Hedging Strategies for Oil End Users

Introductiontilities and industrial consumers of crude and products operate in an environment subject to adverse price movement in the international oil market. This exposure to such risk is enough to increase a company’s costs

or dramatically reduce its profits. As risk exposure reduces the end user’s appeal to investors and makes gaining access to debt markets more difficult, the need to efficiently manage exposure to fluctuating commodity prices is clearly one of the greatest challenges facing oil end users today.

In this presentation, we discuss several swap and option based strategies that oil end users can use to manage their market risk. All of these strategies can be structured for a variety of international crudes and products. Hedging periods and protection levels can be customized to fit any maturity and price level.

While the examples in this presentation are denominated in U.S. dollars, Sempra Energy Trading ® Corp. ("SET") can also offer hedging instruments in other major currencies.

Why Hedge?

Figures 1 & 2 show recent historical volatility of crude prices. As can be seen from these figures, forward crude prices are extremely difficult to predict and subject to rapid and significant change. A comparison of crude and heating oil historical volatilities with those of metals or financial assets shows that oil is one of the most volatile of all commodities.

Stake holders prefer companies that perform as planned

Hedging stabilizes cash flows

1. Reduces cost of capital

2. Secures

 

company objectives

3. Enables management to measure performance

Doing nothing to manage risk is in itself a risky move.

Fixed for Floating SwapsParticipation SwapsSpread SwapsCaps and FloorsCollarsHybrid Strategies

Figure 1. WTI 20-Day Moving Average: 1996-2007

 

Figure 2. Average of 20-Day Historical Volatility (In Percent)

Fixed For Floating Swaps  

Overview

fixed for floating swap is a privately negotiated, financially settled forward contract covering a series of forward pricing periods.

A swap is designed to transfer, or "swap,"specific price risk between the swap purchaser (e.g., the End User) and the swap provider (e.g., SET) through a contractual exchange of payments. It involves the payment of a fixed price times a notional amount by one party, in exchange for a floating price times the same notional amount from another party.

A swap enables oil end users to fix the purchase price of future oil consumption and thus minimize any exposure to rising prices. By locking in prices, end users gain greater control over the variable revenues and costs inherent in their businesses.

The financial settlement ensures that traditional customer (i.e., physical) relationships are not distributed.

There is no commission for a swap.

Specific Terms of Swap Agreements

Reference Price An agreed upon pricing source and calculation method to establish the current or floating price of the commodity.

Fixed Price The agreed upon price which is multiplied by the quantity of the commodity to calculate the size of the fixed payment.

Floating Price The Reference Price as calculated for a pricing period, which is multiplied by the quantity of the commodity to calculate the floating payment.

Swap Maturity The length of the swap contract, which may cover several pricing periods.

Pricing Periods A schedule of agreed upon forward time periods. At the end of each pricing period the floating price is evaluated, and the floating and fixed payments are exchanged. Monthly, quarterly and annual pricing periods are commonly used.

Reference Quantity The notional amount of the commodity used to determine the swap cash flows at the end of each pricing period.

Application

A large U.S. Refinery wants to establish a new marketing program for its key industrial customers in order to strengthen their long-term relationship. The program would allow the customers to lock in the price they pay the Refinery for a pre-specified quantity of oil products during the coming year.

The Refinery, which buys most of its crude at spot-index prices, realizes that it would lose money if the price it pays for crude exceeds the price it has "guaranteed" to its customers. To protect itself from such financial loss, the Utility enters into a one-year Fixed for Floating Swap with SET to hedge 100,000 barrels of fuel oil per month at a fixed price of $22.00/bbl.

Under the swap agreement, the Refinery makes a monthly fixed payment to SET equal to $22.00/barrel.

SET, in exchange, makes a floating payment to the Refinery based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted.

During the life of the swap,

The Refinery continues to purchase crude it needs from its regular suppliers, which may include SET, at index prices.

On each Settlement Date, the Refinery and SET exchange payments equal to the difference between the index price and the fixed $22.00/bbl swap price.

The floating payment received from SET should closely approximate the payment the Refinery made to its supplier(s) for physical purchase of crude oil. The net result is that by combining the swap with its current physical crude oil contract, the End User pays $22.00/bbl for its crude oil purchase.

Sample Terms

Results

The table below shows the Swap transaction results, given different monthly average WTI prices.

Swap Results on a Settlement Date in US$/bbl (first 5 months)

Discussion

The swap enables the oil end user to fix the purchase price for future periods. The End User receives a positive pay-off from the swap if oil prices rise. However, the End User faces opportunity cost under the transaction if oil prices fall.

Financial settlement ensures that the End User can offset its SET swap transaction with transactions carried out with its traditional suppliers.

Participation Swaps  

Overview

he participation swap contract establishes a maximum average forward purchase price, while offering between 25% -100% participation in

downward price moves.

It is an attractive alternative to many other end user hedging strategies because it overcomes the problem of forfeited downside price movements in a conventional swap.

Because of the forward purchase, the End User achieves complete price protection from any increase in crude oil prices. If prices fall instead, the End User participates in the favorable price move at the participation rate once average prices fall below the forward purchase level.

The participation swap strategy outperforms the basic swap if prices drop sufficiently. It is most appropriate if strong downward price moves are expected, yet prices also seem vulnerable to sudden upward spikes.

Strategy

The End User purchases forward, establishing a maximum average purchase price.

The participation swap price is set at a slight premium to the regular swap price.

In exchange for a higher forward price, the End User receives the right to participate in favorable price moves below a specified participation price level at an agreed upon participation rate.

There is no up-front payment.

Sample Terms

Spread Swaps  

Overview

pread swaps are designed to allow the End Users to lock in the differentials between commodity prices at different time periods (e.g., calendar swaps), or the price differentials between different commodities (e.g., crack swaps).

In a spread swap, the swap purchaser (e.g., the End User) pays a pre-agreed fixed spread level in exchange for a floating spread level from the swap provider (e.g., SET). The transaction is usually financially settled.

Through the use of spread swap, the End User achieves complete price protection from significant shifts in price differentials, without affecting its traditional physical customer relationships.

There is no commission for a spread swap.

Application: Continuous Oil Backwardation Swap (COBS)

Since the inception of the NYMEX in 1983, the forward crude oil market has generally been in backwardation, which is presumed to be caused by a tight near term supply picture coupled with positive refinery margins. Such backwardation has a negative impact on refineries which have to sell petroleum products at a forward price which is a discount to the spot price.

In order to hedge and/or profit from the backwardation market structure, an Oil Refinery enters into a five-year Continuous Oil Backwardation Swap with SET for 500,000 barrels of crude oil per year.

Under the agreement, the End User pays a pre-agreed fixed spread level (on a per-barrel basis) and SET pays a floating price equal to the average daily spread differential between the first and twelfth oil contracts on the NYMEX.

The transaction is financially settled at the end of each year during the life of the swap agreement.

Sample Terms

Caps And Floors  

Overview

aps and floors are options which provide the right, but not the obligation, to enter into a long or short position at a specified price.

Caps, also referred to as "call options," establish a maximum average purchase price for future oil consumption. They provide full protection from rising prices while allowing the buyer to benefit fully from decreases in oil prices. Caps are usually bought by oil end users.

Floors, also referred to as "put options," establish a minimum average sale price for future oil production. They provide full protection from falling prices while allowing the buyer to benefit fully from increases in oil prices. Floors are usually bought by oil producers.

The buyer of the cap or floor agrees to pay a predetermined cash premium for the protection. The premium varies with the selected strike price, term of the contract, and length of the averaging period.

Caps and floors are usually financially settled based on the average oil price over a specified period. While long dated maturities are available, monthly and quarterly averaging periods are the most popular.

Specific Terms of Cap/Floor Agreements

Call Option The right, but not the obligation, to buy a fixed quantity of a commodity, for a predetermined price, at a specific date in the future. A Call option ensures a maximum price at which the commodity can be purchased.

Put Option The right, but not the obligation, to sell a fixed quantity of a commodity, for a predetermined price, at a specific date in the future. A Put option ensures a minimum price at which the commodity can be sold.

Premium The price the option buyer pays and the seller receives for the option.

Strike Price The predetermined price at which the commodity can be purchased or sold, if the option is exercised.

Expiration Date The date on which the option contract ends, and the option is either exercised or expires.

Volatility A measure of the price change of a commodity over a period of time.

Caps A Strip of call options with staggered expiration dates. A Cap ensures a maximum purchase price for several future periods.

Floors A Strip of put options with staggered expiration dates. A Floor ensures a minimum sales price for several future periods.

Averaging Period A predetermined time period ending with option expiration. The payoff of an APO's is determined by comparing the average commodity price over this period with the option strike price.

Application

A large ocean Shipping Company which consumes about 100,000 barrels of fuel oil per day finds itself exposed to highly volatile oil prices, which significantly impacts its cash flow and its ability to compete with other

shippers. The company has determined that oil prices above $24.00/bbl are likely to be a threat to its ability to compete.

In order to gain upward price protection, the Shipping Company enters into a one-year $24.00/bbl cap agreement with SET for 100,000 bbl/month at a $1.25/bbl premium. The reference market price is based on averaging the daily prompt NYMEX crude oil futures contract settlement prices in each forward period over the contract term.

During the life of the agreement,

The Shipping Company continues to buy 100,000 bbl/month of oil from its regular suppliers at agreed-upon index prices.

SET receives a $1.25/bbl monthly premium for providing the price protection above $24.00/bbl.

At the end of each month, if the average of the mean is below $24.00 per barrel, the cap strike price, no payments are due under the cap contract. The Shipping Company buys its oil requirements at market prices and benefits fully from the low prices.

If the average of the NYMEX settlement price of WTI rises above $24.00/bbl, SET pays the Shipping Company the difference between the market price and the cap price.

Arranged in conjunction with the physical purchase, the cap agreement ensures that the oil purchase price paid by the Shipping Company will never be more than $25.25/bbl (i.e., $24.00/bbl + premium of $1.25/bbl).

Sample Terms

Risk-Reward Profile

Discussion

Caps offer the End User the opportunity to minimize exposure to unanticipated increase in oil prices without any loss of participation in favorable price moves.

With cap and floor purchases, all risks are predefined; the maximum "cost" or "loss" incurred by the buyer will always be the up-front premium payment.

The financial upside risks of paying more than $24.00/bbl for its oil are far greater than the cost of the oil price protection.

Collars  

Overview

collar, also referred to as "min-max strategy," is a zero or low cost hedging strategy that assures the Oil End User a minimum / maximum price range for future oil purchases.

Under a collar contract, the minimum possible purchase price is equal to the floor price and the maximum possible purchase price is equal to the ceiling price. For prices within this range, the End User achieves the market price.

The contract is normally financially settled and often covers several pricing periods.

There is usually no up-front premium payment. Under a standard zero cost collar contract, the End User can specify either the "floor" or the "ceiling" price level. The other price level is calculated by SET to ensure a zero-premium expense. If the End User wishes, it can specify both price levels, but then it may incur some premium expense or income.

The End User gains complete price protection from any prices above the ceiling price. However, in exchange for zero up-front premiums, any benefit from an oil price decrease below the floor price is foregone.

The collar is, in many ways, similar to a swap, but it allows for greater flexibility through some market responsiveness. The collar outperforms a swap strategy if prices decrease.

Application

An Electric Utility, which generates its baseload electricity using residual fuel oil (RESID), has signed a two-year rate contract with several key customers. Under the contract, the Utility will "pass through" increases in RESID costs above the fixed index price to its customers, but only up to $1.00/bbl. On the other hand, if RESID prices fall below the fixed index price, the Utility must rebate the savings to its customers, but only up to $1.00/bbl.

To minimize the potential upward price risk, the Utility wants to hedge its exposure to rising RESID prices. However, it does not need full downside benefit since the potential fuel price rebate is limited by the rate contract.

In order to achieve this objective, the Utility enters into a one-year RESID zero-cost collar agreement with SET for 50,000 bbls per month, the projected volume of RESID to be consumed. Under the agreement, the Utility is protected by a cap price of $18.00/bbl. In exchange for this protection, the Utility agrees to limit its downside price participation by selling a price floor of $16.50/bbl.

During the life of the agreement,

The Utility continues to buy RESID from its regular suppliers at index

prices. At the end of each month, if the average RESID price is above the

$18.00/bbl ceiling price level, the Utility receives a payment equal to the difference between the ceiling price and the average price.

If the monthly average RESID price is below the $16.50/bbl floor price level, the Utility is obligated to make a payment equal to the amount by which the average is below the floor price.

If the average prices move within the floor/ceiling range, no payments are required under the contract and the Utility achieves the prevailing market prices.

Sample Terms

Risk-Reward Profile

Discussion

The collar assures that the Utility receive a fixed price range for oil purchases at no monetary cost. The costless collar is partially "paid for" by giving up the potential favorable price movement below the floor.

The collar can be structured to match specific consumption characteristics.

Hybrid Strategies  

Overview

ybrid strategies, sometimes called "hybrids,"

combine the basic building blocks of swaps and options to create highly structured financial products that oil end users can use to meet specific hedging objectives.

Given the over-the-counter financial tools and the flexibility inherent in the oil end user’s physical system, hybrids can be used to address virtually any risk profile. It is possible to establish a hedging program at higher than market levels and/or to reduce the cost of option based strategies.

Hybrids can take on a variety of forms. The more common hybrid products include:

Extendable swaps Double-up or double-down swaps Participating collars Swap options (or "Swaptions") Cross-commodity indexed swaps Range swaps (or other instruments utilizing digital options) Extendable collars (or other applications of compound options) Barrier or "knock-out" options One time settlement options

Extendable Swaps

Extendable swaps are similar to fixed for floating swaps except that SET has the right to extend the contract maturity for a prespecified amount of time for the same Reference Quantity.

The advantage of the extendable swap is that the swap Fixed Price is lower than that of a conventional swap. For example, the Oil End User enters into a one year extendable swap with SET. Whereas the swap Fixed Price for a comparable fixed for floating swap for the same contract maturity and Reference Quantity would be $22 per barrel, the swap Fixed Price for the extendable swap for the crude oil end user would be $21.50 per barrel.

If the prespecified contract extension is set for another year, the End User will continue to buy prespecified quantities for the period at the same price if SET elects to extend the swap maturity.

Extendable Swaps: Application

A Refinery which uses about 100,000 barrel of crude oil per month has found that prices of its refined products remain quite constant in the past

year while crude prices have nearly doubled. Although projected increased demand is likely to significantly raise prices of its products in two years, the management believes that they need to hedge against rising prices for the next two years in order to protect margins. Nevertheless, the current price of a two-year swap--$22.00/bbl--is higher than what it is willing to pay.

As an alternative, the Refinery enters into a two-year extendable swap agreement with SET in which the Refinery pays a fixed price of $21.50/bbl on 100,000 barrels of crude per month. In exchange, SET has the right to extend the swap for an additional year, at $21.50/bbl.

During the life of the agreement,

The Refinery continues to buy crude oil from its regular suppliers at index prices.

At the end of each month, if the average crude price is above the $21.50/bbl fixed price, the Refinery receives a payment equal to the difference between the swap price and the average price.

If the monthly average crude price is below $21.50/bbl, the Refinery is obligated to make a payment equal to the amount by which the average is below $21.50/bbl.

Arranged in conjunction with the current physical contracts, the extendable swap agreement ensures that the Refinery is, in effect, paying $21.50/bbl for its crude.

Near the end of year two, SET must notify the Refinery if it intends to extend the swap through year three.

Extendable Swaps: Sample Terms

Double-Up Swaps

A double-up swap is similar to a basic swap except that it offers the Oil End User the opportunity to significantly improve its effective purchase price.

Under a double-up swap, the End User’s swap fixed price is set lower than for an otherwise identical conventional swap. In exchange, the End User agrees to buy on any settlement date prespecified additional quantities of the commodity at the swap fixed price, if SET elects to sell these additional quantities.

The double-up swap is usually structured for financial settlement.

Participating Collars

Participating collars allow for index flexibility within a specified price range and provide a predetermined percentage gain from any favorable price moves.

Swap Options

Swap Options, or "Swaptions,"provide the right, but not the obligation, to buy or sell a swap at a predetermined fixed price, in exchange for a premium payment.

Cross-Commodity Indexed Swap

Cross-commodity indexed swaps allow the Oil End User to synthetically shift revenues from one commodity to another to reduce price risk and volatility.

 

Range Swaps

In a range swap, the Oil End User buys a swap at a level below the current market. However, the swap ceases to exist if the market settles above the pre-determined level in any individual month.

 

Application

An Oil Refinery purchases a crude oil swap from SET for a fixed price of $21.00/bbl (when the market price is $22.00).

If the market settles above $25.00/bbl in any month, the swap ceases to exist for that month, meaning that the Refinery does not have a hedge.

Barrier or "Knock-Out" Options

Barrier options are similar to conventional options, except for the addition of a second expiration feature which makes them cheaper to purchase.

In addition to the usual option terms, an "out" price level is specified. If the commodity price is at or moves through the "out" price level, at any time during the life of the option, the option expires immediately. Otherwise, the Barrier option

offers the same protection as a conventional option.

Sempra Energy Trading ® Corp. Profile  

empra Energy Trading ® Corp. (SET), formerly AIG Trading Corporation, is a subsidiary of Sempra Energy, a San Diego-based Fortune 500 energy

services holding company with the largest U.S. utility customer base. As of December 31, 1999, Sempra Energy had an equity market value of US$4.2 billion, total assets of US$12 billion and total revenues of US$5.5 billion. Sempra Energy has a credit rating of "A."

Sempra Energy Trading ® Corp. trades financial and physical crude and petroleum products, natural gas, natural gas liquids and electricity as a principal in North America and Europe. SET is one of the largest physical and financial market-makers in the natural gas and power industry in the U.S. and Canada, and one of the leading traders of crude and petroleum products in North America and Europe.

Business Objectives :

SET was established to engage in hedging, trading and financing activities related to the energy and other commodities markets. Each of the SET trading departments includes a team of specialists who have extensive experience with trading, hedging, and corporate finance. SET offers a full array of products including spot, forwards, leases, swaps, options and other derivative products. Furthermore, SET's specialists will structure

hedging and financing programs to meet the specific needs of each client.

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