Oil Futures Market Hedging Price Management 24 February

Oil Futures Market Hedging & Price Management 24 February 2021 1

Outline n Types of Financial Instruments n Jargons n Usages of Financial Instruments n Trading Failures 2

Types of Financial Instruments n n n Forward Contract Futures Contract Derivatives 1. Options Ø Calls Ø Puts 2. Swaps 3

Forward Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price on a specified future date. Payment in full is due at the time of, or following, delivery. ” 4

Future Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price at a specified location. ” 5

Futures Contracts - Characteristics Regulated n Small lots n Monthly quote n Price transparent n Clearing house n Margin money required n Not always physical n 6

Options “a right – but not an obligation- to buy or sell an underlying asset at a fixed price during a specified time period in exchange for a onetime premium payment. ” Call n Put n : the option to buy : the option to sell 7

Where are They Traded ? NYMEX (US) IPE (London) Light sweet crude (WTI) Brent Heating oil (No 2) Gasoil Gasoline Natural Gas SIMEX (Singapore) Fuel Oil 8

Jargons n Contango vs. Backwardation n Long vs. Short n Bull vs. Bear 9

Contango If at any point in time… Market prices RISE through future months… Then the market is in CONTANGO 10

Backwardation If at any point in time…. . Market prices FALL through future months… Then the market is in BACKWARDATION 11

IPE Gasoil Curve 12

Pay Out Diagram – Long Position Profits $ Profits as Market rises 27 28 29 $/bbl Losses as Market falls Losses $ 13

Pay Out Diagram – Short Position Profits $ Profits as Market falls 31 32 33 $/bbl Losses as Market rises Losses $ 14

Use of Financial Instruments 1. Speculation 2. Hedging 3. Price Management 15

Speculation n Outright position taking n Pure paper traders n Directional price movement 16

A Speculative Market 17

Hedging Definition: Taking an opposite position on futures to that on physical to remain… “PRICE NEUTRAL” n Objective: “TO REDUCE RISK” n 18

Hedging - Example n n n n n It is October 29 th. A trader loads a gasoil cargo ex-Yanbu. The FOB price is $270/ton. His freight cost is $15/ton. He also has agreed to sell it CIF to a buyer in Rotterdam at Platts 0. 2%S CIF on arrival. Vessel is due Rotterdam November 9 th. Today, Platts 0. 2%S CIF price is $293/ton IPE December Futures price for gasoil is $291/ton. The trader intend to make $8/ton in profits. 19

Hedging – Example (continue) n Hedging plan (Part I) u When the physical is priced in, he should sell futures (October 29 th) n Action: 1. Buy physical @ $270/ton 2. Sell Futures @ $291/ton 20

Hedging – Example (continue) Hedging plan (Part II) When the physical is priced out, he should buy futures (November 9 th) n On November 9 th, u Platts CIF Cargoes price is $280/ton u IPE December Futures price is $278/ton n Action: 1. Sell physical @ $280 2. Buy Futures @ $278 n 21

Hedging – Example (continue) Accounting Physical FOB Purchase Fright $/ton -270 CIF Sale 280 Net -5 -15 Futures Sell on Oct. 29 th Buy on Nov. 9 th $/ton +291 Net 13 OVERALL NET = +$8/TON -278 22

Price Management Definition: Using futures and forward markets as a vehicle to… “CATCH THE MARKET” n Objective: “LOCKING IN A PRICE” n 23

Price Management - Example n n n It is November 1 st A Japanese refinery is due to load Dubai crude on December 15 th As usual, price will be determined 5 days around B/L Buyer fear that crude prices are increasing next month and would like to lock current price Action: 1. Buy Dubai futures now 2. Sell Dubai futures at time 24 physical is priced

Why Do You See Trading Failures? Failure to understand risk & exposure n Poor organizational structure n Excessive speculation n No position tracking n Absence of controls n Extreme market volatility n 25

Crude Oil Prices 26

Crude Oil Price Volatility OPEC Meeting (Vienna) 27

Summary Many financial instruments n Three motives to use financial instruments. n There is a distinct difference between hedging and speculation n Hedge to reduce risk n Trading Failures n 28