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ENERGY In an efficient market, the magnitude of the change in price is influenced
by the size of the demand-supply imbalance to be corrected.
COMMODITIES This applies to both the short term and long term.
MG676 Increasing volatility and complexity of the energy commodities have made
it an attractive market for financial players including hedge funds.

For example, take the Arab Spring, which caused crude output to fall
There has been high volatility in the energy industry over the past few quickly and significantly.
years especially with regard to commodity prices. Oil prices rose from $92 per barrel in January, 2011 just prior to unrest in
The key factors that drive energy price volatility are structural and are Tunisia, to $120 per barrel in April after violence erupted in Libya.
likely to have a long-term impact. Irans threats to close the Strait of Hormuz, through which one third of the
Furthermore, significant events such as natural disasters, political worlds traded oil passes, energy analysts predict oil prices could rise 50
uncertainty, and corporate misconduct have spurred instability in the percent or more within days.
energy markets. Speculation about the closure alone has been known to keep oil prices
above $100 a barrel.



Price Risk: The risk of loss from changes in market price.

We have produced 100,000 barrels (bbls) of gasoline to sell into a highly
Basis Risk: Different price movements in different commodities due to priced market.
quality differences, timing or delivery, and locational differences.
Due to unforeseen circumstances, we cannot sell the barrels for another
Credit Risk: Risk of default due to bankruptcy, broken contracts, etc. month, and we fear that the market prices will drop in that time.
Operational Risk: Risk of transportation delays, off-spec cargoes, etc. Our target market is New York, so we shall sell the RBOB futures today to
Exchange Rate Risk: Risk due to fluctuations in currency movements. lock in the current market values.

Interest Rate Risk: Risk due to increased funding costs etc. The term "RBOB" shall mean Reformulated Regular Gasoline Blendstock
for blending with 10% Denatured Fuel Ethanol (92% Purity) as defined in
Weather Risk: Fluctuations in volume and hence profitability, due to the American Society for Testing Materials (ASTM) D-4806
weather events such as flooding and hurricanes.


Reformulated Gasoline Blendstock for Oxygen Blending (RBOB) refers to

Corporations use various hedging strategies to minimize or eliminate their
unleaded gas.
exposure to the risks listed above.
The NYMEX RBOB future is an outright gasoline contract between a
The goal of hedging is not to make a profit but to eliminate unwanted risk,
buyer and seller.
which may be done by locking in a profit.


This is a very simple example to show how hedging strategies can work.

Sell (short) NYMEX RBOB futures for current market value$125.00 per While the example shows how to lock in a margin, we can also participate
bbl in upward price movements and protect ourselves from decrease in
Buy (long) the physical gasoline barrel at market value$120.00 per bb
We will focus on price and basis risks and demonstrate how hedging
strategies can be effectively employed to mitigate these risks.


There has been a significant increase in commodity prices, especially in

Here, we have locked in a profit of $5/bbl.
oil and natural gas in recent years.
Assuming a 100 percent correlation between the physical and financial
This volatility is reflected in the fluctuations in gasoline and electricity
markets, we will make a profit of $5/bbl regardless of whether the market
moves up or down.
Price behavior is influenced by cost, market structure, and various
macroeconomic factors that dictate the demand-supply scenario.
Soll (short) Buy back @ Future lose $5/bbl
NYMEX@$125 $130
Long physical @ Sell @$ 125 Physical Gains $5/bbl $5 profit/bbl



One key factor driving price that is monitored closely is the inverse
relationship of commodity price to the value of the U.S. dollar.
One of the main reasons for the impact of the dollar on commodity prices
is that commodities are priced in dollars.
When the value of the dollar drops, it will take more dollars to buy
The relationship between crude futures and the U.S. dollar index is a
good example to illustrate this.



Global imbalances remain an issue as long as unemployment remains

On the other hand, Asian equity markets are gaining strength, and some
of the recent economic releases for Asia suggest a strong momentum.
The sudden demand growth in the Asian economies, especially China
and India, has resulted in a resource scarcity.
Many middle-income and emerging countries are also growing rapidly as
a result of better economic policies and financial stability.
As a result, production costs are spiking, resulting in an increase in
commodity prices.


The major fluctuations in the oil market, at least in the short term, seem to
However, there exist long lead and lag times in this relationship, and be totally divorced from actual supply-and-demand fundamentals.
hence it takes some time for the inflation factor to start trickling down. Therefore, it is imperative to cap the total value of speculative positions in
A weakening dollar for example has served to mask a larger systemic any commodity market.
weakness in the market. This would help regulate the number of pure speculators in the market
against businesses who buy futures to hedge their risk.


Absolute prices of energy products are no longer driven solely by the

fundamental factors; the influence of the flow of funds across a wide
range of commodities will drive absolute movement and will result in
The biggest expense for an airline company is aviation fuel (jet fuel).
continued volatility.
Their ideal goal would be to hedge the risk of higher fuel prices.
It has been widely noted that the huge capital inflow from hedge funds,
financial trades, and other long-term investors is invested in energy (oil) Due to the lack of active jet fuel markets, these companies hedge their
futures to reap a quick profit rather than to hedge risk. risk using derivatives on crude oil.
This in turn is creating artificial demand and driving up the price for



Jet fuel is refined from crude oil, so theoretically their
prices should move together.
However, this relationship does not always hold and
the risk associated with this imperfect correlation is
called basis risk.
Risk due to difference in the quality of the underlying asset and the
Basis risk is therefore the risk in price changes
between a futures/forward market and a cash/spot
market. For example, a person trying to hedge jet fuel with heating oil is exposed
to quality basis risk.


1. Locational Basis Risk:

Risk due to difference in the delivery location of the underlying asset and Risk due to difference in maturity period of the underlying asset and the
the hedge contract. Consider, a natural gas producer in Alberta, Canada, hedge.
hedging with NYMEX futures.
For example, hedging gasoline to be delivered in August with an October
The producer is still exposed to the basis risk between Henry Hub (the futures contract.
pricing point for NYMEX natural gas futures contracts) and the spot
market in Alberta.


When there is a physical asset involved, there is a cost of carry.

Cost of carry is the cost incurred while holding or carrying a position and
The basis (futures price minus spot price) might increase or decrease includes interest on the securities, storage, inventory shrinkage, and
depending on storage and handling costs, interest rates, transportation insurance.
costs from the current location to the futures delivery point, supply-
demand balance in the spot market, and other cash flows generated by Speculators trade on the cost of carry using the spread between the
the underlying asset. futures and the underlying spot asset.

Supply and demand factors determine the shape of the futures curve.
Factors such as cost of carry, interest rates, and so on affect demand and
Hedging helps to reduce the exposure to basis risk but does not eliminate
it completely. The futures curve also moves up or down as market participants keep
changing their view of the future expected spot price.
Quite often, people trade on the spread between the underlying asset in
the spot market and futures contract and this is known as basis trading. Ultimately, futures converge to spot, and basis converges to zero upon
maturity of the futures contract.


For example, consider a futures contract purchased on September 19,

A positive basis indicates that the futures price is higher than the 2011, that is due to expire in six months.
expected future spot price and hence, a positive cost of carry; this implies Assume that the expected future spot price is $100. If the price of the
that markets are in contango. futures contract is $120 today, the futures price is more than the expected
Contango refers to a situation where the future spot price is below the future spot price and hence a contango.
current price, and people are willing to pay more for a commodity at some In six months, the futures price must drop (unless the expected future
point in the future than the actual expected price of the commodity. spot price changes), so this is a perfect time to short the contract!

The futures price will therefore decrease with time to converge to the
expected spot price and benefit speculators who are net short.
Oil futures contracts are delivered every month. The back months are
A negative basis indicates that the futures price is lower than the
expected future spot price and hence a negative basis; this implies that usually priced slightly higher reflecting the cost of carry, indicating a
markets are in backwardation. contango market.
However, this market can also be in backwardation.
Backwardation is essentially the opposite. It occurs when the delivery
price of a futures contract must converge upwards to meet the futures Contango is a situation where the futures price (or forward price) of a
price. It occurs in an "inverted futures curve" environment. Essentially, commodity is higher than the expected spot price.
on the maturity date, the futures price will converge higher to the spot
Normal backwardation, also sometimes called backwardation, is the
rate. This means that a commodity is worth more right now than it is in
market condition wherein the price of a forward or futures contract is
the future.
trading below the expected spot price at contract maturity.
Speculators who are net long prefer this market, as they want prices to



For example, in the event of a natural disaster such as a hurricane,

supply tends to get disrupted and prices of commodities (such as
natural gas) spike upward.

The figure above shows the forward curves for West Texas Intermediate
Buyers who need natural gas immediately would be willing to pay the high (WTI) crude and Brent crude respectively.
price, but for investors in the futures market this is good news.
WTI as the name suggests is Texas crude traded on the CME while Brent
They make profits by rolling the futures (sell and buy new contracts) at a is North Sea crude traded on ICE.
discount as the expiring contracts trade at a premium to the back-dated
contracts being purchased. WTI is in contango while Brent is in backwardation.

What ultimately profit or hurts the speculator is any unexpected change in This means a trader/hedger would get a premium by rolling forward
the basis! month to month short WTI futures or long Brent futures.


Historically price differences between Brent and other index crudes

have been based on physical differences in crude oil specifications and Many reasons have been given for this widening divergence ranging
short-term variations in supply and demand. from a speculative change away from WTI trading (although not
Prior to September 2010, there existed a typical price difference per supported by trading volumes), Dollar currency movements, regional
barrel of between 3 USD/bbl compared to WTI and OPEC Basket; demand variations, and even politics.

however, since the autumn of 2010 Brent has been priced much higher The depletion of the North Sea oil fields is one explanation for the
than WTI, reaching a difference of more than $11 a barrel by the end of divergence in forward prices.
February 2011 (WTI: 104 USD/bbl, LCO: 116 USD/bbl).

In February 2011 the divergence reached $16 during a supply glut, The US Energy Information Administration attributes the price spread
record stockpiles, at Cushing, Oklahoma before peaking at above $23 between WTI and Brent to an oversupply of crude oil in the interior of
in August 2012. North America (WTI price is set at Cushing, Oklahoma) caused by
It has since (September 2012) decreased significantly to around $18 rapidly increasing oil production from Canadian oil sands and tight oil
after refinery maintenance settled down and supply issues eased formations such as the Bakken Formation, Niobrara Formation, and
slightly. Eagle Ford Formation.


Oil production in the interior of North America has exceeded the

A riskless arbitrage situation assumes perfect futures market, no taxes, no
capacity of pipelines to carry it to markets on the Gulf Coast and east
transaction costs, and short selling of the commodity.
coast of North America;
For example, consider the contango situation described above in WTI
as a result, the oil price on the US and Canadian east coast and parts
of the US Gulf Coast since 2011 has been set by the price of Brent
Crude, while markets in the interior still follow the WTI price. If an investor bought 10 WTI contracts for $96.50/bbl and sold them in the
forward market at $104.50/bbl, the investor would make a gross profit of
Much US and Canadian crude oil from the interior is now shipped to the
$8/bbl before storage, transportation, and other miscellaneous costs.
coast by railroad, which is much more expensive than pipeline.


Price imbalances may occur due to locational differences, structural

Arbitrage is the simultaneous purchase and sale of the same securities or disparity between exchanges, differences in contract expiration dates,
commodities in different markets to take advantage of unequal prices, the demand supply disruptions, or even market perceptions.
profit being the difference in market prices.
Therefore, multiple factors need to be considered to see whether there is
Arbitrageurs take advantage of such a situation by buying at a lower price an open product arbitrage, such as price differentials, transportation
in one market and selling at a higher in another market costs, insurance, tolls/port charges/import duties, differences in product
specifications, and so forth.


One of the key factors for arbitrage economics is transportation cost. The key factors to be considered in this case are:
An arbitrage is considered open only if the price differentials are wide Transportation costs from the North Sea to U.S. Gulf Coast.
enough to offset the transportation costs.
Seaway Pipeline tariffs.
For example, refiners choose between competing crudes from across the
globe on a daily basis.

Premium for quality differencesBrent contains around 0.37 percent

sulfur compared to WTI, which has only 0.24 percent sulfur (the lower the
sulfur, the sweeter the crude).
Approximate transportation period is 3035 days.
This crude arbitrage is mainly affected by the value of the end products
that can be extracted from the different crudes. This means that todays Brent prices should be compared with WTI prices
in 3035 days, hence the WTI prices need to be adjusted for this market
There exists a difference (spread) in crude prices at Cushing, OK (WTI) structure effect.
and North Sea (Brent) as discussed previously.
Two of the most common arbitrage (arb) situations in commodities are
storage arbs and the existence of an open product arb to or from key



The presence of a storage arb is determined by:

1. Price of the physical commodity in the cash market
2. Futures price of the physical commodity
3. Storage and transportation costs

A storage arb exists if the cash price plus storage and associated costs
are less than the futures price; then we can get paid to store the If at the time of delivery, the spot market is trading above the NYMEX, we
commodity and sell it out in the future. can buy the futures and sell the product in the spot market.
The solid lines in Exhibit 17.4 show the forward curve minus the cash On the other hand, if the spot is trading below the NYMEX, we need to
price at a given point in time. deliver the product to NYMEX to realize the full potential of the trade.
The larger shaded area is the storage cost and gray area is the cost of Consider moving gasoline from northwest Europe to New York Harbor
money over time. (NYH).
If for example, we had purchased spot distillates in August, stored till This would involve availability of ships, docking space, offloading
February and simultaneously sold February futures, we could have made capacity, and more.
$0.15 per gallon.


This arb averaged around 14.50 cents/gal in 2011 with a range of 825
The presence of an arbitrage situation can be determined by examining cents/gal.
three components:
In October 2011, certain refinery-related announcements caused a rally in
1. Price of gasoline in Europe the NYMEX RBOB prices.
2. Price of gasoline in New York This created an arbitrage opportunity for European exports of gasoline,
3. Freight cost from Europe to New York and other costs despite low consumption levels in the United States.

A positive arb number indicates open arb while a negative arb numbers
indicates closed arb.

European gasoline is quoted in metric tons while NYH gasoline is quoted Other costs, such as port charges, cost of spill insurance, product loss
in gallons. cost, and so forth, are also used in determining whether an arb is open or
closed, as they add a few cents per barrel to the product cost.
Converting to equivalent units (1 metric ton = 358 gallons), we have
This cost is however very minimal and therefore not usually considered in
arb calculations.



The objective of hedging is to mitigate the risk of any adverse movements

A short hedge protects the commodity producer/owner from the risk of
in prices, and there exists a strong positive correlation between the spot
falling prices. It implies shorting a derivative contract to hedge the asset
and futures prices.
held in the long position.
The majority of the futures contracts do not result in an actual delivery;
The producer has therefore eliminated the risk of price change by locking
they end up being liquidated. Individuals or businesses can reduce their
in a floor and ceiling price, subjecting themselves to a basis risk.
exposure by hedging with futures or hedging with options.
Short hedges work well if the basis improves (decrease in spot price) as
Futures hedging mitigates price risk with the gain/loss in the futures prices
seen in the example below.
while a gain in option value reduces negative price risk.


An oil refiner has entered into a contract to sell 420,000 gallons of regular
unleaded gasoline to be delivered in December 2011.
Companies or businesses can hedge themselves from the extremely The parties agreed to use the futures settlement price on the delivery day
volatile energy markets by taking a short/long position in the futures as the sale price.
The contract was entered into in September 2011; the spot price at that
Futures hedging is of two typesshort hedges and long hedges time was $3.55/gallon and the futures price for delivery in 3 months was
depending on whether you are a net consumer (i.e., use a long hedge $3.58/gallon.
position) or producer (i.e., use a short hedge position).
Based on historical seasonality trends, the refiner feels that gasoline
prices will dip in the winter months and so she enters into a short position
for 10 contracts (1 contract = 42,000 gallons) at $3.58/gallon.



As expected, gasoline prices fell to $3.00/gal on the delivery date, and the
refiner has to sell the gasoline at this price according to the sales A long hedge protects the commodity consumer/buyer from the risk of
contract. increasing prices.
The refiner also buys back the future contract at $3.00/gal to close her The long hedger therefore buys futures to hedge his position as he
short position. benefits from a decline in basis (increase in spot price).
Assume that the transaction involves no commissions.
The proceeds from this sale can be summarized as follows:

Gain from sale of gasoline $3.00 * 420,000 $1,260,000

Gain on the futures (3.58 3.00) * 420,000 $243,600 A power company has to buy 500,000 MMBtu of natural gas in three
Net Gain $1,503,600 The spot price of natural gas in March 2011 was $3.95/MMBtu, and the
futures price for delivery in three months was $3.98/MMBtu.
This is equivalent to selling 10 contracts at The company wanted to hedge against an increase in natural gas prices
and decided to take a long position at $3.98/MMBtu for 50 contracts (1
$3.5800/gallon. contract = 10,000 MMBtu)



Three months later, natural gas prices rose almost 11 percent, and the Option hedges are analogous to insurance policies; we pay a premium to
spot price on the delivery day was $4.38/MMBtu. mitigate the risk and execute the option when prices move against us.
Since the company entered into the long hedge position at $3.98/MMBtu, Options provide you the right but not the obligation to take a particular
they had a futures gain. position on the underlying futures.
The transaction details are recorded here: There are two types of optionsput and call


Purchase price of $4.38 * 500,000 $2,190,000

natural gas

Gain on the futures (4.38 3.98) * $200,000 A put option sets the floor price for the commodity.
500,000 This gives the option holder the right but not the obligation to take a short
position in the futures at a certain strike price for a premium.
Net Payable $1,990,000 The difference between the strike price and the premium is the profit for
the option holder.

This is equivalent to buying 50 contracts at $3.98/MMBtu.




A call option sets the ceiling price for the commodity. The risk management function has progressed to become a core
business area mainly driven by investors and the board, not just to hedge
This gives the option holder the right but not the obligation to take a long
against losses but also to gain a competitive advantage.
position in the futures at a certain strike price for a premium.
The hedging process in most corporations is usually a five-pronged
The difference between the strike price and the premium is the maximum
approach as shown in the figure below.
price paid by the option holder for the commodity.


The option holder has the right to exercise the option or let it expire or
offset it by transferring the rights to a third party.


Organizations need a systematic way to ensure that all their significant

exposures are being captured in the decision-making process.
The idea is to leverage analytical expertise to establish short, medium,
The entire process has now shifted from simply responding to threats to
and long-term points of view and thereby support the decision-making
meeting the expectation of investors and stakeholders and improving the
activities of other corporate functions.
reputation of the organization.


1. Creating risk awareness by educating the organization, especially the
senior management, on practical aspects of risk management
2. Identifying and analyzing current exposuresfinancial, operational,
political, and reputational
The risk management process involves establishing the strategic and 3. Assessing the risk appetite and its likelihood, magnitude, and impact.
organizational context such as nature of the business, inherent risks in
4. Defining the tolerance level based on past experiences and operational
the business, and so forth along with risk awareness.
Organizations need a systematic way to ensure that all their significant
5. Examining the financial instruments/derivatives available in the market
exposures are being captured in the decision-making process.
to mitigate exposure to the identified risks.
6. Measuring the likelihood and impact of the risk.
7. Setting strong controls and governance.


Organizations with effective risk management models and tools perceive

Most organizations have a risk management committee that defines their
risk as an uncertain event that can be identified, measured, monitored,
risk appetite.
mitigated, and eventually leveraged.
This is usually a corporate function at a central level that consolidates the
The concept of risk is not new to the energy industry and the oil sector in
risk across different business units and implements the risk management
The development of enterprise-wide risk management (ERM) strategies
They are in turn supported by a mid-office function that keeps track of
has become important.
policy compliance and risk reporting.
However, there exist many unexplored risks providing an opportunity for
The key function of this committee is to establish guidelines, limits, and
organizations to design strategies that cover a wider spectrum and
triggers for routine risk exposures.
thereby gain a competitive edge.


The key task of the risk management infrastructure is to monitor price risk,
basis risk, and any kind of operational risk across the different business
Some of the conventional risk-management techniques taught in
classrooms are not applicable in the real world.
Price risk exposure for example can be mitigated by purchasing hedging
In fact, no forecasting model predicted the impact of the 2008 economic
instruments such as options or swaps or by structuring contracts that cap
the companys exposure to increasing prices.
This is a perfect example of a Black Swan eventevents with a low-
Most of the companies maintain a book structure that helps identify,
probability and high-impact that are almost impossible to forecast.
measure, and monitor risk-return of individual activities as well as for
providing information across business units. The complex environment in which we live increases the incidence of
such events and makes forecasting them even more difficult.
The risk assessment and mitigation functions are integrated with
performance review mechanisms such as bonus metrics.


Performance measurement is vital in determining the effectiveness of the

One of the key mistakes made by energy companies is to consider hedging strategy.
hedging as a source of revenue.
Therefore, it is important to define certain key performance indicators
Hedging should only be used as a tool to protect against a fall in prices (KPIs) that have an impact on the companys bottom line (such as
and thereby provide a revenue certainty. liquidity, EBITDA, etc.).
Most of the slip-ups in these companies are a result of a poor hedging EBITDA is essentially earnings (net income with interest), taxes,
policy and/or absence of a hedging strategy. depreciation, and amortization added back to it, and can be used to
Hedging decisions should never be based on the companies point of analyze and compare profitability between companies and industries
view regarding the future prices. because it eliminates the effects of financing and accounting decisions.

All this in turn can be attributed to the lack of clarity in governance. The choice of KPIs is critical and should be closely linked to the
objectives of the hedging strategy.

Organizations tend to overlook the volatility in todays market and

Exotic hedge strategies can prove to be disastrous if they are not
economic factors.
structured well.
The current uncertainty in the economic situation demands a more
Costless collars are not always the best hedging tools.
systematic and pragmatic risk management approach.
If not hedged dynamically, they can lead a company to bankruptcy.
The absence of a risk management committee to clearly delineate and
communicate the individual roles and responsibilities, set hedging goals For example, in late December 2010 a crude oil producer expected Brent
and objectives, and monitor them on a constant basis leads to a highly prices to decline, when the prompt contract was trading in the $85 range.
disorganized hedging process and lack of transparency in communicating
So, the producer entered into a costless collar: $77 put option (floor) and
the strategies to the stakeholders.
$97 call option (ceiling) for 2011.


Dated Brent prices averaged around $112/bbl in 2011, meaning the

producer had $15/bbl on the table, and also tied up a line of credit until
the positions expired at the end of the year.
A better hedge would have been the purchase of an outright put option or
a three-way option such as the purchase of an additional call option with a
higher strike price to mitigate the exposure of being short the $97 call

There has been a considerable increase in investment in emerging assets

and unconventional resources.
Energy companies need to plan carefully, develop strategies for effective
capital management, and be prepared to adapt to industry and economic
changes quickly.