The Mercatus Energy Pipeline

A Beginner's Guide to Crude Oil Options - Part III

Tue, 21 May 2013 10:48:00 GMT

As we discussed A Beginner's Guide to Crude Oil Options - Part I & Part II, there are four primary factors that determine the price of crude oil, as well as refined product, options:

Prevailing price of the underlying future or swap relative to the strike price of the option
Time value (also know as tenor or duration)
Volatility
Interest rates

In our last post, we focused on the second variable, the time value of an option. Today we're going to address one of the other primary variables which determine the price of crude oil options, volatility.

Volatility is an important factor in the pricing of options. In fact, volatility is the key component to pricing an option as it is the only "unknown" variable in an option pricing model. Given the current market price of a crude oil option and knowing the other variables in the pricing model - the price of the underlying crude oil future or swap, the strike price, the time to expiration and interest rate - the remaining factor - the derived volatility - is implied by the option's price.

All else being equal, the price of a crude oil option will increase as the probability of the option(s) expiring in the money increases. As such, option sellers demand higher premiums for options when volatility is or is anticipated to be "high". On the other hand, when volatility is or is anticipated to be "low" the price of an option with be lower.

Historical volatility is calculated from the past movement of crude oil prices over a specified time period. Mathematically, historical volatility is computed as the standard deviation of the log of the changes in crude oil futures, and swaps, prices, expressed in percentage terms, on an annualized basis.

To put it another way, if the implied volatility of a crude oil option is 50%, it means that the market is saying that there is a 68.3% probability (one standard deviation) that a year from now, the underlying price (future or swap) of that option will be 50% higher or lower. Historical volatility is important because many traders use it as a tool for forecasting future volatility.

As mentioned previously, volatility is one of the most important variables when determining the price of a crude oil option. As an example, an August $105.00 ICE Brent crude oil option would currently trade for about $3.22/BBL, based on an implied volatility of 20%. As a comparison, the same option with an implied volatility of 10% would trade at nearly half the price, approximately $1.63/BBL. If volatility were higher, the same option with an implied volatility of 30% would trade for appoximately $4.79/BBL. It should be noted that these examples assume an underlying of $104.93, an expiration date of July 11, 2003 and an interest rate of 0.29%.

So, what does volatility mean in practice to a producer or consumer looking to hedge their exposure to crude oil prices with options? In essence, it means that when volatility is high you will pay for for an option than you would when volatility is low.

UPDATE: This post is the third in a series on crude oil options. The previous posts can be found via the following links:

A Beginner's Guide to Crude Oil Options - Part I

A Beginner's Guide to Crude Oil Options - Part II

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A Beginner's Guide to Crude Oil Options - Part II

Wed, 15 May 2013 12:56:00 GMT

This post is the second in a series on crude oil options. This first post in the series can be found via the following link: A Beginner's Guide to Crude Oil Options - Part I. As mentioned in the previous post, there are four primary variables that affect the premium or price of crude oil options (as well as options on other energy commodities):

Prevailing price of the underlying future or swap relative to the strike price of the option
Time value (also know as tenor or duration)
Volatility
Interest rates

In the last post, we focused on the first variable, the prevailing market price (the underlying crude oil future or swap) vs. the strike price of the option. Today we're going to address another major component of crude oil option prices, the time remaining until the option expires, also known as time value, tenor, duration or more specifically, theta. Why so many different terms? Time value is the "layman's" term, tenor is the term most commonly used in the commodity trading world, duration is the term used in the fixed income world and theta is the term used to describe time value specifically as it relates to mathematical formulas used to determine the value of options. The time value of an option is the value (price) that traders place on the option above the option's intrinsic value. So if we know the value of an option and we subtract the intrinsic value, we also know the time value of the option.

The value of out-of-the-money options are, all else being equal, valued based on time to expiration since their intrinsic value is zero, as are at-the-money options. As options become significantly in- or significantly out-of-the-money, the premium attributed to time value declines substantially.

More specifically, the value attributed to time value for in-the-money options is the value (amount) that exceeds the options' intrinsic value and reflects the possibility that the option may move deeper into-the-money. The time value of an option declines as option approaches the date of expiration. The reason this is the case is that shorter the life of an option, the lower the probability that market prices, in this case crude oil, will change significantly. Given that this is the case, as the time to expiration approaches, there is a decreasing likelihood that an option will increase in value.

In summary, if you were to compare two crude oil options which have the same underlying, strike price, volatility and interest rate, but with different expiration dates, one expiring in one month and the other expiring in two months, the option with two months to expiration would trade at a premium (higher price) to the option with one month to expiration.

As an example, consider the case of two Brent crude oil options, both with a strike price of $102.50/BBL, an underlying of $102.50/BBL, a volatility of 21% and an interest rate of 0.28% but with different expiration dates, one in 26 days (July expiration) and another in 57 days (August expiration). All else being equal, the July option would be valued at approximately $2.35/BBL while the August option would be valued at approximately $3.45/BBL

To expand, if you are a crude oil consumer, refiner, marketer or producer looking to hedge your exposure to crude oil prices by purchasing options, the longer the tenor (time until expiration) of the option, all else being equal, the higher the cost of the option.

In our next post we'll explain the role of volatility in determining the value of crude oil options.

UPDATE: This post is the second in a series on crude oil options. The previous post can be found via the following link:

A Beginner's Guide to Crude Oil Options - Part I

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A Beginner's Guide to Crude Oil Options - Part I

Fri, 10 May 2013 17:05:00 GMT

We're often asked to explain what determines the price of crude oil (as well as bunker fuel, diesel fuel, gasoil, gasoline and jet fuel) options. This post will be the first in a series on how the pricing of crude oil options.

If you are unfamiliar with crude oil options, you can think of them as a form of insurance against rising or falling crude oil prices. In return for the right to buy or sell crude oil (or it's financial equivalent) without the obligation, options buyers pay (and options sellers receive) an upfront premium, very similar to how you pay a premium for an insurance policy.

The four major variables that determine the price of crude oil options are:

Prevailing price of the underlying future or swap relative to the strike price of the option
Time value (also know as tenor or duration)
Volatility
Interest rates

The variable which has the most influence on the price of an option is the relationship between the price of the underlying crude oil futures or swap and the strike price of the option. Depending upon the price of the underlying swap relative to a given strike price, an option is said to be at-the-money, in-the-money, or out-of-the-money.

An option is at-the-money when the strike price equals or is very close to the price of the underlying futures or swap. An option is considered in-the-money when the price of the underlying future or swap is above the strike price of a call option or when the price of the underlying swap is below the strike price of a put option. Lastly, an option is considered out-of-the-money when the price of the underlying future or swap is below the strike price of a call option or when the price of the underlying futures or swap is below the strike price of a put option.

To put the terminology into numerical context, if the June 2013 WTI crude oil futures contract were currently trading at $95/BBL, a June 2013 WTI crude oil call option with a strike price of $90/BBL would be considered in-the-money. On the other hand, if the June 2013 WTI crude oil futures contract were currently trading at $95/BBL, a June 2013 WTI crude oil call option with a strike price of $100/BBL would be considered out-of-the-money.

Conversely, if the June 2013 WTI crude oil futures contract were currently trading at $95/BBL, a June 2013 WTI crude oil put option with a strike price of $90/BBL would be considered out-of-the-money while a put option with a strike price of $100/BBL would be considered in-the-money.

The amount by which an option is in-the-money, is called intrinsic value. As an example, if the July 2013 Brent crude oil futures contract were currently trading at $100/BBL, and you owned a July 2013 Brent crude oil call option with a strike price of $75/BBL, the intrinsic value of your option would be $25/BBL. This intrinsic value, when combined with the time value of the option, are what determine the total value of the option. Alternatively, if an option is out-of-the-money, it has zero intrinsic value. As such, the price of an out-of-the-money option consists solely of the option's time value.

In our next post we'll explain how time value influences the value of crude oil options.

UPDATE: This post is the first in a series on crude oil options. The subsequent posts can be found via the following links:

A Beginners Guide to Crude Oil Options Part II

A Beginner's Guide to Crude Oil Options - Part III

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Is Your Company Hedging or Are You Really Speculating?

Tue, 07 May 2013 13:24:00 GMT

While most companies begin their energy hedging initiatives with the best of intentions, human nature often leads many down the wrong path, down the path of a speculator. While speculation isn't a bad thing in and of itself, after all hedgers need speculators to provide them with liquidity, speculation masked as hedging often leads to incredibly undesirable results.

Consider the case of the following two, fictitious North American airlines, Purple Airways and Pink Airlines.

Purple Airways consumes, on average, one hundred million gallons of jet fuel per year. Their hedging program is managed by their CFO who "hedges" the company's jet fuel price risk by purchasing ULSD (formerly heating oil) futures, when he determines that ULSD futures, the benchmark for North American jet fuel, are "cheap" relative to where ULSD futures have traded over the course of the past year. The tenor and volumes he chooses to hedge are also based on his perspective of the market such that the more confident he is about his perspective, the larger and longer-dated his transactions.

On the other hand, consider the case of Pink Airlines, who also consumes, on average, 100 millions gallons of jet fuel per year. Pink's hedging program is managed by a fuel hedging committee which consists of their CEO, CFO and treasurer. Pink's hedging program is based on one of the company's main financial goals, which is to produce consistent, positive cash flow. As such, the ultimate goal of Pink's fuel hedging program is to mitigate the impact that fuel prices have on the company's cash flows. To ensure that Pink achieves this goal on a regular basis, the fuel hedging committee has (with the help of their fuel hedging consultants) developed a fuel hedging policy, as well as an accompanying procedural guide, which addresses all of the details that the they are required to know in order for the fuel hedging program to be deemed a sustainable, successful initiative.

In addition, Pink's fuel hedging committee and their hedging consultants, as the result of extensive analysis, have determined that they will be able to meet their goals, regardless of whether fuel prices increase or decrease, by hedging 75% of their projected fuel requirements, on a rolling twelve-month basis, via a combination of Gulf Coast jet fuel swaps (25%) and average price call options (50%). Pink made the decision to hedge with Gulf Coast swaps and call options, at the previously mentioned percentages, as the analysis showed that this strategy will provide them with a hedge portfolio that best reflects their actual fuel price exposure as well as their tolerance for risk while ensuring that they won't face significant cash flow issues if fuel prices decline. As such, Pink's hedging committee has moved forward accordingly, as dictated by their hedging policy and procedural guide. This includes holding, effcient, bi-weekly meetings, during which time they review up-to-date reports of their existing hedge positions, fuel consumption forecasts, current jet fuel swap and option prices, etc. Before the conclusion of the meeting, they determine a course of action for the following two weeks. And two weeks later they repeat the process.

Clearly, Pink's approach provides a sound "system" which will ensure that their fuel hedging program has a very strong probability of producing the desired results. Purple's approach is, arguably, little more than a series of speculative bets on ULSD futures, based on their CFO's option about the market at any given time. Furthermore, given that Purple's approach lacks any sound analysis, Purple will never be able to say with any confidence, whether their hedging initiative will provide sustainable, meaningful results.

All else being equal, if you had to choose between becoming a shareholder or board member of either Purple Airways or Pink Airlines, which one would you choose? Given that the answer should be Pink Airlines, why do so many companies choose the path chosen by Purple Airways?

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May 2013 Energy Hedging Update

Wed, 01 May 2013 14:02:00 GMT

Since our April update, forward prices for crude oil and refined products have declined significantly, esentially erasing the gains from the prior month. On average, the forward curves for the core, global crude oil and refined products have declined 5.84% over the past month, led by NYMEX RBOB gasoline which declined by 7.93%.

In the natural gas space, NYMEX futures continue to increase, with the one year forward curve up 6.5% since our April update. It's also worth noting that, year-over-year, the one year, natural gas forward curve has increased by 153%.

Forward prices for natural gas liquids decreased by an average of 4.45% over the past month, led by normal butane, which declined by 10.89% since our April update. In contrast, forward ethane prices resisted the trend, with the forward curve increasing by 0.20% over the past month.

The following table displays the indicative, one year, forward strip prices as of the close of business on April 30, 2013, as well as the respective changes since our previous update, which was based on prices as of the close of business on March 28, 2013. Crude oil, refined product and NGL forward curves are comprised of May 2013 - April 2014 calendar swaps while the NYMEX natural gas forward curve is based on June 2014 - May 2014 futures.

	Current	Previous	Change ($)	Change (%)
NYMEX Crude Oil ($/BBL)	92.10	96.16	-4.06	-4.22%
ICE Brent Crude Oil ($/BBL)	100.47	107.23	-6.76	-6.31%
Dubai Crude Oil ($/BBL)	97.84	104.62	-6.77	-6.48%
NYMEX ULSD ($/Gal)	2.8533	3.0168	-0.1634	-5.42%
NYMEX RBOB Gasoline ($/Gal)	2.6436	2.8714	-0.2278	-7.93%
ICE Gasoil ($/MT)	860.62	917.82	-57.20	-6.23%
Gulf Coast ULSD ($/Gal)	2.8129	2.9805	-0.1676	-5.62%
Gulf Coast 6 Oil 3% ($/BBL)	89.52	94.58	-5.06	-5.35%
Rotterdam 3.5% Fuel Oil ($/MT)	570.11	599.90	-29.79	-4.97%
Singapore Fuel Oil 180 CST ($/MT)	602.38	632.66	-30.28	-4.79%
Gulf Coast Jet Fuel ($/Gal)	2.7587	2.9510	-0.1923	-6.52%
Singapore Jet Fuel ($/BBL)	115.31	122.63	-7.32	-5.97%
NWE Jet Fuel ($/MT)	931.59	991.72	-60.13	-6.06%
NYMEX Natural Gas ($/MMBtu)	4.468	4.195	0.272	6.50%
Mont Belvieu Propane ($/Gal)	0.9475	0.9722	-0.0247	-2.54%
Mont Belvieu Natural Gasoline ($/Gal)	1.9990	2.0820	-0.0831	-3.99%
Mont Belvieu Normal Butane ($/Gal)	1.2842	1.4412	-0.1570	-10.89%
Mont Belvieu Ethane ($/Gal)	0.3064	0.3057	0.0006	0.20%

The prices used in our monthly updates are "rolled" each month such that the previous update was based on one year (twelve month) strips beginning in April 2013 and ending in March 2014, for all but natural gas, which began with May 2013 and ended with April 2014.

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Does Hedging with Costless Collars Present Additional Basis Risk?

Mon, 29 Apr 2013 19:39:00 GMT

Over the past couple years we have addressed various aspects of both basis risk and costless collars however, until now, we have not addressed the two as they relate to one another. Which begs the question, when a company hedges with costless collars, are they potentially exposing themselves to unacknowledged basis risk?

Consider the case of a maritime company (cruise line, shipping, etc.) who has hedged their fuel oil (bunker fuel) price risk with a $110/$90 Brent crude oil costless collar, consisting of a long position on a $110 call option and a short position on a $90 put option. In essence this means that the company has hedged itself against Brent crude oil prices rising above $110/BBL while putting itself at risk if Brent crude oil prices declining below $90/BBL.

However, the company doesn't consume Brent crude oil nor does it consume fuel oil which references the price of Brent crude oil, rather the majority of it's fuel oil is priced via the Rotterdam 3.5% fuel oil index. As such, the company is exposed to the basis risk between Brent crude oil futures and Rotterdam 3.5% fuel oil. While many companies appear to understand and accept basis risk of this nature in exchange for the better liquidity in crude oil derivatives, many fail to recognize the very significant risk they are exposing themselves to when they sell options which reference crude oil (as well as heating oil/ultra low sulfur diesel and gasoil), rather than the fuel they are consuming, in this case fuel oil.

As the following chart indicates, over the past three years, the monthly average prices of Brent crude oil and Rotterdam 3.5% fuel oil are very highly correlated, approximately 97%. Note that for ease of comparison, we have converted Rotterdam fuel oil to barrels at a rate of 6.35 barrels per metric ton.

However, when we examine the correlation of the month-over-month changes between Brent crude oil and Rotterdam fuel oil, which is essential given the potential cash flow issues associated with the costless collar, the correlation isn't nearly as strong, as you can see on the following chart.

And this is where the unacknowledged basis risk may come into play for the company who is short the $90 Brent crude oil put option. When the average monthly prices of both Brent crude oil futures and Rotterdam 3.5% fuel oil increase or decrease in line with one another, the company's costless collar will perform pretty well. However, if Brent crude oil prices decrease more than Rotterdam 3.5% fuel oil, the company could find itself in a position where they are exposed to a loss on the $90 put option which is not offset by a corresponding, lower Rotterdam fuel oil price, a situation which has occurred more than a few times, as can be seen on the chart. The situation could be even worse if Brent crude oil futures were to decline while Rotterdam fuel oil prices are flat or increasing.

Clearly the opposite situation could occur as well, which would benefit the company. That is, if Rotterdam fuel oil prices were to decrease more than Brent crude oil futures, the company would benefit via the combination of lower fuel oil prices and a smaller than anticipated loss, or no loss at all, on the $90 Brent crude oil put option. However, hedging based on such assumptions is a potentially dangerous endeavor to say the least.

So how could the company mitigate their Brent Crude oil vs. Rotterdam fuel oil basis risk associated with their short $90 Brent crude oil put option? While we'll save the in-depth answer for a future post, in short, they could mitigate their exposure via a basis swap or option on the crack spread between Brent crude oil and Rotterdam fuel oil.

While our example focused on the basis risk between crude oil and fuel oil, the same methodology could be utilized to examine nearly any cross-commodity, quality or locational basis risk, as it relates to hedging with costless collars or any other strategy which involves selling options.

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Costless Collars - Energy Hedging Friend or Foe?

Thu, 25 Apr 2013 13:58:00 GMT

As has been the case many times in the past and certainly will be many times in the future, the debate regarding the advantages and disadvantages of hedging with costless collars is once again front and center.

If you've followed are blog for any period of time, you're well aware that we are of the opinion that costless collars can be a sound hedging strategy, when they are fully understood and utilized with caution and sound analysis. Why? It's really quite simple, costless collars are one of the leading causes of "unanticipated" hedging losses. Yes, you read that correctly. While costless collars are certainly viable hedging instruments, the potential negative implications (mark-to-market losses, negative cash flow, etc.) of being short an in-the-money- put option (in the case of a consumer) or call option (in the case of a producer) are often much greater than they are perceived to be at the time of execution.

Consider the case of an oil (fuel) consumer who entered into a $130/$100 (long a $130 call option, short a $110 put option) Brent crude oil costless collar in early February. At the time, crude oil prices appeared rather strong having traded as low as $106.66/BBL in early December. As such, a $130/$110 costless collar may have appeared to be an attractive strategy to some oil consumers. However, from a statistical perspective, this shouldn't have been the case. While crude oil prices did indeed appear to be quite strong as they approached $120 in early February, proper analysis at the time would have shown that Brent hadn't traded at such a level since May 2012 and had traded in a rather narrow range for the previous five months. In addition, Brent has shown a rather strong mean reverting tendency for the better part of the past few years.

On the contrary, due to their being in the opposite situation, early February may have been an attractive opportunity for an oil producer to consider the opposite strategy, buying a $110 put option and selling a $130 call option.

So why do so many companies hedge with costless collars? For many it's the attraction of "free" optionality. But optionality is very rarely free, in fact it's often quite expensive. As a result, what most consider to be costless collars aren't truly costless, they are just structured such that the premium paid for the long option is offset by the premium received for the short option.

Further to this point, unless you request that they do so, many derivative marketers quote costless collars without mentioning the premium cost associated with each leg of the collar. If you do decide to hedge with costless collars, it's imperative that you know the true value of both options as doing so is the only proper way to determine if the prices (both the strike prices as well as the premiums) being quoted are competitive, let alone whether the option is indeed "costless".

Costless collars can certainly be a viable hedging strategy but given that they require one to sell an option, before you decide to hedge with costless collars, you need to obtain a solid understanding of what it means to be short an option (and to assume the risk of being short an option). Otherwise, you risk coming face to face with the previously mentioned, "unanticipated" losses which have surprised far too many companies.

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Can Your Hedging Strategies Tolerate Significantly Lower Oil Prices?

Wed, 17 Apr 2013 13:57:00 GMT

Are oil prices poised to collapse again, as they did in 2008? We don't claim to know the answer to such a question as doing so would require us to have the ability to accurately predict global, macroeconomic events, which is beyond difficult to do in a normal environment, let alone in the current environment. That being said, we do think it's a question that deserves serious consideration given the fragility of the global economy as well as recent decline in not only oil but other asset classes (i.e. gold, which has declined approximately 15% in less than one week) as well.

For those of you who haven't paid close attention to crude oil and refined product prices in recent months, Brent crude oil, WTI crude oil, ultra low sulfur diesel (formerly heating oil), gasoline and gasoil futures have all declined more than 10% from their year-to-date highs. Since peaking in late January to early February (with the exception of gasoline which peaked in early March) Brent, WTI, ULSD, gasoline and gasoil futures have declined 15.97%, 11.57%, 13.34%, 15.51% and 18.92%, respectively.

So what's driving prices lower? In short, rising crude oil stocks. Year-over-year, as of April 5th, crude oil stocks are up 6.49%. On the products side, gasoline stocks are up 2.17% while distillate stocks are down 14.46%. On the demand side of the equation, (also as of April 5) gasoline demand is down 2.35% while distillate demand is up 2.03%. In addition, since the beginning of the year, gasoline demand is up 5.37% while distillate demand has been quite strong, up 21.58%. Clearly the market appears to be quite focused on the ever growing crude oil stocks, despite increasing demand for both distillates and gasoline. At 388.774MM BBLs, crude oil stocks are at their highest level in nearly 23 years and third highest level since the inception of the EIA's data, which dates back to August 20, 1982.

So back to the question at hand, can your hedging strategies tolerate significantly lower oil prices? How can you know? For starters, we would suggest that you stress test your portfolio (which is something that should be done on a regular basis regardless of the current price environment) to determine how a significant price decline would impact your positions, as well as your credit lines and bottom line. This is especially important for companies that employ hedging strategies which could potentially subject them to significant downside price risk i.e. swaps and collars in the case of consumers, three-way collars in the case of producers, etc. While we aren't forecasting a steep decline in oil prices, such an occurrence shouldn't be ruled out given the fragile state of the global economy, even more so with crude oil stocks at their highest level since 1990.

In summary, most, if not all, companies will be very well served to take a closer look at their hedging strategies to determine how such strategies will perform if/when we experience a period of significantly lower oil prices, or worse, a repeat of anything remotely similar to 2008.

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Three Strategies for Dealing with Rising Fuel Costs

Thu, 11 Apr 2013 12:24:00 GMT

Join Mercatus Energy Advisors and Allegro, Tuesday April 23, 2013 at 9:00 AM CT, for a 30 minute live webinar to learn about three strategies for dealing with rising fuel costs.

Rising fuel costs can cripple businesses that consumes large volumes of fuel. Hear from Mike Corley, founder and president of Mercatus, and consultant to some of the world’s largest industrial and commercial consumers of fuel on best practices in hedging fuel costs. Then learn how leading energy consumers utilize technology to improve cost control from Michael Hinton, Allegro Chief Customer Officer.

Learn ways to manage costs during the fuel procurement process using three primary hedging strategies including:

Swaps (fixed price) which provide you the ability to "fix" your fuel price and are the most popular fuel hedging instrument
Call options (capped price) which provide you the ability to "cap" your exposure to rising fuel prices but also allow you to benefit if fuel prices decline
Collars (cap and floor) which provide you the ability to "cap" your exposure to rising fuel prices as well as a "floor" which provides the ability to partially benefit from declining fuel prices

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A Conservative Hedging Strategy for Natural Gas Consumers

Tue, 09 Apr 2013 14:14:00 GMT

Over the course of the past year, the price of prompt month NYMEX natural gas futures have doubled since bottoming just below $2/MMBtu. The reasons are many (weather, coal to natural gas fuel switching, declining rig counts, etc.) and are prompting many commercial and industrial gas consumers, who thought they would long enjoy lower natural gas prices due ever increasing production, wondering how they should hedge in the current environment.

In our opinion, prices alone shouldn't drive hedging decisions, rather hedging decisions should be driven by significant business decisions. Better said, if you hedge your anticipated natural gas consumption for the period of in quiestion, how will the price impact your bottom line? What does it mean in terms of reward vs. risk? Is the potential benefit of declining prices so significant that you are willing to face higher prices in the interim?

Given the current environment, in recent weeks we've received several inquires as to how natural gas consumers can implement conservative, short-term hedging strategies.

So what strategies are available to companies looking for short-term, conservative strategies to hedge against higher natural gas prices? Beyond traditional futures, swaps and call options, one such strategy is a bull call spread. A bull call spread is the combination of buying one call option, with a "low" strike price, and selling another call option, with a higher strike price.

As an example, let's assume that you are looking to hedge your June 2013 natural gas consumption. If we look at the forward market for June natural gas futures, we see that they are currently trading in the $4.117/MMBtu range. In addition, let's assume that your analysis indicates that you want to be hedged against natural gas prices prices rising above $4.50/MMBtu. Last but not least, let's further assume that the maximum "out of pocket" cost you are willing to pay for such a hedge is $0.15/MMBtu.

Based on your needs, one potential strategy to consider a June $4.100/$4.600 bull call spread. This transaction would entail the combination of purchasing a $4.100 call option and selling a $4.600 call option. The net cost would be approximately $0.1400/MMBtu as the current prices for the $4.100 and $4.600 June natural gas call options are approximately $0.18/MMBtu and $0.04/MMBtu, respectively.

As the chart above indicates, by hedging with a $4.100/$4.600 bull call spread, you are hedged against prices rising above $4.100 up to a maximum of $4.600, at which point your maximum gain on the position would be $0.50/MMBtu. In addition, this position is a low risk hedging strategy as the position would not expose you to losses should natural gas prices decline. In fact, by hedging with a bull call spread, you would be well positioned to benefit from lower prices such that your net cost would simply be the settlement price of the June natural gas futures plus the $0.140/MMBtu premium paid for the call option spread.

The "downside" to hedging with spreads on options is that your maximum potential gains are limited. As mentioned above, in this example, if the June natural gas futures contract settles above $4.600, your gain would be limited to $0.50/MMBtu. In addition, when you include the premium cost, your maximum net gain would be $0.36/MMBtu.

In closing, for commercial and industrial natural gas consumers seeking conservative, short-term hedging strategies against rising prices, bull call spreads are one strategy to consider.

Similarly, natural gas producers seeking a conservative, short-term hedging strategy against declining natural gas prices, can consider a bear put spread, a strategy we highlighted last November in a post titled A Low Cost Natural Gas Hedging Strategy For E&P Companies.

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How to Reduce Basis Risk by Hedging with Options - Part II

Thu, 04 Apr 2013 12:12:00 GMT

A few weeks ago, in a post titled How to Reduce Basis Risk by Hedging with Options - Part I, we looked at how a large fuel consumer, such as an airline, can utilize options to mitigate their exposure to basis risk. Similarly, energy producers can also reduce their basis risk by hedging with options.

As an example, let's consider the case of a Latin American oil producer. Like the case of the African airline, there aren't any liquid derivative markets for crude oil in Latin America. As such, Latin American oil producers have to hedge with one of the actively traded crude oil indices such as NYMEX WTI or ICE Brent.

Let's assume that the oil company has determined that the liquid index which is most highly correlated to the price at which is sells its crude oil is NYMEX WTI crude oil. Let's further assume that the airline is looking at hedging their April 2013 - March 2014 crude oil production with either NYMEX WTI calendar swaps or average price (also known as Asian) put options. Based on current market prices, the company has decided to hedge their oil production with either a $93/BBL WTI calendar swap or a WTI average price put option with a strike price of $93/BBL.

As you can see from the chart above, both the $93 swap and $93 put option provide the producer with a decent hedge when both WTI Brent and the price at which the oil company sells their oil are both decreasing, despite the basis. However, when both WTI and the oil company's sales prices both begin to increase, as is the case beginning in month seven of the chart, the swap exposes the oil company to significantly more basis risk than the put option. This is because a swap puts the oil company "at risk" to losses when WTI prices increase above $93, so long as the basis isn't static, which it is not. It's import to note that basis relationships are rarely static as regional prices (i.e. the price as which the oil company sells their oil) are largely driven by regional supply and demand, while global prices (i.e. Brent and WTI) are largely driven by macroeconomics, geopolitics, etc. Last but not least, the put option not only allows the oil company to mitigate their basis risk but it also allows them to benefit when oil prices as a whole (i.e. WTI) increase, which isn't the case with the swap.

There's no question that hedging with options can be costly. However, in addition to providing companies with the ability to benefit from advantageous prices moves, hedging with options can also help companies mitigate their exposure to basis risk. While this example focused on a Latin American oil producer, the same methodology can be applied to energy producers across the globe who do not have the ability to mitigate their basis exposure via their marketing or supply agreements and/or derivatives which are highly correlated to prices in their region(s).

This post is the second in a series on hedging energy basis risk with options. This first post can be accessed via the following link:

How to Reduce Basis Risk by Hedging with Options - Part I

For more information regarding basis risk and basis hedging see the following posts:

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NYMEX Heating Oil Completes Transition to Ultra Low Sulfur Diesel

Tue, 02 Apr 2013 14:05:00 GMT

As of yesterday, NYMEX heating oil futures and options are now ultra low sulfur diesel fuel (ULSD) futures and options. The transition is a long time in the making as the CME first announced the transition back in June of 2011. At that time, the exchange planned to delist heating oil futures and options and to replace them with ULSD futures and options. However, last May, the exchange announced that rather than delisting the heating oil contracts, they would transition the existing heating oil contracts to ULSD contracts.

With the expiration of the March heating oil contract last week, heating oil futures and options are now extinct and have been replaced by ULSD futures and options. Most of the contract specifications remain the same except that ULSD futures must meet the "Delivery specifications of Colonial Pipeline's Fungible Grade 62 Ultra Low Sulfur Diesel, and being properly designated for sale in New York Harbor in accordance with U.S. Environmental Protection Agency (EPA) regulations." In practice, this means that the futures are now based on 15 PPM (sulfur content) ULSD rather than 2,000 PPM heating oil.

Why the transition? In essence, the change was necessary to reflect the changes occurring in the physical market, as a result of federal (EPA) and state regulations which require lower sulfur content in distillate fuels.

So what does the transition mean as it relates to pricing and hedging? In essence, ULSD futures are now the "Americas" benchmark for distillate fuel prices and as such, the rest of the "Americas" distillate fuels complex will now trade at a premium or discount to the ULSD futures, rather than heating oil futures.

Excluding those who consume, market, trade or refine traditional heating oil, the transition should be welcomed by most market participants as the transition to a lower sulfur benchmark reduces "quality" basis risk for those who have traditionally hedged lower sulfur products with (higher sulfur) heating oil futures, swaps and options. In addition, the market has been anticipating this change for quite some time, and has reflected the pending transition via the spreads between heating oil futures, swaps and options, ULSD futures, swaps and options and the rest of the distillate fuel complex. That being said, for those who do need to trade or hedge heating oil itself, you can still do so by trading the spread between heating oil (in the spot market as well as swaps and options on heating oil) and ULSD futures, swaps and/or options, so long as there remains a viable market for heating oil and/or financial derivatives on heating oil.

A similar transition is also underway in Europe. In August of 2011, ICE introduced numerous low sulfur distillate contracts including a low sulphur gasoil futures contract (10 PPM), which will ultimately replace ICE's traditional (1,000 PPM) gasoil futures and options. However, ICE is giving the traditional gasoil futures and options a longer life than than the CME gave to heating oil futures and options. Based on their current plans, ICE will continue to list gasoil futures and options through the January 2015 contract, at which time the low sulphur gasoil futures and options will become the default, not only for gasoil but also as the European benchmark for other European distillate fuels. In the meantime, both the traditional gasoil futures and options and the low sulphur gasoil futures are trading side by side.

As an aside, for those of you interested in the history of commodity markets, heating oil futures were the first, successful energy futures contract to be traded anywhere in the world, having made their debut on the NYMEX in 1978.

Last but not least, if you're wondering why the NYMEX contracts are spelled sulfur and the ICE contracts are spelled sulphur, it's simply due to difference in the American and British spellings of the word.

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April 2013 Energy Hedging Update

Mon, 01 Apr 2013 20:05:00 GMT

Since our last update, all but one of the major crude oil and refined product forward curves have increased, with NWE jet fuel standing out as the exception. On average, the forward curves for global crude oil and refined products prices increased 1.45% over the past month, with WTI crude oil leading the way, having increased 5.22% since our March update.

On the natural gas side, NYMEX futures continue to show strength with the one year forward curve up 11.85% since our March update.

In the natural gas liquids space, the NGL forward curves increased by an average of 6.33% over the past month, led by ethane which increased by 11.38% since our March update. On the contrary, normal butane bucked the trend, with the forward curve declining by .03% over the past month.

The following table displays the indicative, one year, forward strip prices as of the close of business on March 28, 2013, as well as the respective changes since the previous update, which was based on prices as of the close of business on March 1, 2013. Crude oil, refined product and NGL forward curves are based on April 2013 - March 2014 calendar swaps while NYMEX natural gas forward curves are based on May 2014 - April 2014 futures.

	Current	Previous	Change ($)	Change (%)
NYMEX Crude Oil ($/BBL)	96.16	91.39	4.77	5.22%
ICE Brent Crude Oil ($/BBL)	107.23	105.92	1.31	1.24%
Dubai Crude Oil ($/BBL)	104.62	102.78	1.84	1.79%
NYMEX ULSD (Heating Oil) ($/Gal)	3.0168	2.9612	0.0556	1.88%
NYMEX RBOB Gasoline ($/Gal)	2.8714	2.7965	0.0749	2.68%
ICE Gasoil ($/MT)	917.82	910.38	7.44	0.82%
Gulf Coast ULSD ($/Gal)	2.9805	2.9319	0.0486	1.66%
Gulf Coast 6 Oil 3% ($/BBL)	94.58	93.24	1.34	1.44%
Rotterdam 3.5% Fuel Oil ($/MT)	599.90	593.94	5.96	1.00%
Singapore Fuel Oil 180 CST ($/MT)	632.66	627.19	5.47	0.87%
Gulf Coast Jet Fuel ($/Gal)	2.9510	2.9444	0.0066	0.23%
Singapore Jet Fuel ($/BBL)	122.63	122.25	0.38	0.31%
NWE Jet Fuel ($/MT)	991.72	993.91	-2.19	-0.22%
NYMEX Natural Gas ($/MMBtu)	4.195	3.751	0.444	11.85%
Mont Belvieu Propane ($/Gal)	0.9722	0.8798	0.0924	10.50%
Mont Belvieu Natural Gasoline ($/Gal)	2.0820	2.0118	0.0702	3.49%
Mont Belvieu Normal Butane ($/Gal)	1.4412	1.4417	-0.0005	-0.03%
Mont Belvieu Ethane ($/Gal)	0.3057	0.2745	0.0312	11.38%

The prices used in our monthly updates are "rolled" each month such that the previous update included one year (twelve month) strips beginning in March 2013 and ending in February 2014, for all but natural gas, which began with April 2013 and ended with March 2014. In addition, all of the strips, expect NYMEX natural gas, are for "calendar swaps" rather than futures, as the majority of consumers and producers hedging crude oil, refined products and NGLs hedge with calendar swaps, rather than futures.

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Energy Hedging Seminars - London & Dallas

Wed, 27 Mar 2013 14:02:00 GMT

In case you missed our previous annoucements, in the coming months we will be hosting the following seminars, which are currently open for registration.

On May 22-23 we will be hosting a crude oil & refined products hedging & risk management Seminar in London. In this seminar, which is geared toward consumers, producers and marketers, as well as those in related businesses, we will cover numerous aspects of hedging and risk management, from the core fundamentals to more advantage strategies, across the entire barrel - crude oil, bunker fuel, diesel fuel, heating oil, gasoil, gasoline, jet fuel and natural gas liquids. You can learn more about the London seminar ($200 discount ends April 4) via this link.

On June 19-20 we will be hosting a crude oil & natural gas hedging seminar in Dallas. In this seminar, which is geared toward oil and gas producers, as well as those in related businesses, we will cover numerous aspects of hedging and risk management, from the core fundamentals to more advantage strategies, for crude oil, natural gas and natural gas liquids. You can learn more about the Dallas seminar ($400 discount ends April 1) via this link.

In addition, we will also be hosting several additional seminars later in the year. If you would like to suggest a seminar geared towards a specific audience and/or in a specific location(s) or on a specific date(s), please contact us and we will do out best to consider your request.

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Hedging Energy Risk with Price Targets: A Losing Proposition?

Mon, 25 Mar 2013 14:32:00 GMT

In our role as energy hedging advisors, we regularly receive inquires from companies who have had a difficult time, if not worse, in producing desirable hedging results. On more than a few occasions, these companies have told us something similar to the following, "We set to set up our hedging program based on price targets but we ended up losing a lot of money in the process".

Hedging energy prices (regardless of whether we're talking about crude oil, electricity, natural gas, natural gas liquids or refined products) is both art and science. There's no question that prices should receive significant attention when one is determining when and how to hedge but, hedging based on price targets or market timing is neither a proper way to manage energy price risk nor to minimize your costs/maximize your revenues.

We often hear things along the lines of, "We're going to wait until prices decline below (or increase above) $100/BBL" or something similar. Both energy consumers and producers who attempt to pursue a "hedging strategy" of this nature are attempting to manage their price risk by hedging when they can obtain a price that they perceive to be attractive or advantageous. In essence, an energy producer employing this strategy is trying to maximize their cash flows and revenues by waiting for prices to increase as much as possible before executing a hedge. Ideally, these producers want to hedge at the "top of the market". On the contrary, an energy consumer employing this strategy is trying to minimize their costs and cash flows by waiting for prices to decrease as much as possible before executing a hedge. Ideally, these consumers want to hedge at the "bottom of the market". Unfortunately, most of us don't have the luxury of living in an ideal world 100% of the time.

Energy commodity prices can be incredibly volatile and, in the words of often quoted economist John Maynard Keynes, "Markets can remain irrational longer than you can remain solvent." Prices can change quickly and drastically, without warning and without regard for the arbitrary price targets of those seeking to hedge their exposure to energy prices. If the Brent crude oil, one year forward curve strip is currently trading at $100/BBL, what happens to a fuel consumer with a target price of $85/BBL if the forward curve increases to $120/BBL before eventually, say five months later, finally declining to $85/BBL or lower? The pursuit of an additional $15/BBL ends up costing the company up to $20/BBL for every barrel, metric ton, gallon or liter of fuel that they consume during the initial five months. That's not risk management.

And what about an oil producer who has a price target of $125/BBL? If oil prices never rise to $125/BBL, the producer remains exposed to the market, all the way down to $85 or lower. Nor is that not risk management.

If you consider how these types of "hedging strategies" would play out, for both consumers and producer, in the long run, it won't put them in a position to effectively manage their price risk, minimize cash flow volatility or to minimize their costs/maximize their revenues. If the market never reaches their target price, the company remains fully exposed to the spot market, no matter how high/low prices go. Once again, not risk management. At best "hedging" in this manner is what we call hedgulation (hedging + speculation) and while hedgulation may produce desirable short term results, in the long run it will inevitably lead to very undesirable results.

If you've come to the conclusion that you need to incorporate price targets into your hedging strategy, you should also set a "stop loss" price(s) which essentially requires you to go ahead and execute a transaction, regardless of your price targets. Why? The stop loss will ensure that if prices move in the opposite direction of your price target, and remain in an undesirable range for an extended period of time, that you will indeed be hedged against prices moving even further away from your target price.

In short, utilizing a hedging strategy which is based on target prices and/or market timing almost ensures that the company will be exposed to undesirable price volatility or worse. In the case of producers, this means they will be exposed to the lowest prices offered by the market and, unless they are unusually lucky, they will never receive the highest prices offered by the market. Conversely, In the case of consumers, this means they will be exposed to the highest prices offered by the market and, unless they are unusually lucky, they will never receive the lowest prices offered by the market. Energy commodity prices are cyclical, hard to predict and always will be. The only certainly is that energy commodity prices will rise again and they will fall again, in no certain order.

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The Key Elements of a Successful Energy Hedging Program

Tue, 12 Mar 2013 12:22:00 GMT

Since the NYMEX introduced the heating oil futures contract in 1978, energy consumers, producers, marketers, refiners and processors have had the ability to hedge their exposure to volatile oil and gas prices. However, for many companies, hedging can cause as many challenges as solutions. The key to developing a successful energy hedging program is to develop a sound plan and stick with it. By following these six key steps you should be able to develop, implement and manage a successful energy hedging program.

Identify, Analyze and Quantify Your Market Related Risks

Identify all of your market related risks including price, basis, credit, operational and regulatory risk. Once all of the risks have been identified, you should analyze, categorize and prioritize each risk. Many risks can be rigorously analyzed via quantitative analysis, while others have to be evaluated through a more qualitative approach. Risks that are not identified and analyzed cannot be properly hedged, mitigated or managed

Develop an Official Hedging Policy

All market risks should be addressed through a process that establishes risk management goals and objectives as well as risk tolerance. This should be formalized through a hedging policy which explains your hedging objectives, goals, risk tolerance and approved hedging strategies in order to clearly define the decision-making process and determine responsibility for each step of the hedging process i.e. pre-trade analysis, trade execution, financial reporting, etc. The hedging policy should be approved by the board of directors and/or management team.

Controls and Procedures

A hedging policy needs to be supported by controls and procedures that ensure hedging activities receive an appropriate level of attention and oversight, such as the proper execution and reporting of trades. A poor but well implemented hedging policy is often superior to a sound but poorly implemented hedging policy. That being said, there is simply no excuse for not having a sound hedging policy.

Implementation of Hedging Strategy

Once you’ve completed the first three steps you should be able to begin implementing your initial hedging strategy(s). For most companies, implementation and management of the hedging program should be a consistent, dynamic process, as opposed to a static process. As such, your hedge positions need to be properly analyzed on a regular basis and if applicable, optimized if and/or when your goals, objectives and/or market conditions change.

Monitoring, Analyzing and Reporting Risk

All risks related to hedging need to be continuously monitored, measured and reported through the company's hedging “framework”. As the company's risk exposure changes, there should be a systematic process for reporting and determining if the hedging policy or strategies need to change or if the existing policy and strategies remain sound. If a change in policy or strategy needs to occur, the change should be preceded by proper analysis and discussion, not a spur of the moment decision.

Repeat

While the five previous elements should be the primary building blocks of your hedging program, the "last" step is the most important: repeating the entire process as often as is necessary. While your formal hedging policy may only materially change once every year or two, the other steps should become a standard process that occurs on a regular basis, depending on your company’s specific needs. For companies with very active hedging programs this could be as often as a daily, while companies with more “basic” hedging programs may only need to go through the process as infrequent as once a month or quarter.

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How to Reduce Basis Risk by Hedging with Options - Part I

Thu, 07 Mar 2013 13:05:00 GMT

As readers of our blog are well aware, we spend a lot of time analyzing and discussing basis relationships and the accompanying risk. While it's nearly impossible for most companies to completely eliminate their exposure to basis risk, there are numerous ways to mitigate it.

The simplest way to mitigate your exposure to basis risk is to enter into supply (in the case of a consumer) or marketing (in the case of a producer) agreements that reference a "primary" index (i.e. NYMEX natural gas furtures, ICE Brent crude oil, etc) or one of the numerous, liquid (actively traded) regional indices (i.e. Platts' Rotterdam 3.5% Fuel Oil, Platts Singapore jet kerosene, etc).

As an example, in order to mitigate their exposure to basis risk, a North American natural gas producer could enter into a marketing contract which references the NYMEX natural gas futures contract, plus or minus a premium On the consumer side, an Asian airline for example, could enter into a supply agreement which references Platts' Singapore jet kerosene.

If you don't have the ability to enter into supply or marketing agreements which reference a transparent index, another possibility is to hedge with a combination of a futures contract, or swap, which references one of the primary indices AND a basis swap which references the difference between one of the primary indices and a regional index.

For example, a Colorado based natural gas producer could hedge their exposure to natural gas prices in Colorado through a combination of a NYMEX natural gas future contract (or a swaps which references the futures contract) and a Rockies basis swap which references the basis (price difference) between the Platts' Rocky Mountain index and the NYMEX natural gas futures contract. Similarly, an airline looking to hedge their exposure to jet fuel prices in the Northeast US could mitigate their basis exposure by hedging with a combination of a NYMEX heating oil swap and a basis swap which references the basis between Platts' New York jet fuel index and NYMEX heating oil.

While the previously mentioned approaches to mitigating basis risk are quite common, one approach which we don't see used often enough involves hedging with options. As an example, let's consider the case of an African airline. Given that there aren't any liquid derivative markets for jet fuel or crude oil in Africa, African airlines generally have to hedge with one of the liquid indices in another region such as Rotterdam or Singapore jet fuel or Brent crude oil. Clearly this isn't ideal but it can certainly be more advantageous than not hedging at all.

When a company is faced with hedging with an instrument which doesn't reflect the spot price in their local or regional market, basis risk is ever more present, as in the case of African airlines. However, as we will explain shortly, there are hedging strategies available which can greatly reduce a company's exposure to basis risk.

Getting back to the African airline, let's assume that the airline has determined that the liquid index which is most highly correlated to it's own jet fuel costs is ICE Brent crude oil. Let's further assume that the airline is looking at hedging their jet fuel exposure for the next twelve months with either fixed price swaps or call options on ICE Brent crude oil. Lastly, let's assume that they airline is considering either a $105/BBL swap or a call option with a strike price of $105/BBL.

As the chart above indicates, both the $105 swap and $105 call option perform pretty well when both Brent and the airline's actual fuel costs are increasing, despite the basis. However when both Brent and the airline's fuel costs are declining, as is the case beginning in month five of the chart, the swap exposes the airline to significantly more basis exposure than the call option. This is because a swap puts the airline "at risk" when prices decline below $95, which isn't the case with the call option. It's also import to note than if the price of Brent declines while the airlines fuel cost increases, as in the case of month seven, the basis exposure is ever more present.

While it can't be debated that the cost of hedging with options can be significant, the case of the African airline shows how hedging with options, as opposed to fixed price instruments, can help companies mitigate their exposure to basis risk. In a future post we'll explore this concept further with several additional examples as well as how hedging with costless collars often presents "hidden" basis risk, a scenario which all too often leads to unexpected hedging losses.

This post is the first in a series on hedging energy basis risk with options. This second post in the series can be accessed via the following link:

How to Reduce Basis Risk by Hedging with Options - Part II

For more information regarding basis risk and basis hedging see the following posts:

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March 2013 Energy Hedging Update

Mon, 04 Mar 2013 12:14:00 GMT

Since our February update, all of the major crude oil and refined product forward curves have declined significantly over the past month. On average, the forward curves for global crude oil and refined products prices declined by 5.68% over the past month, led by WTI crude oil, which declined 7.10% since our February update. At the request of several subscribers, we are now including Dubai crude oil calendar swaps to our monthly update.

On the natural gas side, NYMEX futures have continued to strengthen since our last update with the one year forward curve up 3.48% since our February update.

In the natural gas liquids space, the NGL forward curves declined by an average of 5.05% over the past month, led by normal butane which collapsed by 10.41% since the February update.

The following table displays the indicative, one year, forward strip prices as of the close of business on March 1, 2013, as well as the respective changes since the previous update, which was based on prices as of the close of business on February 1, 2013. Crude oil, refined product and NGL forward curves are based on March 2013 - February 2014 calendar swaps while NYMEX natural gas forward curves are based on April 2013 - March 2014 futures.

	Current	Previous	Change ($)	Change (%)
NYMEX Crude Oil ($/BBL)	91.39	98.38	-6.99	-7.10%
ICE Brent Crude Oil ($/BBL)	105.92	112.10	-6.18	-5.51%
Dubai Crude Oil ($/BBL)	102.78	110.03	-7.25	-6.59%
NYMEX Heating Oil ($/Gal)	2.9612	3.1363	-0.1751	-5.58%
NYMEX RBOB Gasoline ($/Gal)	2.7965	2.9383	-0.1418	-4.83%
ICE Gasoil ($/MT)	910.38	967.43	-57.05	-5.90%
Gulf Coast ULSD ($/Gal)	2.9319	3.1039	-0.1720	-5.54%
Gulf Coast 6 Oil 3% ($/BBL)	93.24	98.61	-5.37	-5.45%
Rotterdam 3.5% Fuel Oil ($/MT)	593.94	627.38	-33.44	-5.33%
Singapore Fuel Oil 180 CST ($/MT)	627.19	658.98	-31.79	-4.82%
Gulf Coast Jet Fuel ($/Gal)	2.9444	3.1297	-0.1853	-5.92%
Singapore Jet Fuel ($/BBL)	122.25	129.60	-7.36	-5.68%
ARA Jet Fuel ($/MT)	993.91	1052.67	-58.76	-5.58%
NYMEX Natural Gas ($/MMBtu)	3.751	3.625	0.126	3.48%
Mont Belvieu Propane ($/Gal)	0.8798	0.9164	-0.0366	-3.99%
Mont Belvieu Natural Gasoline ($/Gal)	2.0118	2.1793	-0.1675	-7.69%
Mont Belvieu Normal Butane ($/Gal)	1.4417	1.6092	-0.1675	-10.41%
Mont Belvieu Ethane ($/Gal)	0.2745	0.2694	0.0051	1.88%

The prices used in our monthly updates are "rolled" each month such that the previous update included one year (twelve month) strips beginning in February 2013 and ending in January 2014, for all but natural gas, which began with March 2013 and ended with February 2014. In addition, all of the strips, expect NYMEX natural gas, are for "calendar swaps" rather than futures, as the majority of consumers and producers hedging crude oil, refined products and NGLs hedge with calendar swaps, rather than futures.

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Bunker Fuel Hedging With Call Option Spreads

Fri, 22 Feb 2013 11:50:00 GMT

This post is the fourth in a series on hedging bunker fuel price risk. The first post in the series, An Introduction to Bunker Fuel Hedging, discussed how swaps can be used to hedge bunker fuel price risk. The second post in the series, Hedging Bunker Fuel Price Risk With Call Options, addressed how a company can use call options to hedge their exposure to volatile bunker fuel prices. The third post in the series, Hedging Bunker Fuel With Costless Collars, explored the pros and cons of hedging bunker fuel prices with costless collars.

While swaps, call options and costless collars are definitely the most popular bunker fuel hedging strategies, many companies in the maritime industry are seeking additional hedging strategies which will provide them with a lower cost, short-term hedge against rising bunker fuel prices. One strategy that maritime companies may find attractive given such requirements is a call option spread, also known as a bull call spread.

A bull call spread is simply the combination of purchasing a call option with a "low" strike price and selling an additional call option with a strike price which is higher than that of the "low" strike price option.

As an example, let's assume that your hedge committee has decided that you need to hedge your May 2013 European bunker fuel consumption with a call option spread. In looking at the Rotterdam 3.5% fuel oil forward curve, you see that the May swap is currently trading at approximately $640/MT and the committee has determined that you need to be hedged against bunker fuel prices rising above $660/MT. In addition, the committee has determined that the most you can spend on option premiums is $7.50/MT. Given these requirements, what hedging strategies can you employ?

One potential strategy is to purchase a $660 Rotterdam 3.5% fuel oil call option for a premium of $17.85/MT. However, given that your option premium budget is only $7.50/MT, you can reduce the cost of the $660 call option by selling an additional call option with a higher strike price, for example, $680/MT. The $680 call option is currently trading for $11.40/MT which means that you can buy the $660 call option for $17.85 and sell the $680 call option for $11.40 which when combined form a $660/$680 bull call spread at a net premium cost of $6.45/MT, $1.05/MT below your budget of $7.50/MT .

By spending $6.45/MT, you have hedged yourself against the cost of Rotterdam 3.5% fuel oil rising above $660/MT to a maximum of $680/MT or $20/MT. The limitation of this strategy is that if the average price of Rotterdam 3.5% fuel oil during May averages more than $680/MT, the maximum that you can gain on your hedge is $20/MT.

The following chart shows the risk profile of the $660/$680 Rotterdam 3.5% fuel oil call option spread, excluding the option premium, basis, transportation and taxes.

While bull call spreads (call option spreads) are a viable hedging strategy for companies seeking a low cost, short-term bunker fuel hedging strategy, as previously noted, call option spreads only provide a limited hedge against rising bunker fuel prices, in this case $20/MT.

UPDATE: This article is the fourth in a series on bunker fuel hedging. The previous articles can be found via the following links:

An Introduction to Bunker Fuel Hedging

Hedging Bunker Fuel Price Risk With Call Options

Hedging Bunker Fuel With Costless Collars

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The Fundamentals of Oil & Gas Hedging - Put Options

Wed, 20 Feb 2013 12:10:00 GMT

This article is the third in a series exploring the most common strategies used by E&P companies to hedge their exposure to crude oil, natural gas and natural gas liquids prices. The first two articles explored how E&P companies can hedge with futures and swaps while this article will focus on hedging with put options. In subsequent posts we'll explore how E&P companies can hedge with collars, basis swaps and more complex instruments.

An option is contract which provides the buyer of the contract the right, but not the obligation, to purchase or sell a particular amount of a specific commodity (such as crude oil or natural gas) on or before a specific date or period of time.

There are two primary types of options, call options (which are often referred to as a ceilings or caps) and put options (which are often referred to as floors). A call option provides the buyer of the option with a hedge against a potential price increase while a put option provides the buyer of the option with a hedge against a potential price decrease.

E&P companies often utilize put options to mitigate their exposure to declining crude oil, natural gas and natural gas liquids prices while end-users often use call options to mitigate their exposure against potentially rising prices such as gasoline, diesel fuel, jet fuel and natural gas.

As an example of how an E&P company can use a put option, let's assume that you're company produces natural gas in Louisiana and you need to hedge your exposure to potentially declining natural gas in April 2013. For sake of this example, let's assume that you are looking to hedge 80% of your anticipated, April 2013 natural gas production, which you estimate will be about 100,000 MMBtu. As such, you are looking to hedge 80,000 MMBtu.

In order to do accomplish this you could purchase a eight (1 option contract = 10,000 MMBtu) April 2013 NYMEX natural gas put options. Let's further assume that you need to be hedged against April NYMEX natural gas prices falling below $3.00/MMBtu in order to meet your budget. As this is being written, an April 2013 NYMEX natural gas put option is trading for a premium of $0.0350/MMBtu, which would mean that your net cost of buying eight put options would be $2,800 (80,000 MMBtu X $0.0350/MMBtu).

Now let's take a look at how the $3.00 April NYMEX natural gas put option would impact your budget if NYMEX natural gas futures are trading both higher and lower than $3.00 when your put options expire on March 26, 2013.

In the first scenario, let's assume that NYMEX natural gas prices increase and that on March 26 the NYMEX natural gas futures settle at $3.50/MMBtu. In this scenario, your hedge would be "out-of-the-money" and you would not receive a return, nor would you incur a loss, on the option. However, this should be a pleasant surprise as natural gas prices are higher than your bugeted price of $3.00/MMBtu. As such, the actual price that you realize at the wellhead should also have increased accordingly to $3.50, excluding basis and transportation. However, recall that you paid $0.0350/MMBtu for the option, so your actual net revenue per MMBtu, including the cost of the option, would be $3.465/MMBtu, again excluding baiss and transportation.

In the second scenario, let's assume that NYMEX natural gas prices decrease and that on March 26 the NYMEX natural gas futures settle at $2.75/MMBtu.. In this scenario, your put option would result in a hedging gain of $0.25/MMBtu ($3.00 - $2.75 = $0.25) or $20,000 ($0.25 X 80,000 MMBtu). As a result, you would receive a payment of $20,000 on the put option, which would offset the lower price ($2.75) you receive for your actual natural gas production, again excluding basis and transportation. Furthermore, given that you paid $0.0350/MMBtu for the option, your net gain would be $0.2150/MMBtu ($0.25 - $0.0350) or $17,200 ($20,000 - $2,800).

The following chart shows the "risk profile" of the $3.00 NYMEX natural gas put option as described above. As the chart shows, when NYMEX natural gas futures trade at or below $3.00/MMBtu, the producer's net hedged price is $2.9650/MMBtu. Conversely, when NYMEX natural gas futures trade above $3.00/MMBtu, the producer's net hedged price is equivalent to the NYMEX natural gas futures price minus $0.035/MMBtu.

As this example shows, hedging with put options allows E&P companies to hedge their exposure to potentially declining natural gas (as crude oil and natural gas liquids) prices. In addition, while this example focused on producer hedging with put options, natural gas consumers can also hedge against potentially increasing natural gas prices by purchasing natural gas call options.

UPDATE: This article is the third in a series on oil and gas hedging. The previous articles can be found via the following links:

The Fundamentals of Oil & Gas Hedging - Futures

The Fundamentals of Oil & Gas Hedging - Swaps

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Optimizing "In-The-Money" Fuel Hedging Strategies

Mon, 18 Feb 2013 12:15:00 GMT

Given the recent increase in global fuel prices we thought it would be beneficial to explore how companies can optimize their existing fuel hedging positions. While the term optimize can mean many different things, in terms of fuel price risk management, we tend to think of it in the sense of improving your existing positions by reducing your risk and improving your liquidity.

To put things in perspective, prompt month heating oil and gasoil futures, the global benchmarks for distillate fuels (diesel fuel, jet fuel, etc.) have increased by ~21% over the past eight months, rising from approximately $2.65/gallon and $850/MT to $3.35/gallon and $1,030/MT, respectively.

If a company entered into long-term hedges during the summer, when prices were lower, the subsequent price increase is providing a great opportunity to optimize said positions. As an example, let's consider the case of a transportation company who executed a 2013 heating oil swap in mid June at the prevailing market price of approximately $2.70/gallon. The remaining months of the swap (for simplicity let's consider March - December as the remaining months) are currently trading for approximately $3.15, a $0.45/gallon increase over the swap price of $2.70.

While it's safe to say the company should be satisfied with the current results of their swap, the price increase has provided them with a good opportunity to reduce their risk by optimizing their swap position. While this could easily be accomplished by selling their swap and pocketing the gain, or selling the swap and utilizing the gain to purchase a call option, there is a more effective strategy which results in better hedge at a lower cost. In trading lingo it's referred to as a synthetic call option. In practice, it is the combination of a swap and a put option, which when combined, creates a risk profile which is the same as a call option.

As an example, one way the company can optimize the $2.70 swap is by converting the swap into a $2.70 synthetic call option is by purchasing a $2.70 put option for a premium of $0.03/gallon. While the company's original swap protected them against heating oil prices settling above $2.70, they were also at risk should heating oil prices settle below $2.70. By converting their $2.70 swap into a $2.70 synthetic call option the company will retain their hedge at $2.70 while eliminating their risk below $2.70, at a cost of $0.03/gallon. In addition, by converting the swap into a synthetic call option, they will have eliminated their need to support the swap with cash, collateral or a credit facility, which improves their liquidity.

In summary, by paying a premium of $0.03/gallon to convert their $2.70 swap into a synthetic call option, the company can guarantee itself a "win-win" situation, regardless of whether heating oil prices trade higher or lower between now and the end of December.

While many companies approach hedging with a "hedge it and forget it" mentality (see The Case For Employing A Dynamic Fuel Hedging Program for more on this topic), this example shows how and why companies should seek opportunities to optimize their "in-the-money" hedges. If the cost is low, why would a company not want to improve their position while reducing risk and improving liquidity?

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The Fundamentals of Oil & Gas Hedging - Swaps

Fri, 15 Feb 2013 13:50:00 GMT

This article is the second in a series exploring the most common strategies used by E&P companies to hedge their exposure to crude oil, natural gas and natural gas liquids prices. You can access the first post, The Fundamentals of Oil & Gas Hedging - Futures, via the following link. In subsequent posts we'll explore how E&P companies can hedge with options, basis swaps and more complex instruments.

A swap is an agreement whereby a floating (or market) price is exchanged for a fixed price or a fixed price is exchanged for a floating price, over a specified period(s) of time. Swaps earned their name as the transaction involves buyers and sellers “swapping” cash flows.

Oil and gas producers can hedge with swaps in order to lock in or fix their cash flow and revenues. In addition to energy, swaps are also utilized by companies seeking to hedge their exposure to agriculture commodities, metals, foreign exchange and interest rates, among others.

As an example of how an E&P company can use a swap to hedge it's crude oil, let's assume that you're a North Sea oil producer who wants hedge your April 2013 production to ensure that your April cash flow meets or exceeds your budget estimates. For sake of simplicity, let's assume that you are looking to hedge 25,000 barrels of your your anticipated, April production. In order to accomplish this, you could sell a 25,000 BBL April 2012 ICE Brent crude oil calendar swap. If you had sold an April 2013 swap last Friday the price would have been approximately $115.50/BBL.

Now let's take a look at how this swap would impact your revenue, and in turn cash flow, if the prompth month Brent crude oil futures during the month of April average $20 higher and $20 lower than your swap price of $115.50.

In the first scenario, let's assume that average price for the prompt month ICE Brent crude oil futures, for each business day in April, is $135.50/BBL. In this scenario, your gross revenue would be $3,387,500 (25,000 BBLS X 135.50/BBL). However, your net revenue (including the impact of the swap) would be $2,887,500 due to a hedging "loss" of $20/BBL ($135.50 – $115.50 = $20.00) or $500,000 ($20 x 25,000 BBLS = $500,000). In this scenario, while you did experience a hedging loss of $20/BBL, the hedge did perform as expected and allowed you to lock in your budgeted price of $115.50/BBL.

In the second scenario, let's assume that average price for the prompt month ICE Brent crude oil futures, for each business day in April, is $95.50/BBL. In this scenario, your gross revenue would be $2,387,500 (25,000 BBLS X 95.50/BBL). However, your net revenue (including the impact of the swap) would be $2,887,500 due to a hedging "gain" of $20/BBL ($115.50 - $95.50 = $20.00) or $500,000 ($20 x 25,000 BBLS = $500,000). Similar, but opposite of the previous scenario, the hedge did perform as expected and allowed you to lock in your budgeted price of $115.50/BBL

As this example indicates, E&P companies can hedge their exposure to volatile crude oil prices by hedging with swaps. If the price of crude oil declines, the gain on the swap offsets the decrease in revenue. On the other hand, if the price of crude oil increases, the loss on the swap is offset by the increase in revenue. While this example focuses on how oil and gas producers can hedge crude oil price risk with swaps, E&P companies can utilize the same methodology to hedge natural gas liquids.

In addition, end-users, marketers and refiners can also utilize crude oil to hedge their revenues, cash flows, costs, inventories and profit margins. As an example, many large fuel consumers (i.e. airlines, cruise lines, etc.) hedge their oil price risk by crude oil swaps.

While this example provides a basic overview of how one can hedge crude oil price risk with swaps, one must do their homework to determine if hedging with swaps is an appropriate strategy based on your risk tolerance. If you have questions or would like to discuss how we can assist you with hedging crude oil and natural gas, please give us a call or send us a message.

UPDATE: This article is the second in a series on oil and gas hedging. The previous and subsequent articles can be found via the following links:

The Fundamentals of Oil & Gas Hedging - Futures

The Fundamentals of Oil & Gas Hedging - Put Options

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The Case For Employing A Dynamic Fuel Hedging Program

Wed, 13 Feb 2013 12:28:00 GMT

Historically, many large fuel consuming companies have utilized passive fuel hedging strategies but, companies who "hedge and forget it" often accept unnecessary risks and leave money on the table. As such, due to their failure to actively manage their hedge positions, many companies are not obtaining the optimal or maximum value from their hedge portfolios. A dynamic fuel hedging portfolio can mitigate price, credit and cash flow risk while increasing the ability to benefit should fuel prices decline.

The more traditional, passive approach to fuel hedging, whereby a company buys a swap or enters into a costless collar and holds the position until expiration limits the company's ability to benefit from favorable price moves. Due to the fact that most companies are required to post cash or collateral or utilize a credit facility to buy a swap or collar, passive hedging strategies can also present an inefficient use of capital, not to mention cash flow and credit challenges. As an example, when oil prices collapsed in 2008-2009, many companies who were hedging with swaps and collars were forced to post additional cash or collateral to support their fuel hedges. In other cases, their mark-to-market losses were so large that their credit facilities weren't large enough to support their hedge positions. Making matters worse, due to the state of the global economy during this time, most companies needed to use their cash, collateral and credit facilities to fund their day-to-day operations.

So how can companies employ fuel hedging strategies that provide them with opportunities to further reduce risk, lower costs and improve liquidity? One answer is to transition from a static ("hedge it and forget it") hedging program to a dynamic (opportunistic) hedging program.

As an example, consider the case of an airline who in early August 2012 entered into a July 2013 - December 2013 Brent crude oil costless collar, comprised of an $115 call option and $85 put option, to hedge their Q3 and Q4 fuel price risk. In this example, the airline would be hedged against prices rising above $115/BBL and exposed (at risk) to prices declining below $85/BBL. When this transaction was executed, the July 2013 - December 2013 Brent crude oil forward curve was trading in the $100.50 range and has since risen significantly, closing near $112 on Friday.

When the airline entered into the costless collar, the premiums for both the $115 call and $85 put options were both about $5.90/BBL. As of the close of business on Friday, due to the increase in the Brent forward curve in recent months, the price of the $85 put option has declined to approximately $1.10/BBL. And this is where the "dynamic" aspect comes into play. If the airline does nothing and allows both the calls and puts to remain as they are until expiration ("hedge it and forget it"), they will continue to be hedged against above prices rising above $115/BBL and exposed to prices declining below $85/BBL.

However, if they decide to take advantage of current market prices, they can buy back the $85 put option for approximately $1.10/BBL. As a result of buying back the $85 put option, they will no longer be exposed (at risk) to Brent crude oil trading below $85/BBL, which also means they will no longer be required to post cash or collateral or utilize a credit facility to support the $85 put option. Perhaps better said, by paying $1.10/BBL to buy back the $85 put option, the airline will remain hedged against prices rising above $115/BBL and be positioned to benefit should Brent crude oil prices decline, as shown on the following graph.

Hedge it and forget it may have worked well in the past but the due to the ongoing changes in the commodity markets, passive hedging strategies are now far from ideal, in fact they are often problematic. For most companies, utilizing dynamic hedging strategies, rather than passive hedging strategies, is one of the key factors to developing a successful, sustainable fuel hedging program. A dynamic fuel hedging portfolio will not only provide protection against rising fuel prices but, will also provide the ability to benefit from declining prices and reduce credit and cash flow exposures.

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The Fundamentals of Oil & Gas Hedging - Futures

Mon, 11 Feb 2013 15:14:00 GMT

This article is the first in a series where we will be exploring the most common strategies used by E&P companies to hedge their exposure to crude oil, natural gas and natural gas liquids prices.

In the energy markets there are six primary energy futures contracts, four of which are traded on the New York Mercantile Exchange: WTI crude oil, natural gas, heating oil and RBOB gasoline and two which are traded on the IntercontinentalExchange: Brent crude oil and gasoil.

A futures contract gives the buyer of the contract, the right and obligation, to buy the underlying commodity at the price at which he buys the futures contract. On the other hand, a futures contact gives the seller of the contract, the right and obligation, to sell the underlying commodity at the price at which he sells the futures contract. However, in practice, very few commodity futures contracts actually result in delivery, most are utilized for hedging and are sold or bought back prior to expiration.

So how can an E&P company use a futures contract to hedge their energy price risk?

As an example, let's assume that you are an E&P company who wants to hedge the price of your future natural gas production. For sake of simplicity, let's assume that you are looking to hedge (by "fixing" or "locking" in the price) 10,000 MMBtu of your July 2013 production. To hedge this production with futures, you would sell one natural gas futures contract. If you had sold this contract based on the closing price on Friday, you would have hedged 10,000 MMBtu of your July 2013 production at $3.531/MMBtu.

Let's now assume that it is June 26, 2013, the expiration date of the July natural gas futures contract. Because you do not want to make delivery of the futures contract, you buy back one July natural gas futures contract at the prevailing market price.

To compare how your strategy will work if July natural gas futures increase and decrease let's examine the following two scenarios.

In the first scenario, let's assume that the prevailing market price, at which you buy back the July natural gas futures contract, is $4.031/MMBtu, a fifty-cent increase over the price at which you sold the futures contract. In this scenario, you would receive $4.031/MMBtu for your July 2013 production. However, your net revenue for July (excluding the basis differential) would be $3.531MMBtu, the price at which you originally sold the futures contract, as you would incur a loss of $0.50/MMBtu ($4.031 - $3.531 = $0.50) on the futures contract.

In the second scenario, let's assume that the prevailing market price, at which you bought back the futures, was $3.031/MMBtu, fifty-cents below the price at which you sold the futures contract. In this scenario, you would receive $3.031/MMBtu for your July 2013 production. However, your net revenue for July (excluding the basis differential) would be $3.531MMBtu, the price at which you originally sold the futures contract, as you would receive a gain of $0.50/MMBtu ($3.531 - 3.031 = $0.50) on the futures contract.

While there are numerous details that need to be considered before you decide to hedge your natural gas production with futures, the basic methodology is rather simple: if you need or want to hedge your exposure to natural gas prices, you can do so by selling a natural gas futures contract.

Last but not least, while this example focused on hedging natural gas production with futures, the same methodology applies to other futures contracts as well.

UPDATE: This article is the first in a series on oil and gas hedging. The subsequent articles can be found via the following links:

The Fundamentals of Oil & Gas Hedging - Swaps

The Fundamentals of Oil & Gas Hedging - Put Options

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February 2013 Energy Hedging Update

Mon, 04 Feb 2013 13:05:00 GMT

Since our January update, all of the primary crude oil and refined product forward curves have increased, many by a substantial amount. On average, the forward curves for global crude oil and refined products prices increased by 5.81% over the past month, led by NYMEX RBOB gasoline and Rotterdam fuel oil (bunker fuel), whose forward curves increased by 7.58% and 7.45%, respectively, since our January update.

On the natural gas side, NYMEX futures have bounced back slightly since our last update with the one year forward curve up 3.45% since our last update.

In the natural gas liquids space, the NGL forward curves increased by an average of 1.4% over the past month. However, as has often been the case in recent months, once again the average isn't representative of the group as both ethane and natural gasoline forward curves increased while the propane and normal butane forward curves both declined since our last update.

The following table displays the indicative, one year, forward strip prices as of the close of business on February 1, 2013, as well as the respective changes since the previous update, which was published on January 2, 2013. Crude oil, refined product and NGL forward curves are based on February 2013 - January 2014 calendar swaps while NYMEX natural gas forward curves are based on March 2013 - February 2014 futures.

	Current	Previous	Change ($)	Change (%)
NYMEX Crude Oil ($/BBL)	98.38	93.22	5.16	5.53%
ICE Brent Crude Oil ($/BBL)	112.10	106.95	5.16	4.82%
NYMEX Heating Oil ($/Gal)	3.14	3.00	0.14	4.51%
NYMEX RBOB Gasoline ($/Gal)	2.94	2.73	0.21	7.58%
ICE Gasoil ($/MT)	967.43	912.25	55.19	6.05%
Gulf Coast ULSD ($/Gal)	3.10	2.96	0.14	4.72%
Gulf Coast 6 Oil 3% ($/BBL)	98.61	93.30	5.31	5.69%
Rotterdam 3.5% Fuel Oil ($/MT)	627.38	583.88	43.50	7.45%
Singapore Fuel Oil 180 CST ($/MT)	658.98	619.21	39.77	6.42%
Gulf Coast Jet Fuel ($/Gal)	3.13	2.98	0.15	5.00%
Singapore Jet Fuel ($/BBL)	129.60	122.28	7.32	5.99%
ARA Jet Fuel ($/MT)	1,049.56	990.51	59.05	5.96%
NYMEX Natural Gas ($/MMBtu)	3.625	3.504	0.121	3.45%
Mont Belvieu Propane ($/Gal)	0.92	0.94	-0.02	-2.12%
Mont Belvieu Natural Gasoline ($/Gal)	2.18	2.08	0.10	4.90%
Mont Belvieu Normal Butane ($/Gal)	1.61	1.63	-0.02	-1.35%
Mont Belvieu Ethane ($/Gal)	0.27	0.26	0.01	4.16%

The prices used in our monthly updates are "rolled" each month such that the previous update included one year (twelve month) strips beginning in January 2013 and ending in December 2013, for all but natural gas, which began with February 2013 and ended with January 2014. In addition, all of the strips, expect NYMEX natural gas, are for "calendar swaps" rather than futures, as the majority of consumers and producers hedging crude oil, refined products and NGLs hedge with calendar swaps, rather than futures.

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