Energy Trading {Unit 06}

8/14/2019 Energy Trading {Unit 06}

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Unit- 6

HEDGING STRATEGY

Energy price volatility ruled the 1990s. Crude oil prices soared as high as $40/bbl during

the Gulf War and dropped as low as single digits in 1998 and 1999. They were at 10

year highs as this book went to press. Natural gas prices experienced as much or even

greater volatility as changes in temperatures increased and decreased the size of the

gas bubble. These wild swings in energy commodity prices wreaked havoc on the

bottom lines of many energy producers, refiners, marketers, traders and end-users.

One outgrowth of these market developments was sprouting of energy price risk

management programs throughout the energy industry. For a few companies, the

experience was a highly visible financial disaster owing to the misuse ormisunderstanding of the use of derivatives in so called hedging programs. For the

vast majority of companies, success in energy price risk management was mixed. As a

result, comprehensive, and enterprise wide risk management programs are still not

widespread throughout the industry.

From my experience analyzing energy risk management programs since 1979,

there are several key reasons why there are relatively few really successful energy

price risk management programs. First and most fundamental is the failure to properly

establish an important and sustaining rationale for the hedging program. In every

company, there will be wide ranging opinions as to whether the company should be

expected.

A second critical reason is the Failure to properly analyze and quantity the

companys portfolio risk exposure on a continuous basis. Clearly if the risk is

misdiagnosed, like a disease, it can not be properly treated or controlled.

A third crucial reason is lack of a systematic strategy properly designed to

address the companys portfolio risk. Few companies have what I consider to be a

formal strategy, with decision rules. Many that does have rules based on physical rather

then financial events.

A fourth major reason is the lack of structure and discipline in the implementation

of the risk management process. Often expectations are not set or, again , very widely


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among executives . Evaluations of result, if they take place at all, are ofteninconsistent

with risk reduction objectives.

To hedge or not to hedge

For hedging to gain lasting acceptance in any company , it must be seen as a

means by which the company can better attain its corporate strategic or financial goals.

Such goal may include meeting or exceeding a budget, protecting against a drop in

cash flow that could threaten debt rating or payments , or batter enabling a company to

have a competitive cost or price . In short, it must provide a viable alternative to simply

accepting the market risk and its impact. It is managements responsibility to set the

proper objectives for risk management and the proper evaluation criteria.In my view, there are at least two valid hedging objectives:

To achieve the highest risk adjusted return on capital employed To reduce the risk of unacceptably low returns on capital employed

Over the years, I have heard many reasons why executives believe their their

companies should not hedge some believe that their companies are being rewarded in

the stock market for taking energy market risk. Even for those companies that are

oriented toward accepting the markets energy price exposure, I believe hedging is stilllogical. Why? Because companies should take the risk that have the highest risk

adjusted expected returns.

Why take risks on exposures that are expected to lose money? If an unhedged

portfolio has market exposures with negative expected returns, those exposures should

be hedged. By hedging those exposures, the company can afford to take additional risk

on exposures with positive expected returns. This is simply the most logical method to

allocate risk capital. Wheather the outcome of such capital allocation is favorable or not

the company would at least be making more rationale risk management decision than

exposure with negative expected returns.


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Backwardation

Backwardation is a market condition where spot prices exceed forward prices.

Contango is the opposite condition, where forward prices exceed spot prices. The terms

are most commonly used in oil markets but are also applied in certain commodities and

energies markets. In oil markets, the prevailing condition may reflect immediate supply

and demand. If crude oil is contango, it may indicate immediately available supply.

Backwardation can indicate an immediate shortage. Anything that threatens the steady

flow of oil around the world, such as imminent war, tends to drive the oil market intobackwardation.

A theory developed in respect to the price of a futures contract and the contract's time to

expire. Backwardation says that as the contract approaches expiration, the futures

contract will trade at a higher price compared to when the contract was further away

from expiration. This is said to occur due to the convenience yield being higher than the

prevailing risk free rate.

When backwardation does occur in a futures market it has been suggested that an

individual in the short position would benefit the most by delivering as late as

possible.Backwardation in futures contracts was called "normal backwardation" by

economist John Maynard Keynes. This is because he believed that a price movement

like the one suggested by backwardation was not random but consistent with the

prevailing market conditions. Backwardation is the opposite of contango.

Backwardation (sometimes incorrectly referred to as "backwardization") is a futures

market term: it means an downward sloping forward curve (as in an inverted yield

curve): one says that the forward curve is "in backwardation" (or sometimes:

"backwardated").


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Formally, it is the situation where, and the amount by which, the price of a commodity

for future delivery is lower than the spot price, or a far future delivery price lower than a

nearer future delivery.

The opposite market condition to backwardation is known as contango.

More generally, the term is sometimes applied to forward prices other than those of

futures contracts, when analogous price patterns arise. For example, if it costs more to

lease silver for 30 days than for 60 days, it might be said that the silver lease rates are

"in backwardation.

Notable examples of backwardation include,

1.Commodities: Copper circa 1990, apparently arising from market manipulation

by Yasuo Hamanaka of Sumitomo Corporation.

2.FX: The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006:

the backwardation occurs simply because Australian dollar bonds pay so much more

interest at every point in the yield curve than Japanese yen bonds do. Any high-yield

foreign currency contract will show backwardation in its pricing.

3.NYMEX traded natural gas currently (May 2007).

Trend

The general direction of a market or of the price of an asset. Trends can vary in length

from short, to intermediate, to long term. If you can identify a trend, it can be highly

profitable, because you will be able to trade with the trend. As a general strategy, it is

best to trade with trends, meaning that if the general trend of the market is headed up,

you should be very cautious about taking any positions that rely on the trend going inthe opposite direction.

A trend can also apply to interest rates, yields, equities and any other market which is

characterized by a long-term movement in price or volume.


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Market trends

Market trends reflect the general direction of prices or rates in financial markets. [1]

Participants in a given market use price charts to observe these trends, and to identify

investment and trading opportunities.

That market prices do move in trends is one of the major premises of technical

analysis, [2] though the description of market trends is common to Wall Street, [3] the

economics profession, and the Federal Reserve. [4]

Market trends unfold in periods when bulls (buyers) consistently outnumber bears

(sellers), or vice versa. A bull or bear market describes the trend and sentiment driving

it, but can also refer to specific securities and sectors ("bullish on IBM", "bullish on

technology stocks," or "bearish on gold", etc.)


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Bull market

The Charging Bull in Bowling Green, New York is a symbol of the bull market.

A bull market tends to be associated with increasing investor confidence, motivating

investors to buy in anticipation of further capital gains. The longest and most famous

bull market was in the 1990s when the U.S. and many other global financial markets

grew at their fastest pace ever.[5]

In describing financial market behavior, the largest group of market participants is

often referred to, metaphorically, as a herd . This is especially relevant to participants

in bull markets since bulls are herding animals. A bull market is also described as a

bull run . Dow Theory attempts to describe the character of these market

movements.

The United States has been in a long-term bull market since about 1983, with briefupsets including the Panic of 1987 and the NASDAQ Crash in 2000.

Bear market

A bear market tends to be accompanied by widespread pessimism. Investors

anticipating further losses are motivated to sell, with negative sentiment feeding on

itself in a vicious circle. The most famous bear market in history was 1930 to 1932,

marking the start of the Great Depression. [6] A milder, low-level long-term bear

market occurred from about 1967 to 1983, encompassing the stagflation economy,

energy crises in the 1970s, and high unemployment in the early 1980s.


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Prices fluctuate constantly on the open market; a bear market is not a simple

decline, but a substantial drop in the prices of a range of issues over a defined

period of time. By one common definition, a bear market is marked by a price

decline of 20% or more in a key stock market index from a recent peak over a 12-

month period. However, no consensual definition of a bear market exists to clearly

differentiate a primary market trend from a secondary market trend.

Investors frequently confuse bear markets with corrections. Corrections are much

shorter lived, whereas bear markets occur over a longer period with typically a

greater magnitude of loss from top to bottom.

A secondary trend is a temporary change in price within a primary trend. Theseusually last a few weeks to a few months. A temporary decrease during a bull

market is called a correction ; a temporary increase during a bear market is called a

bear market rally .

Whether a change is a correction or rally can be determined only with hindsight.

When trends begin to appear, market analysts debate whether it is a correction/rally

or a new bull/bear market, but it is difficult to tell. A correction sometimes

foreshadows a bear market.

Correction

A market correction is sometimes defined as a drop of at least 10%, but not more

than 20% (25% on intraday trading) over a short period of time. The major difference

between a bear market and a correction is magnitude and duration. Bear markets

last much longer, and the magnitude of loss is greater.

Major disasters or negative geopolitical events can spark a correction. One example

is the performance of the stock markets just before and after the September 11,

2001 attacks. On September 7, 2001, the Dow fell 234.99 points to 9,605.85,

thoroughly pushing the Dow into a correction. On September 17, 2001, the first day


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of trading after the attacks, the Dow Jones Industrial Average plunged 684.81 points

to 8,920.70. That loss officially pushed the Dow, not just even further into a

correction, but into a bear market. (Although unless investors had prior knowledge of

the events of September 11, 2001, it would be impossible for the attacks to have

had an effect on the markets ahead of time.) How can this be called a, "correction"

when on 9.7.01 the Dow fell 2-3% and on 9.17 by 7-8%? Both numbers, eight and

three are less than ten, therefor this is not a, "correction" by the definition stated

above.

Because of depressed prices and valuation, market corrections can be a good

opportunity for value-strategy investors. If one buys stocks when everyone else is

selling, the prices fall and therefore the P/E ratio goes down. In addition, one is ableto purchase undervalued stocks with a highly probable upside potential.

Bear market rally

A bear market rally is sometimes defined as an increase of at least 10%, but no

more than 20%.

Notable bear market rallies occurred in the Dow Jones index after the 1929 stockmarket crash leading down to the market bottom in 1932, as well as throughout the

late 1960s and early 1970s. The Japanese Nikkei stock average has been typified

by a number of bear market rallies since the late 1980s while experiencing an

overall downward trend.

A secular market trend is a long-term trend that usually lasts 5 to 25 years, and

consists of sequential primary trends. In a secular bull market the bear markets are

smaller than the bull markets. Typically, each bear market does not wipe out the

gains of the previous bull market, and the next bull market makes up the losses of

the bear market. Conversely, in a secular bear market , the bull markets are smaller

than the bear markets and do not wipe out the losses of the previous bear market.


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An example of a secular bear market was seen in gold over the period between

January 1980 to June 1999, over which the nominal gold price fell from a high of

$850/oz to a low of $253/oz, [7] which formed part of the Great Commodities

Depression. Conversely, the S&P 500 experienced a secular bull market over a

similar time period. [8]

An example of a secular bull market would be the US Stock market between August

1982 and June 2007. The DJIA, S&P500 and Wilshire 5000 indexes all made new

record highs in 2007 with only a single cyclical bear market low in October 2002

after the cyclical bull market high made in March 2000.

These secular bull and bear market trends are also termed "super cycles". "Grandsupercycles" of 50 to 300 years have also been proposed by Nikolai Kondratiev and

Ralph Nelson Elliott.

Price risk identification

The best way I have found to identify a company's portfolio risk to commodity prices

is to create a model of their earnings. The objective of building the model is to

determine how the company's earnings change if "market prices" of related com-

modities change. Though any number of market prices can be used in building the

earnings' model, I often use NYMEX futures contract prices. The futures price curve

could be viewed as an unreliable input since it keeps changing all the time. However,

the benefit of this approach is that one can "lock-in" projected earnings if they are high

enough, or if the downside is perceived to be great. In a sense, the "prediction" can

become a self-fulfilling prophecy through hedging, no matter how the price curve

changes after the hedge is established.

Earnings models

Earnings can be forecast by linking NYMEX futures prices to a company's sales

prices and costs. The equations can be developed through multiple regression analysis.


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By inserting the current forward strip, an earnings forecast for forward months can be

generated. As NYMEX prices change, new earnings forecasts can be automatically

generated.

Stress tests

A stress test is a means for assessing the impact of an extreme price movement on

future earnings. For example, with an earnings model, crude futures prices could be

increased or decreased by $l/bbl to determine the effect such a change would have on

future earnings.


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WHAT IS MONTE CARLO SIMULATION?

The drawback of stress testing is that the probability of the scenario being tested is not taken

into account. To assess the likely distribution of earnings for any given month, a probabilitydistribution for futures prices is needed. Further, the relationships among futures prices must be

maintained for the resulting distribution to be realistic. One analytical method to develop a

distribution of earnings is "Monte Carlo simulation." A Monte Carlo simulation is a method by

which price scenarios are randomly selected from their distribution according to their frequency in

the distribution. The output of the simulation is a distribution showing the frequency of different

earnings estimates The standard deviation of an earnings distribution is a generally accepted

measure of portfolio risk. A new standard deviation can be computed when hedge positions areincluded in the portfolio by running the Monte Carlo simulation. If the new standard deviation is

lower, the hedge has reduced portfolio risk, and vice versa.

What do we mean by "simulation?" When we use the word simulation , we refer to

analytical method meant to imitate a real-life system, especially when other analyses are too

mathematically complex or too difficult to reproduce. Without the aid of simulation, a spreadsheet

model will only reveal a single outcome, generally the most likely or average scenario.

Spreadsheet risk analysis uses both a spreadsheet model and simulation to automatically analyzethe effect of varying inputs on outputs of the modeled system.

One type of spreadsheet simulation is Monte Carlo simulation , which randomly

generates values for uncertain variables over and over to simulate a model.

How did Monte Carlo simulation get its name?

Carlo simulation was named for Monte Carlo, Monaco, where the primary attractions are casinos

containing games of chance. Games of chance such as roulette wheels, dice, and slot machines,

exhibit random behavior.

The random behavior in games of chance is similar to how Monte Carlo simulation selects variable


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values at random to simulate a model. When you roll a die, you know that either a 1, 2, 3, 4, 5, or 6

will come up, but you don't know which for any particular roll. It's the same with the variables that

have a known range of values but an uncertain value for any particular time or event (e.g. interest

rates, staffing needs, stock prices, inventory, phone calls per minute).

What do you do with uncertain variables in your spreadsheet?

For each uncertain variable (one that has a range of possible values), you define the possible

values with a probability distribution. The type of distribution you select is based on the conditions

surrounding that variable. Distribution types include:

.

To add this sort of function to an Excel spreadsheet, you would need to know the equation that

represents this distribution. With Crystal Ball, these equations are automatically calculated for you.

Crystal Ball can even fit a distribution to any historical data that you might have.

What happens during a simulation?

A simulation calculates multiple scenarios of a model by repeatedly sampling values from the

probability distributions for the uncertain variables and using those values for the cell. Crystal Ball

simulations can consist of as many trials (or scenarios) as you want - hundreds or even thousands -

in just a few seconds.

During a single trial, Crystal Ball randomly selects a value from the defined possibilities (the range

and shape of the distribution) for each uncertain variable and then recalculates the spreadsheet


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Portfolio Risk Theory

Before addressing the questions of what to hedge, when to hedge or how much to

hedge , the company needs to know the nature the magnitude of its price risk . The

lessons learned about its price risk are often as valuable in making other business

decisions as they are in making the determination of whether to hedge- e.g. refinery

optimization and inventory management.

The application of portfolio theory to business and not just stock portfolios, began

to take hold in the latter part of the 1990s. Many financial firms , and even some

industrial firms , embraced the concept of managing the enterprise or global risk of

their business portfolio.

A business portfolio is a group of assets-such as a company's oil reserves,

refineries, or inventories. A financial portfolio may be a group of oil futures contracts,

swaps, and/or derivatives. Each has its own set of risk/return characteristics, depending

on what a portfolio includes. When a financial portfolio is combined with the firm's

business portfolio, the combination (or total portfolio) will have new risk-return

characteristics, or market exposure, than either one separately. Diversification of risk

enables the total portfolio to have lower risk than either the business portfolio or

financial portfolio has separately. Controlling the risk of the financial portfolio separatelyis inconsistent with managing the risk of the total portfolio.

It is this portfolio framework that one must apply in the construction of hedges.

Otherwise, determining the proper portfolio is just guesswork that may lead to a result

the opposite of what is expected.

The Financial Accounting Standards Board (FASB) has defined commodity price risk

as the sensitivity of a firm's income to changes in prices . Many large oil companies are

exposed to changes in literally thousands of prices, 1 and so the problem of price risk

identification and quantification is analytically challenging.

As a result, many firms do not conduct a comprehensive, portfolio risk assessment

to identify their risk exposure. The most common mistake is that someone identifies one

risk within the portfolio and the company hedges that risk.


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However, a risk analysis that addresses only part of a company's portfolio (i.e., a

partial risk analysis) is inherently flawed. Correlations among all risk factors need to be

quantified. The result of considering only part of a company's portfolio risk exposure can

in fact lead to a hedging strategy that actually increases, rather than reduces, risk.

If you were to craft the perfect investment, you would probably want its attributes to

include high returns coupled with little risk. The reality, of course, is that this kind of

investment is next to impossible to find. Not surprisingly, people spend a lot of time

developing methods and strategies that come close to the "perfect investment". But

none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at

the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the

management of your portfolio.

The Theory

One of the most important and influential economic theories dealing with finance and

investment, MPT was developed by Harry Markowitz and published under the title

"Portfolio Selection" in the 1952 Journal of Finance . MPT says that it is not enough to

look at the expected risk and return of one particular stock. By investing in more thanone stock, an investor can reap the benefits of diversification - chief among them, a

reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification,

also known as not putting all of your eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will be

lower than expected. In other words, it is the deviation from the average return. Each

stock has its own standard deviation from the mean, which MPT calls "risk".

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in

holding any single one of the individual stocks (provided the risks of the various stocks

are not directly related). Consider a portfolio that holds two risky stocks: one that pays

off when it rains and another that pays off when it doesn't rain. A portfolio that contains


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Figure 1

The Efficient Frontier

Now that we understand the benefits of diversification, the question of how to identify

the best level of diversification arises. Enter the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and

for every level of risk, there is a portfolio that offers the highest return. These

combinations can be plotted on a graph, and the resulting line is the efficient frontier.

Figure 2 shows the efficient frontier for just two stocks - a high risk/high return

technology stock (Google) and a low risk/low return consumer products stock (Coca

Cola).


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Figure 2

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum

expected return for a given level of risk. A rational investor will only ever hold a portfolio

that lies somewhere on the efficient frontier. The maximum level of risk that the investor

will take on determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock

portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is

funded by borrowing, can actually increase returns beyond the efficient frontier. In other

words, if you were to borrow to acquire a risk-free stock, then the remaining stock

portfolio could have a riskier profile and, therefore, a higher return than you might

otherwise choose.

What MPT Means for You

Modern portfolio theory has had a marked impact on how investors perceive risk, returnand portfolio management. The theory demonstrates that portfolio diversification can

reduce investment risk. In fact, modern money managers routinely follow its precepts.

That being said, MPT has some shortcomings in the real world. For starters, it often

requires investors to rethink notions of risk. Sometimes it demands that the investor


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take on a perceived risky investment (futures, for example) in order to reduce overall

risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated

portfolio management techniques. Furthermore, MPT assumes that it is possible to

select stocks whose individual performance is independent of other investments in the

portfolio. But market historians have shown that there are no such instruments; in times

of market stress, seemingly independent investments do, in fact, act as though they are

related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio

returns, but finding a truly risk-free asset is another matter. Government-backed bonds

are presumed to be risk free, but, in reality, they are not. Securities such as gilts

and U.S. Treasury bonds are free of default risk, but expectations of higher inflation andinterest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification. How

many is enough? Mutual funds can contain dozens and dozens of stocks. Investment

guru William J. Bernstein says that even 100 stocks is not enough to diversify away

unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book

"Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would

come very close to achieving optimal diversity after adding the twentieth stock.

Conclusion

The gist of MPT is that the market is hard to beat and that the people who beat the

market are those who take above-average risk. It is also implied that these risk takers

will get their comeuppance when markets turn down.

Price Risk and Derivatives

Diversification and insurance are the major tools for managing exploration risk and

protecting firms from property loss and liability. Firms manage volume risknot having

adequate suppliesby maintaining inventories or acquiring productive assets.


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Derivatives are particularly appropriate for managing the price risk that arises as a result

of highly volatile prices in the petroleum and natural gas industries.

Petroleum and Natural Gas Price Risks and Risk Management Strategies

Participants Price Risks

Risk Management Strategiesand Derivative Instruments

EmployedOil Producers Low crude oil price Sell crude oil future or buy put

option

Petroleum Refiners High crude oil price Buy crude oil future or calloption

Low product price Sell product future or swapcontract,buy put option

Thin profit margin Buy crack spread

Storage Operators High purchase price or lowsale price

Buy or sell calendar spread

Large Consumers

Local Distribution Companies(Natural Gas)

Unstable prices, wholesaleprices higher than retail

Buy future or call option, buybasis contract

Power Plants (Natural Gas) Thin profit margin Buy spark spreadAirlines and Shippers High fuel price Buy swap contract

Source: Energy Information Administration.

The typical price risks faced by market participants and the standard derivative

contracts used to manage those risks are shown in table . Price risk in the petroleumand natural gas industries is naturally associated with each participants stage of

production. Some companies integrate their operations from exploration through final

sales to eliminate the price risks that arise at the intermediate stages of processing. For

example, for an integrated producer, an increase in the cost of crude oil purchased at its

refinery will be offset by revenue gains from its sales of crude oil. Other, smaller


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companies usually do not have integrated operations. Independent producers want

protection from low crude oil prices, and they sell to refiners who want protection from

high prices. Refiners want protection from low product prices, and they sell to storage

facilities and customers who are concerned about high prices. At each stage, suppliers

and purchasers can split the risk in order to allay their concerns. They typically

supplement exchange-traded futures and options with over-the-counter (OTC) products

to manage their price risks.

Risk managers in the petroleum and natural gas industries commonly use derivatives to

achieve certainty about the prices they pay or receive. Depending on their

circumstance, they may be concerned with the price paid per se , with price spreads

(differences between prices), with ceilings and floors, and/or with price changes overtime. In addition, volumetric production payment contractsa variant of a standard

swapmay be used to reduce uncertainty about cash flows and credit. Some of the

instruments particular to the oil and gas industries are described below.

The principal difficulty in using exchange-traded products is they often do not exactly

correspond to what the trader is attempting to hedge or to speculate in. For examples,

price movements in premium gasoline are not identical to those in unleaded gasoline.

Similarly, the price of natural gas at Henry Hub is not identical to that at Chicago. Thedistinction between what exchange products can hedge and what the user wants to

hedge is the source of basis risk . Basis risk is the risk that the price difference between

the exchange contract and the commodity being hedged will widen (or narrow)

unexpectedly. To a large extent, the OTC market exists to bridge the gap between

exchange-traded products and the needs of individual traders, so that the two markets

in effect have a symbiotic relationship.

Basis Contracts

Price certainty in a unified market can be bought with forward sales, futures contracts,

or swaps (contracts for differences). When one or both parties face a spot market price

that differs from the price in reference market, however, other derivative contract


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instruments may be needed to manage the resulting basis risk. For example, a local

distribution company (LDC) in Tennessee could enter into a swap contract with a

natural gas producer, using the Henry Hub price as the reference price; however, the

LDC would lose price certainty if the local spot market price differed from the Henry Hub

price. In this example, when the Henry Hub price is higher than the Tennessee price by

more than it was at the initiation of the swap contract, the LDC gains, because its

payment from the producer will exceed the amount it pays to buy gas in its local market.

Effectively, the LDC will pay less per thousand cubic feet than the fixed amount the LDC

pays the producer. Conversely, if the Tennessee price is lower, the producers payment

will not cover the LDCs gas bill in its local market.

A variety of basis contracts are available in OTC markets to hedge locational, product,and even temporal differences between exchange-traded standard contracts and the

particular circumstances of contract users. The simplest is a basis swap . In the example

above, the OTC trader would pay the LDC the difference between the Tennessee price

and the Henry Hub price (for the nominal amount of gas) in exchange for a fixed

payment. The variety of contractual provisions is unlimited. For example, the flexible

payment could be defined as a daily or monthly average (weighted or unweighted) price

difference; it could be capped; or it could require the LDC to share the costs when the

contracts ceiling price is exceeded. What this OTC contract does is to close the gap

between the Henry Hub price and the price on the LDCs local spot market, allowing the

LDC to achieve price certainty.

The traders supplying basis contracts can survive only if the basis difference they pay

averaged over time and adjusted for both financing charges and the time value of

moneyis less than the fixed payment from the LDC. Competition among OTC traders

can only reduce the premium for supplying basis protection. Reducing the underlying

causes of volatile price differences would require more pipeline capacity, more storage

capacity, cost-based transmission pricing, and other physical and economic changes to

the delivery system itself.


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Risk limits

Creating risk limits is one of management's most important steps in the process of

controlling risks and the effects of risk management activities. Unfortunately, the risk

limits we have seen relate to the risk associated with the hedge positions instead of the

corporation's total risk exposure. This is backwards, because the purpose of risk

management positions should be to reduce the corporation's total risk exposure.

Instead, the risk associated with those positions is treated as a new risk to the

corporation, consistent with the view some have that hedging is speculation.

An overall limit to portfolio risk for a given time-period (month, quarter, or year)

should be set for the corporation and approved by the board. The company's portfolio

risk needs to be assessed on an on-going basis and reported. All proposed hedge

transactions should be input to the corporation's portfolio risk model to ensure that it

would reduce the portfolio's risk exposure. All positions actually taken need to be input

when taken, and removed when closed to the portfolio risk model for all future

calculations.

Testing proposed transactions

With an earnings model, proposed hedge or speculative transactions can be tested

to determine their impact on portfolio risk. If the proposed transaction reduces portfolio

risk, it is a hedge transaction. If it increases risk, it is a speculative transaction. Ideally,the expected risk/return of all proposed transactions should be evaluated before they

are entered, and they should meet the pre-determined risk/return "hurdle rates"

established by management.

DETERMINING IDEAL HEDGE PORTFOLIO

The risk-minimizing portfolio of hedge contracts can be mathematically derived with

an earnings model. The hedge portfolio that is effective in eliminating market risk is the

ideal hedge portfolio, or risk-minimizing hedge portfolio. The hedge ratio is therelationship between the size of the hedge and the size of the position being hedged.

For example, if one million barrels of crude were being hedged by 1,000 NYMEX crude

contracts, the hedge ratio would be 1.0 (i.e. , 1,000,000 barrels divided by 1,000 contract

times = 1,000 barrels per contract).


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Optimal hedge ratios are rarely 1.0 in the real world. They must be determined by

correlations and volatilities such as running Monte Carlo simulations within an earnings

model.

Hedge index concept

The size of the hedge should be proportional to the size of the risk. Therefore, as the

size of the risk changes, so should the size of the hedge.

Determining the relationship between hedge sizes and risk can be determined

objectively or subjectively. Further, the hedge index can be customized to reflect

management's appetite for risk.

By characterizing management's "risk preferences" at various earnings levels, it is

possible to create a hedging strategy using the hedge index concept. The hedge indexconcept simply defines in advance the level of hedging that will take place depending on

what level of earnings is forecast.

Formal corporate risk preference assessments are highly beneficial for several

reasons. They:

translate management's views to actionable decision rules

provide the guidance needed for implementation reduce the time required by senior management ensure greater consistency in program implementation

Hedge strategy development

A hedging strategy is a set of decision rules that define when to enter the hedge, how

and when to adjust its size, and when to exit a hedge.

An efficient hedge strategy specifies all key position inputs in advance, i.e., the effect

risk exposure will have, and the effect predicted income would have on determining the

percent hedged. Positioning programs translate the strategy to daily decisions. There is

no need to reinvent the wheel everyday. Consistency, not emotion, is the key.

Simulating the actual effect of a hedging strategy is both informative in the process of

developing the strategy and essential in the process of obtaining management buy-in.


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Institutionalizing risk analysis, hedging strategy, and evaluation

To integrate the development of a risk management program with its implementation,

it is important to develop and/or revise the company's risk management policies and

procedures to reflect the company's objectives, strategy, and structure. The goal should

be to provide the necessary means to enable management to successfully control the

corporation's risk exposures and guide all risk management activities. All major

participants should review drafts of the policies and procedures for their input,

understanding, and commitment to their success.

The creation of a risk management committee (RMC) to steer the management of a

company's risks is a good idea that works. Generally, there are issues that require input

from numerous corporate departments, and so the timely and recurring input of each is

useful. Therefore, it makes sense to keep key executives and departments informed on

a regular basis. Because risk management is a financial function, the chief financial

officer or treasurer should normally chair the RMC. The person acting as risk manager

should be a knowledgeable manager of traders, supply or purchasing, depending on the

business.

More specifically, some key elements the policies and procedures should include:

Define an evaluation criterion that specifically measures how well the company ismeeting its objectives for risk management.

Define the methodologies that shall be used to measure portfolio risk exposures.

Relate to the company's overall price risk exposures, and not be limited to

controlling risks of derivatives only. Create an earnings model and risk manager's

model to project portfolio risk and return.

Require the development and implementation of a formal risk management

strategy with decision rules for hedge entry, hedge size, and hedge exit. Identify the risk management instruments that can be used. Define management's responsibilities in monitoring and controlling risk

measurement and management.


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Specify levels of authority, risk limits, and "red flags" -such risk limits not simply

being a maximum derivative loss. Specify the process for quickly and effectively addressing any development that

has been "flagged." Provide the necessary level of reporting to those responsible for managing,

implementing, and monitoring risk management activities.

Define management reports that management can understand. Provide clear separation between those implementing the risk management

activities and those controlling the activities. Specify hedge criteria and establish the infrastructure for hedge accounting.

Evaluating hedging effects

Typically, most companies do not determine in advance how they will judge their

hedging performance. Of course, this causes unpleasant surprises after the fact.

Most companies measure results only in terms of hedge gains or losses-the same

way they would measure the success of a speculative trading program. We recommend

the use of both risk and return measures.

Over time, a successful hedging program will outperform both the "blind hedge" (i.e.,

100% hedge) and the "unhedged" case, in risk-adjusted return.

Energy price risks are out there. You can manage them or hope for the best.


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Hedging techniques with help of Example.

Example 1

Crude Oil Producer's Short Hedge (Short Hedge)

One of the most common commercial applications of futures is the short hedge, or seller's hedge, whichis used for the protection of inventory value. Once title to a shipment of a commodity is taken anywherealong the supply chain, from wellhead, barge, or refinery to consumer, its value is subject to price riskuntil it is sold or used. Because the value of commodity in storage or transit is known, a short hedge canbe used to essentially lock in the inventory value. A general decline in prices generates profits in thefutures market, which are offset by decline in the value of the physical inventory. The opposite applieswhen prices rise. A crude oil producer agrees to sell 30,000 barrels a month for each of six months at theposted prices prevailing at delivery. When he agrees to the deal, posted prices are $70.50 barrel, but asmarket conditions appear to be weakening, he wants to protect his revenues against a decline, andexecutes a short hedge. The example shows how the producer's revenue is protected from the full brunt

of a declining market.In this example, the oil producer establishes hedges for the second, third, fourth,fifth, sixth, and seventh contract months against his production during the first, second, third, fourth, fifth,and sixth months ahead. Near-month futures positions are liquidated after a price posting is established(normally on the first day of the calendar month). In a surplus crude market, spot prices generally fallfaster than postings, regardless of whether prices decline more slowly, as in Case 1, or more rapidly, asin Case 2.

DateCash Market Futures Market

FuturesResults

NetPriceRece

Dec-1 Commits to sell 30,000barrels in each monthfor January, February,March, April, May, Junecrude at the posted price

Sells 30 crude contractsin each month for:February, $70.00; March,$69.75;April, $69.50; May, $69.50;June $69.25; July, $69.00

Case 1: Slowly Declining Prices

Jan.1

Posted price for January crude:$71.00/bbl.

Buys back February contractsat $70.50 ($0.50) $70.50

Feb.1

Posted price for February crude:$70.50/bbl.

Buys back March contracts at$69.75

0 $70.50


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Mar.1

Posted price for March crude:$70.00/bbl.

Buys back April contracts at$69.00

$0.50 $70.50

Apr.1

Posted price for April crude:$69.50/bbl.

Buys back May contracts at$68.50 $1.00 $70.50

May1

Posted price for May crude:$69.50/bbl.

Buys back June contracts at$68.75

$0.50 $70.00

Jun.1

Posted price for June crude:$70.00/bbl.

Buys back July contracts at$69.50

($0.50) $69.50

Case 2: Rapidly Declining Prices

Jan.1

Posted price for Januarycrude:$70.00/bbl.

Buys back February contractsat $69.50

$0.50 $70.50

Feb.1

Posted price for February crude:$69.50

Buys back March contracts at$68.75

$1.00 $70.50

Mar.1

Posted price for March crude:$69.00

Buys back April contracts at$68.00

$1.50 $70.50

Apr.1

Posted price for April crude:$68.50

Buys back May contracts at$67.50

$2.00 $70.50

May1

Posted price for May crude:$68.50

Buys back June contracts at$67.75 $1.50 $70.00

Jun.1

Posted price for Junecrude:$69.00/bbl.

Buys back July contracts at$68.50

$0.50 $69.50

Selling Prices ($/bbl.)

Unhedged

Month Hedged Case 1 Case 2

January $70.50 $71.00 $70.00

February $70.50 $70.50 $69.50

March $70.50 $70.00 $69.00

April $70.50 $69.50 $68.50

May $70.00 $69.50 $68.50


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June $69.50 $70.00 $69.00

Average $70.25 $70.08 $69.08

Increased cash flow

Case 1 $70.25 - $70.08 = $0.17 x 180,000 barrels = $30,600Case 2 $70.25 - $69.08 = $1.17 x 180,000 barrels = $210,600

If the producer could not lock in revenue, he could be faced with shutting in all or part of the production.

The example shows two possible outcomes. Case 1, with relatively high posted and futures prices, andCase 2, with relatively low posted and futures prices. Short hedges for February, March, April, May, June,and July (against January, February, March, April, May, and June production) are initially established onDecember 1.

Assuming the futures hedge is placed on December 1, the near-month contract is January and thesecond month out is February. Because the January crude futures contract expires three business daysprior to December 24, and the posted prices for January are not finally established until January 2, theexample attempts to have the liquidation of the futures coincide with the setting of the posted price.

In summary, the nearby contract is used to hedge current production. For example, the February futurescontract is utilized to hedge January production because the timing is better matched

Example 2

Petroleum Marketer's in Rising and Falling Markets. (Long Hedge)

A long hedge is the purchase of a futures contract by someone who has a commitment to buy (is short) inthe cash market. It is used to protect against price increases in the future.

An end-user with a fixed budget, such as a manufacturing company that uses natural Gas, can use a longhedge to establish a fixed cost.

A fuel marketer may offer customers fixed-price contracts for a number of reasons: to Avoid the loss ofmarket share to other marketers or alternative fuels, to expand market

Share; or to bid on municipal contracts requiring a fixed price. On September 7, the New York Harborprice (Future price) for heating oil is 55 cents and the cash market price at the fuel dealer's location is 54cents a gallon, a 1 cent differential, or basis, between New York Harbor and the retailer's location.

The dealer agrees to deliver 168,000 gallons to a commercial customer in December at 70 cents pergallon. On September 7, he buys four December heating oil contracts (42,000 gallons each) at 57 cents;the price quoted that day on the Exchange's NYMEX Division. Total cost: $95,760 (42,000 x 4 x $0.57).


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Case 1 - Rising Prices

On November 25, the fuel dealer buys 168,000 gallons in the cash market at the prevailing price of 59cents a gallon, a 1 cent differential to the New York Harbor cash quotation of 60 cents, Cost: $99,120(168000 x0 .59) .He sells his four December futures contracts (initially purchased for 57 cents) at 60cents a gallon, the current price on the Exchange, realizing $100,800 on the sale, for a futures marketprofit of $5,040 (3 cents a gallon). His cash margin is 11 cents (the difference between his agreed-uponsales price of 70 cents and his cash market acquisition cost of 59 cents for a total of $18,480 ($0.11 pergallon x 168,000 gallons).

CashMarket

Futures Market

Sept 7 Buys 4 December futures contracts for57 per gallon

Nov. 25 Buys

168,000gallons at59 pergallon

Sells 4 December heating oil futures for

60 per gallon

A cashmarginof:

$18,480 or11/gallonplus

Afuturesprofit of:

$5,040 or3/gallonequals

A totalmarginof:

$23,520 or14/gallon

Case 2 - Falling Prices

On November 25, the dealer buys 168,000 gallons at his local truck loading rack for 49 cents a gallon, theprevailing price on that day, based on the New York Harbor cash quotation of 50 cents a gallon. He sellshis four December futures contracts for 50 cents a gallon, the futures price that day, realizing $84,000 onthe sale, and experiencing a futures loss of $11,760 (7 cents a gallon).

Cash Market Futures MarketSept 7

Buy 4 December heating oil futures at 57per gallon

Nov.25

Buys 168,000 gallonsfor 49 per gallon

Sells 4 December heating oil futures for per50 per gallon

A cashmarginof:

$35,280 minus


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Afutureslossof:

($11,760) (7/gallon) equals

A total

marginof: $23,520 or 14/gallon

In summary, the fuel retailer guarantees himself a margin of 14 cents a gallon regardless of price movesupwards or down in the market. With the differential between cash and futures stable, as in Cases 1 and2, spot-price changes in either direction are the same for both New York and the marketer's location. As aresult, a decline in the futures price, which causes a loss in the futures market, is offset cent-for-cent bythe increase in the cash margin.

Example 3

Fixing Refiner Margins through Crack Spreads

In January, a refiner reviews his crude oil acquisition strategy and his potential distillate margins for thespring. In January, he sees that distillate prices are strong, and plans a two-month crude-to-distillatespread strategy that will allow him to lock in his refinery margins. On January 22, the spread betweenApril crude ($70 per barrel) and May heating oil ($1.2564 per gallon or $52.77 per barrel) presents whathe believes to be a favorable $17.23 per barrel. The refiner sells the April/May crude-to-heating oilspread, thereby locking in the $17.23 margin. In March, he purchases the crude for refining into products.Crude oil futures are $71 per barrel in March, $1 higher than the original crude futures position ( $70 ).Heating oil is trading at $1.2588 per gallon ($52.87 per barrel), which equals a margin of $18.13 Had therefiner been unhedged, his margin would have totaled only the $18.13. Instead, the net margin from the

combination of the futures position and the cash position is the $17.23 he originally sought.

Date Cash Financial Effect FuturesFinancial EffectCash

Futures($/bbl)

Jan. -- Sell crack spread:Buy crude -- ($70.00)Sell heating oil at$1.2564/gal.

$52.77

Net $17.23Mar. Buy crude at $71 ($71.00)

Sell heating oil at $1.2588/gal. $52.87

Net $18.13Buy crack spread:Sell crude $71.00Buy heating oil at$1.2588/gal

($52.87)

Net ($18.13)Futures gain (loss) $0.90


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Cash refining margin (loss)without hedge

$18.13

Final net margin with hedge $17.23

Example 4

Trucking Company Hedges Diesel Purchases

On September 7, the cash market price of diesel fuel is 60 cents a gallon, exclusive of taxes, a five-centdifferential, or basis, to the prevailing New York Harbor heating oil futures price of 55 cents. The truckingcompany intends to buy 168,000 gallons of diesel fuel in December at the prevailing futures price at thattime plus 5 cents per gallon.

On September 7, he buys four December heating oil contracts (42,000 gallons each) at 57 cents, theDecember price quoted that day on the Exchange's NYMEX Division. Total cost: $95,760.If futures prices are unchanged by the time he has to take delivery, his fuel cost will be 62 cents a gallon.

Case 1 - Rising Prices

On November 25, the trucker buys his December fuel allotment of 168,000 gallons in the cash market for65 cents a gallon, 5 cents over the spot New York Harbor heating oil futures quotation of 60 cents. Cost:$109,200. He sells his four December futures contracts (initially purchased for 57 cents) at 60 cents agallon, the then current price on the Exchange, realizing $100,800 on the sale, for a futures market profitof $5,040 (3 cents a gallon). His effective cost of diesel fuel is 62 cents per gallon or $104,160 (the cashprice of the fuel, less his 3 cents gain on the futures, when the contracts rose in price from 57 cents to 60cents).

Cash Market Futures MarketSept.7

Buy 4 December heating oil futures at 57

Nov.25

Buys 168,000 gallons of diesel fuel at 65/gal. Sells 4 December futures at 60/gal.

Case 2 - Falling Prices

On November 25, the trucker buys 168,000 gallons at 54 cents a gallon for a cost of $90,720, theprevailing heating oil futures price of 49 cents plus 5 cents a gallon.He sells his four December futures contracts for 49 cents a gallon, realizing $82,320 on the sale, and

experiencing a futures loss of $13,440 (8 cents a gallon).

His fuel cost, however, is only 54 cents a gallon, 8 cents less than the 62 cents that he would have paidhad futures prices been unchanged when he entered the hedge. The loss on his futures position is offsetby his gain in the physical market.


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Cash Market Futures Market

Sept.7

Buy 4 December heating oil futures at 57

Nov.25

Buys 168,000 gallons of diesel fuel at 54/gal. Sells 4 December futures at 49/gal

Example 5

Trading application of the crack spread Options

A purchaser of put can protect acquisition costs for crude oil relative to market demand for refinedproducts. A long crack put consists of being short the products and long the crude oil. Refiners ashedgers are natural crack spread longs as they are continually buying crude and selling products.If crackspreads rise or widen , only the premium is at risk, meanwhile ,the refiner is protected if refining marginshould narrow.

A purchase of a call can offset contract and forwars term sales of gasoline and heating oil to bulkmarketers. A purchaser of crack calls is long product and short crude ,If spread fall, or narrow .only thepremium is at risk.

Selling a call is also refiners strategy. It enhances returns on refining margins as the premiumincome is used to offset the risk of product market declines outpacing crude declines whivh will squeezehis margin in the cash market. A writer of crack calls incurs a short product futures position and a longcrude oil position. Refiners are natural writers of calls. If the crack spread widens, a refiner is at riskbecause his position could be exercised against him. However , he will likely be able to mitigate theriskby turning out additional products and recouping the higher margins in the cash markets.

A writer of the puts is long the product and short the crude. The seller of the put incurs the riskthat the spread will narrow , and his position could be assigned against him.

Example 6

The following example shows a refiner locking in a margin between crude oil and heating oil.

Refiner with a Diversified Slate, 3:2:1 Crack Spread

An independent refiner who is exposed to the risk of increasing crude oil costs and falling refined productprices runs the risk that his refining margin will be less than anticipated. The refiner initiates a long hedgein crude and short hedges in heating oil and gasoline to fix a substantial portion of his refining margin.

On September 15, the refiner incurs a Future obligation to buy 6,000 barrels of crude oil on Oct 16 atprevailing cash prices. He is also obliged to sell 84,000 gallons (2,000 barrels) of heating oil and 168,000gallons (4,000 barrels) of gasoline on November 28 at prevailing spot prices.

The crack spread has ensured that refining crude oil will be at least as profitable in November as it was inSeptember, regardless of whether the actual cash margin narrows or widens. A decline in the cashmargin is offset by a gain in the futures market; conversely, any gain in the cash market is offset by a lossin the futures market. The example assumes a crack spread of three crude, two gasoline, one heating oil.


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Date Prices Action Futures MarketSept 15. Sweet crude:

Cushing - $18.90Agrees to buy atprevailingprices: 6,000 bbl.sweetcrude on Oct 16

Buys 6 Nov sweet crudecontracts at $18.45/bbl.

Heating Oil:Gulf Coast,$0.4875/gal,$20.47/bbl

Commits to sell atprevailing prices:84,000 gal. heating oilonNov 28

Sells 2 Dec. heating oil contracts,$0.5255/gal,$22.07/bbl

N.Y. Harbor,$0.5125/gal,$21.52/bbl

Gasoline: Commits to sell atprevailing prices:168,000 gal. gasolineon Nov. 28

Sells 4 Dec. New York Harbor gasolinecontracts,$0.5275/gal, $22.15/bbl

Gasoline Gulf Coast, $0.5450/gal, $22.89/bblGasoline N.Y. Harbor, $0.5850/gal, $24.57/bblGulf Coast cash margin: (6 x $18.90)-[(2 x $20.47)+(4 x $22.89)]/6 = $3.18/bbl.

Cushing / NY Harbor cash margin: {[(2 x $21.52)+(4 x $24.57)]-(6 x $18.90)}/6 =$4.65/bbl.Crack spread: {[(2 x $22.07)+(4 x $22.15)]-(6 x $18.45)}/6 = $3.67

Cashbasis

- $1.47/bbl ($3.18-$4.65)

Futures Crack Spread: $3.67/bbl

Expectedmargin

$2.20/bbl ($3.67-$1.47)

.

Case A: Rising Crude, Falling Product Prices, Stable Basis

Oct16

Crude: Buys 6,000/bbl crude at $19 Sells 6 Nov sweet crude

contracts at $19/bbl.NYMEX Div. crude

oil futures,$19/bbl.

Nov28

Heating Oil:Sells 84,000 heating oil$0.4850/gal.

Buys 2 Dec heating oil contracts at$0.4942/gal

Gulf Coast,


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$0.46/gal,$19.32/bbl.

N.Y. Harbor,

$0.4850/gal,$20.37/bbl

Gasoline:

Gulf Coast,$0.4625/gal,

Sells 168,000 gasoline at$0.4875/gal.

Buys 4 Dec N.Y. Harbor gasolinecontracts at $0.4936/gal.

$19.42/bbl

N.Y. Harbor,$0.4875/gal,

$20.47/bbl.

Results

Cashmargin

$1.44 {[(2 x $20.37) + (4 x $20.47)] - (6 x $19)} / 6

Futuresprofit $1.94 ($3.68 - $1.74) Crack spread:

Realizedmargin

$3.38 $1.74/bbl.

Case B: Falling Crude, Rising Product Prices, Stable Basis

Oct16

Crude:Buys 6,000/bbl crude at$17.50

Sells 6 Nov sweet crude

contracts at $17.50

NYMEX Div. crude

oil futures,$17.50/bbl.

Nov28

Heating Oil: Sells 84,000/gal. heating Buys 2 Dec heating oil

Gulf Coast,0.50/gal,

oil at $0.5250/gal. contracts at $0.52/gal.

$21/bbl.


$22.05/bbl.


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Gasoline:Sells 168,000/gal. gasoline at$0.60/gal.

Buys 4 Dec N.Y. Harborgasoline contracts at$0.5950/gal

Gulf Coast,$0.56/gal,

$23.52/bbl


$25.20

Results

Cashmargin

$6.65 {[(2 x $22.05) + (4 x $25.20)] - (6 x $17.50)} / 6

Futuresprofit

($2.66) ($3.68 - $6.34) Crack spread:

Realizedmargin

$3.99/bbl. $6.34/bbl.

Timing risk and basis risk can be quantified and are usually less than the absolute price risk to which therefiner is subjected. The example assumes fixed points in time of obligation to buy and sell in the cashmarket. In practice, these may not be entirely known or fixed.

Energy Trading {Unit 06}

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