3/11/2015. Crude Oil Price Risk Management. Crude Oil Price Risk Management. Crude Oil Price Risk Management. Outline

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1 1 Phoenix Energy Marketing Consultants Inc. 2 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 3 What is? Attempt to mitigate the negative effects 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 1

2 P R I C E (U S $ / b b l) /11/2015 Price Risk? What Price Risk? 4 From 1996 to present, monthly average crude oil prices in North America have ranged from $11.32 (Dec. 98) to $ (June 08). Average is $55.09 over the period. Price Risk? What Price Risk? 5 Observe this 3-month period in 2008: Huge price moves! $US/bbl 150 WTI Daily Settle Jun-08 9-Jun Jun Jun Jun-08 7-Jul Jul Jul Jul-08 4-Aug Aug Aug Aug-08 1-Sep-08 8-Sep Sep Sep Sep-08 Why Manage Price Risk? 6 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 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 2

3 How to Manage Price Risk? 1. Diversify Product / Feedstock / Energy Source s: Produce oil in various grades light, heavy, oil sands, synthetic crude Produce natural gas s: 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 s: Various producing basins in North America and around the world Nexen is in the WCSB, U.S., Middle East, North Sea s: 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 7 Physical Oil Price Risk Management: Purchase & Sale Contracts Five Requirements 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. 8 Physical Oil Price Risk Management: Purchase & Sale Contracts Example #1: Physical purchase & Sale of oil at a floating price. 9 Edmonton posting $C/bbl Floating Price Alberta Quantity Product Edmonton posting is a floating price Was price risk managed? 400 bbl/day Nov API crude oil At Edmonton Location Term 3

4 Physical Oil Price Risk Management: Purchase & Sale Contracts 10 Example #2: Physical purchase & Sale of oil at a fixed price. Fixed Price $C95.00/bbl Alberta 400 bbl/day Nov API crude oil At Edmonton Was price risk managed? What are the potential challenges in actually getting this deal done? What other risks might the producer & user both be concerned with? 11 Linking Physical to Financial: The Futures Contract 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 Futures Contract Price Curve 12 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) $US/bbl NYMEX WTI Swap Histroical Forward Curves Flat Backwardated Contango January 4, 2007 August October 4, 2007 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 4

5 13 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. Futures Contracts: Attributes: 14 Organized Exchange Regulated by Government (CFTC) Standardized Contracts Product Quality (37 0 to 42 0 API) 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 Futures Contract Physical Delivery Example 15 Example #3: On December 10, 2008, a and who are both at Cushing, OK use February 09 NYMEX futures contracts $45.00/bbl $45.00/bbl NYMEX 28 Contracts Feb Contracts Feb. 09 February 09 futures contact expires (last trading day) on January 22 NYMEX matches with for physical delivery at Cushing delivers 1,000 bbl/day from February 1 to 28 and receives $45.00/bbl receives 1,000 bbl/day from February 1 to 28 and pays $45.00/bbl Was price risk managed? What about other risks? 5

6 Attention!! Critical Information: Crude Futures: The 2/3, 1/3 Rule 16 Trading of a futures contract terminates at the close of business on the third business day prior to the 25 th calendar day of the month preceding the delivery month. If the 25 th calendar day of the month is a nonbusiness day, trading shall cease on the third business day prior to the business day preceding the 25 th calendar day. Examples: Feb 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 prompt contract From Feb. 21 to Mar. 19, April is the prompt contract Consider the calendar month of February: For the first 2/3, March is the prompt futures contract For the last 1/3, April is the prompt future contract Yes, But so What????? Crude Futures: The 2/3, 1/3 Rule: So What? 17 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: $US/bbl Edmonton Edmonton Posting Posting vs WTI vs Futures WTI Promt Prompt Month Month WTI Futures WTI Prompt Prompt Month Month Edmonton Posting July 2007 Monthly Average Edmonton Posting WTI Futures - $ Edmonton Posting WTI Prompt - $71.28 Month Jul-07 4-Jul-07 6-Jul-07 8-Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul-07 Trading August as Prompt Month Trading September as Prompt Month 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 18 # of Contracts 350, , , , , ,000 50,000 WTI vs NYMEX Open Interest Price (right scale) Open Interest (left scale) $US/bbl 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

7 19 Financial Oil Price Risk Management: What do companies really do? Most use Over-the-Counter ( OTC ) markets Customized price risk management tools s 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 s will quote even very long time periods No fees (except on trading screens) More flexible credit terms 20 Financial Oil Price Risk Management: Futures vs. Forwards Futures Contracts Organized Exchange Standardized Contracts Product Quality (37 0 to 42 0 API) 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 OTC Forward Contracts 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 21 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 at Cushing, OK sells a NYMEX CMA swap to Some time before July 1, sells physical oil for July 1-31 at Cushing, OK Floating 400 bbl/d NYMEX CMA Swap Cushing posting $U.S./bbl Financial OK Physical Fixed $U.S /bbl 400 bbl/day July API crude oil at Cushing 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 $

8 22 Financial Oil Price Risk Management: Forward Fixed for Floating Swap Results: pays dealer on financial swap settlement = $2.74 ($ $71.28) receives $74.12 for sale of physical oil s net result is $71.38 ($ $2.74) $ bbl/d NYMEX CMA Swap $74.12 Cushing posting $U.S./bbl Financial $U.S /bbl OK Was price risk managed? Physical 400 bbl/day July API crude oil at Cushing Financial Oil Price Risk Management: Forward Fixed for Floating Swap Example #5: This is what Example #4 would look like if the location was Edmonton, not Cushing 23 C$ bbl/d NYMEX CMA Swap C$74.87 Edmonton posting C$/bbl Financial Edmonton Physical C$75.53/bbl 400 bbl/day, July 1-31, 42 0 API crude oil at Edmonton Result = C$ (C$75.53 C$77.75) = C$72.65/bbl No FX risk gave a C$/bbl price U.S. $71.28 = C$75.53 at C$/U.S.$ FX rate (Actual for July was $1.0503) No volume mismatch traded 400 bbl/d (for 31 days) No timing mismatch gave an average of the daily NYMEX price to match the posting method Basis risk between Cushing (NYMEX) & Edmonton remains Financial Oil Price Risk Management: Put Options 24 Example #6: in Oklahoma sells physical oil at Cushing & buys OTC put options to protect against falling prices U.S.$9.00/bbl Cushing posting premium U.S.$/bbl Financial OK Physical U.S.$85.00 puts on 400 bbl/d NYMEX Calendar Month Average Nov. 1- Jan. 31 What are the payoffs? Was Price Risk managed? How effective is a put relative to a fixed price swap? 400 bbl/day Nov. 1-Jan API crude oil at Cushing, OK 8

9 Financial Oil Price Risk Management: Put Options A simple payoff table reveals the effects of buying a put Revenue from Oil = NYMEX settle + Payout Option Premium NYMEX Put Option Is Settle < TD Pays Pays Settle Strike Strike? on Option Net Price NO 0 Premium NO NO NO NO NO NO NO NO NO NO YES YES YES YES YES YES YES YES YES YES Financial Oil Price Risk Management: Call Options Example #7: Chemicals manufacturer in Alberta buys physical oil at Edmonton & buys OTC call options to protect against rising prices. 26 U.S.$7.50/bbl premium Alberta Chemical Co bbl/day Nov. 1-Jan API crude oil at Edmonton U.S.$90.00 calls on 1000 bbl/d NYMEX Calendar Month Average Jan. 1/08 Dec.31/08 Edmonton posting C.$/bbl What are the payoffs? Was Price risk managed? How effective is a call relative to a fixed price swap? Financial Oil Price Risk Management: Call Options A simple payoff table reveals the effects of buying a call Cost of Oil = NYMEX settle Payout + Option Premium 27 9

10 Financial Oil Price Risk Management: Costless Collar 28 Example #8 : Chemicals manufacturer in Alberta buys physical oil at Edmonton & buys OTC call options while simultaneously selling OTC put options. U.S.$90.00 puts 42 0 API crude oil at Edmonton Premiums net to Zero U.S.$ 8.00/bbl premium U.S.$ 8.00/bbl premium Alberta Chemical Co. Edmonton posting C $/bbl U.S.$ calls What are the payoffs? Was Price risk managed? How effective is a collar relative to a fixed price swap or call options? 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 + Payout to 29 Chem Co. Chem Co. Receives on Pays on Put Call Option Option NYMEX Call Option Is Settle > Put Option Is Settle < Chem Co. Settle Strike Strike? Strike Strike? Net Price YES NO YES 8 90 NO YES 6 90 NO YES 4 90 NO YES 2 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 NO NO 0 90 YES NO 0 90 YES NO 0 90 YES NO 0 90 YES NO 0 90 YES What types of deals do companies really do? Hedging by Type of Instrument 30 Forwards or futures 3% Three-way collars 3% Swap Put Costless collars 37% Swap 45% Costless collars Forwards or futures Three-way collars Put 12% Source: How do Firms Hedge Risks? (Mnasri et al, 2013) 10

11 Mark-to-Market 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 $100 If the market rises and 2 weeks later the same deal is 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 Conclusion 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 33 11

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