Crude Oil Price Risk Management
Phoenix Energy Marketing Consultants Inc.
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Crude Oil Price Risk Management
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Outline
• What is “crude oil price risk management”?
• Why manage crude oil price risk?
• How do companies manage crude oil price risk?
• What types of deals do companies really do?
• Conclusion
Crude Oil Price Risk Management
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What is “Crude Oil Price Risk Management”?
• Attempt to mitigate the negativeeffects of oil price movements on a business
• Mitigation level dependent on impact on business
• “Unhedged” vs. “Fully Hedged” continuum
• Oil producers concerned with revenue / cash inflow
• Want to avoid falling crude oil prices
• Also want to avoid wider differentials and higher Can.$/U.S.$ exchange
• Oil users/consumers concerned with expense / cash outflow
• Want to avoid rising crude oil prices
Crude Oil Price Risk Management
0 20 40 60 80 100 120 140 160
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
P R I C E (U S $ / b b l)
Price Risk? What Price Risk?
From 1996 to present, monthly average crude oil prices in North America have ranged from
$11.32 (Dec.’98) to $134.04 (June ‘08). Average is $55.09 over the period.
Crude Oil Price Risk Management
5WTI Daily Settle
90 100 110 120 130 140 150
2-Ju n-0
8 9-Ju
n-0 8 16-Jun-0
8 23-Jun-0
8 30-Jun-0
8 7-Ju
l-08 14-Jul-08
21-Jul-08 28-Jul-08
4-Au g-0
8 11-Au
g-0 8 18-Au g-0
8 25-Au
g-0 8 1-Se
p-0 8 8-Se
p-0 8 15-Se
p-0 8 22-Se
p-0 8 29-Se
p-0 8
$US/bbl
Price Risk? What Price Risk?
Observe this 3-month period in 2008: Huge price moves!
Crude Oil Price Risk Management
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Why Manage Price Risk?
1. Ensure financial stability
• Repay bondholders & bank loans 2. Ensure minimum profitability / cash flow
• Jan ‘08: American Airlines said it had hedged 24% of its fuel needs for ’08 3. Protect shareholder returns
• Dividends from E&P companies
• Dividends from manufacturing companies 4. Protect investments: acquisitions / future capital projects
• Nexen protected Buzzard acquisition using put options
• Western Oil Sands protected AOSP project expansion using collars
• Suncor protected capital program with $60 puts for Cal ‘09 & ‘10
Crude Oil Price Risk Management
7How to Manage Price Risk?
1. Diversify Product / Feedstock / Energy Source
• Producers:
• Produce oil in various grades – light, heavy, oil sands, synthetic crude
• Produce natural gas
• Users:
• Chemical Plants: oil &/or natural gas
• Wood mills: wood chips, natural gas, electricity or heating oil
• Public transit: gasoline, natural gas, diesel, or electricity 2. Diversify Geographically
• Producers:
• Various producing basins in North America and around the world
• Nexen is in the WCSB, U.S., Middle East, North Sea
• Users:
• Locate factories near cheap energy
• Nova Chemicals is in Canada, U.S., Argentina
• Methanex has facilities on every continent except Antarctica 3. Enter into price risk management contracts
• Physically or financially
Crude Oil Price Risk Management
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Physical Oil Price Risk Management: Purchase & Sale Contracts
FiveRequirements for every deal
1. Product: What quality? Light, sweet worth more than heavy, sour 2. Location: Oil in Alaska is worth less than oil in Chicago
• Transport costs account for most of this “basis” differential 3. Quantity: How many barrels over what time period?
4. Term: Start & End dates 5. Price: Fixed price or floating price?
• Currency is important, too.
Crude Oil Price Risk Management
9Physical Oil Price Risk Management: Purchase & Sale Contracts
• Edmonton posting is afloating price
• Was price risk managed?
Alberta Producer 400 bbl/day Nov. 1-30 User
420API crude oil At Edmonton Edmonton posting
$C/bbl
Floating Price
Quantity
Product Location Term
Example #1: Physical purchase & Sale of oil at a floatingprice.
Crude Oil Price Risk Management
Physical Oil Price Risk Management: Purchase & Sale Contracts
Example #2: Physical purchase & Sale of oil at a fixedprice.400 bbl/day Nov. 1-30 420API crude oil
At Edmonton
• Was price risk managed?
• What are the potential challenges in actuallygetting this deal done?
• What other risksmight the producer & user both be concerned with?
Alberta Producer User
Fixed Price
$C95.00/bbl
Crude Oil Price Risk Management
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1 crude oil futures contract (“CL”)
=
1,000 bbl light sweet crude oil delivered at Cushing, OK Ratably over a particular month
Contracts are listed 9 years into the future (Monthly for 6 years then Dec & June only for next 3)
(see description at http://www.cmegroup.com/trading/energy/crude- oil/light-sweet-crude_contractSpecs_futures.html)
Linking Physical to Financial: The Futures Contract
Crude Oil Price Risk Management
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NYMEX WTI Swap Histroical Forward Curves
50 55 60 65 70 75 80 85
Feb-07 May-0
7 Aug-07
Nov-07 Feb-08
May-0 8 Aug-08
Nov-08 Feb-09
May-0 9 Aug-09
Nov-09 Feb-10
May-1 0 Aug-10
Nov-10 Feb-11
May-1 1 Aug-11
Nov-11 Feb-12
May-1 2 Aug-12
Nov-12
$US/bbl
January 4, 2007 August 22 2007 October 4, 2007 Contango
Flat
Backwardated
Futures Contract Price “Curve”
Each monthly futures contract has its own price
• Charting this strip of prices gives us a curve shape
• “Contango” : an upward-sloping curve (January 4, 2007)
• “Backwardated” : a downward-sloping curve (October 4, 2007)
Crude Oil Price Risk Management
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Futures Exchanges
• Crude Oil Futures contacts trade on organized futures exchanges:
• New York Mercantile Exchange (NYMEX)
• International Petroleum Exchange (IPE) in London
• NYMEX Trading hours (New York/ET time):
• Open outcry Monday to Friday from 9:00 am until 2:30 pm.
• Electronic (via CME Globex) Sunday to Friday from 6:00 pm until 5:15 pm with 45 minute break each day at 5:15 pm.
Crude Oil Price Risk Management
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Futures Contracts: Attributes:
• Organized Exchange
• Regulated by Government (CFTC)
• Standardized Contracts
• Product Quality (370to 420API)
• Location (Cushing, OK)
• Quantity (1,000 bbl)
• Term (monthly delivery periods)
• Price ($U.S./bbl)
• Limited Products
• Fixed Price & Vanilla Options
• Credit Protection
• Performance Guaranteed by Clearinghouse
• Buyers & Sellers Post Cash Margin
• Clearing & Brokerage Fees
Crude Oil Price Risk Management
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Futures Contract Physical Delivery Example
Example #3: On December 10, 2008, a Producer and User who are both at Cushing, OK use February ‘09 NYMEX futures contracts
• February 09 futures contact expires (last trading day) on January 22
• NYMEX “matches” Producer with User for physical delivery at Cushing
• Producer delivers 1,000 bbl/day from February 1 to 28 and receives $45.00/bbl
• User receives 1,000 bbl/day from February 1 to 28 and pays $45.00/bbl
• Was price risk managed?
• What about other risks?
28 Contracts Feb. 09 28 Contracts Feb. 09
Producer NYMEX User
$45.00/bbl $45.00/bbl
Crude Oil Price Risk Management
Attention!! Critical Information:
Crude Futures: The “2/3, 1/3” Rule
Trading of a futures contract terminates at the close of business on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25thcalendar day of the month is a non- business day, trading shall cease on the third business day prior to the business day preceding the 25thcalendar day.
Examples:
• Feb. 2009 contract last day is Jan. 22/09
• Mar 2009 contract last day is Feb. 20/09
• April 2009 contract last day is Mar. 19/09
The “Prompt” or “Nearby” contract is the first one listed and still active on the futures screen:
• From Jan 23 to Feb. 20, March is the promptcontract
• From Feb. 21 to Mar. 19, April is the promptcontract Consider thecalendar month of February:
• For the first 2/3, March is the promptfutures contract
• For the last 1/3, April is the promptfuture contract
Yes, But so What?????
Crude Oil Price Risk Management
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Crude Futures: The “2/3, 1/3” Rule: So What?
In order to effectively use futures contracts for financial price risk management of physical crude sale (or purchases), it is critical that the futures price and the physical price are highly correlated. Prompt month futures contract is highly correlated to the Edmonton daily posted price:
Edm onton Posting vs W TI Prom t Month
66 67 68 69 70 71 72 73 74 75 76
2-Jul-07 4-Jul-07 6-Jul-07 8-Jul-07 10-Jul-07 12-Jul-07 14-Jul-07 16-Jul-07 18-Jul-07 20-Jul-07 22-Jul-07 24-Jul-07 26-Jul-07 28-Jul-07 30-Jul-07
$US/bbl
Edm onton Posting W TI Prom pt M onth
Trading August as Prom pt M onth T rading Septem ber as Prom pt M onth Edm onton Posting
W TI Prom pt M onth Edmonton Posting vs WTI Futures Prompt Month
WTI Futures Prompt Month
July 2007 Monthly Average WTI Futures - $ 74.02 Edmonton Posting - $71.28
Crude Oil Price Risk Management
18WTI vs NYMEX Open Interest
0 50,000 100,000 150,000 200,000 250,000 300,000 350,000
May 2008
Aug 2008 Nov 2008
Feb 2009 May 2009
Aug 2009 Nov 2009
Feb 2010 May
2010 Aug 2010
Nov 2010 Feb 2011
May 2011
Aug 2011 Nov 2011
Feb 2012 May 2012
Aug 2012 Nov 2012
Feb 2013
$US/bbl
90 92 94 96 98 100 102 104 106
# of Contracts
Price (right scale)
Open Interest (left scale)
Financial Oil Price Risk Management: What do companies really do?
In reality, futures contacts rarely used. Why?
• Standardized contracts are not flexible enough
• Mismatched volume & timing
• Costs: posting margin, brokerage & clearing fees, employee time & effort
• Not enough liquidity – especially longer term
Crude Oil Price Risk Management
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Financial Oil Price Risk Management: What do companies really do?
Most use Over-the-Counter (“OTC”) markets
• Customized price risk management tools
• Dealers offer flexible volume, time periods, location, index and currency
• Better liquidity
• Trading screens, dealer market, brokers
• Volume of trading on the OTC market is 10+ times more than futures contract
• Better visibility
• Dealers will quote even very long time periods
• No fees (except on trading screens)
• More flexible credit terms
Crude Oil Price Risk Management
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Futures Contracts OTC Forward Contracts
• Organized Exchange
• Standardized Contracts
• Product Quality (370to 420API)
• Location (Cushing, OK)
• Quantity (1,000 bbl)
• Term (monthly delivery periods)
• Price ($U.S.)
• Performance Guaranteed by Clearinghouse
• Buyers & Sellers Post Cash Margin
• Clearing & Brokerage Fees
• Regulated by Government
• Fixed Price & Vanilla Options
• No Exchange – Bilateral Contracts (ISDA)
• Customized Contracts
• Any Product Quality
• Any Location
• Any Quantity
• Any Term
• Any Price (Any Currency)
• No Automatic Performance Guarantees
• Credit Terms Negotiated
• No Fees
• Largely Unregulated
• Fixed Price, Vanilla & Exotic Options
Financial Oil Price Risk Management: Futures vs. Forwards
Crude Oil Price Risk Management
21OK Producer
Dealer User
Financial Oil Price Risk Management: Forward “Fixed for Floating” Swap
Example #4 : Step 1: Enter the Forward Swap and Physical Deals• On May 25, 2007, a Producer at Cushing, OK sells a NYMEX “CMA” swap to Dealer
• Some time before July 1, Producer sells physical oil for July 1-31 at Cushing, OK
Step 2: Achieve correlation between futures and physical prices
• Financial: Let the NYMEX swap settle automatically at $74.02
• Physical: Deliver physical oil every single day July 1-31, receive $74.12 400 bbl/day
July 1-31 420API crude oil at Cushing
$U.S. 71.28/bbl 400 bbl/d NYMEX
“CMA” Swap
Cushing posting
$U.S./bbl
Financial Physical
“Floating”
“Fixed”
Crude Oil Price Risk Management
OK Producer
Dealer Financial Physical User
Financial Oil Price Risk Management: Forward “Fixed for Floating” Swap
Results:• Producer pays dealer on financial swap settlement = $2.74 ($74.02 - $71.28)
• Producer receives $74.12 for sale of physical oil
• Producer’s net result is $71.38 ($74.12 - $2.74)
Was price risk managed?
400 bbl/day July 1-31 420API crude oil at Cushing
$U.S. 71.28/bbl 400 bbl/d NYMEX
“CMA” Swap Cushing posting
$U.S./bbl
$74.12
$74.02
$74.02
Crude Oil Price Risk Management
23Financial Oil Price Risk Management: Forward “Fixed for Floating” Swap
Example #5: This is what Example #4 would look like if the location was Edmonton, not CushingEdmonton Producer
Dealer User
400 bbl/day, July 1-31, 420API crude oil at Edmonton C$75.53/bbl
400 bbl/d NYMEX CMA Swap
Edmonton posting C$/bbl
Financial Physical
• Result = C$74.87 + (C$75.53 – C$77.75) = C$72.65/bbl
• No FX risk – Dealer gave a C$/bbl price
• U.S. $71.28 = C$75.53 at 1.0596 C$/U.S.$ FX rate (Actual for July was $1.0503)
• No volume mismatch – Dealer traded 400 bbl/d (for 31 days)
• No timing mismatch – Dealer gave an average of the daily NYMEX price to match the posting method
• Basis risk between Cushing (NYMEX) & Edmonton remains
C$77.75 C$74.87
Crude Oil Price Risk Management
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Financial Oil Price Risk Management: Put Options
Example #6: Producer in Oklahoma sells physical oil at Cushing & buys OTC “put” options to protect against fallingprices
OK Producer
Dealer User
400 bbl/day Nov. 1-Jan.31 420API crude oil
at Cushing, OK U.S.$85.00 puts on 400 bbl/d
NYMEX Calendar Month Average Nov. 1- Jan. 31 U.S.$9.00/bbl
premium
Cushing posting U.S.$/bbl
Financial Physical
• What are the payoffs?
• Was Price Risk managed?
• How effective is a put relative to a fixed price swap?
Crude Oil Price Risk Management
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NYMEX Settle
Put Option Strike
Is Settle <
Strike?
TD Pays on Option
Producer Pays Premium
Producer Net Price
95 85 NO 0 9 86
94 85 NO 0 9 85
93 85 NO 0 9 84
92 85 NO 0 9 83
91 85 NO 0 9 82
90 85 NO 0 9 81
89 85 NO 0 9 80
88 85 NO 0 9 79
87 85 NO 0 9 78
86 85 NO 0 9 77
85 85 NO 0 9 76
84 85 YES 1 9 76
83 85 YES 2 9 76
82 85 YES 3 9 76
81 85 YES 4 9 76
80 85 YES 5 9 76
79 85 YES 6 9 76
78 85 YES 7 9 76
77 85 YES 8 9 76
76 85 YES 9 9 76
75 85 YES 10 9 76
Financial Oil Price Risk Management: Put Options
• A simple payoff table reveals the effects of buying a put
• Revenue from Oil = NYMEX settle + Dealer Payout – Option Premium
Crude Oil Price Risk Management
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Financial Oil Price Risk Management: Call Options
Example #7: Chemicals manufacturer in Alberta buys physical oil at Edmonton & buys OTC
“call” options to protect againstrising prices.
Producer
Dealer Alberta
Chemical Co.
1000 bbl/day Nov. 1-Jan.31 420API crude oil at
Edmonton
U.S.$90.00 calls on 1000 bbl/d NYMEX Calendar Month Average Jan. 1/08 – Dec.31/08
U.S.$7.50/bbl premium
Edmonton posting C.$/bbl
• What are the payoffs?
• Was Price risk managed?
• How effective is a call relative to a fixed price swap?
Crude Oil Price Risk Management
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Financial Oil Price Risk Management: Call Options
• A simple payoff table reveals the effects of buying a call
• Cost of Oil = NYMEX settle – Dealer Payout + Option Premium
Crude Oil Price Risk Management
Financial Oil Price Risk Management: Costless Collar
Example #8: Chemicals manufacturer in Alberta buys physical oil at Edmonton & buys OTC call options while simultaneously selling OTC put options.
Producer
Dealer Alberta Chemical
Co.
420API crude oil at Edmonton U.S.$90.00 puts
Edmonton posting C $/bbl
• What are the payoffs?
• Was Price risk managed?
• How effective is a collar relative to a fixed price swap or call options?
Dealer
Premiums net to Zero
U.S.$ 8.00/bbl premium
U.S.$ 8.00/bbl
premium U.S.$110.00
calls
Crude Oil Price Risk Management
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NYMEX Settle
Call Option Strike
Is Settle >
Strike?
Chem Co.
Receives on Call Option
Put Option Strike
Is Settle <
Strike?
Chem Co.
Pays on Put Option
Chem Co.
Net Price
120 110 YES 10 90 NO 0 110
118 110 YES 8 90 NO 0 110
116 110 YES 6 90 NO 0 110
114 110 YES 4 90 NO 0 110
112 110 YES 2 90 NO 0 110
110 110 NO 0 90 NO 0 110
108 110 NO 0 90 NO 0 108
106 110 NO 0 90 NO 0 106
104 110 NO 0 90 NO 0 104
102 110 NO 0 90 NO 0 102
100 110 NO 0 90 NO 0 100
98 110 NO 0 90 NO 0 98
96 110 NO 0 90 NO 0 96
94 110 NO 0 90 NO 0 94
92 110 NO 0 90 NO 0 92
90 110 NO 0 90 NO 0 90
88 110 NO 0 90 YES 2 90
86 110 NO 0 90 YES 4 90
84 110 NO 0 90 YES 6 90
82 110 NO 0 90 YES 8 90
80 110 NO 0 90 YES 10 90
Financial Oil Price Risk Management:
Call Option + Put Option = Costless Collar
• A simple payoff table reveals the effects of buying a call & selling a put
• Cost of Oil = NYMEX settle – Payout from Dealer + Payout to Dealer
Crude Oil Price Risk Management
30Swap 45%
Put 12%
Costless collars 37%
Forwards or futures 3%
Three-way collars 3%
Swap Put Costless collars Forwards or futures Three-way collars
Hedging by Type of Instrument
Source: How do Firms Hedge Risks? (Mnasri et al, 2013)
What types of deals do companies really do?
Crude Oil Price Risk Management
• Mark-to-Market calculation measures the difference between the value of the hedge transaction and the current market value of the same transaction
• Example: One Year Fixed Price Swap on 1,000 bbl/day @ $100
• If the market rises and 2 weeks later the same deal is priced @$125
• MTM = ($100-$125) x 1,000 bbl/day x 365 days = - $9,125,000
• Seller of this swap may/may not be required to post margin against this negative MTM position, depending upon terms of bi-lateral agreement with Buyer.
• Margin calls and financial assurances are often provided in cash or letters of credit from creditworthy banks.
• If margin call is not met, a default event is triggered and contract may be terminated
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“Mark-to-Market”
Crude Oil Price Risk Management
32Conclusion
What?• An attempt to mitigate the (negative) effects of oil price movements Why?
• Ensure financial stability
• Ensure minimum profitability / cash flow
• Protect shareholder returns
• Protect investments How?
• Products/feedstock & market/geographic diversification
• Physical & financial price risk management tools
• Financial tools available on future exchanges & OTC
• OTC Fixed price swaps, puts, calls & collars are the most common
