Energy price risk

1.Tom James Energy Price Risk

2. ENERGY PRICE RISK 3. Energy Price Risk TOM JAMES 4. Tom James 2003 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. The information presented in this book has been derived from sources believed to be accurate and reliable, but it has not been independently verified in all cases. Accordingly, neither the author nor the publisher gives any representation or warranty of the accuracy, completeness or currentness of such information. The methods and examples in this book are only intended to demonstrate the relevant concepts in general terms. They may have to be adjusted or modified to be applied to real transactions. Moreover the information in this book is not intended as financial advice or as a recommendation for any financial transaction. Neither the author nor the publisher is liable for any actions prompted or caused by the information presented in this book. Any views expressed herein represent those of the author and do not necessarily represent the views of Carr Futures or its affiliated entities. First published 2003 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martins Press, LLC and of Palgrave Macmillan Ltd. Macmillan is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1403903409 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 07 06 05 04 03 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne 5. Contents Foreword xi Preface xiii 1 Risk Management 1 The Risk Matrix 1 Financial Risks 2 Basis Risk 3 Legal, Operational and Tax Risks 6 Summary 7 2 Energy Derivatives Markets: On-Exchange and Off-Exchange 8 On-Exchange and Over-the-Counter 9 Futures 10 Swaps and Options 15 Summary 24 Generally Accepted Oil Conversion Factors Used in the Derivatives Industry 30 Generally Accepted Gas Conversions 31 Volume 31 API Gravity and Density/Volume per Tonne 32 Power and Gas Conversion Factors 32 3 Energy Futures Contracts 33 Introduction 33 Key Facts About Futures Contracts 33 Futures Options Contracts 35 Hedging in Futures Markets 36 Exchange of Futures for Physicals (EFP) and Deliveries via Futures Markets 37 IPE (London) Brent Crude Futures Contract Specification 44 Ipe (London) Brent Crude Options Contract Specification 44 v 6. IPE (London) Gasoil Future Contract Specification 46 IPE (London) Gasoil Options Contract Specification 47 IPE Natural Gas Futures Contract Specification 48 NYMEX WTI Light, Sweet Crude Oil Futures 49 WTI Light, Sweet Crude Oil Calendar Spread Options 52 NYMEX Heating Oil Futures 53 NYMEX New York Harbor Unleaded Gasoline Futures and Options 56 NYMEX Henry Hub Natural Gas Futures and Options 58 TOCOM Tokyo Commodity Exchange Middle East Crude Oil Futures Contract 60 TOCOM Futures Contract Specifications Kerosene 63 TOCOM Futures Contract Specifications Gasoline 66 Coal Futures 68 Central Appalachian Coal Futures 69 4 OTC Energy and Related Derivative Markets 72 OTC Energy Derivative Markets 72 The OTC Oil Derivatives Market 73 The Key Oil and Gas Related OTC Swaps 78 European Power and Gas Markets 81 Global Power Markets With Developed or Developing Derivatives Markets 81 European Gas Markets 85 European Coal Swaps (Cash Settled not Physical Settlement) 88 Weather Derivatives 91 Developments Freight Rate Swaps (Cash Settled) 96 Derivatives Forward Curve Assessments 97 5 Options Trading and Hedging Application Strategies 107 Volatility 108 Types of Options 110 Option Strategies for Hedging Energy Price Exposure 110 The Greeks 111 Option Strategies 113 OTC Options and Popular Structures 115 Options Trading Volatility Trading 119 6 Energy Option Pricing Which Models Are Used? 125 Types of Options in the Energy Markets 125 General Rules for Option Values 125 Types of Options Models Utilised in the Energy Industry 127 Option Pricing Bibliography 128 vi CONTENTS 7. 7 Value At Risk and Stress Testing 130 A Risk Management Scenario 130 VAR and Other Risk Measurement Methods 131 What Does VAR Do? 133 Variance/Covariance VAR 134 Historical Simulation VAR Method 135 Monte Carlo VAR Simulation (Stochastic Process) 136 VAR Recap 137 VAR to Illustrate Hedge Effectiveness 137 Stress Testing and Value-At-Risk 138 Summary 140 8 Questions to Ask When Establishing a Risk Management or Trading Program 141 9 Management Controls 145 The Collapse of Barings 145 The Lessons of History 147 Creating a Risk Management or Trading Policy 149 Corporate Derivatives Risk Management Policy and Procedures Document 152 Back Office Systems 153 Role of External or Internal Audit and Compliance 158 A Risk Management Review 159 The Collapse of Enron, 2001 160 10 An Eavesdroppers Guide to Hedging 164 Nine Great Sayings on Hedging Heard in the Market With Comments 164 Conclusion 166 11 Operational Risk 167 Key Components of Operational Risk 167 Assessing and Controlling Operational Risk 169 Gathering Information on Operational Risk 172 Operational Risk Reduction, Control and Containment 173 Summary 175 12 Derivatives Contracts Application Listing and Some Hedging Scenario Examples 176 What is Hedging? 176 General Recap on Energy Derivatives 177 Energy Derivatives Selection Grid 177 Hedging Application Examples 178 CONTENTS vii 8. 13 Risk Management Process and Policy Creation Guidelines 201 The Risk Management Process 201 Trading Controls Position Limits 203 Some Key Guidelines for a Risk Management Policy 205 14 Applied Technical Analysis in the Energy Markets 211 What is Technical Analysis? 212 The Principles of Technical Analysis 213 The Technical Analysis Bar Chart 213 Other Types of Chart 219 Price Gaps as Price Targets 222 Fibonacci Retracement Levels 224 Mathematical Indicators 225 Moving Averages 228 Chart Patterns 228 Summary 240 15 After Enron A Practical Guide to Credit Control and Risk Mitigation Methods 241 The Collapse of Enron 241 Methods for Managing Credit Risk Exposure 244 Ways to Reduce Credit Risk via the ISDA Schedule 246 Collateralisation 249 Guidelines for Taking Collateral From Counterparts 250 Credit Insurance 252 The New Tool of the Trade Credit Default Swaps (CDS) 253 The Development of the CDS Market 260 Total Return Swaps 262 Credit Risk Mitigation via Clearing Houses 263 Management Guidelines on Establishing a Credit Control Framework 266 16 Finance in Energy 268 Credit Status in the Energy Sector 268 Financing Using Derivative Structures 276 17 OTC Derivatives Legal Risk Control and Documentation 286 The ISDA Agreement 287 The ISDA Master Agreement 287 ISDA Publications 288 Pre-Confirmations and Long-Form Confirmations 289 ISDA Documentation Processing 290 Trading Before an ISDA is Signed 293 ISDA Master Agreement Schedule 293 viii CONTENTS 9. Step by Step Explanation of a Typical ISDA Master Agreement Schedule Between a Trader and a Bank 294 Additional Notes 311 Proposed ISDA Changes 311 The Advent of Independent Sources of Data that can be Applied to Replacement Value Calculations 315 Arbitration 315 18 International Accounting Standards for Derivatives 317 Introduction 317 Consolidation and Clarification of Accounting Standards Since 2001 319 FAS 133 Effective From 1 January 2001 in the USA 320 International Accounting Standards Board (IAS) 323 FRS 13 UK Accounting Standards Board 327 Closing Note 328 Totem Risk 331 19 Glossary of Terms 337 Appendices 1 Example of a Risk Management Review of a Company Using Derivatives to Hedge Oil Requirement 442 2 The Main Energy Sector and Transportation Names/Credits Traded in the CDS Market (September 2002) 457 3 The ISDA Master Agreement 461 4 Example Derivatives Trade Confirmation Under ISDA 486 Index 000 CONTENTS ix 10. Foreword Roy Leighton When Lord Keynes travelled to Bretton Woods in 1944 in his briefcase were four files to be decided upon by distinguished world financial leaders as the basis for stable economic growth and recovery after the Second World War. Three of these files came to fruition in institutions which we know today as the World Bank, WTO and IMF. The fourth file never saw the light of day the World Commodity Fund (WTF) this was considered too big a challenge for struggling post-War economies. Since then, the best brains of governments and business have tried to solve the economic problems of commodity-dependent countries and businesses. They have experimented with buffer stocks, price support mechanisms and other ideas, but most of these schemes have failed and been an expensive waste of scarce donor aid. In the UN and at the World Bank there is much talk of the Debt Problem of the Third World, but in many cases debt is only the symptom the reality is a Commodity Problem. Fortunately, today the modern financial services industry has developed risk management instruments to manage volatile commodity markets, and these tools are now being recognised by multilateral institutions as the viable alternative to wasteful traditional projects designed to aid poor countries. Risk management in energy is a top priority for heavily indebted poor countries. For the first 70 years of the twentieth century the price of energy was fairly stable, despite world conflicts, and the business of energy was largely conducted between governments and multinational blue chip corporations. Suddenly it all changed in 1973, when the Middle East realised the true value of their black gold and oil prices shot up as OPEC asserted powers over supply. Since then the volume of activity on open and transparent trading markets has soared; initially in oil, then in gas and nowadays electricity and weather. Hedging activities have flourished, initially for high energy consumers airlines, aluminium smelters, electricity generators and the like. Today xi 11. no equity investment analyst presentation for these types of companies is complete without a clear explanation of the hedging strategy and position. Energy producers are now following the hedging approach of consumers due to the economic chaos brought about by unhedged exposure to crude oil which quite recently saw prices of US$10 per barrel and US$28 per barrel within an 18 month period. Too often in derivatives the potential user of these price risk instruments is blinded by a blend of trading jargon and mathematical formulae. You dont need to know how to price derivatives mathematically to be able to shop around and use them effectively. This book demystifies todays world of risk management and effectively explains to the reader the mitigation tools and strategies available in the market. Failure to utilise such risk management tools is truly to speculate. Roy Leighton Chairman: European Advisory Board Crdit Lyonnais SA Futures & Options Association xii FOREWORD 12. Preface The relationship between risk and reward is at the heart of business. In any endeavour, the risk of heavy losses is seen as a justification for hand- some returns, while lower risk enterprises command more modest margins. Perhaps for this reason, the most risky and rewarding businesses are sometimes portrayed as a species of high-stakes casino. But such a comparison is misleading. All successful businesses must learn to assess and manage risk in ways that allow them to exploit opportunities while limiting their exposure to unpredictable factors in their operating environment. The more volatile the market, the more important this process of risk management becomes. The energy industry and its associated markets certainly experience more than their fair share of volatility. Indeed, historians use the more turbulent incidents in the industrys recent past (the oil price shock of 1973, the Gulf War of 1991) as key mileposts in general economic history. So its no surprise that, over the years, the energy industry has honed risk management into a fine art, although still perhaps not an exact science. One of the key concepts in this fine art is the use of derivatives: financial instruments that derive their value from an underlying asset. Deriva- tives contracts allow some players in a market to hedge their risks while others take advantage of the opportunities that such hedging provides. As in other financial markets, the three main tools are futures, options and swaps. A futures contract is a way of agreeing to buy and sell an asset for delivery at a future date, while an option is a contract which confers the right, but not the obligation, to do so. A swap is an agreement to fix a price in an otherwise floating market. The idea of using derivatives in the energy market has been around for many years. The first Heating Oil (Gasoil) Futures contracts were traded on the New York Mercantile Exchange in 1979 and the first oil swap was reported in 1986 (between a bank, an oil trader and an Asian airline). But it was the Gulf War of 1991 that really brought the market to life. The perceived threat to the worlds oil supplies posed by Saddam Husseins invasion of Kuwait in August 1990 caused the price of crude oil xiii 13. to jump by over 50% in a single month and the markets have never forgotten that brutal lesson. Since then, the continuing tensions in the Middle East, changes in legislation and the ongoing deregulation of economies and markets around the world have introduced more and more businesses to the risks and rewards of the volatile oil, power and gas markets. The result is that the demand for energy derivatives has increased exponentially over recent years. This book aims to provide a practical introduction to the trading of energy derivatives and their use as tools of price risk management. These are normally considered to be highly specialised activities, but this does not mean that they should be treated in isolation. Energy derivatives cannot be properly understood or effectively used unless they are considered as part of a bigger picture. When a company chooses to control price risk through the use of derivatives it may find that it increases the risks in other areas of its business; for example, it may increase its operational, legal or tax risks. For this reason, this book covers many of the issues and topics surrounding energy price risk management to ensure that the use of derivatives does not cause any unwanted or unplanned difficulties. Tom James [email protected] xiv PREFACE 14. CHAPTER 1 Risk Management In most financial markets there are a fairly small number of fundamental price drivers which can be easily translated into pricing and risk management models. In currency markets, for example, the commodity that has to be delivered is cash, a piece of paper which is easily stored, transferred and not sensitive to weather conditions. But energy markets are concerned with bulky, dangerous commodities that have to be transported over vast distances through some of the most politically unstable regions of the world. This means that there are a large number of factors that can affect energy prices. A fairly short list might include: the weather, the balance of supply and demand, political tensions, comments from country leaders, decisions taken by OPEC, analysts reports, shipping problems, and changes to tax and legal systems. All these contribute to the high levels of volatility in energy markets which often experience sudden price movements from one day to the next, or even from one minute to the next. THE RISK MATRIX One way of understanding how these factors combine to influence energy prices is to use the risk matrix pictured in Figure 1.1. It illustrates how all the risks shown interrelate and affect one another and makes it clear that relationships between them are never two-dimensional. It also makes the point that it is impossible to manage price risk effectively without reviewing all the other risks that an individual or a firm may face. As the matrix shows, the key risks to be managed in an organisation when using derivatives for trading or price risk management purposes are: credit risk, liquidity risk, cash flow risk, basis risk, legal risk, tax risk and operational risk. All these risks will have a direct bearing on which derivatives are employed and the choice of trading partner. They will also affect decisions on where trading takes place (which is dependent on 1 15. jurisdiction and tax risk), and how much is traded (which will depend on operational risks). FINANCIAL RISKS Price risk This is the risk of losing money as a result of price movements in the energy markets and is sometimes referred to as market risk. Typically, producers will lose money when prices fall, while users will find themselves out of pocket when prices increase. Credit risk Credit risk is the risk of financial losses due to the counterpart to a contract defaulting. It is often said that a hedge contract is only as reliable as the credit standing of the counterpart and credit risk management has moved to the top of the priority list for the energy industry. The credit crunch felt in the USA energy sector in the aftermath of the Enron disaster has prompted energy traders to review credit policies and also review effective methods to control and reduce credit risk wherever possible. Liquidity risk In the context of this book, this is the risk of losses caused by a derivatives market becoming illiquid. This happened during the Gulf War when there was so much volatility in the markets that many banks and oil traders would not give a bid or offer price. Companies who were exposed to those 2 ENERGY PRI CE RI SK C T L Ca b Le Or P Price risk P Credit risk C Liquidity risk L Cashflow risk Ca Basis risk B Legal risk Le Tax risk T Operational risk Or FIGURE 1.1 The risk matrix 16. markets at the time were sometimes unable to close out their positions or could only do so at great cost to themselves. Cash flow risk This is the risk that an organisation will not be able to produce the cash to meet its derivatives obligations. In the late 1990s, Korean Airlines found itself in this kind of situation and suffered heavy losses as a result. The company had been hedging against movements in the jet fuel price by using derivatives which were denominated in dollars. When the Korean won suddenly fell in value against the dollar, the company found that the cost of the dollars needed to service its derivatives contracts had soared. The company lost out because it had not hedged against the risk of a negative movement in the currency differential between the won and the US dollar. BASIS RISK What is basis risk? Basis risk is the risk of loss due to an adverse move or the breakdown of expected differentials between two prices (usually different products). In the context of price risk management, basis risk describes the risk that the value of a hedge (using a derivative contract or structure) may not move up or down in sync with the value of the price exposure that is being managed. In the energy market, these market movements may be triggered by factors such as poor weather conditions, political developments, physical events or changes in regulation. These can lead to basis risk occurring in circumstances such as the following: 1 Physical material in one location cannot be delivered to relieve a shortage in another location. 2 A different quality of product cannot be substituted for an energy product in severe shortage. This often happens in the pipeline gas and power markets if there are any problems with transmission networks. 3 There is not enough time to transport or produce an energy product to alleviate a shortage in the market. When conducting price risk management, the ideal derivatives contract is one that has a zero risk or the lowest basis risk with the energy price that protection is needed from. The larger the basis risk, the less useful the derivative is for risk management purposes. The attraction of over-the-counter (OTC) swaps and options is that basis risk can at times be zero, as OTC contracts can often price against the same price reference as the physical oil. However futures contracts (sometimes referred to as On-exchange derivatives) traded on exchanges like the BASIS RISK 3 17. International Petroleum Exchange, the New York Mercantile Exchange and the Tokyo Commodity Exchange all have their pricing references and terms fixed in the exchanges regulations. This means that if their pricing reference does not match the underlying physical exposure, the basis risk must either be accepted or an OTC alternative needs to be sought. (There 4 ENERGY PRI CE RI SK THE PERILS OF LIQUIDITY AND CASH FLOW RISK: METALLGESELLSCHAFT AG In 1993 the German conglomerate Metallgesellschaft AG announced that its Refining and Marketing Group (MGRM) had been responsible for huge losses of around $1.5 billion, which it had incurred by writing oil futures contracts on the New York Mercantile Exchange (NYMEX). The great irony of the situation was that its position had been perfectly sound from an economic point of view. The companys difficulties stemmed from the fact that it had ignored the perils of liquidity and cash flow risk. In the early 1990s MGRM agreed to sell 160 million barrels of oil at a fixed price at regular intervals over a ten-year period. At the time this kind of forward contract looked like a lucrative strategy; as long as the spot price for oil remained lower than the price that MGRM had fixed, the company was sure to make a profit. However, it was vulnerable to a rising oil price, so it hedged this risk using futures contracts. Now, if the oil price rose it would lose on its fixed price forward contracts, but gain on its futures. If the price fell, it gained on the forward contracts, but lost on the futures. This appeared to adequately hedge MGRMs price risk, but unfortunately failed to take account of its liquidity and cash flow risk. One of MGRMs problems was the sheer size of the position it had taken. The 160 million barrels of oil that it had committed to sell were equivalent to Kuwaits entire production over an 83 day period. It has been estimated that the number of futures contracts needed to hedge the position would have been around 55,000. NYMEX was known to be a large and liquid market, but its trade in contracts relevant to MGRMs position averaged somewhere between 15,000 to 30,000 per day. There was thus a clear theoretical risk that MGRM could have problems liquidating its futures position. This risk created an imbalance in the market as many other players realised the size of MGRMs position, which became in itself a factor in market pricing. Prices inevitably began to move against the company. This liquidity risk was compounded by the cash flow risk which resulted from the way that MGRMs hedge had been structured. As was noted earlier, when oil prices went down, the value of the companys fixed rate forward contracts rose and the value of the futures fell. The problem arose because although the forward contracts increased in value, they did not generate the cash flow which was needed to fund the regular margin calls that were due on the futures contracts. The structure of the hedge had succeeded in dealing with price risk over the life of the hedge, but had failed to deal with cash flow risk in the short term. This was probably the major factor in the staggering losses that the company suffered. 18. will be more on the differences, advantages and disadvantages of on- exchange versus OTC in later chapters.) Components of basis risk See Figures 1.2 and 1.3. Mixed basis risk Mixed basis risk occurs when an underlying position is hedged with more than one type of mismatch between the energy that is the subject of the price risk management and the pricing index reference of the derivatives instrument that is being used. For example, if a January Gasoil (heating oil) Cargo is hedged with a March Jet Kerosene swap, it would leave both time and product basis exposures. BASIS RISK 5 Time basis This is a common exposure in many markets In energy markets a time basis exposure can be very dangerous, particularly when there is a sudden shift in demand or transportation problems occur. For example, let us take a Merchant Power generator in the USA who is expecting stronger natural gas prices in the summer time (due to additional use of air conditioning etc.). It hedges its position by buying the August contract in NYMEX Natural Gas Henry Hub futures If a severe heat wave was to arrive early in summer, say in late June, then the price of July natural gas may become much stronger than the August price. Therefore August natural gas futures may not give adequate price risk cover against the July natural gas requirement. FIGURE 1.3 Time basis risk Locational basis You utilise a derivatives contract which prices against exactly the same specification of energy you are hedging price risk against. However, the derivatives contract is pricing against the same energy contract but in a different geographic region. You have locational basis risk. Localised supply/demand factors, political tension, grid problems or, in the case of hydrocarbons/gas, pipeline problems, in either the location used for pricing the derivatives contract or the location where your physical supply is located, could make your derivatives contract a liability rather than a risk-reducing benefit, e.g. European Gasoil Singapore Gasoil FIGURE 1.2 Locational basis risk 19. LEGAL, OPERATIONAL AND TAX RISKS Legal risk This is the risk that derivatives contracts may be not be enforceable in certain circumstances. The most common concerns in this area surround clauses on netting of settlements, netting of trade, bankruptcy and the concern that the liquidation of contracts may be unenforceable. Opinions on many jurisdictions around the world can be obtained from the Interna- tional Swaps Dealers Association (ISDA). (Legal contract issues and nego- tiation pointers are covered in Chapter 17.) Operational risk The risk that may occur through errors or omissions in the processing and settlement of derivatives is known as operational risk. Internal controls alongside an appropriate back office system (whether manual or computerised) should be employed to reduce this risk. 6 ENERGY PRI CE RI SK BRENT CRUDE FUTURES AND THE CUSHING CUSHION The success of the Brent Crude Oil Futures contract is an interesting example of the importance of basis risk in the energy markets. This contract was first traded on Londons International Petroleum Exchange (IPE) in 1983, two years after the West Texas Intermediate (WTI) crude futures contract had been launched on the NYMEX in New York. On the surface, both contracts do similar jobs, for hedging purposes, at least. So, over the years, why have international companies chosen to hedge with the IPE Brent futures contract rather than its better established and more liquid American rival? The answer is a particular kind of basis risk, known in the industry as the Cushing Cushion (after the Cushing refinery in Oklahoma, the destination of several of the south-east USAs major oil pipelines). The Cushing Cush- ion means that WTI s crude price in the USA can act totally independently from international market prices. This can be because pipeline bottlenecks at the Gulf coast are preventing additional foreign crude from reaching the mid-continent refineries or it can be because bad weather has closed the Louisiana Offshore Offloading Point (LOOP), halting the offloading of foreign crude from carriers into the pipeline system. In situations like these, the first reaction of speculators and refineries which depend on oil in the pipeline system is to buy WTI NYMEX Futures. Sometimes WTI Premiums of US$3.00 a barrel over the IPE Brent price have been seen due to LOOP problems, pipeline problems or both. So for anyone hedging international crudes such as West African, Brent, Middle East crude oils, Dubai or Tapis, the WTI NYMEX contract carries a significant basis risk. The IPE Brent future, on the other hand, is exempt from this basis risk, which is almost certainly one of the keys to its success. 20. Tax risk Tax risk can occur when there are changes to taxation regulations that affect either the derivatives market directly or the physical underlying energy market in some way. This can create additional costs to the trade. For derivatives contracts the issue of imposed withholding taxes on any settlement payments is normally an issue covered by ISDA contracts (see Chapter 17). SUMMARY When designing an energy price risk management or trading program, it is essential to be aware of all the risks that are involved in the energy market and the ways in which they interrelate. These can be summarised as: credit risk, liquidity risk, cash flow risk, basis risk, legal risk, tax risk and operational risk. But it is important to remember that any hedging strategy which focuses narrowly on any one of these and ignores the others may be worse than having no hedging strategy at all. SUMMARY 7 21. CHAPTER 2 Energy Derivatives Markets: On-Exchange and Off- Exchange Derivatives normally make the headlines for all the wrong reasons. In the public mind, they are often associated with the activities of greedy speculators or with highly publicised corporate financial disasters. This is ironic because derivatives are essentially instruments to manage and reduce risk. They were created to provide opportunities to minimise price risk and to lock in profits, while reducing balance sheet volatility and the potential for losses. It is true that there have been cases in which the use of derivatives has led to spectacular losses, but this has normally been the result of their mistaken misuse or outright abuse by incompetent or ruth- less individuals. Certainly, in the normal course of business life, derivatives are a prudent and, indeed, indispensable tool of price risk management. Derivatives are financial contracts that derive their price or value from an underlying price or asset reference. They can be divided into three main types: futures contracts, swaps contracts and options. Energy futures contracts are legally binding standardised agreements on a regulated futures exchange to make or take delivery of a specified energy product (oil, gas, coal, power), at a fixed date in the future, and at a price agreed when the deal is executed. Energy swaps represent an obligation between two parties to exchange or swap cash flows, one of which is a fixed price normally agreed at execution, while the other is based on the average of a floating price index during the contract period. No physical delivery of the underlying energy takes place; there is only money settlement. Options are agreements between two parties that give the buyer of the option the right, but not the obligation, to buy or sell at a specified price 8 22. on or before a specific future date. They can apply to a specific futures contract (a futures option) or a specific cash flow (if an OTC Option) or they can be used to buy or sell a specific swap contract (if an OTC Swaption). When the option is exercised, the seller of the option (also know as the writer of the option) must deliver, or take delivery of the underlying asset or contract at the specified price (unlike a swap in which there is no obligation). The specified price is known as the strike price, which is the price level at which the option becomes profitable independent of whether you are a seller or a buyer. Derivatives are often referred to as off-balance sheet items. This term is used because, in the past, there was no need for derivatives to appear on a companys balance sheet (now this is only the case when hedging using derivatives). Derivatives were not required to appear on the balance sheet because a derivatives contract requires no transfer of the principal value of the contract; in other words, there is no commitment to lend money or take money. For example, when a one million dollar swap is traded, the principal value of one million dollars is not exchanged. Instead, an exchange is made of the cash flow of the difference between the agreed fixed price on the derivative instrument and the forward floating price reference that the derivative prices out against. ON-EXCHANGE AND OVER-THE-COUNTER In the energy industry, derivatives can be bought and sold in two main ways: on-exchange and over-the-counter (OTC). On-exchange refers to the futures markets which are found on regulated financial exchanges such the New York Mercantile Exchange (NYMEX) and Londons Interna- tional Petroleum Exchange (IPE). The OTC market is specific to the non- standard swaps and OTC options. These are usually traded directly between two companies (principals, players) in the energy markets. Although the futures markets are important to the energy industry, it relies much more heavily on OTC derivatives. This is because OTC derivatives are customised transactions, whereas their on-exchange counterpart, the futures contract, is a standard contract. In theory, each deal on the OTC market is unique, so it is important to be alert to contract terms, pricing mechanisms and price reference when using OTC derivatives. Some companies find that the measurement and control of risks can be more difficult with an OTC contract because of the lack of price and liquidity transparency in the OTC market (unlike regulated futures exchanges, which publish public real-time price data) and this can create the possibility of an unexpected loss. There are also sometimes additional legal, credit and operational risks with OTC derivatives compared to on- ON-EXCHANGE AND OVER-THE-COUNTER 9 23. exchange futures contracts. However, the OTC market remains a popular option for price risk management purposes. Many companies find that there are benefits in the flexibility of an OTC derivative because it can be valued against the same price reference as the energy which is being produced or consumed. As the pie chart in Figure 2.1 shows, energy OTC derivatives markets are far less liquid than most other financial derivatives markets (see also Table 2.1), accounting for less than half of one per cent of the value outstanding on derivatives markets worldwide. This means that those who take part in energy markets whether as market makers, traders or end-users (usually companies with underlying price risk in the energy being hedged either as a producer or consumer), need to have clear policies for derivatives usage, including strong management controls and organisational reporting structures effective before derivatives are employed. They should also provide shareholders with information that will put to rest any unjustified fears associated with their companys use of derivatives. Indeed, as a result of the concerns of regulators and public shareholders around the world, more and more information is now required by international accounting standards (for more on this point, see Chapter 18). Table 2.2 shows more historical data. FUTURES A brief history of the futures markets Oil futures contracts have been traded on financial exchanges since the 1970s, although ad hoc negotiated physical supply contracts have been 10 ENERGY PRI CE RI SK 120 90 60 30 0 98 H1 Evolution since 1998 99 H1 00H1 01 H1 Product breakdown at end-2001 Interest rate 80.1% Equity 1.9% Commodities 0.6% Foreign exchange 17.3% FIGURE 2.1 OTC derivatives contracts: global amounts outstanding (US$ tril- lions). Source: BIS (Bank for International Settlement; http://www.bis.org/) 24. around since oil was drilled in the USA in the 1850s. The first formalised regulated futures exchange for oil was the New York Mercantile Exchange (NYMEX) which started contracts on heating oil in 1977 (relaunched as the FUTURES 11 Notional amounts Gross market values End June 2000 End Dec 2000 End June 2001 End Dec 2001 End June 2000 End Dec 2000 End June 2001 End Dec 2001 Grand total 94,008 95,199 99,755 111,115 2,572 3,180 3,045 3,788 Foreign exchange contracts 15,494 15,666 16,910 16,748 578 849 773 779 Outright forwards and forex swaps 10,504 10,134 10,582 10,336 283 469 395 374 Currency swaps 2,605 3,194 3,832 3,942 239 313 314 335 Options 2,385 2,338 2,496 2,470 55 67 63 70 Interest rate contracts2 64,125 64,668 67,465 77,513 1,230 1,426 1,573 2,210 FRAs 6,771 6,423 6,537 7,737 13 12 15 19 Swaps 47,993 48,768 51,407 58,897 1,072 1,260 1,404 1,969 Options 9,361 9,476 9,521 10,879 145 154 154 222 Equity-linked contracts 1,645 1,891 1,884 1,881 293 289 199 205 Forwards and swaps 340 335 329 320 62 61 49 58 Options 1,306 1,555 1,556 1,561 231 229 150 147 Commodity contracts3 584 662 590 598 80 133 83 75 Gold 261 218 203 231 19 17 21 20 Other 323 445 387 367 61 116 62 55 Forwards and swaps 168 248 229 217 ... ... ... ... Options 155 196 158 150 ... ... ... ... Other4 12,159 12,313 12,906 14,375 392 483 417 519 Gross credit exposure5 937 1,080 1,019 1,171 Memorandum item: exchange-traded contracts6 13,918 14,215 19,464 23,540 1All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis--vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the gross negative market value of contracts with non-reporting counterparties. 2Single- currency contracts only. 3Adjustments for double-counting estimated. 4Estimated TABLE 2.1 The global OTC derivatives market1: amounts outstanding (US$ billions). Source: BIS Report published 15 May 2002: OTC Market Size (http:// www.bis.org/) 25. current contract in 1979) which was followed by West Texas Intermediate contract (WTI crude). On the other side of the Atlantic, the International Petroleum Exchange (IPE) of London was launched in 1981 and now boasts, in the Brent Crude Oil Futures contract, the leading international benchmark for the pricing of physical crude markets around the world; approximately 70% of the worlds crude oil markets price in some way against Brent Crude Oil. Both NYMEX and IPE also operate futures markets for Natural Gas and Electricity/Power. In recent times, there has been concern that the liquidity in the physical Brent crude oil market has been getting smaller, and as a result some oil majors have taken the initiative to participate in the development of BrentFortiesOsenberg (BFO)-related trading rather than just Brent- related trading. Pricing information services such as Platts have already modified the crudes they include in their Brent price reporting and even the International Petroleum Exchange is examining (September 2002) the use of BFO prices in its price index for settling the Brent Futures contract. In the Far East, SIMEX (now merged into SGX in Singapore) ran a popular Fuel Oil Futures contacts in Singapore until the early 1990s, when it was overtaken in popularity by the OTC (off-exchange over-the-counter derivatives market) and Asia is now totally dependent on OTC derivatives for risk management purposes in energy markets. However, a Tokyo Commodity Exchange (TOCOM) contract for Middle East crude oil has been attracting both interest and trading volume, and this could become a useful on-exchange futures contract tool for Middle East crude hedging, 12 ENERGY PRI CE RI SK Jun 1998 Dec 1998 Jun 1999 Dec 1999 Jun 2000 Dec 2000 Jun 2001 Dec 2001 Total commodity contracts 451 415 444 548 584 662 590 598 Gold 193 182 192 243 261 218 203 231 Forwards and swaps 103 76 87 119 120 101 88 101 Options 82 99 102 124 141 116 116 130 Other precious metals 25 50 62 54 57 55 25 30 Forwards and swaps 15 22 24 14 9 11 10 16 Options 11 28 38 40 49 44 15 14 Other commodities 233 183 190 251 266 389 361 337 Forwards and swaps 138 114 103 148 159 238 218 201 Options 95 69 87 103 106 152 143 135 TABLE 2.2 Billions of OTC derivatives notional outstanding. Source: BIS (http://www.bis.org/) 26. particularly since Asia is heavily dependent on Middle East crude imports for oil refinery operation. Futures versus OTC At one time it was easy to distinguish the futures market from the OTC market and also to establish the pros and cons of using one or the other. As Figure 2.2 shows, when risk managers or traders used futures contracts they knew that the contract would be traded on an exchange, that they would have an account with their futures broker and that they were operating in a highly regulated market. They could also see the price of the contract on a screen and they could be sure that the security of the contract and its performance would be guaranteed by the clearing house of the exchange. This in turn was guaranteed by margins (good faith payments by everyone with a futures position on that particular exchange), plus the funding the exchange raised itself and the funds contributed by its clearing broker members. Margins on a futures exchange can be split into two types: initial margins and variation margins. Initial margins are the good faith deposit that is placed with the clearing house or that a broker finances (at a cost) when a trade is opened. A variation margin is the daily revaluation of a portfolio with the clearing house. If the valuation is negative, you or your broker (if you have a credit line) will have to place a margin to cover that negative variation margin. If the next day the portfolio has a positive FUTURES 13 Client A Wants to buy 1 futures Clearing house Broker trades on the Futures Exchange Broker Broker Clearing house creates 1 new futures contract: a Buy + a Sell. It guarantees the performance on these trades Broker Broker Client B Wants to sell 1 futures Client A Broker informs Client that the new Futures position has been created Client B Broker informs Client that the new Futures position has been created FIGURE 2.2 Basic futures trade transaction flow 27. variation margin (i.e. it is showing an unrealised profit), because the position has not been traded or closed out yet, some of that margin will be returned. However when OTC contracts are used there is always the credit risk of the other company in the transaction, as well as a liquidity risk and a lack of price transparency because there is no screen to display a real-time price. The convergence of OTC and futures The clear distinction between the OTC energy market and the futures markets is now disappearing as the two markets converge. Clearing houses around the world have started to accept OTC trades into their guarantee umbrella. This means that after executing bilateral OTC trades with one another, both counterparts can agree to give-in their OTC deal to a clearing house. This process basically makes the clearing house the counterpart to the OTC deal, so that the two OTC counterparts can benefit from the higher credit quality of the clearing house as well as getting other benefits such as more netting opportunities on settlement and offsetting of positions. The usual market approach is for two OTC counterparts to trade an OTC derivative contract with one another directly and to take on one anothers credit risk: In the new convergence environment we now sometimes have a situation like this: Although market share penetration has been slow in the oil sector, we have seen the newer power and gas markets embracing electronic trading platforms in a big way. This has brought about greater price transparency as users can view and trade prices onscreen like futures markets. As a result, power and gas markets have been the quickest to embrace OTC clearing. Futures contracts settlement on expiry Energy futures contracts all entail physical and cash delivery on expiry (apart from IPE Brent Crude Futures in London). So if a seller (someone 14 ENERGY PRI CE RI SK OTC counterpart OTC counterpartClearing house Two companies negotiate an OTC deal with one another but on the basis of the clearing house becoming what is termed the central counterpart. OTC counterpart OTC counterpart 28. who is short in the market) holds the futures contract to expiry he will have to deliver the underlying physical energy (oil, gas, power) and if a buyer (someone who is long in the market) holds the contract to expiry, he will have to take delivery of the underlying physical energy. However, actual delivery via futures markets like the NYMEX or IPE is very small, normally less than 2% of the total open interest (the total amount of outstanding contracts in the market). The majority of trades on these markets are for hedging and or speculative purposes, with consumers or producers of energy preferring to make delivery via the normal physical markets rather than through the futures markets. SWAPS AND OPTIONS Swaps contracts settlement on expiry Swaps are contracts which, unlike futures, never go to physical delivery. They are by their very legal structure purely financially based contracts, which allow companies to benefit from the price/value movement of the underlying asset that the swaps price is derived from. It is called a swap because the two counterparts to the deal, the buyer and the seller (the long and the short) exchange an agreed fixed price today for the unknown floating price In the future. When traders are negotiating an OTC deal they focus on: The fixed price The floating price reference (see Chapter 3 for a listing) Pricing period (e.g. one month, quarterly, calendar year) Start date or effective date End date or termination date Payment due date. For example, for a swap priced against an American or European floating price reference, payment due date is normally the fifth business day after the last pricing day of each pricing period. In energy and generally commodity markets, OTC derivatives will price out monthly, so even if a quarterly contract is traded, after each month during the pricing period, one third of the volume will price out and a settlement will become due by or a payment received by the organisation. For contracts pricing against an Asian-based floating price reference, payment for settlement is generally due 10 business days (sometimes up to 14 business days) after each pricing period. Option contracts on expiry What happens to an option contract on expiry and when or whether it is exercised (transfers into its underlying) depends very much on the type of SWAPS AND OPTIONS 15 29. option it is and also whether it is a futures option (traded on a futures exchange, referred to as traded options) or whether it is an OTC option. When a traded options position is held on a futures exchange, if the option is in the money on expiry, the clearing house will prompt clearing brokers to notify their customers that their option is in the money and request whether they wish to exercise the option as it is profitable to do so. An option is in the money when it has intrinsic value; i.e. exercising the option into its underlying futures contract (in respect of traded options) and then trading out (closing out) that futures contract would bring a profit. In some instances, if the traded option is heavily in the money, the clearing house of the futures exchange may even exercise it automatically, which acts as a safety net for users of the market. However, there are no safety nets in the OTC world of derivatives. If you have a profitable swaption that could exercise into a profitable swaps position for you and you forget to tell your counterpart that you wish to exercise it by the cut-off time (written in the original option contract), you will be left to negotiate with that other counterpart. It will be up to your counterpart whether they will still let you exercise the swaption and if they do, it will most probably come at a price. Types of swaps in energy markets Plain vanilla terms used to describe a simple averaging swap A plain vanilla swap (Figure 2.3) is a monthly averaging swap with the following features. Fixed prices versus floating prices in the future are exchanged; i.e. they are is swapped. They are used extensively in Oil, LPG and LNG related hedging and trading. When executing the deal counterparts discuss the fixed price agreed today and which floating price reference they will use to calculate the settlement. The following is a cash flow example of a plain vanilla deal: Counterpart A buys fixed price 15.00 (buys fixed, sells floating) Counterpart B sells fixed price 15.00 (sells fixed, buys floating Floating price reference is chosen, e.g. Platts average during the price period (say) March 2003 = 16.00 16 ENERGY PRI CE RI SK A B Fixed Floating FIGURE 2.3 A plain vanilla swap 30. Net result: Counterpart A = +$1.00 (difference between fixed/floating) Counterpart B = $1.00 Counterpart B pays Counterpart A US$1.00. Only the difference is exchanged, not the principal notional amount. Differential swap A differential swap is like a plain vanilla swap except that instead of one fixed price versus a floating price, it is based on the difference between a fixed price in two products. In the oil sector, the most popular differential swap is the Jet Kero versus Gasoil (Figure 2.4), commonly termed the regrade swap. The following is a cash flow example of a differential swap: Counterpart A buys fixed price Kero and sells fixed price Gasoil at a difference of US$0.50 per barrel Kero premium. Counterpart B sells fixed price Kero and buys fixed price Gasoil at a difference of US$0.50 per barrel Kero Premium. Floating price reference is chosen, e.g. Platts Kero and Gasoil average difference during the price period (say) March 2003 = 0.60 Kero premium. Net result: Counterpart A = +$.10 (difference between fixed differential and the floating differential) Counterpart B = $0.10 cents per barrel Counterpart B pays Counterpart A US$0.10. Only the difference is exchanged, not the principal notional amount. Differential swaps are used across the whole energy spectrum. In the power and gas markets we see spark spreads (Table 2.3), where hedgers and traders use derivatives pricing against the difference (referred to as the dif) between power and gas markets. This is based on the amount to be made by burning gas and selling power in a perfect world using a standard percentage efficiency of the conversion of energy. The normal efficiency used is 49.13% and the spark spread is quoted in megawatt hours (MWh). In coal versus power there is the so-called dark spread, which works on the same principle as the spark spread with two fixed prices and two SWAPS AND OPTIONS 17 Gasoil Jet Kero FIGURE 2.4 A differential swap 31. floating prices documented in swaps confirmation. However, the net exposure is only on the differential between the two products/instruments. In the UK, dark spreads use an energy conversion efficiency of 5,000 MT of coal producing 55 MW of electricity at an efficiency of 38%. (There will be more detail on this in Chapter 3.) Participation swaps Participation swaps are similar to regular plain vanilla fixed for floating swaps as the fixed price buyer can be 100% protected when prices rise above the agreed fixed price or the fixed price seller can be 100% protected when prices move down below the agreed fixed price. However, unlike an ordinary swap, the client participates in the downside by only an agreed percentage. The percentage of participation affects the starting fixed price of the swap. A fixed price buyer who only wants to participate in a percentage of any price move lower may find that the fixed price quoted for a participation swap would be higher than a normal swap. On the other hand, if you were a seller of fixed price who wanted to participate in only a percentage of any move higher that would incur a loss on the short swap position, you might find that the fixed price quoted for a Participation Swap would be lower than a normal swap. Double up swaps By using the double up swap, swap users can achieve a swap price which is better that the actual market price, but the swap provider will retain the option to double the swap volume before the pricing period starts. If a company has price exposure to energy prices going higher, but the current plain vanilla swap is not being quoted around its budgeted level, it may find that a double up swap will let it hedge some of its required volume closer to its hedging budget level. The risk is that the market price could move against the derivatives position and the swap could price out against twice the original executed volume. Double up swaps are not commonly used in the market for price risk management purposes (hedgers tend to use options more if the current swap price is not interesting for them). However, double up swaps could offer an interesting 18 ENERGY PRI CE RI SK Gas price Power price Spark spread Pence per therm /MWh /MWh /MWh September 12.15 4.15 12.7 4.26 OctoberDecember 20.55 7.01 16.35 2.08 JulySeptember 16.5 5.63 14.55 3.09 TABLE 2.3 Spark spread 32. opportunity for speculators who have a strong price direction view on their particular energy focus and want to get a head start by buying at a better price level than the current plain vanilla swap, or selling at a higher level than the plain vanilla swap quotes. Margin swaps This is where an organisation can take its overall price risks from several energy inputs and outputs of the business process and get a complete swap structure that guarantees its profit margin. Organisations could construct complex hedges themselves to protect their energy inputs/ outputs. This has a cost in terms of managing many individual positions with perhaps several counterparts. It can therefore be more cost efficient and easier to enter into a margin swap with one counterpart who is willing to provide a contract that covers all the price risks (Figure 2.5). However, it should be remembered that price risk management is never free and there are always costs attached to any control function in a company internally or externally. Administration and human resources available in an organisation will have to be reviewed and adjusted if necessary depending on the level of activity the organisation expects to have in derivatives. SWAPS AND OPTIONS 19 Oil refiner Energy outputsEnergy inputs Crude oil feedstock Naphtha Jet Kero Gasoil Fuel oil Gasoline Refiner Margin swap counterparty Fixed price on feedstock Fixed price on product Floating price risk absorbed by margin swap counterparty One contract FIGURE 2.5 Example of a margin swap for an oil refiner 33. Knock-ins and knock-outs integration with swaps and options Knock-in and knock-out options are two types of barrier option which are activated if the underlying moves through a trigger price level, in the case of a knock-in, and is cancelled or deactivated in the case of a knock-out. A market maker or trader will normally offer a more attractive price on this kind of option because the buyer is giving the seller of the option the opportunity to cancel it before its original expiry/termination date. This adds another dimension of opportunity or potentially reduced risk to the seller of the option; hence the lower price than an option of same strike price, tenure and underlying price reference without such a barrier option structure. Knock-in and knock-out triggers can be integrated with both swaps and options. Figure 2.6 shows how the barrier option either comes to life (is knocked in) or is extinguished (knocked out) under certain conditions. In practice, the event which activates or kills the options is defined in terms of a price level (the barrier). A common example is the up-and-out floor (put) which is typically purchased by an energy producer to hedge their natural long position in the energy markets. Up-and-out floor (put) may be an attractive alternative to the normal floor or put option, as it is less expensive and provides the same price protection if prices move down from current levels. However, if prices move upwards, the increase in the underlying commoditys price reduces the need for downside risk protection at the original strike price. If the price moves up sufficiently to cross the selected barrier price, then the option is cancelled/extinguished. The owner may consider re-entering a hedge by buying another floor at a higher strike price, which gives more valuable protection than the floor with the lower strike price which was cancelled. The barrier option may also be combined with a rebate. For a knock-out option, the rebate is paid when the option is cancelled prior to its normal expiry as a compensation to the holder. The up-and-out barrier is less expensive than a standard Asian, Euro- pean or American option because the underlying price may fall below the 20 ENERGY PRI CE RI SK Price Up Down Out In Up-and-out Up-and-in Down-and-out Down-and-in Type of option FIGURE 2.6 Barrier options caps/floors 34. strike price after initially rising, hitting the barrier and cancelling the option. However, there may be liquidity issues with this strategy, as there are a limited number of traders in the market who may be able to quote you this more complicated option strategy. The common and more liquid option markets in energy calls and puts, caps and floors On futures exchanges, traded options are referred to as calls and puts, while in the OTC market the same sort of contracts are referred to as caps and floors. If an organisation buys a call or cap, it gives the buyer of the option price protection against the market moving above the agreed price, the strike price, in return for the payment of a premium or fee. The strike price is the level at which the players can participate in the market via the option contract. If an organisation buys a put or floor, it gives the buyer of the option protection against the market moving below the strike price, again in return for the payment of a premium or fee. Figure 2.7 illustrates the various possibilities. Options strategies can be very flexible and can help companies achieve exactly the risk reduction or risk exposure profile they want to have. When a buyer purchases an option, the cost of the contract is the premium paid, and the buyer will not be required to pay any more than whatever the market price demands. If an option is sold on its own, it is called a naked option. This means that the seller does not own the underlying physical commodity or does not have another futures or swaps position against the option that has been sold. In this case, there is unlimited risk if the market price moves in an adverse way (Figure 2.8). SWAPS AND OPTIONS 21 Original option cost Value of commodity Call/cap Market higher Value increases Put/floor Market lower Value increases FIGURE 2.7 Calls and puts, caps and floors 35. Main option styles American style An American style option is one that may be exercised into its underlying instrument (i.e. a futures contract) on any business day until expiry. All the IPE and NYMEX traded options on energy futures contracts are American style. These options are more expensive than European options because they give so much flexibility to the buyer as to when the option can be exercised. European style These are not very common in the energy markets, as they only permit the buyer to exercise the option on expiry. European options are cheaper than American options, but generally more expensive than Asian-style. OTC Asian style This is the most common option style in the OTC market and they are sometimes called restrospective or path-dependent options. The reason for this is that they are average price options, with their profit being dependent on the price history of the underlying energy market that is being used as the price reference, either overall or sometimes at a specific stage in the life of the option. The cost of an option its premium There are many types of option models available and each one has its own particular use depending on the type of option that is being used. It is not necessary to have an in-depth understanding of the mathematics of these models. However, users should understand what needs to be put into the model in order to obtain the right answers and they should be able to interpret the output results. It is fair to say, though, that the core factors that play an important role in determining the value of any option are generally those shown in Figure 2.9. Margin options These are options that can price against a complex structure of differentials instead of pricing against a single floating price reference. Earlier in 22 ENERGY PRI CE RI SK Cap/call Floor/put If the option is sold as a naked option: Potential unlimited loss exposure on the option if the underlying market price moves above the strike price of the option Potential unlimited loss exposure on the option if the underlying market price moves below the strike price of the option FIGURE 2.8 The risks of naked options 36. the chapter, we looked at the illustration of a margin swap for an oil refiner. That oil refiner could have bought an option on its refining margin instead of using the swap strategy. The option strategy might at first appear less attractive, as it contains an up-front premium cost, whereas the swap strategy would not require any such cost. However, the flexibility offered by the option strategy becomes apparent if the margin gets better. If the refiner had used the swap strategy its profitability would be fixed, although if the margin improved, any loss on the swap would be offset by better prices on the resale of its physical assets: the petroleum products. In this case, it would just have the opportunity cost. But if it paid a premium for an option strategy (e.g. a margin option) then if the margin improved more than the cost of its option strategy, it would still be able to benefit from that margin improvement. This is most useful when dealing with a present day or even forward negative margin a situation which has been experienced by oil refiners in some of the fuel oil markets for a long time. In this case, the refiners might have good margins which they wish to lock in by using swaps on the middle distillates (e.g. Naphtha, Gasoil, Jet) but they are still faced with the need to halt any further exposure in the Fuel Oil margin becoming more negative (and at the same time, they do not want to lock in a negative margin). In this instance, the refiner could look at a Crack Option (Crude (feedstock) versus Fuel Oil) and still have the potential to benefit and profit from any improvement in the margin on this product in the future. Option premium cash flow When a traded option is purchased on a futures exchange, it is normal to put up margin, in the form of a good faith deposit (approximately 10% of the notional value, subject to market volatility at the time of the trade). After that, the position will be marked to market on a daily basis and there SWAPS AND OPTIONS 23 Reference rate (benchmark e.g. futures or swaps) Strike Expiry Volatility estimate Interest rate (risk-free e.g. base rate) Option pricing model Premium/ cost of option FIGURE 2.9 Option premium calculation principles premium. 37. will be an obligation to finance any negative variation margin. In the case of an OTC option, the buyer normally pays the premium up-front to the seller. This generation of cash premium is where OTC options can offer interesting opportunities for linkage to commodity- or energy-linked projects that require financing. It is possible to create structures that offer a price risk hedge at the same time as generating prompt cash flow which can be reinvested in the project or in other business activities of the organisation (these activities are usually associated with the structured finance departments of banks). For traders who are trying to make money by speculating in the very risk of the energy price moving or not (as the case may be), options offer the ability to do the following: Create trading strategies that profit from price direction moves Create trading strategies that profit from the price moving in a particular price band Create trading strategies that profit from the price staying the same by using volatility trades; money can be made not from the market price moving up or down, but on volatility increasing or decreasing. SUMMARY The energy derivatives markets provide risk managers and traders with an enormous choice of instruments both for price risk management and for speculation. Traditionally, the energy industry has favoured over-the counter (OTC) derivatives which can be customised to meet the needs of both counterparts to the deal. However, some companies have found drawbacks to the OTC market such as a lack of liquidity or price transparency. But these problems should be ironed out as the OTC market converges with the on-exchange market to provide a more effective and efficient service to all parties concerned. 24 ENERGY PRI CE RI SK 38. SUMMARY 25 KEY OPTIONS TERMINOLOGY American option An option which can be exercised on any business day up to and including the expiry date. Asian option A path-dependent option, also known as an average rate options. This is an option where the settlement is based on the difference between the strike and the average price of the underlying floating reference price over a determined period of time. At-the-money An option term used to describe the fact that the option- underlying is equal to the options strike price. This can be applied to a futures contract, a swaps contract or some average price of an underlying energy market. Delta Delta gives you a mathematical measurement of how sensitive an option is to price changes in the underlying energy market. Delta operates on a scale of 0 to 1. For example a Delta of 0.5 implies that if the underlying moved by US$1 dollar the option could move by US$0.50, or half of the underlying energy markets price move. European option An option which can be exercised on the expiry date only. Fair value The combination of intrinsic value and time value, as calculated by the option pricing model. Implied volatility The volatility value placed on option quotes. In-the-money It means the option is profitable, if you exercise the option or trade out of it you can gain a profit. Intrinsic value The difference between the strike price and the current market rate. Out-of-the-money The option is not in-the-money, and it would not profitable to exercise the option or trade out of it. Premium Price or cost of an option. Strike price The entry price into the underlying; participation level. Time value The difference between the option premium and the intrinsic value, including time until expiry, volatility and cost of carry (interest percentage). Value date The date when the underlying is settled or delivered. Volatility The normalised annualised standard deviation of the underlying futures/swap contract. 39. 26 ENERGY PRI CE RI SK KEY DERIVATIVES TERMINOLOGY Abandon Where an option holder chooses not to exercise his or her option. Arbitrage The purchase or sale of an instrument and the simultaneous taking of an equal and opposite position in a related market when the pricing is out of line. For example, in the oil markets, major arbitrages are traded between Heating Oil in New York and Gasoil in Europe, and Gasoil in Europe versus Gasoil in Singapore. Assignment (futures) Notice sent by a clearing house of a futures exchange to an option writer (option seller) that the option has been exercised. Assignment (swap) Where the original counterpart to a swap deal transfers the position to a third party organisation who then takes over as the counterpart to the deal. We were able to see instances of this happening during the Enron collapse in 2001. In order to reduce overall losses on its books it assigned profitable OTC derivative deals that it held in one commodity with one counterpart with losing trades held with other counterparts. All parties involved had to accept these assignments. Average price contract A contract which is conditional on an average of market prices rather than a single market price on one single day. Very common average price contracts are the monthly average price swaps in the OTC oil markets. Back office A term for the department handling the operation functions of processing trades done by the trading operation. Backwardation The decrease in the forward prices of the market as their expiration time increases (i.e. the energy market is cheaper the further in the future you check out the prices). Benchmark A pricing reference from which other energy markets are compared to or priced off using some pricing formula. (e.g. 70% of the worlds crude oil markets are priced off the Benchmark Brent Crude Oil in the UK North Sea. A lot of the worlds natural gas is priced of crude oil benchmarks) Book Another term for a derivatives portfolio (e.g. the companys book is long (they have bought) German Power for 4th Quarter). Call/cap A call option is the futures market equivalent of an OTC cap option. These options give the purchaser of the option the right, but not the obligation, to buy the options underlying asset at some future point in time at the options strike price. (The strike price is the price you agree you would buy at if you had bought the call/cap or sell if you had sold the call/cap whatever the option is based on, e.g. a futures contract or a swaps contract.) Carry cost The cost of storing energy, oil, gas etc. from one pricing or delivery month to another. For example, to store Gasoil in the AmsterdamRottderdamAntwerp storage region in North West Europe you may find a typical storage cost of US$1.25 per MT per month. If the IPE 40. SUMMARY 27 Gasoil futures contract today was US$250 per MT and next month US$252 dollars, then in a perfect world, you could buy storage, fill it up with Gasoil at a cost of US$250 per MT, and use the futures market or OTC swaps market to lock in the value of US$252 dollars per MT and make a profit of US$0.75 per MT (US$252 minus storage cost US$1.25 minus Gasoil cost of US$250 = US$0.75 per MT). Cash-settled contract A derivative contract in which counterparties exchange money at settlement rather than delivering actual oil, gas or power, in exchange for cash. The money exchanged is based on the value of the underlying energy. Whether a derivative contract goes to physical delivery instead of the cash-settled route can affect accounting rules that can be applied even if an organisation is hedging and not speculating (see Chapter 18). Contango The situation in which forward prices increase the further forward you look (also known as a normal market in the USA). Counterparty risk The risk of one side of a party to a contract not fulfilling an obligation of a contract. Credit derivative Also known as a Credit Default Swap or CDS for short. It enables the trading and also the risk mitigation/reduction of credit risk on a particular entity or group of entities. More widely used now in the energy sector. A CDS is usually more expensive than traditional trade credit insurance, where available, but there are generally more specific payout trigger events than those seen in credit insurance contracts, which brings more comfort to users. Deal capture This describes the operational process of recording a signed derivatives contract in the organisations trading book. Day trade A position opened and closed within the same trading day. Delivery The process of final settlement of a futures contract, swaps contract or option via cash settlement or physical delivery (in the case of futures). Delta Delta represents the change in overall value of an option given one unit change in the price of the underlying of the option (i.e. the option price movement in relation to the futures contract it is based on or the swaps contract it is based on). Derivative contract A financial contract that derives its price (value) from an underlying energy price or asset. Early exercise Indicates exercising the option prior to its expiration date. Limited to American style options. Embedded option An optionality within a contract that is not specifically referred to as an option. End user Generally refers to buyers of derivatives contracts or risk management services who use the oil, gas or power for their own purposes. EFET European Federation of Electricity Traders. This is the organisation that created the EFET master trading agreement which the forward power and natural gas markets of continental Europe tend to trade under. 41. 28 ENERGY PRI CE RI SK Events In derivatives contract terms, an event is something that happens in the real world and in turn triggers an event in a swap agreement. For example, when Enron had its credit rating downgraded this triggered a credit event in some of its derivatives trades and it was forced to place collateral with some of its counterparts, creating a huge cash flow crunch and in turn triggering its downfall. It can also mean, in terms of the market place, an extreme event that triggers rapid price movement in the energy markets. Exchange This is usually a regulated trading centre that offers standard contracts and requires the use of their clearing house and margining of trades. Exercise The process of taking up the options rights on an option contract. Exotic contract A derivatives contract with a complex structure. The opposite of a plain vanilla contract, which is simple. Exotic options New OTC options including barriers. Expiration The date on which a forward, futures, swap or option contract expires/terminates. In an OTC trade it is usually described as the end date. Extrinsic value The amount by which the premium on an option exceeds the intrinsic value, often caused by time value in the option. Front office A term to describe the trading operation of marketing, trading and managing the trading books. Usually the department that provides the means of executing a companys hedging or trading strategy. Future A standardised contract offered by an exchange allowing a company or individual to trade or protect against future price movements. On expiry in energy markets, it usually goes to physical delivery. GTMA Grid Trading Master Agreement, created by Allen & Overy lawyers in London, UK. UK Electricity forward markets trade under this agreement, unlike other energy swaps which trade under ISDA Master Agreements. Hedge A derivative transaction that reduces or mitigates the price risk an organisation may have in its day-to-day business operation. For example, an airline hedges its exposure to Jet Fuel prices by using Jet Fuel/Kero-related derivatives contracts. Historical volatility An indication of past volatility in the energy market. Initial margin The good faith collateral placed with the clearing house for futures exchange or OTC contracts. Initial margin is paid on the opening of a new derivative position. The clearing house sets the level of initial margin required on each derivatives contract based on current market circum- stance, including price volatility. The initial margin is returned once the derivative position has been closed out either through expiry or by the user trading out of the contract by trading an opposite position. Implied volatility The volatility implied from the market price of an option. You can use an option model to reverse engineer what the level of implied volatility is from an option premium being quoted in the market. ISDA International Swaps & Derivatives Association (http://www.isda. org/), the group that created the ISDA Master Agreement 1992, the backbone 42. SUMMARY 29 for the majority of energy-related derivatives trades (with the exception of UK and European Power and Nat Gas OTC, which trade under GTMA, NBP and EFET agreements). IPE International Petroleum Exchange of London (http://www.ipe.uk. com/). Liquidity This is based on the amount of trading going on in a particular derivatives contract. The greater the liquidity, the greater a users confidence may be in the efficiency of that market and in turn the value of the prices generated by that market. Liquidity can play a big part in selecting derivatives contracts for hedging or speculation purposes. Long A trading term that describes someone who has already bought a futures contract, a call option or swap, and who is holding a derivative that benefits them if energy prices move higher. Marked-to-market The daily revaluation of a derivatives portfolio, sometimes referred to as marking-to-market. The norm in the energy trading world is to mark-to-market derivatives every day for risk management and general management reporting and control purposes. Traders may refer to their MTM value, which is the latest marked-to-market value of their derivatives portfolio or even their derivatives plus physical energy position. Maturity The time at which a contract expires. Notional The dollar value of the underlying asset upon which a derivative contact is based. For example, a user sells 500,000 barrels of crude oil swaps at a fixed price of US$28. Besides being a pretty good level to sell crude oil on a historical basis, the notional value of the deal is 500,000 US$28 = US$14 million. NYMEX The New York Mercantile Exchange (http://www.nymex.com). Open position The number of contracts that have not been offset by close of business. Paper contract A derivatives contract that allows the counterparties to the deal to cash-settle with money and not through physical delivery. All swaps contracts are cash-settled, but most futures contracts go to physical delivery. Settlement price The price at which all futures are margined; a represen- tative price for the close of the days trading. Swaption An option on a swap transaction. These options can be buyers or sellers of the underlying swap and also American or European style. Tick The standard minimum price movement, usually referring to the minimum price movement of an on-exchange futures contract. However, the OTC energy markets have created their own kind of standardisation as well. Price discovery The process of determining the market value of a particular energy derivatives contract. Risk management The process of evaluating, measuring and managing the various risks within a companys portfolio of financial and energy exposures as well as any assets. 43. GENERALLY ACCEPTED OIL CONVERSION FACTORS USED IN THE DERIVATIVES INDUSTRY Barrels per tonne Crude Oil 7.96.5 Brent Crude 7.57 Naphtha 9.0 Motor Gasoline 8.98.0 Gasoil and Kero/Jet 7.45 Fuel Oil 6.96.3 US gallons price to US$ per tonne Heating Oil (NYMEX) Heating oil price 3.1323 e.g. 74.00 (cents per US gallon) 3.1323 = 231.79 per MT This is utilised for calculating the arbitrage between International Petroleum Exchange of London Gasoil Futures contracts and the NYMEX New York Harbor Heating Oil, both similar grades of petroleum product. (Arbitrage is the difference in price for two similar grades of oil in different locations; if the arbitrage is on it means you can move oil from one location to another and cover the cost of shipping). 30 ENERGY PRI CE RI SK Short Someone who has sold futures or swaps or has bought a put/floor option. They benefit from the market going lower. It can also mean someone who is naturally short in the physical market. For example, consumers of energy are naturally short, always exposed to the prices going higher, unless they hedge. VAR Value At Risk is a type of derivatives position analysis that provides users with a possible profit/loss within a set probability parameter: usually 95% or 99% confidence level over 24 hours. There are different approaches to VAR analysis, and these are discussed in later chapters. Variation Daily movements of debits and credits to and from exchange clearing members, as a result of futures and options positions being marked- to-market. With some OTC contracts now also being cleared via futures clearing houses, this is starting to be applied to OTC contracts as well. 44. US gallons price to US$ per barrel Heating Oil (NYMEX: http://www. nymex.com/) Heating oil price 42 e.g. 0.74 dollars per gallon 42 = US$31.08 GENERALLY ACCEPTED GAS CONVERSIONS Litres/tonne Ethane 2730 Propane 1962 Butane 1735 Naphtha (distillate feedstock) 1463 Aviation Turbine Fuel 1248 Aviation Turbine Fuel, Wide Cut 1260 Middle Distillate Feedstock 944 Derv Fuel 1182 Gasoil 1172 1 tonne of liquid methane 16 barrels = 50,000 cubic feet 100 million cubic feet of natural gas per day = 360 million therms per annum 1 therm = 100,000 Btu = 105.5 MJ = 29.3 kWh 1 Btu (British thermal unit) = 1.055 kJ 1 Btu/lb = 2.326 kJ/kg 1 kilowatt hour (kWh) = 3.6 MJ VOLUME 1 gallon (US) = 3.78541 litres 1 barrel = 42 gallons (US) = 158.987 litres GENERALLY ACCEPTED GAS CONVERSIONS 31 45. API GRAVITY AND DENSITY/VOLUME PER TONNE Degrees API @ 60 EF Density @ 15 EC Barrels per tonne 25.0 903.7 6.97 26.0 897.9 7.02 27.0 892.3 7.06 28.0 886.7 7.10 29.0 881.1 7.15 30.0 875.7 7.20 31.0 870.3 7.24 32.0 865.0 7.28 33.0 859.7 7.33 34.0 854.5 7.37 35.0 849.4 7.42 36.0 844.3 7.46 37.0 839.3 7.51 38.0 834.4 7.55 39.0 829.5 7.60 40.0 824.7 7.64 41.0 819.9 7.69 42.0 815.2 7.73 POWER AND GAS CONVERSION FACTORS kWh GJ therm mn Btu ft3 m3 t LNG t oe 1 kWh 0.0036 0.0342 0.00342 3.3367 0.094515 0.000066 0.0000855 1GJ 277.8 9.478 0.95 950 26.25 0.018 0.022 1 therm 29.3071 0.1055 0.1 96.59 2.766 0.0019 0.0024 1 mn Btu 293.1 1.055 10 965.9 27.66 0.019 0.024 1 ft3 0.2997 0.0011 0.0102 0.001 0.0283 0.000019 0.000024 1 m3 10.58 0.0381 0.362 0.0362 35.3023 0.00072 0.00083 1 t LNG 15,000 52 520 52 48,690 1,379 1.2 1 t oe 11,700 42.2 400 40 39,220 1,110 0.77 kWh kilowatt hour GJ gigajoule therm therm mn Btu million British thermal units ft3 cubic feet m3 cubic metres 1 t LNG 1 tonne Liquid Natural Gas 1 t oe 1 tonne oil equivalent 32 ENERGY PRI CE RI SK 46. CHAPTER 3 Energy Futures Contracts INTRODUCTION Futures markets have been used by traders in commodities for hundreds of years. Trading in rice futures was being conducted in Osaka, Japan as early as the 18th century. The New York Mercantile Exchange (NYMEX), the worlds largest regulated energy futures exchange, started life in 1872 as the Butter and Cheese Exchange of New York, before being renamed ten years later. Exchange-traded futures and options provide several important economic benefits, including the ability to shift or otherwise manage the price risk of cash and physical market positions. As open markets where large numbers of potential buyers and sellers compete for the best prices, futures markets like the TOCOM in Tokyo, SGX in Singapore, IPE in London, EEX in Germany, Nord Pool in Scandinavia, NYMEX in New York, and Intercontinental Exchange out of the USA, allow energy companies to discover and establish competitive prices. Partly because these markets provide the opportunity for leveraged investments, they attract large pools of risk capital. As a result, futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, fosters their use by a wide range of businesses and investors who want to manage price risks. Todays futures industry functions with a number of time-tested institu- tional arrangements, including clearing house guarantees and exchange self-regulation. KEY FACTS ABOUT FUTURES CONTRACTS A futures contract is a standardised agreement between two parties that: Commits one party to sell and the other party to buy a stipulated quantity and grade of oil, gas, power, coal, or other specified item at a set price on or before a given date in the future. 33 47. Requires the daily settlement of all gains and losses as long as the contract remains open. For futures contracts remaining open until trading terminates, the expiry of the contract provides either for delivery of the underlying physical energy product or a final cash payment (cash settlement). Futures contracts have several key features: The buyer of a futures contract, the long, agrees to receive delivery. The seller of a futures contract, the short, agrees to make delivery. The contracts are traded on regulated exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerised network. Futures contracts are marked-to-market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing futures accounts held by brokers for their customers. Futures contracts can be terminated by an offsetting transaction (i.e. an equal and opposite transaction to the one that opened the position) executed at any time prior to the contracts expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than by delivery. For example, on the IPE and NYMEX less than 2% of the open interest (total contracts open) in their energy futures contracts go to physical delivery each month. A standardised energy futures contract always has the following specific items : Underlying instrument: the energy commodity or price index upon which the contract is based. Size: the amount of the underlying item covered by each contract. Delivery cycle: the specified months for which contracts can be traded. Expiration date: the date on which a particular futures trading month will cease to exist and therefore all obligations under it will terminate. 34 ENERGY PRI CE RI SK MAIN GLOBAL OIL, GAS, COAL AND POWER FUTURES EXCHANGES IPE London: http://www.ipe.uk.com/ EEX: http://www.eex.de/ UKPX: http://www.ukpx.com/ NYMEX New York: http://www.nymex.com/ TOCOM Tokyo/SGX: http://www.tocom.or.jp/ SGX Singapore: http://www.sgx.com/ Nord Pool: http://www.nordpool.com/ 48. Grade or quality specification and delivery location: a detailed description of the energy commodity, or other item that is being traded and, as permitted by the contract, a specification of items of higher or lower quality or of alternate delivery locations available at a premium or discount (e.g. NYMEX WTI Crude futures contract allows traders to deliver alternative crudes and they have a table of premium and discounts that are fixed for those alternative crude oils). Settlement mechanism: the terms of the physical delivery of the underlying item or of a terminal cash payment. In fact, the only non-standard item of a futures contract is the price of an underlying unit, which is determined in the trading arena. The mechanics of futures trading are straightforward: both buyers and sellers deposit funds called initial margin (a sort of good faith deposit) with a brokerage firm who would be a clearing member of the exchange the futures contract it on. This initial margin amount is typically a small percentage around 10% of the total notional contract value. If you buy (go long) a futures contract and the price goes up, you profit by the amount of the price increase multiplied by the contract size. On the other hand, if you buy and the price goes down, you lose an amount equal to the price decrease multiplied by the contract size. If you sell a futures contract (go short) and the price goes down, you profit by the amount of the price decrease multiplied by the contract size. If you sell and the price goes up, you lose an amount equal to the price increase multiplied by the contract size. These profits and losses are paid daily via the variation futures margin which a clearing broker must deposit with the clearing house every day on behalf of its customers. The broker either finances this for its customer or calls its customer for collateral against unrealised losses. Some futures exchanges have position limits dependent on whether you are a speculator, trader or hedger. Sometimes daily maximum price movements are also enforced. These usually only apply to USA-based exchanges contracts. For example, price limit and position limits do not apply to IPE oil futures contracts. During the Gulf War some participants found that NYMEX was forced to suspend trading, while the IPE carried on trading. These are points to consider when choosing futures contracts. FUTURES OPTIONS CONTRACTS An option is the right, but not the obligation, to buy or sell a specified number of underlying futures contracts or a specified amount of an energy commodity or index at an agreed price (based on the strike price of the option) on or before a given future date. FUTURES OPTIONS CONTRACTS 35 49. Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardised with respect to the quantity of the underlying futures contracts, expiration date, and strike price (the

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