Energy trading scenario 2016

Rakesh Sharma, Executive Director & Head of Financial Engineering Team, Financial Algorithms

Energy Trading Scenario 2016Slump in Crude Oil Prices – Modelling Prices & Volatilities

March, 2016

Financial Algorithms™

2Energy Trading Scenario 2016

Topics

1. Oil Prices – examining fundamentals as uncertainty continues

2. Modelling Oil Price, Volatility from Market Instruments

3. Correlation monitoring in energy derivatives



1Oil Prices – examining

fundamentals as uncertaintycontinues



World Oil Outlook 2015 – a subtext

» The OPEC published its World Oil Outlook 2015 (WOO) in late December 2015, which struck a muchmore pessimistic note on the state of oil markets. On the one hand, OPEC does not see oil pricesreturning to triple-digit territory within the next 25 years, a strikingly bearish conclusion.

» The group expects oil prices to rise by an average of about $5 per year over the course of this decade,only reaching $80 per barrel in 2020. From there, it sees oil prices rising slowly, hitting $95 per barrel in2040.

» Although this estimate carries an error, barring price modeling which involves an array of variables, andmodifications in certain assumptions – such as GDP projections or the pace of population growth – thiscan lead to dramatically different conclusions. So the estimates should be taken only as a reference caserather than a serious attempt at predicting crude prices in 25 years.

» In estimates, the world will consume an extra 6.1 million barrels of oil per day between now and 2020. Butdemand growth slows thereafter: 3.5 mb/d between 2020 and 2025, 3.3 mb/d for 2025 to 2030; 3 mb/d for2030 to 2035; and finally, 2.5 mb/d for 2035 to 2040. The reasons for this are multiple: slowing economicgrowth, declining population rates, and crucially, efficiency and climate change efforts to slowconsumption.

» In fact, since 2014 WOO, OPEC lowered its 2040 oil demand projection by 1.3 mb/d because it seesmuch more serious climate mitigation policies coming down the pike than it did last year. Such outcomesyet to be seen but we are seeing some shifts in oil production levels (next slide)

OPEC released World Oil Outlook 2015

http://oilprice.com/Energy/Crude-Oil/10-Trillion-Investment-Needed-To-Avoid-Massive-Oil-Price-Spike-Says-OPEC.html



Crude Oil Production in OPEC region over the last fewyears

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan 2013 Jan 2014 Jan 2015 Jan 2016

Mill

ion

Bar

rels

per

day

Estimated Historical Unplanned OPECCrude Oil Production Outages

million barrels per day

Indonesia

Saudi Arabia

Kuwait

Iraq

Nigeria

Libya

Iran

Source: Short-Term Energy Outlook, March 2016.



Crude Oil Production in Non-OPEC region over the lastfew years

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0.2

0.4

0.6

0.8

1.0

1.2

Jan 2013 Jan 2014 Jan 2015 Jan 2016

Mill

ion

Bar

rels

per

day

Estimated Historical Unplanned Non-OPECLiquid Fuels Production Outages

million barrels per dayOther

United States

Mexico

Canada

Sudan / S. Sudan

Colombia

Brazil

North Sea

Yemen

China

Syria




What is next after Shell gas discovery : Energy securityscenario across regions affecting oil price levels» There was a gap between business as-usual supply and business-as-usual demand of around 400

EJ/a – the size of the entire oil & natural gas industry in 2000. Though ,this has been reversed byvarious factors over the last few years.

» As in focus on national energy security, immediate pressures drive decision makers, especially theneed to secure energy supply in the near future for themselves and their allies. National governmentattention naturally falls on the supply-side levers readily to hand, including the negotiation of bilateralagreements and incentives for local resource development. Growth in coal and biofuels becomesparticularly significant.

0.00 1.00 2.00 3.00

World OilSupply

World OilDemand

Million barrels per day

World Oil Demand-Supply growth forfirst 3 quarters of 2015

Source: By OPEC Secretariat

» Despite increasing rhetoric, action to address climatechange and encourage energy efficiency is pushed into thefuture, leading to largely sequential attention to supply,demand and climate stresses.

» Clean energy sources such as nuclear energy rapidlygaining support from energy thirsty economies.

» Demand-side policy is not pursued meaningfully until supplylimitations are acute. Likewise, environmental policy is notseriously addressed until major climate events stimulatepolitical responses.

» Customized tool development such as DECC 2050 for majoreconomies is gaining popularity; but it has its limitations.



Oil Prices : OPEC investments in US economy, a drivingfactor

A big risk is that the Saudi Kingdom is selling some of its treasury holdings, believed to be among thelargest in the world, to raise needed dollars. As a matter of policy, the US Treasury has never disclosedthe holdings of Saudi Arabia, long a key ally in the volatile Middle East, and instead groups it with 14other mostly OPEC nations including Kuwait, the United Arab Emirates and Nigeria.

Source : http://ticdata.treasury.gov/Publish/mfh.txt

China,, 1237.9

Japan, 1123.5

Carib, 350.5

Oil Exporters,293

Brazil, 255.7Ireland, 252.2

Switzerland,237.4

UnitedKingdom,

223.2

Hong Kong,201.6

Luxembourg,200.1

Other, 862.3

US Treasury Holdings by Top 10 Countries - Jan2016 in billion dollars» Earlier OPEC nations were

plowing cash into U.S.Treasuries at a more than 50percent faster rate than all otherforeign investors, during the timewhen crude oil was tradingabove $100 a barrel.

» Higher prices boosted theircurrency reserves. While bookingsuper profits, OPEC countriesparked this profit in UStreasuries.



2 Modelling Oil Prices, Volatilityfrom Market Instruments



WTI : Probabilities projecting price levels

Using realized volatility (historical) – probabilities were calculated to project price levels for the range of WTIcontracts. These probabilities imply that WTI prices may trade between USD 30-45 in most likely scenariofor the entire year; though with limited upside chances.

0%

10%

20%

30%

40%

50%

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17Contract month

Probability of WTI spot price fallingbelow certain levels

Price < $25Price < $30Price < $35

0%

10%

20%

30%

40%

50%

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17Contract month

Probability of WTI spot priceexceeding certain levels

Price > $55Price > $50Price > $45

Source: EIA Short-Term Energy Outlook, March 2016, and CME Group (http://www.cmegroup.com)



Zomma (DGammaDVol) Sensitivity on WTI Futures usingBlack’s Forward Model

WTI Price as of 27th March 2016 : $ 37.87 & OVI Index level : 52 week low 29; current 47.18, 52 week high :109. Zomma is a useful sensitivity to monitor when maintaining a gamma-hedged portfolio as Zomma helpsthe trader to anticipate changes to the effectiveness of the hedge as volatility changes.

37.5

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29.7

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5

18.0

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-0.0050

-0.0040

-0.0030

-0.0020

-0.0010

0.0000

0.0010

0.0020

0.0030

0.10

0.36

0.63

0.89

WTI price

Zom

ma

leve

ls

Time tomaturity

Deep in the money Call - DGammaDvol for theyear 2016

62.5

0

59.2

5

56.0

0

52.7

5

49.5

0

46.2

5

43.0

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39.7

5

36.5

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33.2

5

30.0

0-0.0030

-0.0025

-0.0020

-0.0015

-0.0010

-0.0005

0.0000

0.0005

0.0010

0.0015

0.10

0.36

0.63

0.89

WTI price

Zom

ma

Leve

ls

Time tomaturity

Deep in the money Put - DGammaDvol for theyear 2016



High volatility sensitivity : Zomma & Vanna (DDeltaDvol)for Call using forward-forward model

OVI Level : 109 : Vanna is also a very useful sensitivity to monitor when maintaining a delta- or vega-hedged portfolio as vanna will help the trader to anticipate changes to the effectiveness of a delta-hedgeas volatility changes or the effectiveness of a vega-hedge against change in the underlying spot price.Here suggesting WTI price to hover between USD 30-45 zone for the year.

45.0

0

42.0

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39.0

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36.0

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-0.0004

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-0.0002

-0.0001

0.0000

0.0001

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0.0004

0.10

0.36

0.63

0.89

WTI price

Zom

ma

Leve

ls in

hig

h vo

latil

ity s

cena

rio

Time tomaturity

Deep in the money Call - DGammaDvol for the year2016

45.0

0

42.0

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39.0

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15.0

0-0.0020

-0.0010

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0.0010

0.0020

0.0030

0.0040

0.0050

0.10

0.36

0.63

0.89

WTI price

Vann

a Le

vels

in h

igh

vola

tility

sce

nario

Time tomaturity

Deep in the money Call - DDeltaDvol for the year2016



Gasoline Prices in US : RBOB in long term mean zone

» As shown in the figures below, the spread of gasoline and diesel is almost flat over the last few yearswith respect to crude oil prices.

» Except for January 2015, the volatility levels were in a normal zone, suggesting mean reversion factoracting up and maintaining the price levels at $1.9 – 2.3 for gas & $2-2.5 for diesel.

Forecast

0.000.501.001.502.002.503.003.504.004.505.00

Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017

U.S. Gasoline and Crude Oil Pricesdollars per gallon

Price difference

Retail regular gasoline

Crude oil


Crude oil price is composite refiner acquisition cost. Retail prices include stateand federal taxes.

Forecast

0.000.501.001.502.002.503.003.504.004.505.00

Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017

U.S. Diesel Fuel and Crude Oil Pricesdollars per gallon

Price differenceRetail diesel fuelCrude oil


Crude oil price is composite refiner acquisition cost. Retail prices include stateand federal taxes.



Speed Greek Sensitivity : mean level vs. high level volsfor calls & puts using forward-forward model

2.252.101.951.801.651.501.351.201.050.900.75

-1.0000

-0.5000

0.0000

0.5000

1.0000

1.5000

2.0000

0.10

0.360.63

0.89

Gasoline price

Time tomaturity

Speed sensitivity at high level vols for Gasoline

2.252.101.951.801.651.501.351.201.050.900.75

-15.0000

-10.0000

-5.0000

0.0000

5.0000

10.0000

15.0000

0.100.36

0.630.89

Gasoline price

Time tomaturity

Speed sensitivity at mean level vols for Gasoline

3.753.503.253.002.752.502.252.001.751.501.25

-4.0000-3.0000-2.0000

-1.0000

0.0000

1.0000

2.0000

3.0000

4.0000

5.0000

0.100.36

0.630.89

Diesel priceTime tomaturity

Speed sensitivity at mean level vols for Diesel

3.753.503.253.002.752.502.252.001.751.501.25

-0.4000-0.3000-0.2000-0.10000.00000.10000.20000.30000.40000.50000.60000.7000

0.10

0.360.63

0.89

Diesel price

Time tomaturity

Speed sensitivity at high level vols for Diesel



NatGas Henry Hub : Probabilities projecting price levels» In a highly correlated market, Natural Gas exhibiting range bound price levels. In a most likely

scenario, NatGas may move between US$ 3.00 to US$ 3.50, with a very limited upside price levels forthe entire years.

» During spring and summer time, seasonality holding down Henry Hub spot prices below US$ 2.00 butsupporting levels pushing up prices in a US$ 2.00-3.00 range.

0%

10%

20%

30%

40%

50%

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17

Contract month

Probability of Henry Hub spot priceexceeding certain levels

Price > $4.00

Price > $3.50

Price > $3.00

0%

10%

20%

30%

40%

50%

Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17

Contract month

Probability of Henry Hub spot pricefalling below certain levels

Price < $1.25Price < $1.50Price < $1.75

Source: EIA Short-Term Energy Outlook, March 2016, and CME Group (http://www.cmegroup.com)



Vanna & price adjusted Gamma sensitivity using forwardmodel for Henry Hub underlying» Although, price levels suggesting US$ 2.00-3.50 range for NatGas, Vanna sensitivity suggesting high

volatility levels may stop rally in the NatGas & price may remain range bound i.e. US$ 1.50 – 2.75 for theentire year.

» Price adjusted Gamma exhibiting skewness towards positive side suggesting price to hover betweenUS$ 2.00 – 3.25 in a most likely scenario.

3.753.

383.002.632.251.881.50

-0.0080

-0.0060

-0.0040

-0.0020

0.0000

0.0020

0.0040

0.0060

0.0080

0.0100

0.0120

0.10

0.36

0.63

0.89

Henry Hub price

Time tomaturity

Henry Hub ITM Call - Vanna (DDeltaDvol) for theyear 2016

3.753.

383.002.632.251.881.50

0.0000

0.0050

0.0100

0.0150

0.0200

0.0250

0.0300

0.0350

0.0400

0.0450

0.10

0.36

0.63

0.89

Henry Hub price

Time tomaturity

Henry Hub ITM Gamma-P Call for the year 2016



3 Correlation monitoring in energyderivatives



Correlation factors : Eagle’s eye can slice good profits

OPEC & Non-OPEC Oil Production & Trading

Price Levels,Spreads i.e.

Crack /RBOB/Diesel

etc.

CurrencyReserves

Investments overseas

US treasuries& Bonds i.e.

10Y/30Y

Investmentsin otherregions

Impact on g-local economies

Price Levels determiningriskiness of asset

classes across regionsEconomic growth & Core

inflationary levels

OPEC Productionforecasting using internalmodels

World GDP growth &energy demand per capitaprojections



Climate Change Status

Planetary Boundaries Status

Climate Change (atmospheric CO2 concentration and change inradiative forcing) Boundary Exceeded

Rate of Biodiversity Loss Boundary Exceeded

Nitrogen Cycle -part of a boundary with the Phosphorus Cycle Cycle Boundary Exceeded

Phosphorus Cycle -part of a boundary with the Nitrogen Cycle Cycle Approaching Limit

Ocean acidification Approaching Limit

Global fresh water use Approaching Limit

Change in land use Approaching LimitStratospheric ozone depletion Not exceededAtmospheric aerosol loading Not yet quantified

Chemical pollution Not yet quantifiedSource : Shell Scenarios 2050 signals sign posts

Research published by the Stockholm Resilience Centre in early 2009 proposes a framework based on‘biophysical environmental 2 subsystems’. The Nine Planetary Boundaries collectively define a safeoperating space for humanity where social and economic development does not create lasting andcatastrophic environmental change. Political response to these metrics will affect the energy marketand shift in preferences of energy products.



Geo-political & Behavioral factors – next generationvariables

» The global economic crisis has coincided with a shift in geopolitical and economic power from west toeast. This decisive shift is transforming the global economic and political system. Middle east isturbulent, US & Russian grappling with Eurasian political scenario.

» The world is facing a period of uncertain global politics. Strategic fault lines are emerging. Risingpowers are increasingly and confidently asserting what they see as their national interests.– Key drivers going forward : G20 governance | The China-US relationship | Sharing the burdens of adjustment | New policy

paradigm

» Behavioral economics has enhanced our ability to understand how consumers make choices. It hashelped governments find ways to reduce energy demand without losing votes. It has helped businessesdevelop more innovative and profitable ways to serve consumers. Hydro-gen engines may be the nextbig thing in utility driven energy markets suggesting shifting trends as the economy of scale introducesthe cost effectiveness in car manufacturing with such engines.

» The environment and climate change were overshadowed by concerns about economic security as thefinancial crisis deepened in the last decade. Events such as the Gulf of Mexico oil spill, while hardeningpublic attitude towards energy providers, did little to change the energy consumption habits ofconsumers.

» A new communications boom is also creating marked shifts in consumer behavior. While connectivityaccelerates the spread of information, it can also deepen uncertainty. Research shows that the structureof the network connections people use can strengthen or weaken the spread of behavioral trends inunpredictable ways.



Financial Algorithms

» Financial Algorithms offers wide variety of services including derivatives pricing, modelvalidation, valuation of exotic and structured products.

» Advisory services includes advisory in trading derivatives & structured products, hedging ofvarious exposures in Interest Rates, Foreign Exchange, Commodities and Equities.

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www.financialalgorithms.co

» Or email at [email protected]



Rakesh SharmaExecutive Director & Head of Financial Engineering TeamFinancial Algorithms18, Scheme No. 59 (II), Western Ring RoadIndore – 452001, India

Email : [email protected]

www.financialalgorithms.com

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Energy trading scenario 2016

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