Producer Hedging the Production of Heavy Crude Oil

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1 Producer Hedging the Production of Heavy Crude Oil An oil producer sells its future production of heavy crude oil to a customer at an agreed-upon price today. The producer seeks to lock-in this price to protect against an adverse price movement between the time the price is agreed upon (today) and the time the heavy crude oil will be produced and delivered in three weeks. The price of one barrel of heavy crude oil (specifically, Western Canadian Select or WCS) is quoted in the market at US$10.00 below the price of West Texas Intermediate (WTI). Since Canadian crude oil is priced at a differential to WTI, the producer is exposed to the risk of large fluctuations in the price differential between heavy crude oil and light crude oil. Specifically, if the price differential widens, the producer s profitability and cash flow will be adversely impacted. So, the producer is looking to lock-in the price differential between WCS heavy crude oil and WTI light crude oil to hedge the production of heavy crude oil. The producer can use Canadian Heavy Crude Oil Differential Price futures (or WCH DIFF futures) and WTI Light Crude Oil futures (or WTI futures) to hedge efficiently the production of heavy crude oil. Backdrop Scenario TODAY IN THREE WEEKS Price of the WTI futures US$70.00 US$66.00 WCS WTI differential price (the NGX WCS WTI Crude Oil Index represents the price differential between WCS and WTI) -US$10.00 US$10.00 per barrel lower than WTI. -US$16.00 US$16.00 per barrel lower than WTI. Implied price of one barrel of WCS US$60.00 US$50.00 Strategy ACTION TODAY IN THREE WEEKS REMARKS Step 1 - Hedge the price of one barrel of WCS Sell WTI US$70.00 Buy WTI US$66.00 Producer closes out the position in WTI futures. Note: there is no delivery of WTI crude oil as the position is closed before the expiration of the WTI futures. Profit = +US$4.00 Implied price of one barrel of WCS (producer s inventory of heavy crude oil resulting from future production) US$60.00 US$50.00 Loss as a result of the price drop of one barrel of WCS heavy crude oil. Loss = -US$10.00 Cont d... >>

2 ACTION TODAY IN THREE WEEKS REMARKS Step 2 - Hedge the basis risk between heavy crude oil and light crude oil Producer sells WCH DIFF -US$10.00 or US$90.00 as per the quotation method of the NGX WCS WTI Crude Oil Index for the WCH futures contract Note: the NGX WCS WTI Crude Oil Index is the underlying index of the WCH DIFF futures Sell WCH DIFF US$90.00 Buy WCH DIFF US$84.00 Producer closes out the position in WCS DIFF futures. Note: The producer sells WCH DIFF futures to hedge the basis risk between heavy crude oil and WTI light crude oil. Profit = +US$6.00 Net profit/loss Net profit/loss = US$0.00 (resulting in a fully hedged position) Therefore, the producer s strategy to sell the WTI futures contract (to hedge the price of one barrel of WCS) combined with the sale of the WCH DIFF futures contract to hedge the basis risk (specifically, to hedge against a widening of the price differential between one barrel of WTI and one barrel of WCS) results in an efficiently hedged position. Had the producer not used the WCH DIFF futures contract, he would have suffered a loss of US$6.00 per barrel. The loss is explained by the fact that the WTI futures contract does not account for the basis risk between heavy crude oil and WTI light crude oil. Therefore, the producer is faced with an additional risk that is not covered by using only WTI futures contracts. To hedge the basis risk (price differential), a producer must sell WCH DIFF futures contracts as well. In this scenario, regardless whether the price of WTI or WCS rises or drops, the producer s motivation for initiating the transaction is to hedge against the risk of a widening of the price differential between WTI and WCS. As shown in the following figure, a widening of the differential generally leads to poorer profitability for Canadian heavy oil producers and a narrowing of the differential generally leads to poorer profitability for oil refiners. Therefore, both producers and end users have a price risk to manage that would be mitigated using the Canadian Heavy Crude Oil Differential Price futures contract (WCH). FIGURE 1: FINANCIAL IMPACT OF THE PRICE DIFFERENTIAL BETWEEN LIGHT AND HEAVY CRUDE OIL FOR PARTICIPANTS Source: Petro Canada

3 Refiner Hedging a Narrowing Price Differential between Heavy Crude Oil and Light Crude Oil A refiner s processing margins are gradually being squeezed as a warm winter has sharply reduced the demand for heating oil. The refiner expects margins to shrink further from current levels as OPEC and Canadian producers cut output of heavy crude oil, as global demand slows, tightening supply and narrowing the price discount of heavy crude oil relative to light crude oil. Refiners buy crude oil as the raw material for their operations to produce and sell refined products typically, heating oil and gasoline. So, refiners make money from the differential between different grades of crude oil (light and heavy) and prices of refined products, not the price of crude oil and gasoline alone. Since Canadian crude oil is priced at a differential to WTI, the refiner is exposed to the risk of large fluctuations in the price differential between heavy crude oil and light crude oil. Specifically, a narrowing price differential between heavy crude oil and light crude oil implies that it costs the refiner more to produce heating oil by refining heavy crude oil, thereby cutting into profitability. Consequently, the refiner seeks to lock-in the price differential between heavy crude oil and light crude oil to hedge against the risk that the price differential will narrow between the time the price is agreed upon with the producer and the time the heavy crude oil will be delivered in four weeks. To hedge the risk against further erosion in processing margins, the refiner decides to adopt a strategy using Canadian Heavy Crude Oil Differential Price futures (or WCH DIFF futures). Backdrop Scenario TODAY IN FOUR WEEKS Price of the WTI futures US$80.00 US$70.00 WCS WTI differential price (the NGX WCS WTI Crude Oil Index represents the price differential between WCS and WTI) -US$12.00 US$12.00 per barrel lower than WTI. -US$5.00 US$5.00 per barrel lower than WTI. Implied price of one barrel of WCS US$68.00 US$65.00 Strategy ACTION TODAY IN FOUR WEEKS REMARKS Step 1 - Hedge the price of one barrel of WCS Buy WTI US$80.00 Sell WTI US$70.00 Refiner closes out the position in WTI futures. Note: there is no delivery of WTI crude oil as the position is closed before the expiration of the WTI futures. Loss = -US10.00 Implied price of one barrel of WCS (change in the price of heavy crude oil over the time period) US$68.00 US$65.00 It costs the refiner US$3.00 less (per barrel) to buy WCS heavy crude oil. Profit = +US$3.00 Cont d... >>

4 ACTION TODAY IN THREE WEEKS REMARKS Step 2 - Hedge the basis risk between heavy crude oil and light crude oil Refiner buys WCH DIFF -US$12.00 or US$88.00 as per the quotation method of the NGX WCS WTI Crude Oil Index for the WCH futures contract Note: the NGX WCS WTI Crude Oil Index is the underlying index for the WCH DIFF futures. Buy WCH DIFF US$88.00 Sell WCH DIFF US$95.00 Refiner closes out the position in WCH DIFF futures. Note: The refiner buys WCH DIFF futures to hedge the basis risk between heavy crude oil (WCS) and light crude oil (WTI). Profit = +US$7.00 Net profit/loss Net profit/loss = US$0.00 (resulting in a fully hedged position) Therefore, the refiner s strategy to buy the WTI futures contract (to hedge the price of one barrel of WCS) combined with a long position in the WCH DIFF futures contract to hedge the basis risk (specifically, to hedge against a narrowing of the price differential between one barrel of WTI and one barrel of WCS) results in a efficiently hedged position. Had the refiner not used the WCH DIFF futures contract, he would have suffered a loss of US$7.00 per barrel. The refiner can hedge the basis risk using WCH DIFF futures contracts. In this scenario, regardless whether the price of WTI or WCS rises or drops, the refiner s motivation for initiating the transaction is to hedge against the risk of a narrowing of the price differential between WTI and WCS.

5 Investor Expecting the Price Differential between Heavy Crude Oil and Light Crude Oil to Widen An investor believes that the price differential between heavy crude oil and light crude oil will widen from the current level of -US$12.25 per barrel (as measured by the level of the NGX WCS WTI Crude Oil Index, which represents the price of one barrel of Western Canadian Select Heavy Crude Oil minus the price of one barrel of West Texas Intermediate Crude Oil). Supporting the outlook is the view that demand for asphalt and roofing tar (produced by refining heavy crude oil) will be considerably lower in the foreseeable future on slower construction activity, and demand for gasoline (produced mainly by refining light crude oil) will be higher ahead of the summer driving season. Against this backdrop, the investor expects the price of heavy crude oil to underperform relative to the price of light crude oil. Strategy The investor decides to use Canadian Heavy Crude Oil Differential Price futures contracts (or WCH futures) to benefit from the expectations of a widening of the price differential between heavy crude oil and light crude oil. Specifically, the investor sells five WCH futures. PRICE METHODOLOGY : The price of the WCH futures contract is quoted based on the following methodology: the price differential* between one barrel of WCS and one barrel of WTI * as measured by the NGX WCS WTI Crude Oil Price Index The price of the WCH futures contract is quoted at US$87.75 (implying that the price differential between heavy crude oil and light crude oil is -US$12.25 per barrel). The investor sells five WCH futures contracts (equivalent of 5,000 barrels of heavy crude oil). In Two Months In two months, the price of the WCH futures contract drops to US$83.50 (implying a price differential between heavy crude oil and light crude oil of -US$16.50 per barrel), and the investor closes out the position. Consequently, the price differential between heavy crude oil and light crude oil widened from -US$12.25 to -US$16.50 per barrel. Thus, the investor realizes a gain of US$4.25 per barrel for a profit of US$4, per futures contract (calculated by multiplying US$4.25 per barrel by the trading unit of 1,000 barrels of the futures contract), excluding commissions. The investor s total profit on the position of five contracts is calculated as follows: US$4.25 per barrel X 1,000 barrels per contract X 5 contracts = US$21, NUMBER OF WCH FUTURES BUY SELL CONTRACTS LEVEL Today PROFIT/LOSS (PER CONTRACT) PROFIT/LOSS (FOR TOTAL POSITION) In two months US$4, US$21, Cont d... >>

6 Given available research or fundamental market information, investors must consider as well the historical volatility and the price evolution of the differential price between heavy crude oil and light crude oil before initiating a position in the WCH futures contract. As shown in the following figure, the differential price between Canadian heavy crude oil (WCS) and light crude oil (WTI) is very volatile. The volatility, as measured by the standard deviation of the differential prices over a 20-day period, has ranged from a high of 270% to a low of 15%. Moreover, the differential price has ranged from a high of US$45.00 per barrel to a low of US$5.00 per barrel. FIGURE 1: DIFFERENTIAL PRICE AND 20-DAY ANNUALIZED VOLATILITY (WTI LIGHT MINUS WCS HEAVY) JANUARY 2005 TO APRIL % % % 150% % 15 50% % Jan 05 Jul 05 Jan 06 Jul 06 Feb 07 Aug 07 Feb 08 Aug 08 Mar 09 Sep 09 Mar Day Annualized Volatility Differential Price (US$ per barrel) Source: Bloomberg L.P.

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