Optimal Hedging Strategies for Oil and Gas

Cross-Cutting Project
Optimal strategies for oil and gas hedging
FERRANTI Matteo, MARTINI Umberto, AKOUM

Samy-Adrien
Master 203 - M2
April 28, 2017

Outline I
1 Whats the story and why do you care?
2 Theoretical Framework
3 Estimation of parameters
4 Hedging - Risk Reward Curve

Whats the story and why do you care?
In a Nutshell
How should private companies manage risk? Is it possible to

manage risk? Is it possible to model power prices?
Futures contracts are agreed in most cases for hedging
reasons; most companies would rather reduce price risk by
selling (or buying for a net consumer of electricity) some of
their final delivery position in advance.
Hedging is the reason why it is so important to be able to
model the forward price dynamics
And we care because...
Air France-KLM, Europes largest airline, on Wednesday

unveiled a net loss of 147m (219.8m) in its second quarter
after suering large losses on its fuel hedges.
It said it had changed its policy on fuel hedges, including a
shift to shorter contracts, after suering heavy losses. The
company lost 179m in the second quarter from pre-2009 fuel
hedges and a total of 430m in the second half. Source: FT,
2009
Remember This
Hedging
Investors want to reduce their risk by buying some quantity forward
Risk-reward
For a given level a risk, one wants to know the level of
performance he can get
Optimal strategy
From todays futures price curves, one would choose the optimal
quantity to buy through forward contracts for each commodity he
is selling.
Theoretical Framework
Univariate case - 2 factors HJM
We consider a classical two-factor model for commodity forward

prices, in which forward prices satisfy the following Stochastic
Dierential Equation (SDE) :
Assumptions of the model

dF (t, T )
= s exp( a(T t))dWts + l dWt
l
F (t, T )
s is the short-term maturity

l is the long-term maturity
a is the speed of mean-convergence
Through Ito for semi-martingales, we get:

1 aT X s +X l
V +e
F (t, T ) = F (t0 , T )e 2 t t
S(t) = limT !t F (t, T )

1 at X s +X l
V +e
S(t) = F (t0 , t)e 2 t t
With the following notations

Z t
s au s
Xt = s e dWu
t0
Z t
Xtl = l dWul
t0
Z t
2 2a(T u) a(T u) 2 u l
V = se + 2 s le + l dW u
t0
We can show the following properties of the forward price:
E[F (t, T )] = F (t0 , T )
V[F (t, T )] = F (t0 , T )2 (e V 1)

Which will prove to be a good way to check the consistency of our
forward simulations
Correction for future product delivery period
The equations discussed so far are only valid for future

products with instantaneous delivery. However that is never
the case in power markets
Z
1 T +
F (t, T , ) = F (t, u), du
T
dF (t, T , )
= ca, s exp( a(T t))dWts + l dWt
l
F (t, T , )
With the correction factor for futur product delivery period:
1 a
ca, = (e 1)
a

1 aT X s +X l
V +e
F (t, T , ) = F (t0 , T , )e 2 t t
S(t) = limT !t F (t, T , )

1 at X s +X l
V +e
S(t) = F (t0 , t, )e 2 t t

Z t
au
s
Xt = ca se dWus
t0
Z t
Xtl = l dWul
t0
Z t
2 2 2a(T u) a(T u) 2 l
V = ca se + 2 s le + l dW
u u
t0
Univariate Simulations for gas forward
Figure: Gas forwards

Univariate Simulations for gas spot
Figure: Gas spot simulation

Univariate Simulations for gas spot
Figure: Gas spot simulations mean

Multivariate case - 2 factors HJM
We consider a classical two-factor model for commodity forward

prices, in which forward prices satisfy the following Stochastic
Dierential Equation (SDE) :
Assumptions of the model

dFi (t, T )
= s,i exp( a(T t))dWts + l,i dWt
l
Fi (t, T )
s,i is the short-term maturity of asset i

s,i is the long-term maturity of asset i
ai is the speed of mean-convergence of asset i
Multivariate case - 2 factors HJM

1
V +e ai T X s,i +X l,i
Fi (t, T ) = Fi (t0 , T )e 2 i t t
Si (t) = limT !t Fi (t, T )

1
V +e ai t X s,i +X l,i
Si (t) = Fi (t0 , t)e 2 i t t

Z t
s,i ai u
Xt = s,i e dWus,i
t0
Z t
Xtl,i = l,i dWul,i
t0
Z t
2 2ai (T u) ai (T u) 2 l,i
Vi = s,i e + 2i,j s,i l,i e + l,i dW
u u
t0

1
V +e ai T X s,i +X l,i
Fi (t, T , ) = Fi (t0 , T , )e 2 i t t
Si (t) = limT !t Fi (t, T , )

1
V +e ai t X s,i +X l,i
Si (t) = Fi (t0 , t, )e 2 i t t

Z t
s,i ai u
Xt = ca,i s,i e dWus,i
t0
Z t
Xtl,i = l,i dWul,i
t0
Z t
2 2 2ai (T u) ai (T u) 2 u ul,i
Vi = ca,i s,i e + 2i,j s,i l,i e + l,i dW
t0
Correlated brownian noises
One needs to deal with and build the correlated Brownian motions
so as to simulate the dierent futures curve and spot prices. If we
draw a matrix of four independent standard normal variables Y , we
will obtain correlated variables by using:
1
Ycorr = 2 Y
Correlated brownian noises

With covariance equals to:
With the correction factor for futures product delivery period:

1 ai
cai , = (e 1)
ai
1 (ai +aj )
cai +aj , = (e 1)
(ai + aj )
Multivariate Simulations for gaz spot
Figure: Gas spot simulations

Simulations mean for gas spot
Figure: Gas spot simulations mean

Multivariate Simulations for oil spot
Figure: Gas
Oil spot simulations
Simulations mean for oil spot
Figure: Oil spot simulations mean

Estimation of parameters
Many of the model parameters are almost observable, if we have

sufficient historical data of futures curves at hand. In fact, S and
l could be approximated by the volatility of short and long-dated
continuous futures contracts, and by their empirical correlation.
In fact, for T ! 1, we can formally write:
dFi (t, T ) l
l dWt
Fi (t, T )
So a good approximation for the long-term volatility is:

m
X
1
l (ztLi L ) 2
m 1
i=1
Where:
m
1 X L
L = z ti
m
i=1
In fact, for T ! 0, we can formally write:
dFi (t, T ) s
l dWt
Fi (t, T )
So a good approximation for the long-term volatility is:

m
X
1
l (ztsi s ) 2
m 1
i=1
Where:
m
1 X s
s = z ti
m
i=1
We can also give an initial estimate for the correlation

parameter as:
m
X
1 (ztsi
s )2 (ztli l ) 2
=
m 1 s l
i=1
Estimation of parameters - Max Likelihood
These rough estimates could be used directly, or as input

parameters for a more rigorous statistical estimation
procedure. For example, we can use the maximum likelihood
method.
0 dF (t,T ) 1 0 1
i 1
Fi (t,T1 ) e a(T1 t) s (1 e a(T1 t) ) l
B C
zt = B ..
. C , Ht = B
@
..
.
..
.
C
A
@ A
dFi (t,TN ) e a(TN t) (1 e a(TN t) )
F (t,T ) s l
i N
is the model parameters vector
= (a, s, l , )
Then an Euler discretization of the SDE gives the equation:
zt = Ht xt , t 2 t1 , ..., tm
Where (xti ) are independents Gaussian 2-d vectors such that:
xti N (0, ), 1 < i < m
And:
1
=
1
The likelihood maximization could then be written as the

minimization of the function:
m
1 X
min L(xt1 , ..., xtm |) = log (det()) + xtTi 1
xt i
m
i=1
Where the xt , t 2 t1 , ..., tm are given by zt = Ht xt , i.e.:
xt = (HtT Ht ) 1
HtT zt
So, the model estimation procedure is equivalent to the following

minimization problem:
8 Pm
< min L(xt1 , ..., xtm |) = m1 i=1 log (det()) + xtTi 1 xti
:
= (a, s, l , )
Estimation of parameters - Results
Rough estimates of S, L and are used as initial point for the

algorithm.
Hedging - Risk Reward Curve
Hedging Strategy - Univariate Case
Since futures contracts are the most liquid assets in the

natural gas and oil market, and are strongly correlated to the
spot price, they form an ideal hedging instrument
One can use the simulated futures curve to hedge at time
t = t0
The basic idea of a financial hedging strategy is to add to the
physical spot trading, a strategy of buying and selling, at a
trading date tj , a quantity Q(Ti , Tj ) of futures contracts
F (Ti , Tj ) for 1 < j < m
One can write the cashflow of the hedging supplier as:

365
X 12
X TX
i +i
CF = V i Si + Qi (F (t0 , T , i ) ST )
i=1 i=1 T =Ti
There are two dierent strategies so as to build a risk reward curve

function of the quantities bought forward:
Computing analytically E(CF ) and V(CF ) and use the
subsequent closed formulas to build the risk-reward
environment.
Through the Monte-Carlo simulations, we can build the
risk-reward curve by computing E(CF ) and V(CF ) of the
dierent simulations. Simulating all the combinations of the
Qi s was very time-computational intensive.To solve this issue,
we operated in three dierent ways, yielding dierent results
Risk Reward Curve - Univariate Case
Computing analytically E(CF ) and V(CF ) and use the subsequent

closed formulas to build the risk-reward environment.
Since St = F (t0 , T , ), we get:
365
X
E(CF ) = Vt F (t0 , T , )
t=1
We can show that:

12
X X
V(CF ) = (Vt Qi )2 F (t0 , T1 , )(e V 1)
i=1 t2[Ti 1 ,Ti ]
Risk Reward Curve - Univariate Case, via Monte Carlo
First method: we simulate both Qgaz and Qoil from 0 to

Vmax
Second method: The Qgaz and Qoil are kept constant for
the whole year and drawn from 0 to yearly Vmax
Third method: We discretize the range [0, Vmax ] in 10
intervals and extract Qgaz and Qoil monthly from one of these
intervals
Through MC, First Method: both Qgaz and Qoil
Figure: First Method

Qaverage
Hedging coefficient represents the ratio Vaverage
Through MC, Second Method: Qgaz and Qoil are kept

constant for the whole year
Figure: Second Method

Qaverage
Through MC, Third Method: We discretize the range

[0, Vmax ] over 10 sub-intervals
Figure: Third Method

Qaverage
Hedging Strategy - Multivariate Case
In the case of the two-commodities model the cashflow is:

365
X
CF = Vi max(Sig , f
i Si )
i=1
12
X TX
i +i
+ Qigas (F gas (t0 , T , i ) STgas )

i=1 T =Ti
12
X TX
i +i
+ Qioil (F oil (t0 , T , i ) SToil )

i=1 T =Ti
Where:
F gaz (t0 , T )
i =
F oil (t0 , T )
Hedging Strategy - Multivariate Case
There are two dierent strategies so as to build a risk reward curve

function of the quantities bought forward:
Computing analytically E(CF ) and V(CF ) and use the
subsequent closed formulas to build the risk-reward
environment.
Through the Monte-Carlo simulations, we can build the
risk-reward curve by computing E(CF ) and V(CF ) of the
dierent simulations. Simulating all the combinations of the
Qi s was very time-computational intensive.To solve this issue,
we operated in five dierent ways, yielding dierent results
Risk Reward Curve - Multivariate Case
Computing analytically E(CF ) and V(CF ) and use the subsequent

closed formulas to build the risk-reward environment.
In order to try to calculate the expected value and the variance
of such cash flows, one need to get rid of max(Stgaz , T Stoil ).
After careful analysis this can be written as a spread option
and a long position:
max(Stgaz oil
T St , 0) + oil
T St
But we prefer to write it as a call option

gaz
St
max T,0
Stoil
Risk Reward Curve - Multivariate Case
Stgaz
We can study the dynamics of Yt = Stoil
:
F (t,T )gaz
At t = T , Y (t, T ) becomes F (t,T )oil
After multi-dimensional Ito, we get:
F (t, T )gaz F (t0 , T )gaz X1 +X2 X3 X 4 1

V (t0 ,t,T )
= e 2
F (t, T )oil F (t0 , T )oil
Where the Xi are the stochastic integrals derived from Ito,

and V the variance of dY (t,T )
Y (t,T )
But we get stuck when computing the corresponding expected
value...
Risk Reward Curve via Monte Carlo
First method: we simulate both Qgaz and Qoil from 0 to

Vmax
Second method: Qgaz is kept constant at 0 and Qoil varies
from 0 to monthly Vmax
Third method: Qoil is kept constant at 0 and Qgaz varies
from 0 to monthly Vmax
Fourth method: The Qgaz and Qoil are kept constant for the
whole year and drawn from 0 to yearly Vmax
Fifth method: We discretize the range [0, Vmax ] in 10
intervals and extract Qgaz and Qoil monthly from one of these
intervals
Through MC, First Method: both Qgaz and Qoil
Figure: First Method

Qaverage
Through MC, Second Method: Qgaz equal to zero and

Qoil varies
Figure: Second Method

Qaverage
Through MC, Third Method: Qoil is equal to zero and

Qgaz varies
Figure: Third Method

Qaverage
Through MC, Fourth Method: Qgaz and Qoil are kept

constant for the whole year
Figure: Fourth Method

Qaverage
Through MC, Fifth Method: Discretization of the range

[0, Vmax ] in 10 sub-intervals
Figure: Fifth Method

Qaverage
Std : Qgaz and Qoil constant

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
CEaR: Qgaz and Qoil constant

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
Std : Qgaz = 0 and Qoil varies

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
CEaR: Qgaz = 0 and Qoil varies

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
Std : Qoil = 0 and Qgaz varies

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
CEaR: Qoil = 0 and Qgaz varies

= 1, 0.75, 0.5, 0.25, 0, 0.25, 0.5, 0.75, 1
Distribution of Cash Flows
Figure: Distribution of Cash Flows

Distribution of Cash Flows for Two Commodities
Figure: Distribution of Cash Flows for Two Commodities

Distribution of Cash Flows for One commodity
Figure: Distribution of Cash Flows for One commodity

Optimal Hedging Quantities to minimize Variance One

commodity
Figure: Optimal Hedging Quantities to minimize Variance

Optimal Hedging Quantities to minimize Variance Two

commodities
Figure: Optimal Hedging Quantities to minimize Variance

Optimal Hedging Strategies for Oil and Gas

Diunggah oleh

Informasi Dokumen

Deskripsi Asli:

Judul Asli

Hak Cipta

Format Tersedia

Bagikan dokumen Ini

Bagikan atau Tanam Dokumen

Opsi Berbagi

Apakah menurut Anda dokumen ini bermanfaat?

Apakah konten ini tidak pantas?

Hak Cipta:

Format Tersedia

Optimal Hedging Strategies for Oil and Gas

Diunggah oleh

Hak Cipta:

Format Tersedia

Cross-Cutting Project

Optimal strategies for oil and gas hedging

FERRANTI Matteo, MARTINI Umberto, AKOUM

April 28, 2017

1 Whats the story and why do you care?

4 Hedging - Risk Reward Curve

How should private companies manage risk? Is it possible to

And we care because...

Air France-KLM, Europes largest airline, on Wednesday

Univariate case - 2 factors HJM

We consider a classical two-factor model for commodity forward

Assumptions of the model

s is the short-term maturity

Univariate case - 2 factors HJM

Through Ito for semi-martingales, we get:

S(t) = limT !t F (t, T )

With the following notations

Univariate case - 2 factors HJM

We can show the following properties of the forward price:

E[F (t, T )] = F (t0 , T )

V[F (t, T )] = F (t0 , T )2 (e V 1)

Correction for future product delivery period

The equations discussed so far are only valid for future

Correction for future product delivery period

Through Ito for semi-martingales, we get:

S(t) = limT !t F (t, T , )

With the following notations

Univariate Simulations for gas forward

Figure: Gas forwards

Univariate Simulations for gas spot

Figure: Gas spot simulation

Univariate Simulations for gas spot

Figure: Gas spot simulations mean

Multivariate case - 2 factors HJM

We consider a classical two-factor model for commodity forward

Assumptions of the model

s,i is the short-term maturity of asset i

Multivariate case - 2 factors HJM

Si (t) = limT !t Fi (t, T )

With the following notations

Correction for future product delivery period

Si (t) = limT !t Fi (t, T , )

With the following notations

Correlated brownian noises

Correlated brownian noises

With the correction factor for futures product delivery period:

Multivariate Simulations for gaz spot

Figure: Gas spot simulations

Simulations mean for gas spot

Figure: Gas spot simulations mean

Multivariate Simulations for oil spot

Simulations mean for oil spot

Figure: Oil spot simulations mean

Many of the model parameters are almost observable, if we have

In fact, for T ! 1, we can formally write:

So a good approximation for the long-term volatility is:

In fact, for T ! 0, we can formally write:

So a good approximation for the long-term volatility is:

We can also give an initial estimate for the correlation

Estimation of parameters - Max Likelihood

These rough estimates could be used directly, or as input

is the model parameters vector