tomorrow → Neighboring refinery needs to shut down unexpectedly → Have too much oil and are (distressed) seller → Can I show them a bid? If they like the price we can buy their oil and sell ours in the spot market Optimisation process o Commodities are extracted some distance from where they are processed o They are processed some distance from where they are consumed ▪ Moving commodities takes time o Value chain optimization with commodity markets ▪ Observe market prices and decide whether to transport, store, process ▪ Continuously consider buying or selling Examples Traders & market participants Hedgers: Producers, consumers, refiners o E.g. farmers, power plants Speculators: Merchants, trading houses, banks, (hedge) funds o If buyer (seller) of a commodity is not someone who consumers or produces it, he usually called a speculator Arbitrageurs: Merchants and trading houses o Make money from exploiting price differentials between markets o In physical commodities this frequently means shipping and running a logistics business o Tend to be some of the most sophisticated market participants Service providers: Shippers, financial intermediaries, banks, insurance companies o Provide all sorts of service, insurance, and financing o If in market, usually active as hedgers as their business doesn’t have any commodity exposure Merchants and trading houses Match actual physical global supply and demand for commodities o Vitol, Glencore, Trafigura, Cargill, Koch, Mercuria, Noble, Gunvor, archer Daniel’s, BP Trading, Shell Trading, Totsa o Many privately owned, secretive by reputation Arbitrageurs make money from exploiting price differentials in different physical and financial markets Derivatives are an important part of the tools used to offset their price exposure o Logistics are usually more important for them than financial engineering In the industry not much is hidden or secret – we are talking about large industrial plants, ginormous ships, power grids, or pipelines It is a large complex, globally interlinked system in which market forces operate Commodity trading Commodity trading is linked to trade and transport o Most commodities are produced some distance from where they are used o Commodity traders are logistics companies Relative scarcity in one region and abundance in others drives the market to develop trade routes o Silk roads from China, spice & sugar trade, gold, silver, diamonds (romantic) o Oil from the middle east, copper from Chile, gas from Russia, coal from Australia and south Africa (essential) Transport takes time and is risky o Anyone remembers the Evergreen o Weather, geopolitical risk Structure of a physical commodity trade Trades result in delivery of the reference commodity are called physical o As opposed to financial trade in which only cash flows are exchanged Basic structure of a physical trade Boundaries are the geographic borders Physical commodity trade: Complexity and risk Basic structure of a trade is straightforward o Getting out of or into each box or bubble costs money and regulations apply o Where in the chain does the ownership change? Throughout the trade, each party is exposed to risks: o Price risk o Transportation risk: the owner of goods is responsible for the safe transport of the cargo and may have to buy insurance. Sea freight is exposed to weather. And there are risks such as wars, riots, or strikes and pirates. Also, the price of transport can change during the life of a long-term contract.; o Delivery/quality risk: Do the goods delivered meet the specification? This is also a risk for the seller as he might deliver a grade which is too valuable o Credit risk: Is present until the deal is settled Complexity creates plenty of trading opportunities One of the main challenges in the business is doing this for large cargoes, over and over again, for many ships over many years International Commercial Terms (Incoterms) For many commodities, terms of trade are standardized according to incoterms Incoterms standardize how a commodity is delivered in a port and which party pays which part of the cost For seafreight, most important are: o FAS: Free alongside ship – Seller provides goods cleared for export alongside ship in named port ▪ Buyer is responsible for loading costs and subsequent transport and insurance o FOB: Free on Board – Seller provides good cleared for export and pays for the loading onto a ship in a named port. Ownership changes when the goods pass the ships rail. ▪ Seller covers loading costs, buyer takes responsibility for shipping, insurance, and further transportation  o CFR: Cost and Freight – Seller pays for the cost of transport to a port of destination; however, risk passes as soon as the goods are loaded ▪ Buyer is responsible for insurance and any further costs after loading o CIF: Cost, insurance, and freight – Seller pays the insurance, otherwise it is the same as CFR ▪ Risk till passes to buyer when goods are loaded onto the ship, despite seller covering insurance Crude oil trade flows world oil production/consumption ~100 mln bbl/day Spot prices for financial assets, it is straightforward to observe a unique spot price for a commodity spot price we need to specifiy o Type: What commodity and grade (quality) we want to trade o Location: Where do we want to trade? o Delivery: How does the delivery work in detail Spot market price is the average price of all commodities traded during a time window which match a standardized specification o Need sufficiently wide definition to cover a representative bit of te market o Prices are negotiated bilaterally → it is not easy to observe If price is supposed to be accepted by market participants it needs to be objective and unbiased o If we want to settle financially against this price this is key o Similar problems as for futures contracts Commodity Derivatives Over the counter (OTC): Swaps and Forwards o Companies (producers, airlines) call sales people and ask for prices for certain financial products → If they like it they buy or sell o General legal framework (ISDA) has usually agreed with the company beforehand as well as credit lines On exchange: Futures & cleared swaps  Three dates matter for a transaction o Deal date: terms agreed o Payment date: buyer makes payment o Delivery data: Seller makes payment (financial) and delivers goods (physical) If three dates are in next few days we are talking about a spot transaction For swaps, forwards, and futures the payment and delivery data are in the future o As time passes, they become spot transactions o Values is linked to (derived from) spot prices Swaps, forwards, and futures are in zero-net supply: For each long there is a short o Spot physical commodities have a total positive supply → We have a total positive supply of physical goods, and the SFF’s create no net increase in physical supply because they are settled financially Pricing Benchmark pricing in oil Sorting out the logistics for a commodity trade can be very complicated o E.g. if brent in Rotterdam is selling for 100 USD/bbl, what is the fair price of oil to pay at well head in Nigeria, or northern Iraq, or southern Sudan Disentangle price negotiations from logistics, the convention of selling “at market price” emerged from the 1980s o Marc Rich/Glencore and BP claim to have invented this Previously, most oil was sold in long term supply contracts at fixed prices o Idea means to disentangle price of a commodity from logistics o Price was now based on standardized benchmark or index, rather than uniquely determined for each transaction o Means there will always be a winner and a loser to every trade o In absence of a spot market, nobody knew whether they worn or lost Benchmarks are spot prices o Publication of trade journals: Platts argus, opis o Fixing of future contracts (first nearby or prompt futures contract) Contracts for oil in different locations are commonly set by defining a surcharge or discount to a liquid reference price o Supply diesel in port of milford haven at the ARA spot price plus X OPEC countries official selling prices are set at a differences to spot indices Benchmark trading From traders perspective, having a contract (long or short) referenced to the spot index allows you to sit on it while you look for the other side of your trade o Trying to buy at spot minus and sell at spot plus Want to convert spot-indexed transaction into fixed price transaction? Can combine it with a financial swap o Swap contracts based on spot indices developed in parallel As spot prices on single day can be manipulated and be very volatile, it is common to use averaging periods of several days o Industry practice: All price observations during a calendar month Financial commodity swap In commodities, we talk about buyers and sellers of swaps NOT payer and receiver o Because floating leg represents commodity flow On trade day, buyer and seller agree: o Swap buyer: Pay a fixed price o Swap seller: Pay average of the benchmark price of the reference month As both dates are in future, this is a forward transaction At end of reference month, average of benchmark price is calculated by both counterparties and subtracted from the fixed payment o Fixed – Average < 0 → Seller pays balance: Balance needs to be paid by seller to buyer when negative o Fixed – Average > 0 → Buyer pays balance: Balance needs to be paid by buyer when positive Buyer is long the fixed price and is hedging against rising prices Seller of swap receives fixed price and pays the floating market price, seller is short the fixed price and is exposed to market prices because they will pay the floating rate Risk of fluctuating prices is taken on by the seller, while buyer transfers risk by locking in a fixed price Swap seller is party with natural exposure to commodity’s market price, they can hedge by locking in a fixed revenue In this formula we can write this using the expected benchmark values Swap prices are quotes, no need to form expectations Example: Diesel swap We bought 19kt of a swap for diesel in Rotterdam (ULSD 10 ppm FOB barges) We agreed to pay 960 USD/MT for average of September 2013 Settlement is based on the relevant Platt’s index Buying oil at benchmark vs. swap Suppose you buy oil at benchmark index o Buy 1,100,000 bbl of Crude Oil of a tanker FOB Rotterdam at the average price of Brent futures during the month of November o Before pricing started, you did not have exposure o At end of November, you will own 1,100,000 bbl of crude oil and if price goes down, you lose money o On every calendar day (22) you are buying 50,000 bbl of oil o If you do not want the oil price risk, you would have to sell 50,000 bbl worth of brent futures at the daily price Swap contract: No price exposure after swap pricing has fixed Physical trade: Someone holds the barrels and has price risk This is a hedge, the goal is to ensure a stable price to receive predictable cash flows the money we earn when prices fall is offset by the drop in value of our physical cargo and vice versa Futures markets and clearing Futures: Standardised forward contract designed to minimise credit risk o As we have seen standardization also takes place in OTC markets If two parties enter into a futures contract o Buyer buys from clearing house o Seller sells to clearing house At trade inception, clearing house requires the buyer and the seller to post some collateral, the initial margin Clearing house monitors value of all positions and adjusts margin daily If margin of exchange participant drops below the maintenance margin, it will be asked to top up its margin to the level of the initial margin by paying the variation margin o Margins fall into treasury’s domain; either this is managed directly, or more commonly, you get your bank/broker to finance your margin As clearing house is a counterparty to all trades, it is easy to get in and out of positions Swaps vs futures contracts Swaps are mostly traded OTC o Can trade cleared swaps on exchange Futures on exchange o More standardized o Easy to trade in and out of positions Trading swaps requires credit lines o Credit lines may be given against underlying physical business o Each party needs assurance that the other will fulfill their obligations Trading futures requires cash to fund the margin o Variation margin (price shifts), initial margin, and maintenance margin Futures expire on a distinct date whereas swaps are based on average prices o Averaging makes them less volatile and harder to manipulate o Price exposure is usually against average prices Futures contracts design Many new futures contract fail to attract sustainable level of trading volume Contract needs to be specified to appeal to hedgers on both sides o If too specific very few market participants are interested ▪ Gas market liberalization in Germany was done by state o If it is too broad it will be irrelevant and uncorrelated to risk ▪ Nobody has exposure to average electricity price on planet Very important is type of settlement and delivery o Most futures positions are offset or rolled before expiry ▪ Offset: closing out existing position by taking an opposite position in the same contract, e.g. sell identical contract if long or buy identical contract if short ▪ Rolling a future: Closing out position nearing expiration and opening new position in a later expiration contract Done to maintain long-term position without taking delivery of the asset Lock in profit or loss and extend position to later date For a successful futures contract we need: o Large cash market o Price volatility → creates the need to hedge o Accurate tracking Future contracts modifications To keep futures contracts attractive, they are modified and adapted with changing market conditions o Changes are done after consulting with the most relevant market participants o In commodity markets, these are usually the big physical hedgers Since brent futures were launched in 1988, the production of brent crude has declined from a peak of 2.5 mln M^3 per month to 5-6000 M^3 per month Example: Brent futures Intercontinental exchange tried to introduce new futures on brent which had an earlier expiry date, providing better fit with 21-day BFOE market Chicken and egg problem of missing liquidity In summer of 2013, ICE decided to change expiry date of all futures contracts from Mar16 onwards o New expiry will be pen-ultimate business day of the month prior to expiry EU regulations reduced maximum Sulphur content of Gasoil from o.1% to 10 ppm from March 2015 onwards o Killed market for gasoil futures with later maturities Taking brent futures into delivery Any futures position held until expiry goes into delivery o If holder wishes to cash settle, they have to notice exchange within one hour after expiry time (19:30 London time) o Cash settlement is against published at 12:00 noon the day after expiry  o Index references the price of brent forties Oseberg Ekofisk price (BFOE) Contract turns into 21-day BFOE contract o Seller of physical oil has to give buyer at least 21 days notice ahead of a 3 day loading window in the month following expiry o Delivery is at Sullom Voe Terminal (Brent, Shell), Hound Point and Kinneil (forties, BP), Sture (Oseberg, Statoil), or Teeside (Ekofisk, ConocoPhilips) o Cargo size is 600,000 bbl +/-1% at buyers option o Prices are adjusted down if sulphur content is above 0.6% Once loading date is fixed, contract is referred to as dated brent BFOE locations Physical oil contracts Both 21-day BFOE contract and dated brent contract are liquidly traded Dated brent contract is spot market for oil in the north sea o Average price of dated cargoes traded on given day between 16:00 and 16:30 is dated brent spot index against which many swaps settle o 21-day contract is commonly referred to as dated brent Buyer and seller of physical cargo are exposed to price risk Two common instruments are CFD and DFL Contract for differences (CFD) o Swap on spread on the difference of date brent spot prices over a month against the following month of 21-day BFOE o Exchange payments based on difference between dated brent spot price and following (next month) 21-day BFOE price Dated to Frontline (DFL) o Swap on spread between difference of dated brent spot prices and prompt brent futures contracts o Spread between dated brent spot price and prompt brent futures price EFP Trade Exchange for Physical (EFP) trade Two participants in futures market agree to exchange a futures position for a physical commodity Parties agree terms of delivery for physical cargo and link to a futures price on exchange Notify exchange and trade on exchange is recorded at settlement price Settlement via EFP ensures future price will converge to a representative market value and eliminates the basis risk EFP is official physical settlement procedure for Brent futures o Producer has 2 MM bbl of oil production and is short 2000 lots (1000 barrels) of Dec13 brent futures as a hedge o Refiner needs 2 MM bbl and is long 2000 lots of Dec13 Brent as a hedge o Producer agrees to sell cargo to refiner at price of x USD/bbl o Notify exchange that they crossed their futures position o Positions of the buyer and seller is unchanged ▪ Futures hedge has been replaced with a physical sale Lecture 2 - Commodity Derivatives Trading Basis Risk, Forward Curves Physical Oil Trade We are buying oil → What’s the price? What matters? o Quality o Location o Delivery Time o Bulk size o Delivery Term Example Buy cargo of Urals crude oil based on mediterranean spot price (Platt’s assessment) o Urals oil spec: 31-33 API gravity, Suplhur Content 1.3% 7.23 bbl/mt o Delivery is FOB Augusta (sicily) Delivery of cargo is going to be in April next year o Agree to pay average sport price in April Lucky and find buyer for cargo immediately o Want’s fixed price o We find price attractive for now Price exposure o Short (buying on floating index and sold fix) Hedge o Buy urals swap (perfect hedge): illiquid i.e. costly o Proxy hedge (cross hedge) Historical spot price Price appears to be range bound Difference between different grades is much smaller Basis risk Hedging exposure to Urals directly may not be possible o Lack of liquidity o Physical markets frequently 1-way Variation can be hedged in o Physical (dated) brent swaps ▪ Involves physical delivery or financial settlements based on StDev StDev dated brent spot price URALS 5.888 URALS/DTD 1.024 DATED 6.298 URALS/BR 1.082 o Futures based brent swaps BR(1_1) 5.921 DTD/BR 0.881 ▪ Based on brent futures prices rather than physical brent Risk reduction = lower standard deviation of price moves Variation in difference between hedged (spot) price and the (spot) price of the hedge is called the basis risk Basis Risk & Hedge Effectiveness Mismatch between some characteristics between a hedged (spot) price and the (spot or futures) price of the spot gives rise to basis risk Differences in quality, location, time,, mode of delivery, and bulk size Basis risk is small to overall price risk, we may need to quantify how much basis risk we have relative to the overall risk we are taking Metrics o Historical variance or standard deviation o Reduction in overall variance ▪ Historically: Variance of basis over variance of price changes ▪ Forward looking: Implied volatility to get forward variance estimate Quality basis risk Brent spec: 38 API, sulphur 0.45%, 7.312 bbl/mt Urals is of lower quality than brent o Higher gravity: cracks into less valuable products or cracking costs more o Higher sulphur content: Sulpuric acid corrodes metal, stinks Difference quality should be reflected in lower price o Lighter oils should trade at higher price Can measure quality basis risk by variation of difference between price for urals and dated brent StDev URALS/BR(1_1) 1.082 in the mediterranean URALS/DTD MED 0.974 Large part of variation is driven by difference in quality Relative or Absolute Basis Risk Basis (and spreads) can be looked upon as difference in prices or as a percentage of the price of the hedge instrument o Transport and financing cost are linked to oil prices If basis is a percentage of hedge instrument we have some price Simple check for this is to run a regression between the value t-stat basis changes and the price changes Beta 0.173 0.204 For urals/BR(1_1) basis we were looking at earlier, we see very little Contant 0.037 0.046 correlation R2 0.001 adj. R2 -0.023 Relationship between basis and hedge instrument can be different in short and long term Absolute: Difference in prices between physical asset being hedged e.g. brent and hedging instrument e.g. WTI → if 1 = 75$ and 2 = 70$ absolute basis risk = 5$ Relative: instead of difference as flat number, basis can be considered as percentage of hedging instrument’s price Basis Trading Driven by relative supply and demand for similar grades in different locations Physical trades takes time and logistics need to be arranged Can have information advantage and anticipate what is going to happen if zou are aware of what is happening in some part of the supply chain o E.g. lots of oil will end up being shipped into the Mediterranean in 2 months and little into northern Europe, location spread can be expected to widen For this reason, trading houses like to have access to physical flow o Assets that sit in strategic locations ▪ Shipping ports (Suez and Panama Canal), loading terminals (Rotterdam) ▪ Access to production that meets a broad range of specifications and can thus deliver into many locations o In order to make money from basis trades you have to go into physical delivery ▪ May be able to trade swaps but if people know you cannot take delivery or deliver its not a strong position for price negotiation Delivery options in futures Physically delivered contracts have flexibility and tolerance around delivery o Makes contract attractive to wider range of market participants o Gives rise to basis risk as contract approaches expiry Delivery basis in futures Fixed quality differential gives futures seller the option to deliver the grade which is most profitable Location option gives seller right to minimise his shipping cost o Availability of capacity in ports etc. matter  Storage flexibility: Owner of physical inventory can wait for full month whether he wants to sell inventory or roll it forward if this is more profitable o Storage or time spread option Options at sellers choice implies that futures price converges to the price of the cheapest to deliver commodity within the contract specifications From buyers perspective this means o Worst quality o Worst location o Least convenient time EFP trades are one way to get around this o Contract is exchanged for actual physical commodity, with both parties negotiating the quality, location and timing Oil Products & Pricing Prices of oil contracts and oil product contracts are closely linked Products: Everything a barrel of oil can be refined into The price of a ton of Jet Fuel FOB Rotterdam for Nov14 is 855.95 USD/MT o Price of a ton of Gasoil (789.2 USD/MT) plus the Jet-GO diff 66.75 USD/MT o Price of a bbl of BR(1_1) (93.18 USD/bbl) plus the Jet crack 15.75 USD/bbl multiplied by 7.86 bbl/MT Price of each product can be split into o Price of crude oil o Crack spread o Quality, transport, or freight differential Most of differences are a lot less variable than the crude oil price Can think about differences in a similar way we think about basis risk o Some people refer to the cracks as an “input-output basis” Forward curves Value of forward is value of the spot plus the cost of carry (cc) and financing (r) minus the benefit of holding the inventory (convenience yield or cy) Convenience yield is not known o Depends on security of supply/minimum inventory levels o We can estimate cy and cc depending on maturity – really? ▪ We know our cost and trade when profitable Curve shapes o Full carry: Forward prices and spot prices are linked as above ▪ Futures price reflects complete cost of carrying (or holding) the underlying asset until the contracts expiration date o Contango: prices increase with time to expiry o Backwardation: prices fall with time to expiry Shapes of forward curves Tells us how supply and demand is balanced at different points of the curve o Provides signal on how to allocate resources in time o Note that spreads (cracks) also have forward curves Storage is link between different time points: Transform commodity today into commodity in the future  Cost of storage for different commodities are on a continuum – grouped into: o Storables: Commodities that can be stored at fairly low cost o Non-storables: Those that can not be stored or at high cost only ▪ E.g. electricity, freight, weather, livestock Among storables we can further distinguish into o Continuously produced ▪ Exhaustible: e.g. Oil and Gas, Gold (cost of production will rise) ▪ Non-exhaustible: e.g. Base metals (cost of production will not rise) o Periodically produced ▪ Crops and livestock Storables Forward Curve Commodities can only be moved into the future by storage o Most importantly, spot commodities cannot be shorted If spot supply is abundant, there is plenty of inventory and demand is expected to be higher in the future we should store o Forward curve should provide incentive to store: contango or full carry o Think about harvesting season or the pig cycle If spot supply is tight, inventories are low and supply is expected to pick up in the future we should not store o Forward curve provide incentive for consumption: backwardation By hedging inventories, you certainly lose in a backwardated market o Market should be in steep contango when inventory is high o Market should be in steep backwardation when inventory is low Balancing and balances Inventories act as balancing point between supply and demand o Supply > demand, storage levels increase o Supply < demand, storage levels decrease Commodity consumption is local o Here and now Fundamentally and in near term, commodity markets are local markets Need to understand different local supply and demand balances o Critical are supply and demand at trading hubs and delivery locations where we can trade future contracts Depending on current prices we can predict flows between markets o On forward basis markets can seem imbalanced o Physical flows or prices will adjust to balance supply and demand Reality is complex o Nobody knows current fundamental data such as inventories o In extreme (price) situations commodity flows will get redirected Seasonal commodities, one would expect disconnect between prices for new crop and old crop o Most likely inventories of old crop will be replaced by new crop o Empirical data do not support the disconnect Implication is that we are pricing commodity derivatives using a forward curve and not the spot price Brent curve movie – observations Price covered wide price range Curve flipped from contango into backwardation and back All contracts co-move strongly Spread (slope of the curve) moves in line with the level of the curve o If prices fall, spreads fall, if prices rise, spreads rise Realised volatility Calculate realised volatility of forward contract over its life as it rolls down the forward curve o Repeat for many contracts, plot See that on average, front end moves a lot more than the back end of the curve Term structure of volatility Samuelson effect: Volatility term structure of many commodities is (usually) downward sloping Why: o Supply and demand are a lot more elastic long term rather than short term o This can be observed for both implied and realised volatilities Also the volatility of volatility is much higher in near term as compared to long term Long dated exposure Sometimes need to manage longer dated swaps which go out further into future than listed contracts o Futures contracts are currently listed until December 2022 o Not all maturities trade (less of a problem) o Liquidity is limited for very long data contracts (more of a problem) Remember, dated price is used for pricing physical products in global markets and refers to price of product that will be loaded within specific window, it represents the spot market price Lack of liquidity gives opportunity to charge a premium for taking on the long term price risk o Most of flow on backend is from producers, this may give rise to a systematic speculative risk premium Somehow need to hedge the long dated exposure o Futures curves moves largely in line o Hedging with shorted dated futures seems obvious thing to do  Managing calendar basis risk o Risk associated with price difference between contracts of different maturities Long Term Swaps: Stripping Common long-dated exposure is to a longer period, e.g. a swap for several years We would hedge with a strip of futures contracts If swap has N periods, and we can only trade M futures contracts, we could decide to just hedge up to maturity M and leave the remainder unhedged As soon as liquidity picks up, we hedge the next possible period This is called stripping Stripping and stacking Forward curve level is quite volatile o Want to hedge against the changes in the part of the curve we cannot trade Can just stack the unhedged quantities in the last liquid futures contract and roll them forward as soon as liquidity picks up o Take larger-than-usual position in last liquid contract to approximate overall exposure, effectively bunching up all unhedged future exposure into one contract Why? o Manage basis risk: Calendar basis risk o Avoid illiquidity costs: Stick with liquid cost to avoid illiquid contract trading o Maintain flexibility Stack and roll In stack-and-roll hedge we are exposed to changes in calendar spread of the curve o If we are short we lose if the market flips into backwardation Can check risk of trade by inspecting the ¾ year forward spread Calendar spread risk is risk arising from fluctuations in price difference between contracts of different maturities Remember you close out the expiring contract and open a new position in a later-dated contract Stack and roll risk If we buy a swap, we have an idea how long we need to warehouse the futures spread risk from the stack and roll hedge Assume we hold the spread for 20 treading days, we can check the spread changes  average spread change is zero Daily standard deviation of all spread changes is 0.148 USD/bbl per day o For 20-day move we multiply by sqrt(20) = 4.47 about 0.67 USD/bbl o 16th and 85th percentile of 20- day distribution are $-0.67 and 0.56 USD/bbl Hedge ratio Futures contracts with shorter time to maturity are more volatile than the future contracts with longer time to maturity (Samuelson effect) hedge ratio daily StDev charge difference to HR 1 More sensitive to immediate supply and demand shocks 0.9 0.154 0.690 0.026 0.91 0.151 0.675 0.012 Know ex-ante the correlation and volatility, the optimal 0.92 0.148 0.663 0.000 𝜎𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 hedge ratio is the regression coefficient 𝛽 = 𝜌 𝜎 0.93 0.146 0.654 -0.010 𝑠ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 0.94 0.144 0.646 -0.018 If correlation is perfect, coefficient should be smaller than 1 0.95 0.144 0.643 -0.020 since sd lt < sd st 0.96 0.144 0.642 -0.022 We are careful with historical correlations in practice 0.97 0.144 0.643 -0.020 0.98 0.145 0.648 -0.016 We can estimate the daily standard deviation and the 0.99 0.146 0.654 -0.009 difference in risk change 1 0.148 0.664 0.000 Hedge ratio = Beta Charge is the additional cost or risk adjustment incurred when implementing a hedge with a hedge ratio that differs from 1 Hedge below 1 means you’re not fully hedged This shows that the 0.96 hedge ratio is the cheapest Less costs due to less rolling and rebalancing, less transaction costs Arbitrage in commodity markets Arbitrage: Riskless profit achieved by buying and selling assets at same time Under standard black-scholes assumptions, arbitrage doesn’t exist Theory of limits to arbitrage states that arbitrage can persist in financial markets Justified by restrictions placed on majority if investors o Example is arbitrage might become wider before closes, requiring an excessive amount of capital In physical commodity markets, there are plenty of arbitrage opportunities o Commodity traders are transforming commodities in time, space and form o Resulting gain can be seen as an arbitrage profit ▪ Risk assumed is operational, not financial They can be very large and persist for a long time The “Arb”: WTI-brent US benchmark oil is WTI, slightly higher quality that brent o WTI is US domestic grade, it’s a pipeline in the country Brent is oil in a tanker in the Atlantic basin o WRIT – brent is determined by relative demand in US vs rest of the world  US used to be the biggest importer of crude oil in the planet o Defined geopolitics for much of past 60 years Shale revolution changed this dramatically o Improved drilling technology (Horizontal drilling, hydraulic fracturing) o Since about 2000, first gas, then NGL, then Oil o Facilitated by free access to capital and record low interest rates US is now biggest oil producer in the worl US Oil pipeline system US oil pipeline system was built over decades to bring oil into the country Centre of system is cushing, oklahama, the delivery location for WTI Green: Oil pipelines Crude arbitrage From late 2008 onwards, production of shale oil in the US increasingly saturated the refineries in the US mid-west Lack of pipeline capacity led to Cushing being drastically oversupplied o Cushing is delivery location, crude pipelines are built to get oil into cushing Allowed shippers to make record profits as price of crude on gulf coast was closer to brent Crude arbitrage if price differential is high, traders 1. Stop flowing oil into cushing 2. Are looking to ship oil out of cushing (build pipes) Once sufficient capacity was available, oil could move out of cushing o Price difference between cushing and US gulf coast contracted o Glut shifted to the US Gulf coast ▪ Refiners made the profit o US had an export ban since the 70ies (lifted in 2016) ▪ Minimum refining o Still ongoing ▪ New pipelines connect local production with the USGC ▪ Export terminals on the US Gulf coast Lecture 3 - Hedging and Arbitrage Introduction Commodity traders operate on a margin that is small relative to the underlying price moves o What is a good margin for moving a bbl of oil halfway around the world? o How much are oil prices moving per day? Hedging What is hedging? Undertaking of balancing or compensating transactions that protect against losses on an investment or business activity o If we sell a call option, we buy futures as a hedge o In the context of corporations, we take a broader view o Vertical integration along the value chain: buy suppliers or customers o Oil majors own oil fields, refineries, gas stations Many hedging transactions transform one risk into another o Price or credit into liquidity o Price risk into credit or production risk Not easy to distinguish between hedging and speculation o Bp T&S as a business functions as hedge for upstream and midstream activities ▪ Trading tends to perform well in extreme market conditions Why do firms hedge? Value maximising company is not risk averse in the same way as an individual Exposure to certain risks is the purpose of many companies o Oil companies are supposed to carry oil price risk o Company that operates drilling riggs is an example of a oil price exposure it may not want Purpose of hedging is to create value or make money o Benefits need to outweigh costs Create value o Increase cash flow o Decrease risk and cost of capital Not all hedging is done voluntarily o Banks may ask (force) a company to hedge Corporate hedging Corporate risk management Plans and measures that increase the value of a corporation (on a high level) Aims to systematically increase cash flows and decrease cost of capital Define hedge objectives and (maybe) set a hedging policy Sets the framework for commercial hedging o Hedging as part of the day-to-day business of a company o Exploit short term profit opportunities o Determined by hedging policy (at least parts)  o Follow a hedging mandate Note that many commodity producers do not want to hedge o Commodity exposure is why they are in the business in the first place Note many firms will only hedge price exposure that is material o Steel cost in cars are immaterial Hedge objectives When dealing with financial derivatives, hedging objective is straightforward o Portfolio NPV For company managing or even observing NPV is near impossible o Protect/maximise value of a firms’ assets o Minimise cost of liabilities (lowest cost of funding) o Hedge value of equity o Protect cash flows or liquidity o Protect/maximise economic profits or the profit margin ▪ How do you treat sunk cost o Protect/maximise accounting earnings Not the topic of this lecture (more accounting) However, many companies have clear idea of what they want to achieve: o Helpful to know what your counterparty wants to achieve Producer hedging Independent commodity producers do want to hedge o Oil companies are in oil business because they are bullish oil prices Producers have to hedge to secure funding for investment projects In relation to its current activities, the typical producers situation is: o Lots of resources (oil) in the ground o Little cash (maybe 3 months worth of production) o Small cash-flow o Large capital needs for capex On exchange hedging is not possible, cannot afford margin o Hedging with them corresponds to financing their margin Hedging to decrease cost of capital Producer hedges to reduce its cost of capital Explicit cost of capital o Hedging reduces the cash flow volatility and thus cost of financing Information cost o Managers are better informed about a firm’s projects than investors o Investors may assume that a firm will only issue securities when these are overpriced, creating an incentive for the firm to issue less risky securities o This effect is strongest for firms which have intangible investments ▪ E.g. oil reserves in the ground pre-exploration Traders would say that owners/managers are bullish and want to keep the upside Hedging cost Important: Cost of hedge o Any commodity producer wants a high guaranteed price on its production If oil producer asks for a bank loan or wants to issue a bond, creditors will ask for producer to get guaranteed minimum price o Essentially producer has to buy a put option o Producer could also enter a swap but that means giving up upside When negotiating the conditions for a loan, the details of the hedges that need to be put in place are at the core of negotiations o Put strikes o Payment terms Hedging mandate In finance, we usually aim to minimise the variance of the hedged portfolio For (large) companies, this is rarely practicable Common targets are o Hedge to meet thresholds or targets ▪ Minimum capital, minimum margin, profitability o Hedge to minimise sensitivity to price changes ▪ Easy to implement in guidelines o Hedge to minimise volatility or variance ▪ How do we measure variance? – Is this practicable? o Hedging to reduce the downside semi-variance ▪ Firms usually want to keep the upside Hedging mandate determines what kind of structure a company will trade o Swaps, futures, options It determines when a firm trades and how it trades o On exchange, otc, physical agreements Commercial hedging Hedging as part of the day-to-day business of a company o This critical for commodity trades Reduce risk from running the business o Operational hedging o Carrying charge hedging Exploit short term opportunities o Opportunistic, selective, or anticipatory hedging o Objective: in the short term increase cash flow, decrease cost of capital o This can be trading based on the information flow ▪ Can be hard to distinguish from speculation ▪ What we do when managing refineries Operational hedging Commodity price exposure can arise from being in a business o Goldsmith has price exposure while he works on jewellery o Gas stations have gasoline in stock which will be sold at a small profit o Refiners are exposed to crude oil price charges as they are processing it Adverse move in price can be disproportionate to the firms margin Reduces cost, provides diversification, mitigates managerial risk aversion Operational hedging is special case of risk avoidance hedging o Very little volume uncertainty o Usually very specific Main characteristic is that it is short term o Goldsmith is happy to unhedge against long term price moves Hedging and commodity traders Hedging to increase cash flow Exploit profit opportunities o Hedge can be cheaper than own cost o E.g. optimise inventory and synthetic storage in forward market Exploit information advantages or asymmetries o Better insight into current market conditions (inventories, production) o Can be speculation, however its based on private information o Will usually be a spread trade rather than an outright trade Anticipatory hedging is common in both sales and procurement o Seller sells longer term when they think prices are high and will come down o Buyers will buy longer term when they think prices are low and will go up, e.g. log in currently low interest rates This was what commodity trading houses are doing Example: Seaway pipeline Seaway pipeline connects cushing, Oklahoma to freeport, Texas o Two main petroleum hubs in US Built in 1974-1976 to bring oil into cushing Became inactive in 1982 Was converted to NatGas in 1984 Back to oil in 1995 In 2011, flow was reversed Announced nov 2011, effective jun 2012 Pipeline trade Trader buys 10 kbbl/day in cushing and delivers in freeport o Term of deal is calendar year 2016 o Deal date is 9th sep 2015 Buying on a fixed WTI price (WTI – 0.25 USD/bbl =48.65 USD/bbl) 0.25 cents benefit o Producer selling oil to him needs a fixed cash flow  Selling to refiner at Freeport at a spot price (Brent + 0.25 USD/bbl) 50 cent gain in total o Buying at fixed price would create an exposure to refined oil product prices Cost of flowing the pipeline are 2.83 USD/bbl + 0.19 USD/bbl Trader has financing cost of 8% and all activities are tax equally What risk does the trader have and how does he hedge it? Pipeline trade – Day 1 on sep 2015, trader has profit of 6,862 MM USD (NPV) WTI BR Spread Cost Margin Volume in kbbl Profit DF NPV Oct-15 44.15 47.58 - 3.43 - 0.0 99.52% Nov-15 44.80 48.52 - 3.72 - 0.0 98.85% Dec-15 45.48 49.39 - 3.91 - 0.0 98.20% Jan-16 46.20 50.22 - 4.02 3.02 0.50 310.0 465.0 97.53% 453.5 Feb-16 46.88 50.96 - 4.08 3.02 0.50 290.0 452.4 96.87% 438.2 Mar-16 47.52 51.58 - 4.06 3.02 0.50 310.0 477.4 96.26% 459.5 Apr-16 48.07 52.24 - 4.17 3.02 0.50 300.0 495.0 95.61% 473.3 May-16 48.55 52.84 - 4.29 3.02 0.50 310.0 548.7 94.98% 521.2 Jun-16 48.95 53.41 - 4.46 3.02 0.50 300.0 582.0 94.34% 549.0 Jul-16 49.25 53.90 - 4.65 3.02 0.50 310.0 660.3 93.72% 618.8 Aug-16 49.56 54.34 - 4.78 3.02 0.50 310.0 700.6 93.08% 652.1 Sep-16 49.90 54.77 - 4.87 3.02 0.50 300.0 705.0 92.45% 651.8 Oct-16 50.25 55.19 - 4.94 3.02 0.50 310.0 750.2 91.85% 689.0 Nov-16 50.63 55.59 - 4.96 3.02 0.50 300.0 732.0 91.23% 667.8 Dec-16 51.01 55.98 - 4.97 3.02 0.50 310.0 759.5 90.63% 688.3 Cal 16 avg 48.90 53.42 - 4.52 total volume 3,660.0 profit 6,862.6 Contract goes into effect in Jan 2016 o He is buying 3.66 MM bbl fixed, selling floating o Sell WTI as hedge (risk avoidance hedge) o Now has floating-floating exposure ▪ Trader is exposed to price movements based on two different floating price benchmarks, without a fixed price to lock in a guaranteed margin Trader has exposure to WTI brent spread o Short the spread (market convention to have WTI minus brent) o If spread narrows he loses money, if it widens, he makes money o This is a carrying charge hedge ▪ Traders’ cost of transporting physically across time and space are smaller than the cost of moving them synthetically using derivatives Means market is in short term disequilibrium o Long term, more pipelines are built and spread narrows o Short term profit is perfectly fine for business We sell WTI futures to protect ourselves against a rise in WTI prices, where a drop in prices creates a gain that is offset by the drop in the value of our oil, and we buy brent, where when prices increase, our gain is offset by the price at which we are selling the oil We roll the futures or offset them, and use them as a financial hedge, we do not intend to involve physical delivery, but lock in prices Why would we not use swaps? o Liquidity and market accessibility ▪ Swaps are not super liquid meaning it might be difficult to adjust the hedge o Standardisation vs. Customisation ▪ More transparency through standardisation o Hedging efficiency and spread exposure  ▪ Swaps might lead to less basis risk as we can create a basis swap or WTI- brent swap, futures provide a proxy hedge through an indirect approach o Margin requirements ▪ Futures require daily margining, swaps a bit easier o Transaction costs ▪ Swaps can have higher transaction costs due to lack of standardisation Futures: High liquidity, quick entry/exit, minimised counterparty risk (central clearinghouse) Pipeline trade – opportunities Current spread is -4.52 USD/bbl, his cost are 3.02 USD/bbl (2.52 including margin) o Only starts losing if spread tightens by more than 2 USD/bbl Trader might have better insight into market information and strong view on what is going to happen to the spread May leave (some) of his spread exposure unhedged and hedge selectively o Alternatively, he may overhedge his exposure May have a view that current spreads are very attractive and expects to win very similar business in the future and decides to hedge some of it as an anticipatory hedge Pipeline trade – more opportunities Our trader hedged his trade completely on 9 Sep 2015 On 9th oct 2015, prices have moved and his unhedged NPV looks like this: WTI BR Spread Cost Margin Volume in kbbl Profit DF NPV Oct-15 46.12 46.77 - 0.65 - 0.0 100.18% Nov-15 49.63 52.65 - 3.02 - 0.0 99.50% Dec-15 50.14 52.91 - 2.77 - 0.0 98.85% Jan-16 50.82 53.53 - 2.71 3.02 0.50 310.0 58.9 98.18% 57.8 Feb-16 51.40 54.16 - 2.76 3.02 0.50 290.0 69.6 97.51% 67.9 Mar-16 51.88 54.66 - 2.78 3.02 0.50 310.0 80.6 96.89% 78.1 Apr-16 52.25 55.28 - 3.03 3.02 0.50 300.0 153.0 96.24% 147.2 May-16 52.55 55.83 - 3.28 3.02 0.50 310.0 235.6 95.61% 225.2 Jun-16 52.82 56.32 - 3.50 3.02 0.50 300.0 294.0 94.96% 279.2 Jul-16 53.05 56.74 - 3.69 3.02 0.50 310.0 362.7 94.34% 342.2 Aug-16 53.24 57.13 - 3.89 3.02 0.50 310.0 424.7 93.70% 397.9 Sep-16 53.44 57.49 - 4.05 3.02 0.50 300.0 459.0 93.06% 427.2 Oct-16 53.64 57.85 - 4.21 3.02 0.50 310.0 523.9 92.45% 484.4 Nov-16 53.88 58.21 - 4.33 3.02 0.50 300.0 543.0 91.83% 498.6 Dec-16 54.14 58.56 - 4.42 3.02 0.50 310.0 589.0 91.23% 537.3 Cal 16 avg 52.76 56.31 - 3.55 total volume 3,660.0 profit 3,543.0 For Q1 2016, cost of flowing pipeline is higher than synthetic transport by buying and selling oil forward locally He is hedged, what he lost on NPV deal, he made on hedges If he only has to pay pipeline when he flows oil, he can make extra profit o Sell spread hedge and sell WTI/buy Brent locally o Could also try to sell pipeline capacity If spread lowers again, he can hedge and flow oil again Type of trading typical for physical commodity trading house o Trading business gives a deep insight into flow of business and what drives price spreads across time and locations Hedging and liquidity Many hedging transactions transform one risk into another o Price or credit into liquidity o Price risk into credit or production risk Over last few years, exporting LNG from US to RoW has become a business o Shale gas cheaper than LNG o North American natgas is henry hub, quoted in USD/mmBTU o European natgas is ttf, quoted in USD/MWh Cargo of LNG has 20 mln mmBTU, 3.412 mmBTU = 1 MWh How do you hedge? Henry hub ttf spread 2017- 2020 Ignore cost, its about risk Spread between American was between +3 and -0.85 usd/mmbtu Revenue swings between - 17mln/usd and +60 mln Hedging seems sensible but maybe not now We didn’t hedge, what a great market call Hedging in record spreads of 5 usd/bbl didn’t hedge, great market call  Spread blew out further o In the highs it was > 50 usd/mmbtu 50 usd/mmbtu * 20 mln mmbtu/cargo = 1 bln usd variation margin/cargo Physical cargo is providing security, but how far forward have we hedged LNG exports from the US One of the major players in the market is gunvor Gunvor had to cut its LNG positions due to high margin calls Spike in global energy prices → Business profitability goed up but because of the size of the business, the exports will be hedged several months in advance A sharp move in the spread between us gas prices and LNG prices will lead to margin calls on hedges Over time, the profits from the physical trading are going to offset the losses on the hedges, but liquidity management and understanding accounting matters Blending International Maritime Organisation (IMO) is UN specialised agency with responsibility for safety and security of shipping and the prevention of marine and pollution by ships in 2020 Jan 1, new limit on sulphur content in fuel used came into force new limit was 0.5%, down from 3.5% for fuel oil used on board ships operating outside designated emission control areas What happens to bunker oil markets? Ship engines require heavy bunker fuels and cannot switch to e.g. gasoline or kerosene Less demand from 1st January onwards for fuel oil with >0.5% suplhur More demand for FO wit FO 0.5% > FO 1% Can profit when diesel spread < 0.5/1.0 spread 600.00 Price Differences in usd/mt Diesel/FO 0.5 FO 0.5/FO 1.0 400.00 200.00 - Marine fuel prices All we need is a tank for bunker oil and FO 0.5, Blend, Diff in usd/mt a mixer 1,200.00 100.00 Buy 44.44% FO1%, buy 55.56% marine 1,000.00 50.00 diesel and blend 800.00 - o Maximum sulphur content, 600.00 (50.00) check actual spec for higher 400.00 (100.00) margin 200.00 (150.00) Scan forward curves for arbs, include - (200.00) freight and timing One needs to have robust understanding of physical details and timings F05RDAMFB Blend Diff (right) Spread positive → arbitrage Lecture 4 - Real Options Introduction Along value chain we transform commodities in o Time: storage o In form: refine, crack, blend o In space: transport We continuously evaluate whether it is favourable to o Sell now/later (store) o Sell here/move and sell there (transport) o Refine/sell input & buy output (transform) Frame decisions as options and price them as such o Trading paper commodities (spreads) allows us to monetise the option value o Value of an option is the value its hedge Using standard (Black-Scholes-Merton) option pricing theory is built on the assumption that: o The value of the option is the value of the hedge In real life, there is basis risk everywhere and perfect hedges are rarely available (liquidity, maturity) We will usually need to value an option in two situations 1. We want to buy (bid) or sell (offer) 2. Want to own option and want to risk manage it In first case, we are looking for a lower or higher bound o What would I do if I am long (short) this option? o Find liquid hedge instrument, charge for basis risk In second case, we care about optimising operation (exercise) and better risk management o Delta hedging can lead to smoother PnL Practical note Need to consider physical side as it may bring additional risk o Uncertainty about quantity o Uncertainty about quality o Exposure to weather, political risks, unrest o Hedging can constrain what you can do in the future Performance risk can mean that you are adding considerable risk o If you are selling oil forward, you got to be sure that you will have it in the future Are we looking at a specific option (asset, contract, project) or risk management on a book or company level o Diversification o Size does matter (for commodity trading houses) Benefits of better risk management? Lower cost of capital, less downside Practical options pricing Use the black model to interpolate between option prices Value of an option to buy (sell ) an underlying at price K at time T is: o Between rights to buy (sell) at K-x and K+x for all positive x o Between rights to buy (sell) at T—s and T+s for all positive s Second statement is not always correct for commodities  o Transformation in time can be costly or impossible o One special case is power (electricity) for different hours of the day How do we interpolate o Option prices can change very fast o Transform into implied volatilities that are moving more slowly Implied volatilities are option prices, not model parameters o One cannot estimate a price: there is a bid and an offer Volatility and time to maturity Option values increase with volatility and time to maturity o Value is determined by total variance 𝜎 2 𝑇 o Value of ATM option is fairly accurately approximated by ATM = 0.4𝜎√𝑇𝐹 o Notional value is a main determinant of the option value (obvious) Physical oil off-take agreement Oil producers usually sell their cargos on spot index based formula o If oil is loaded onto tanker/pumped into a tank on a certain date, the price payable will be determined by the average oil price around this date o On this date, the bill of lading is issued, the ownership document o Common averages ▪ Day the bill of loading is issued, 2 business days before, 2 after ▪ Average of the month of delivery (swap price) Because of technical reasons there is essentially always a volume tolerance o As we saw in second lecture, dated brent has +/- 1% ▪ Tolerance of +/- 10% is not uncommon Physical oil sale timeline 1. Contact specifies how many cargoes per month/year are sold and general terms and conditions 2. Seller notifies buyer and assigns range of dates during which the oil can be picked uo 3. Buyer arranges for vessel of appropriate size and sends it to pick up the oil 4. On day loading is completed, bill of lading is issued a. Buyer takes ownership of the oil and ships it to a refinery 5. After all the information is available, the price is calculated a. Invoice is issued Example: Oil offtake Buy 1’000’000 bbl/month Brent front line 2-1-2 pricing around the bill of lading date Delivery is FOB Volume tolerance +/- 10% Have 7 day window between 11-Sep-13 and 18-Sep-13 to complete loading Leased tanker for 75k per day Consider basic trading to get around contract and consider variations As we start loading oil, we get longer oil and need to sell o We were short when we signed the contract: pay more when prices go up Sales contracts will usually be structured in a way that we secure a margin against a pricing base-case Remember that swap is based on Oct13 and Nov13 Futures o Brent Oct13 futures expire on 13-Sep-13 (swaps roll 1 day early) Fixed volume 2-1-2 pricing: Step 1 Settlement Oct-13 Nov-13 09/09/2013 113.72 113.72 112.33 extra charter On 9-Sep-13 we need to plan when we want to 10/09/2013 days days USD/bbl Price load the cargo 11/09/2013 4 1 0 113.44 o We get the futures prices and calculate 12/09/2013 3 2 0.075 113.24 13/09/2013 2 3 0.15 113.04 cost of loading on different days 14/09/2013 2 3 0.225 113.11 Decide to load on 17-Sep-2013 15/09/2013 2 3 0.3 113.19 Need to sell 200kb/day at Settlement from 13- 16/09/2013 1 4 0.375 112.98 17/09/2013 0 5 0.45 112.78 Sep13 until 20-Sep-13 18/09/2013 0 5 0.525 112.86 19/09/2013 20/09/2013 Step 2 09/09/2013 10/09/2013 11/09/2013 12/09/2013 Oct13 Futures 113.72 111.25 111.5 112.63 On 10-Sep-13 and every day we calculate our Nov13 Futures 112.33 110.02 110.19 111.53 expected prices 11/09/2013 113.44 111.50 111.63 112.13 12/09/2013 113.24 110.83 111.00 111.76 On 12-sep-13 we see that it is preferable to start 13/09/2013 113.04 110.66 110.86 111.89 loading immediately 14/09/2013 113.11 110.74 110.94 111.97 o Sell 600kb at 112.63 USD/bbl and commit 15/09/2013 113.19 110.81 111.01 112.04 16/09/2013 112.98 110.64 110.83 112.13 ourselves to sell 200kb on the 13th and 16th 17/09/2013 112.78 110.47 110.64 111.98 o 14th and 15th are a weekend 18/09/2013 112.86 110.55 110.72 112.06 19/09/2013 20/09/2013 Step 3 09/09/2013 10/09/2013 11/09/2013 12/09/2013 13/09/2013 On 13-Sep-13 we sell 200 kb at 111.7 USD/bbl Oct13 Futures 113.72 111.25 111.5 112.63 Nov13 Futures 112.33 110.02 110.19 111.53 111.7 On the 16th, we realised that it would be better to wait 11/09/2013 113.44 111.50 111.63 112.13 112.16 12/09/2013 113.24 110.83 111.00 111.76 111.83 2 days 13/09/2013 113.04 110.66 110.86 111.89 112.00 o We buy back 800 kb for 110.07 USD/bbl 14/09/2013 113.11 110.74 110.94 111.97 112.07 15/09/2013 113.19 110.81 111.01 112.04 112.15 o We sell 200kb 16/09/2013 112.98 110.64 110.83 112.13 112.26 17/09/2013 112.78 110.47 110.64 111.98 112.15 o Is it a problem that the Oct13 futures have 18/09/2013 112.86 110.55 110.72 112.06 112.23 expired 19/09/2013 20/09/2013 Step 4 On the 17th, 18th, 19th, and 20th we sell 200kb each 09/09/2013 10/09/2013 11/09/2013 12/09/2013 13/09/2013 16/09/2013 17/09/2013 18/09/2013 19/09/2013 20/09/2013 Oct13 Futures 113.72 111.25 111.5 112.63 Nov13 Futures 112.33 110.02 110.19 111.53 111.7 110.07 108.19 110.6 108.76 109.22 11/09/2013 113.44 111.50 111.63 112.13 112.16 112.16 112.16 112.16 112.16 112.16 12/09/2013 113.24 110.83 111.00 111.76 111.83 111.51 111.51 111.51 111.51 111.51 13/09/2013 113.04 110.66 110.86 111.89 112.00 111.34 110.97 110.97 110.97 110.97 14/09/2013 113.11 110.74 110.94 111.97 112.07 111.42 111.04 111.04 111.04 111.04 15/09/2013 113.19 110.81 111.01 112.04 112.15 111.49 111.12 111.12 111.12 111.12 16/09/2013 112.98 110.64 110.83 112.13 112.26 111.28 110.53 111.01 111.01 111.01 17/09/2013 112.78 110.47 110.64 111.98 112.15 110.85 109.72 110.68 110.31 110.31 18/09/2013 112.86 110.55 110.72 112.06 112.23 110.60 109.09 110.54 109.80 109.89 19/09/2013 (110.07+108.19+110.6+108.76+109.22)𝑈𝑆𝐷/𝑏𝑏𝑙 We are going to pay 5 = 109.37 USD/bbl for the oil We have to pay 0.52 / bbl for the shipping Fixed volume PnL Simple optimisation made us 2 mln o 12-Sep-13: We sell 600 kb* (112.63 – 111.76) USD/bbl = 522’000 o 16-Sep-13: We buy 800 kb * (112.40-110.6) USD/bbl= 1’438’000 USD On the first date, 0.375 USD/bbl come from savings in the charter rate On the second date, we included 0.45 USD/bbl more for the charter We ignored transaction cost o Bid/offer could be 0.1-0.2 USD/bbl We assumed a lot of flexibility around the loading date o Very short notice for changing the date might not be practicable Volume On date bill of lading is issued we can decie whether we want to take more or less oil On that date, we can compare the current market price against partially priced out contract price o Exclude the charter as we have to pay this anyway 09/09/2013 10/09/2013 11/09/2013 12/09/2013 13/09/2013 16/09/2013 17/09/2013 18/09/2013 19/09/2013 20/09/2013 Oct13 Futures 113.72 111.25 111.50 112.63 Nov13 Futures 112.33 110.02 110.19 111.53 111.70 110.07 108.19 110.60 108.76 109.22 Contract Price 112.33 110.02 110.19 111.69 111.76 110.07 108.57 110.01 109.28 109.37 o As there are 2 more days left for price discovery, we can only exercise the option for 3/5 of the volume, 60kb o In our example, we would have sold an additional 60 kb on 18-sep-13 and increased our hedges to 220 kb/day for the 19th and 20th o This would have made 35’400 USD o On the 12th we decided to change the date (much more profitable) Explicit options in offtake agreements Some sovereign oil companies offer the option to pick one of several pricing windows E.g. Nigerian government offers the choice between o Prompt pricing: 5 consecutive price observation days after the BL date o Advanced pricing: 5 consecutive price observation days before the BL date o Deferred pricing: 5 consecutive days price observation starting on the 6th price observation after the BL date When negotiating a contract, the default is prompt pricing and the alternative is the choice in pricing in return against a fixed surcharge o Choice is between prompt and min(Prompt+x, Advanced+x,Deferred+x) Option pricing of contract options Choice of pricing window for an offtake agreement is well defined option Physical risks dominate o Bad weather o Technical issues on tanker and/or terminal o Political stability or credit risk Many of these risks have positive correlation with prices o By hedging the option we increase our exposure to these risks Physical traders tend to think cargo by cargo o Managing options with short averages will have noisy results It is a real option to delay tankers, cause disruption to loading processes o Real relationship withe sovereign producer can be far more valuable long term than the option On a portfolio/management information level option pricing can be helpful and used to benchmark performance Location differentials consider location differential between brass river blend and bonny light, two important Nigerian oils, and WTI (LLS from 2011) and Brent Difference to the US grade seems to be more volatile and crosses the difference to Brent frequently realized Diff WTI Brent Max Brass 2.59 2.00 3.09 Bonny 2.30 1.71 2.80 Cargoes are sold FOB – with a name destination Tanks Tank option Tanks are needed for operational reasons o Shipments arrive on vessels, oil is consumer continuously o Blend oil of different qualities ▪ If you have tanks, you can buy off spec and blend Tanks allow you to transform oil today into oil tomorrow Tanks are fairly specific to what you store o “Clean” used for light products, can be used for the same or heavier products o “dirt”used for heavy products, can be used for the same ore need to be cleaned Gasoil tank in Rotterdam o Delivery location for ICE Gasoil Futures contracts o What’s the options ▪ Buy oil now, sell in the future gasoil spread for 6 months Option pricing Tank (asset) is your option o Rent you pay is option premium o Cost to fill and empty the storage define your strike price ▪ Actual direct cost and financing We chose (bachelier) model that is assuming spread to be normally distributed Do we have a call or put option? Value of the option (K = strike, T = Time to maturity, sigma = volatility, N/n Normal distributed) 𝐾 − 𝑆𝑝𝑟𝑒𝑎𝑑 𝑆𝑝𝑟𝑒𝑎𝑑 − 𝐾 𝑆𝑡𝑜𝑟𝑎𝑔𝑒𝑉𝑎𝑙𝑢𝑒 = (𝐾 − 𝑆𝑝𝑟𝑒𝑎𝑑)𝑁 ( ) + 𝜎√𝑇𝑛 ( ) 𝜎√𝑇 𝜎√𝑇 Cost of storage is 1 USD/month Time to maturity is 3 months How can we use this o Risk management: Trade delta, sell options Simplified, we get a lot of basis risk in there o Cash differentials, timing, opportunity value Storage value and delta Storage value is moving up when spreads are low (put) Trading the gamma (change in delta) makes money when storing doesn’t When the spreads are negative i.e. the market is in contango, the storage value is high Refinery Oil refinery transforms feedstocks into products o Different crude oils that can go into a refinery are called its crude slate o Relative yield of gasoline, diesel, and kerosene etc is the (product) slate Refining process has three steps o Separation (distillation) o Conversion (cracking, modifying) o Treatment and blending As the transformation breaks heavier hydrocarbon molecules into lighter molecules, the volumetric output of a refinery is higher than its input Highest margin: Gasoline (light) and middle distillates (kerosene, heating oil) o Refining aims to maximise the output of these grades Some outputs are used as refinery inputs o Gases and residual fuels are sometimes burned to generate energy Refinery diagram Refinery process Crude oil is split into its components by distillation o Heat oil to 400C until it boils into gas o In distillation tower different components condense according to their molecular weight o Output depends on input: Light crudes generate more gasoline than heavy crudes Less valuable products are converted o Heavy molecules are broken up in cracking (heat and hydrogen addition) o Lighter molecules are combined into gasoline feedstock (higher octane rating) o Outputs like naptha are modified to be fit for petrochemical purposes or gasoline blending Finally, outputs are treated to improve quality o Remove toxic components, sulphur, wax o Heavy residuals can be further boiled into bitumen/asphalt Crude product yields Refinery types Refineries are classified by their complexity o Measured by the Nelson Complexity Factor Typical yields are o Complexity means more steps in the same process Typical refineries can process anywhere between 10’000 and 1’000’000 bbl/day Refinery flexibility Refineries can switch relative yield they get from a product o To account for seasonal demand, switch between Gasoline and Diesel Switching can be done by changing input fuels or changing the refining process Let us consider two examples: o Switching between dated brent and bonny light input o Turning a coking unit on and off as per the last slide Brent and bonny margin We calculate the margins in USD/bbl using the yields from above o Diff is brent margin less bonny margin o Negative diff – it is more profitable to run bonny crude Average realised margins are: o Brent: 7.19 USD/bbl o Bonny: 7.25 USD/bbl o Switching 7.48 USD/bbl Coking refinery margins We see that inputs and outputs strongly co-move Variation within the spreads indicates Coking refinery margins Assume cost of 2.5 USD/bbl for running the coker Propane + refinery fuel are set to 5% of fuel 2.5% of Rdam Margins are: o Cracker: 3.7 USD/bbl o Cocker: 3.82 USD/bbl o Cocker inc. Option: 3.97 USD/bbl We would run the cocker whenever the difference of gasoline+diesel/2 minus fuel oil is larger than 2.5 USD/bbl Refinery spread option Refinery reflexibility comes as a spread option o If we want to monetise, we need to sell option on the spread When defining these options, we have to consider the technical constrain o Switching from very light to very heavy crude can require technical adjustments etc which may take a few days o Feedstock needs to be sourced etc Lot of physical oil grades that go into refineries are not liquidly traded forward o Hard to trade gamma One way of monetising optionality is selling basket swaps and options and manage the refinery in the spot market o If we make money when realised margin is high, we lose on the hedge o In our example, we had a spread option on 50% gasoline and 50% diesel against fuel oil with a strike of 2.5 USD/bbl