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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
Price Risk Management and Trading. Energy risk management expert, Tom James, does it again. His latest book is a timely addition to the rapidly developing energy trading markets. This book should be on every energy trader, risk manager and corporate planer's desk. it is an easy read as Tom goes into great detail to explain the intricacies of this market and its various unique elements. - Peter C. Fusaro, Chairman, Global Change Associates Inc., Best-selling Author and Energy Expert This sensible and practical guide is essential for those seeking an understanding of commerce in energy derivatives. beyond merely informative, this hand book for the practitioner details the finer points of the use of derivatives as tools for price-risk management. No energy trading desk should be without it. - Ethan L. Cohen, Senior Director, Utility and Energy Technology, UtiliPoint International Inc. Energy markets are much more volatile than other commodity markets, so risk mitigation is more of a concern. Energy prices, for example, can be affected by weather, geopo9litical turmoil, changes in tax and legal systems, OPEC decisions, analysis' reports, transportation issues, and supply and demand - to name just a few factors. Tom James's book is a practical guide to assessing and managing these risks. It is a must-read for senior management as well as risk and financial professionals.- Don Stowers, Editor, Oil & Gas Financial Journal This book is the most comprehensive on price risk management-centric efforts. It provides the reader with a tangible experience of derivatives in today's capital and energy markets. The breadth and scope of the passages are immense, in that both developed and developing countries' energy markets are considered and examples applied. Terrific read! - Rashpal Bhatti, Marketing Manager, Energy Trading Asia, Enron/BHP Billiton Tom James has simplified the intricacies of a very complex market. In this new market of "hot" commodities, he has been able to give a fresh course to those who are new to the energy markets and a solid review for those that are well seasoned. he covers everything within the oil market from A to Z in this book and does it well. Coming from a financial background myself, it's good to finally find a book that can bring a better understanding to the field of energy commodities. - Carl Larry, Vice President Citi Energy Global Commodities
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Contents
Introduction
CHAPTER 1 Risk Management in Energy Markets
THE RISK MATRIX
FINANCIAL RISKS
BASIS RISK
LEGAL, OPERATIONAL AND TAX RISKS
SUMMARY
CHAPTER 2 The Energy Derivatives Markets
ON EXCHANGE AND OFF EXCHANGE
ON-EXCHANGE AND OVER-THE-COUNTER
FUTURES
FUTURES VS. OTC
SWAPS AND OPTIONS
TYPES OF SWAPS IN ENERGY MARKETS
KNOCK-INS AND KNOCK-OUTS — INTEGRATING SWAPS AND OPTIONS
THE COMMON AND MORE LIQUID OPTION MARKETS IN ENERGY
CHAPTER 3 Energy Futures Contracts
INTRODUCTION
KEY FACTS ABOUT FUTURES CONTRACTS
FUTURES OPTIONS CONTRACTS
HEDGING IN FUTURES MARKETS
OIL FUTURES
EXCHANGE OF FUTURES FOR PHYSICALS (EFP) AND DELIVERIES VIA FUTURES MARKETS
COAL FUTURES
CHAPTER 4 Pricing Middle East Crude in the Next Century
INTRODUCTION
A FAIR PRICE
CAUSE FOR CHANGE
ASIAN DEMAND, MIDDLE EAST SUPPLY AND GROWING INTERDEPENDENCE
THE VALUE OF CRUDE OIL
FREIGHT RATES
PRICE DISCOVERY AND CRUDE BENCHMARKS IN THE WORLD TODAY
COMPARING WTI, BRENT AND DUBAI
PRICE DISCOVERY: OTC VS. FUTURES MARKETS
A NEW PRICING PARADIGM
CONCLUSION
NOTES
CHAPTER 5 Emissions Trading — Towards a Global Carbon Market
TOWARDS GLOBAL CARBON MARKETS
THE EUROPEAN REGIME
THE CARBON EXCHANGES
CHICAGO CLIMATE EXCHANGE (www.chicagoclimatex.com)
CHICAGO CLIMATE FUTURES EXCHANGE (www.chicagoclimatex.com)
NYMEX (www.nymex.com)
THE EUROPEAN UNION EMISSIONS TRADING SCHEME
THE EUROPEAN CLIMATE EXCHANGE (www.europeanclimateexchange.com)
USING FUTURES CONTRACTS TO HEDGE RISK
NORD POOL (www.nordpool.com)
POWERNEXT (www.powernext.fr)
EEX (www.eex.de)
EXAA (www.exaa.at)
CHAPTER 6 Options Trading and Hedging Application Strategies
VOLATILITY
TYPES OF OPTIONS
OPTION STRATEGIES FOR HEDGING ENERGY-PRICE EXPOSURE
OPTION STRATEGIES
OTC OPTIONS AND POPULAR STRUCTURES
OPTIONS TRADING — VOLATILITY TRADING
BUTTERFLY STRATEGY
RATIO BACKSPREADS
CHAPTER 7 Energy Option-pricing Models
ENERGY-MARKET OPTIONS
GENERAL RULES FOR OPTION VALUES
MODELS USED IN THE ENERGY INDUSTRY
ASIAN OPTION PRICING
CHAPTER 8 Value-at-Risk and Stress Testing
A RISK-MANAGEMENT SCENARIO
VAR AND OTHER RISK-MEASUREMENT METHODS
WHAT DOES VAR DO?
VAR RECAP
VAR TO ILLUSTRATE HEDGE EFFECTIVENESS
STRESS TESTING AND VAR
STRESS TESTING METHODOLOGIES
THE HYPOTHETICAL OR SENSITIVITY STRESS-TEST APPROACH
LIMITATIONS OF STRESS TESTS
SUMMARY
CHAPTER 9 Questions to Ask When Establishing a Risk-Management or Trading Program
CHAPTER 10 Management Controls
THE COLLAPSE OF BARINGS
THE LESSONS OF HISTORY
CREATING A RISK-MANAGEMENT OR TRADING POLICY
CORPORATE DERIVATIVES RISK-MANAGEMENT POLICY-AND-PROCEDURES DOCUMENT
BACK-OFFICE SYSTEMS
WHO SHOULD LOOK AT THE REPORT AND RECORDS?
DERIVATIVE BACK-OFFICE MANAGEMENT
ROLE OF EXTERNAL/INTERNAL AUDIT AND COMPLIANCE
RECONCILIATION AND ACCOUNTING: KEY POINTS TO CONSIDER
RISK-MANAGEMENT REVIEW
THE COLLAPSE OF ENRON, 2001
WHAT CAN WE LEARN FROM ENRON?
CHAPTER 11 Derivatives Controls & Usage Statement and Control Infrastructure
THE RISK MANAGEMENT PROCESS
TRADING CONTROLS — POSITION LIMITS
KEY GUIDELINES
CHAPTER 12 OTC Derivatives Legal Documentation
THE ISDA MASTER
THE ISDA AGREEMENTS
THE ISDA MASTER AGREEMENT
USEFUL ISDA PUBLICATIONS
ISDA DOCUMENTATION PROCESSING
TRADING BEFORE AN ISDA IS SIGNED
ISDA MASTER AGREEMENT SCHEDULE
ADDITIONAL NOTES
THE ISDA AGREEMENTS: A COMPARISON “1992 VERSUS 2002 VERSION”
CHAPTER 13 Energy-Market Hedging Scenarios
WHAT IS HEDGING?
GENERAL RECAP ON ENERGY DERIVATIVES
HEDGING APPLICATION EXAMPLES
HEDGING IN COAL MARKETS
U.K. SPARK SPREAD
CHAPTER 14 Key Technical Analysis for Energy Futures Markets
WHAT IS TECHNICAL ANALYSIS?
THE PRINCIPLES OF TECHNICAL ANALYSIS
THE TECHNICAL-ANALYSIS BAR CHART
SUPPORT AND RESISTANCE
VOLUME
OTHER CHARTS
THE VIP RELATIONSHIP (VOLUME, OPEN INTEREST AND PRICE)
END-OF-TREND SIGNAL
PRICE GAPS AS PRICE TARGETS
FIBONACCI RETRACEMENT LEVELS
MATHEMATICAL INDICATORS
MOVING AVERAGES
CHART PATTERNS
NOTES ON HEAD-AND-SHOULDERS FORMATIONS
THE FLAG FORMATION
PENNANTS
DOUBLE TOPS AND BOTTOMS
SUMMARY
CHAPTER 15 Operational Risk and its Management
KEY COMPONENTS OF OPERATIONAL RISK
ASSESSING AND CONTROLLING OPERATIONAL RISK
GATHERING INFORMATION ON OPERATIONAL RISK
RISK REDUCTION, CONTROL AND CONTAINMENT
TRENDS IN OPERATIONAL PROCEDURES
SUMMARY
CHAPTER 16 A Practical Guide to Credit Control and Risk-Mitigation Methods
METHODS FOR MANAGING CREDIT-RISK EXPOSURE
WAYS TO REDUCE CREDIT RISK VIA THE ISDA SCHEDULE
COLLATERALIZATION
GUIDELINES FOR TAKING COLLATERAL FROM COUNTERPARTIES
CREDIT INSURANCE
THE NEW TOOL OF THE TRADE — CREDIT-DEFAULT SWAP (CDS)
OBSTACLES AND LIMITATIONS: COUNTERPARTY CREDIT RISK
BASIC OVERVIEW OF PRICING AND VALUATION MECHANICS
WHICH CREDITS CAN BE TRADED?
DOCUMENTATION FOR CREDIT DERIVATIVES
THE DEVELOPMENT OF THE CDS MARKET
TOTAL-RETURN SWAPS
OBSTACLES AND LIMITATIONS TO TRS
MITIGATING CREDIT RISK VIA CLEARING HOUSES
MANAGEMENT GUIDELINES ON ESTABLISHING A CREDIT-CONTROL FRAMEWORK
CHAPTER 17 Accounting for Energy Derivatives Trades
INTRODUCTION
CONSOLIDATION AND CLARIFICATION OF ACCOUNTING STANDARDS 2002–06
FAS 133
INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) (www.iasb.org)
IAS 39 FINANCIAL INSTRUMENTS: RECOGNITION & MEASUREMENT
IMPLEMENTING IAS 39
STEPS TO ESTABLISHING HEDGE ACCOUNTING
CLOSING NOTE
Index
Copyright © 2008 by John Wiley & Sons (Asia) Pte. Ltd.
Published in 2008 by John Wiley & Sons (Asia) Pte. Ltd.
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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. Any methods and examples in this book are only intended to demonstrate the relevant concepts in general terms. They may have been 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 Liquid Capital Group Ltd or any of its subsidiaries.
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Introduction
Today, more than ever before, the management of price risk is the center of attention for the majority of energy producers and consumers around the world. Strong demand from the United States and China during the years leading up to 2007 increased geopolitical tensions surrounding energy-producing regions, and increased money flow from traders and fund managers into the energy financial markets has contributed to a combination of increased energy prices and increased volatility.
With over US$100 billion of additional speculative money added to the energy financial markets such as the New York Mercantile Exchange (www.nymex.com) and the Intercontinental Exchange (www.theice.com) between 2000 and 2006, it’s fair to say that even if geopolitical tensions do not create any further volatility in the years to come, the increased money flows created by investors into the energy markets may continue to do so. Although investors cannot determine the long-term price trends in energy markets, which are driven by fundamental supply/demand economics, they can determine short-term volatility in price.
The magnitude of the increase in trading in the energy markets is reflected by the phenomenal growth in the daily volumes of the global energy markets. In early 2007, the average daily value of global oil-futures contracts was around US$300 billion notional value, and close to US$800 billion when the over-the-counter (OTC) swaps markets is factored into the equation.
What does this mean for energy-related or energy-dependent businesses? Increased volatility in prices makes it even more difficult to budget properly for revenues or expenses. Admittedly, the relationship between risk and reward is at the heart of all business. In any endeavor, the risk of heavy losses is seen as a justification for handsome 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 industry’s recent past (the oil price shock of 1973 and the Gulf War of 1991) as key milestones in general economic history. Not to mention the historic and sustained price rise seen in the global oil and gas markets from 2003 to 2006.
So it’s 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. Derivatives 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 world’s oil supplies posed by Saddam Hussein’s invasion of Kuwait in August 1990 caused the price of crude oil to jump by more than 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 practical guidance in the effective trading of energy derivatives and their use as tools of price-risk management.
These are normally considered to be highly specialized activities, but this does not mean that they should be treated in isolation. Energy derivatives cannot be properly understood or used effectively 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.
In this book you will find fact, flavor and formulae. Each is a key element in running a successful hedging strategy but must be integrated into the company’s management ethos. Therefore, this is a book to be read not just in the trading departments, but also in the boardroom, in the finance department and by shareholders in the enterprise.
Whilst the media make much of derivatives scandals, corporate collapses and hedge-fund closures, there are thousands of success stories for every disaster.
Tom James
Head of Commodity Trading
Liquid Capital Markets Ltd
Liquid Capital Group
The Liquid Capital Group was founded by brothers Chris and Gregg Siepman in 2000 and by 2007 the firm had already grown to more than 130 employees with offices in London, Sydney and Chicago. Liquid Capital ranks amongst the top largest global equity derivatives market-makers by volume on Eurex and other equity option markets. In July 2007 Liquid Capital expanded its business into energy and commodity derivatives trading and investment management.
For more information on the group please visit: www.liquidcapital.com
CHAPTER 1
Risk Management in Energy Markets
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, often 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 of such factors might include the weather; the balance of supply and demand; political tensions; comments made by the leaders of certain countries; decisions taken by OPEC; analysts’ reports; shipping problems; and changes to tax and legal systems. All of 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 shown in Figure 1.1. This illustrates how all the risks shown interrelate and affect one another, and makes clear that the 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.
FIGURE 1.1 The Risk Matrix
As the matrix shows, the key additional risks to be managed in an organization 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 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 arising when the counterparty to a contract defaults. It is often said that a hedge contract is only as reliable as the credit standing of the counterparty and credit-risk management has moved to the top of the priority list for the energy industry. The credit crunch felt in the U.S. energy sector in the aftermath of the Enron disaster has prompted energy traders to review credit policies and also to 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 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 organization will not be able to produce the cash to meet its derivatives obligations. In the late nineties, 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 U.S. 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, it 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:
Physical material in one location cannot be delivered to relieve a shortage in another location.
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.
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 from which protection is needed. 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 such as the Intercontinental Exchange, the New York Mercantile Exchange and the Tokyo Commodity Exchange all have their pricing references and terms fixed in the exchange’s 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 will be more on the differences, and respective advantages and disadvantages of on-exchange and OTC contracts in later chapters.)
Components of basis risk
Locational Basis
FIGURE 1.2 Locational basis
Time Basis
FIGURE 1.3 Time basis
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.
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 International Swaps Dealers Association (ISDA).
Operational risk
The risk that may occur through the 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 computerized) should be employed to reduce this risk.
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.
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. But it is important to remember that any hedging strategy which focuses narrowly on any one of the risks outlined in this chapter and ignores the others may be worse than having no hedging strategy at all.
CHAPTER 2
The 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 publicized corporate financial disasters. This is ironic because derivatives are essentially instruments to manage and reduce risk. They were created to provide opportunities to minimize price risk and to lock in profits, while reducing balancesheet 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 ruthless 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 standardized agreements on a regulated futures exchange to make or take delivery of a specified energy product (oil, gas, 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; 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 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 known as the writer) 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 the seller or 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 company’s balance sheet (now this is only the case when hedging using derivatives). Derivatives weren’t 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 US$1 million swap is traded, the principal value 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 is priced 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 as the New York Mercantile Exchange (NYMEX) and London’s International Petroleum Exchange (ICE). 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, they rely much more heavily on OTC derivatives. This is because OTC derivatives are customized 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. Sometimes there are additional legal, credit and operational risks with OTC derivatives compared to on-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.
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 around since oil was drilled in the United States in the 1850s. The first formalized regulated futures exchange for oil was NYMEX, which started contracts on heating oil in 1977 (re-launched as the current contract in 1979) and followed by West-Texas-Intermediate contract (WTI crude). On the other side of the Atlantic, the International Petroleum Exchange (ICE) 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 world’s crude oil markets price in some way against Brent Crude Oil. Both NYMEX and ICE also operate futures markets for natural gas and electricity/power.
In the Far East, SIMEX (now merged into SGX in Singapore) ran a popular fuel-oil futures contract in Singapore until the early 1990s, when it was overtaken in popularity by the OTC derivatives market and Asia is now practically dependent on OTC derivatives for risk-management purposes in energy markets. However, the Dubai Mercantile Exchange (DME) Oman Crude Futures contract launched on 1 June 2007 has been attracting both interest and trading volume and this could become a useful on-exchange futures contract tool for Middle East crude hedging, particularly since Asia is heavily dependent on Middle East crude imports for oil-refinery operation (see Chapter 4).
FUTURES VS. OTC
At one time it was easy to distinguish the futures market from the OTC market and to establish their relative advantages. When a risk manager or trader 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 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) together with 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 and variation. Initial margin is the good-faith deposit that is placed with the clearing house or that a broker finances (at a cost) when a trade is opened. 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 variation margin (that is, it is showing an unrealized profit), because the position has not yet been traded or closed out, some of that margin will be returned.
However, when OTC contracts are used there is usually credit risk of the other company in the transaction to consider, as well as a liquidity risk and a lack of price transparency because there is no screen to display a real-time price. The basic workings of a futures market are illustrated in Figure 2.1.
FIGURE 2.1 Basic futures trade transaction flow
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 counterparties can agree to “givein” their OTC deal to a clearing house. This process basically makes the clearing house the counterparty to the OTC deal, so that the two OTC counterparties 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 counterparties to trade an OTC derivative contract with one another directly and to take on one another’s credit risk, as illustrated in Figure 2.2.
FIGURE 2.2 Direct OTC dealing
In the new convergence environment, the situation is illustrated in Figure 2.3.
FIGURE 2.3 The role of the clearing house
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 on screen as in futures markets.
Settlement on expiry
Energy futures contracts all entail physical and cash delivery on expiry (apart from ICE Brent crude futures in London). So if a seller holds the futures contract to expiry, he will have to deliver the underlying physical energy (oil, gas, power); and if a buyer 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 ICE 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
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 from which the swaps price is derived. It is called a swap because the two counterparties to the deal, the buyer and the seller, exchange an agreed fixed price on a particular day 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); the pricing period (for example, one month, quarterly, calendar year); the start, or effective, date; the end, or termination, date; and the payment-due date.
For a swap priced against an American or European floating-price reference, the payment-due date is normally the fifth business day after the last pricing day of each pricing period. In energy and general 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 or a payment will be received by the organization. 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 option it is, on whether it is a futures option (traded on a futures exchange — a “traded option”) 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. An option is in the money when it has intrinsic value; that is, when 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 futures exchange clearing house 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 one of the parties has a profitable swaption that it could exercise into a profitable swaps position but forgets to tell the counterparty that it wishes to exercise it by the cut-off time specified in the original option contract, it then becomes open to negotiation whether the counterparty will allow the swaption to be exercised; and if they do, it will most probably come at a price.
TYPES OF SWAPS IN ENERGY MARKETS
Plain vanilla
This is the term used to describe a simple monthly averaging swap in which a fixed price is exchanged against a floating price in the future. These swaps are used extensively in oil, LPG, and LNG-related hedging and trading.
When executing the deal, the counterparties agree on the fixed price for that day, and on which floating price reference they will use to calculate the settlement.
FIGURE 2.4 A plain-vanilla swap
Cash-flow example of plain-vanilla deal
Counterparty A buys fixed price
$15.00 (buys fixed, sells floating)
Counterparty B sells fixed price
$15.00 (sells fixed, buys floating)
Floating price reference (for example, Platts) average during the price period $16.00
Differential swap
A differential swap is similar to a plain-vanilla swap except that instead of having one fixed price against 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 against gasoil, commonly termed the “regrade” swap.
FIGURE 2.5 A differential swap
Cash-flow example of differential swap
Counterparty A buys fixed-price kero and sells fixed-price gasoil at a difference of US$0.50 per barrel kero premium.
Counterparty B sells fixed-price kero and buys fixed-price gasoil at a difference of US$0.50 per barrel kero premium.
Differential swaps are used across the whole energy spectrum. In the power and gas markets we see “spark spreads” 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. Normal efficiency used is 49.13% and the spark spread is quoted in megawatt hours (MWh).
Table 2.1 provides an example of a spark spread; that is, the profit margin available for burning gas in a power station and the value at which electricity can be sold.
TABLE 2.1 Spark spread
Where coal is measured against power, there is what is known as the “dark spread”, which works on the same principle as the spark spread, with two fixed prices and two floating prices documented in swaps confirmation. However, the net exposure is only on the differential between the two products/instruments. In the United Kingdom, dark spreads use an energy conversion efficiency of 5,000 MT of coal producing 55Mw of electricity at an efficiency of 38%.
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, 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 might find that the fixed price quoted 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 than 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, they could offer an interesting opportunity for speculators who have a strong view on the price direction of 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
Margin swaps come into play where an organization 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. Organizations could construct complex hedges themselves to protect their energy inputs/outputs but this has a cost in that it involves managing many individual positions with perhaps several counterparties. It can therefore be more cost-efficient and easier to enter into a margin swap with one counterparty that is willing to provide a contract that covers all the price risks. An example of a margin swap is given in Figure 2.6, which shows the key input (crude oil feedstock) that needs to be risk managed and the five main energy outputs as petroleum products. A refiner can obtain a single swap contract that protects the NET overall margin from processing a particular type of crude and the regional values of the petroleum products produced.
But 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. The administrative and human resources available in the organization have to be reviewed and adjusted to correspond with the level of its derivatives activities.
FIGURE 2.6 Example of a margin swap for an oil refiner
KNOCK-INS AND KNOCK-OUTS — INTEGRATING 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 de-activated, 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 the 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 2.7 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).
FIGURE 2.7 Barrier options
A common example is the up-and-out floor (put) which is typically purchased by an energy producer to hedge its natural long position in the energy markets. This 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 commodity’s 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 or 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 compensation to the holder.
The up-and-out barrier is less expensive than a standard Asian, European or American option because the underlying price may fall below the 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 on this more complicated 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 “collars” (see Figure 2.8). A call or cap 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.
A put or floor 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 2.8 Calls and puts, caps and floors
Options strategies can be very flexible and can help companies achieve exactly the risk-reduction or risk-exposure profile they want. 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 the market price demands.
If an option is sold on its own, it is called a “naked option”. Here, 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 (see Table 2.2.).
TABLE 2.2 Naked options
Main option styles
American: An American-style option is one that may be exercised into its underlying instrument (that is, a futures contract) on any business day until expiry. All the ICE 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: 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: These are the most common option style in the OTC market and are sometimes referred to as “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 options — premium
There are many types of option models available and each one has its own particular use, depending on the specific need. While it is not necessary to have an in-depth understanding of the mathematics of these models, users should understand what needs to be put into the model to obtain the right answers and be able to interpret the results. The principles of premium calculation are illustrated in Figure 2.9. Any options pricing model will have some fundamental inputs, as shown below, and these are key factors in determining the value of any option available in the market place. It is fair to say, though, that the following are generally the core factors that play an important role in determining the value of the option.
FIGURE 2.9 The principles of premium calculation
As we saw earlier, margin options can price against a complex structure of differentials rather than against a single floating-price reference. In our example of a margin swap for an oil refiner, the 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. 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, say, a margin option, 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 current or forward negative margin — a situation with which participants in some of the fuel-oil markets will be familiar. In this case, the refiners might have good margins which they wish to lock in by using swaps on the middle distillates (naphtha, gasoil, jet, for example) but they are still faced with the need to halt any further exposure to the fuel-oil margin becoming more negative (and at the same time, they don’t want to lock in a negative margin). In this instance, the refiner could look at a “crack option” (an option contract which insures the refinery against the risk of the profit margin between refining crude oil and producing fuel oil from becoming negative or even more negative, as the case may be, but still allows the refiner to benefit from a recovery in the value of this business) 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 (MTM) on a daily basis and there 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 organization. (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 create trading strategies that profit from moves in price direction, from the price moving in a particular price band, and from the price staying the same by using volatility trades (through which money can be made not from the market price moving up or down, but on volatility increasing or decreasing).
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 eighteenth century. The New York Mercantile Exchange (NYMEX), the world’s largest regulated energy-futures exchange, started life in 1872 as the Butter and Cheese Exchange of New York before being renamed 10 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 — such as the TOCOM in Tokyo, the SGX in Singapore, the ICE in London, the EEX in Germany, Nord Pool in Scandinavia, NYMEX in New York, and Intercontinental Exchange out of the United States — 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.
Today’s futures industry functions with a number of time-tested institutional arrangements, including clearing-house guarantees and exchange self-regulation.
KEY FACTS ABOUT FUTURES CONTRACTS
A futures contract is a standardized 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;
requires the daily settlement of all gains and losses as long as the contract remains open; and
provides, on expiry of the contract, 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 computerized 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 futures accounts held by brokers for their customers.
Futures contracts can be terminated by an offsetting transaction (that is, an equal and opposite transaction to the one that opened the position) executed at any time prior to the expiry of the contract. The vast majority of futures contracts are terminated by offset or a final cash payment, rather than by delivery. For example, on the International Petroleum Exchange and the New York Mercantile Exchange less than 2% of the open interest (total contracts open) in their energy-futures contracts go to physical delivery each month.
A standardized 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
Expiry date
— the date on which a particular futures trading contract will cease and on which all obligations under it will terminate
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 alternative delivery locations available at a premium or discount (for example, a NYMEX WTI Crude futures contract allows traders to deliver alternative crude oils and has a table of premium and discounts that are fixed for these)
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 — the “initial margin” — with a brokerage firm which would be a clearing member of the exchange on which the futures contract is to be traded. This initial margin amount is typically around 10% of the total notional contract value.
If you buy a futures contract (“go long”) 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 the customer or calls the customer for collateral against unrealized losses.
