Business Drivers in Supply and Trading
In this lesson, we’ll discuss business drivers in supply and trading and risk management in oil and gas.
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Supply, Trading, and Risk Management in Oil and Gas
Sound oil supply and trading business risk management strategies must begin with a clear agreement on what is at risk. Risk management analysis must have a clear baseline.
As the chart indicates, the typical supply function has numerous trading and risk mitigation options as companies try to track, monitor and mitigate risks across a wide mix of assets.
- Petroleum Production— Crude oil price hedging
- Refining Operation—Crack Spread hedging
- Spot Product Purchases – Spot market activity and price hedging
- Product Sales – Term and spot sale hedging
For example, most companies view spot supply to be at risk, and often ignore the risk inherent in fixed price term supply contracts, in-transit inventories, inventories in storage, and fixed-price sales agreements to their customers.
The best supply and risk management programs are built on a very clear understanding of what creates risk and what risk the company is willing to take.
Transactions in any market come with a variety of risks, though to varying degrees. The most common risks addressed in crude and products trading include:
- Market risk: The risk that a change in market dynamics, especially price, will change the financial position of an oil company or trader.
- Basis risk: The risk that the differential between prices of the same commodity in different markets – e.g., differences in delivery location or delivery time – will affect the financial position of the oil company or trader.
- Credit risk: The risk that a counterparty will not perform in accordance with the contract terms, either by failing to deliver the agreed upon commodity or to pay the agreed upon price.
- Operational risk: The risk that losses will be incurred due to errors or inadequacies in the various systems or processes necessary to structure, price, trade and manage positions within the organization.
- Liquidity risk: The risk that there is no counterparty quickly identified to accept an offsetting position. Then the organization may be saddled with assets or commitments – physical or financial – that it had not intended to keep.
The interactions of price, supply, and demand make up the essence of what can cause market risk in the physical side of an oil company or trading organization. The skill and consistency of the traders is the key factor in helping manage this type of risk.
Related reading: Hedging vs Speculation
EKT Capital – Oil and Gas Risk Management and Fractional CFO Services
Traders use two approaches to develop these skills and monitor the rapidly changing markets. The first is what is called fundamental analysis for crude oil and products. Often this technique, though important, is not dynamic enough for day-to-day decision making.
Here traders use another way of looking at price volatility, called technical analysis. The core of technical analysis is developing charts, because it assumes that price movements form patterns that are repeated over time. A key premise is that the market has responded to all possible influences by the time it has signaled the response through price.
Pure technical traders base their decisions on price trends instead of on factors that might influence supply and demand. In this case the term used for the activity is to “buy and sell the market.”
Another term that appears often in supply and trading is “basis.” This usually means the difference (or correlation) between the price of a futures contract and that of its corresponding physical commodity.
The fact that it does not, introduces an element of risk, called basis risk, into the simple hedge. This basis risk entails the simultaneous purchase of wet barrels and sale of paper barrels under a futures or forward contract.
There are many reasons for the basis to become volatile.
One of them is that few wet barrel deals exactly replicate the structured, formalized transactions available in the futures market. Even for matching crudes in matching locations, wet-barrel and dry-barrel prices usually do not march precisely in step. Their trends track one another over time but individual price movements do not, causing wide basis changes.
As the chart indicates, prior to the collapse of Enron in late 2001, the majority of OTC-traded derivatives required an established line of credit in order for two counterparties to transact. Not only was Enron trading with parties A-B-C-D, they had simultaneous and interrelated credit obligations with each other.
This structure limited the ability to determine any counterparty’s true credit exposure in a timely manner.
The collapse of Enron, a major trading party, highlighted the vulnerability of the market to credit default risk. With trading volumes collapsing and general risk aversion in the market, the NYMEX seized on the opportunity to extend its dominant position in the energy futures markets into OTC instruments.
The creation of the NYMEX Clearport system was a direct result of this aversion to credit risk. Clearport allows for OTC-traded derivatives to be entered into the exchange’s clearing system with the NYMEX as the counterparty to both sides of the transaction.
In order for a counterparty to have access to this system, they must have an open account with an Exchange Clearing Member firm. Having OTC transactions cleared through the exchange:
- mitigates credit risk,
- provides for a daily settlement and margining process, and
- allows for aggregation of positions and cross-margining between futures and OTC products.
The clearing of OTC products through the NYMEX Clearport mechanism is a major reason for the meteoric rise in recent exchange volumes.
Supply and trading functions historically have balanced their supply networks by concentrating on optimizing physical moves. Today there are numerous paper instruments available to conduct business in a volatile environment and help S&T manage the risk.
Forward trading bridges the difference between physical and futures trading or “wet” and “paper” barrels.
Futures markets make the buying and selling of commodities more efficient by providing:
- Instantaneous access to global movements in prices.
- Instruments to manage risk, allowing producers and consumers to focus on their core business.
- Incentives for speculators (outside the industry) to enter the market with additional capital.
Speculators operating especially in the over-the-counter (OTC)markets provide a valuable service to every commodity trading industry. They are willing (at a price) to accept and transfer a risk that cannot be accommodated with available futures and forwards hedging instruments.
A key principle in managing the risk of an S&T function is to match all the physical and paper positions on a daily basis, and measure their current effectiveness.
The term spot market is often used to describe a refining or market location where a wide variety of prompt, auction-type trades are available, i.e., where crude or products can be bought and sold openly and very frequently. A spot sale is done on a cargo-by-cargo basis. Spot trades occur in various quantities including, pipeline batches, bulk volumes of 25,000 or more barrels and ship cargos.
The chart shows where the active crude and product spot markets are located around the globe.
The reason there is such an active trading environment in crude oil and product commodities is that a global market exists for almost every crude and every product. Though California-grade gasoline is not used in Singapore, most products easily move around the world, i.e., diesel fuel, distillate, fuel oils, regular unleaded gasoline. There are numerous trading opportunities in a large community of brokers and traders. It is a very active market.
Another item important for trading is that the product can be easily moved. Remember, this is a physical operation. In the end some company or customer is going to take ownership of this product. This is not a paper trade, this is an actual physical movement, typically in a large consumption and/or supply area, requiring a free-flow of price and availability information.
The timing on spot deals is usually considered prompt, or in less than one month. At that point the books are cleared and both sides of the trade are closed.
Liquidity, in general, is defined as the ease with which an asset can be converted into cash. The liquidity, or lack thereof, in a market can greatly affect the perceived risk of a given position or portfolio.
A liquid financial market is one with many diverse participants, price transparency, and enough volume on quoted instruments to move in and out of positions without greatly moving the market price.
- Liquid markets include those of US Treasury Bonds, major currencies, S&P futures, and most listed stocks, and some crude and product futures contracts.
- Conversely, an illiquid market exists when few participants, low levels of transparency, and small volumes make adjusting positions difficult. Illiquid markets would include art, real estate, and exotic financial products.
Liquidity affects risk in that a large position in a liquid market could be more accurately marked and easily adjusted than a small position in an illiquid market or contract.
Example of Application:
There can be a big variation in the liquidity of contracts depending on their relativity to the prompt month that is traded.
As the chart for the NYMEX crude contract indicates, the first few months (called front months) will generally be considered very liquid with hundreds of thousands of contracts traded, while the 2,500 contracts in the three years or more out (the back months) could be very illiquid.
Accurate, accessible pricing data is essential to an efficient commodity market. The chart shows the various sources and types of news and price services. Platts and Argus are the most widely used sources for daily worldwide assessments of spot market transactions.
Reporting of prices for crude and products is not like the stock exchanges in New York or London. There is no global exchange or bulletin board where deal prices are posted. The published crude oil and product prices are more of an index of actual transactions.
Platts, Argus and other publishers compile the data, collected by teams of price reporters who spend their days contacting traders for the price, quantity and delivery terms of their latest deals.
Today, use of electronic markets for both trades and reporting has significantly improved price index information.
Crude pricing market information services do not attempt to report prices for every type or quality of crude traded. As the chart indicates, they cover the crudes that are considered representative of particular sources and refining centers, termed marker crudes. For example:
- At Rotterdam in the Netherlands, Brent crude from the North Sea is the normal benchmark.
- Brent also is quoted on the US Gulf Coast, along with West Texas Intermediate (WTI) and Alaskan North Slope.
- In Europe, Urals crude serves as a marker crude for the Russian exported crudes.
The WTI crude-oil benchmark has diverged so drastically from prices of other grades of crude in recent times, that some market participants call it a “broken benchmark.“ With rapidly declining supplies, WTI may lose its trading position in the future in favor of Brent as the basis for the world’s most widely traded energy contract.
Generally, other crudes trade against markers, with adjustments for quality differences. Price variances of one crude against a marker are called differentials, which must be calculated to include the distance from the supply source as well as quality.
A key indicator of refinery margins (and ultimately profitability) is called the crack spread. The crack spread is the differential between petroleum product prices and the price of the crude purchased to produce these products. The term comes from the refinery process known as cracking – used to produce gasoline from crude oil.
As the chart shows, a common indicator is the 3-2-1 crack spread, which assumes 3 barrels of crude oil can be used to produce 2 barrels of gasoline and 1 barrel of distillate (diesel or fuel oil).
- A positive crack spread value indicates that the product value produced is above that of the crude.
- A negative crack spread value would indicate that the product value produced is below that of the crude.
Note that spread does not take into consideration all product revenues and excludes refining costs other than the cost of crude oil. Thus it is just an indicator of refinery profitability.
The key challenge is to try routinely make sense of this global business with very volatile pricing.
One method is to assemble as many short-term signals from various market segments as possible to recognize the important forces at work and to determine what they mean to a particular supply network.
It is not always easy. For example, every Wednesday in the US, prices of oil futures contracts on the NYMEX can rise or fall in response to basic industry inventory data released by the American Petroleum Institute (API). How can one tell if these price changes are significant?
Although it is quite normal to hear mention of “the oil price,” no such thing exists. As discussed, there is no single price of oil – reported prices are more of an index. The term “oil” can also mean crude oil or petroleum products.
Wholesale gasoline prices, are posted in most places for all the world to see. Even when a product has similar specifications, prices can fluctuate across regional markets. They differ from one location to the next and most often because of changing patterns of supply and demand.
Furthermore, crudes vary tremendously in quality and composition. Just as there are various grades of gasoline, there are many different grades and corresponding different prices of crude.
There are also long-term drivers of price change.
- The biggest one today is the uncertain geo-political situation.
- Another is changing economic patterns as emerging countries put more demand on the supply system which causes prices to move up.
- Finally, the pace and acceptance of renewables on the future price of crude oil is adding uncertainty to the long-term investment decisions needed in the industry.
Analysts measure volatility by ranking past prices and determining an average variation from the price holding the middle position in the list, called the median price.
For crude oil, products and natural gas, the chart lists the volatility ranges, average and “spike” or peak volatility as of mid year 2008. Seasonal demand variations alone account for a large portion of the volatility.
This data suggests that crude oil and products pricing variations most often move together. However, this is not always the case especially because crude oil movements reflect global supply-demand and refined products pricing often reflects the refining status in the host country.
Natural gas is much more volatile than crude oil, because it very quickly reflects market forces. Since natural gas has limited storage capability, and a tighter regional supply connection from wellhead to consumer, a sudden unexpected cold snap can send prices soaring. Conversely, an unexpected decline in the price of competing fuels, such as oil, can cause industrial customers to use much less gas than expected and the price of natural gas can decline precipitously.
No single entity has significant influence over both upstream and downstream markets, even though those markets influence each other as much as ever, if not more.
As the chart indicates, the result is what often is called increasing volatility. Crude and product prices change more frequently and to a greater degree than they did in the past. Volatility is the key measure of commodity risk.
In physical, futures and options markets, a workable, nontechnical definition for volatility might be the market’s relative changeability. Analysts measure volatility by ranking past prices and determining an average variation from the price holding the middle position in the list, called the median price.
There are two main types of volatility.
- Historical volatility measures past price movements.
- Implied volatility measures expected price movements, which are used to price a hedging instrument called an option.
Futures hedging, like any other major business transaction, require authorization and approval prior to execution. In oil companies, this is usually done in three steps as shown on the chart.
First, the senior leadership set overall dollar limits on the hedging exposure that are applicable to the business over some planning horizon:
- A conservative company (that is supply driven) will have low limits.
- A company with more of a spec trading orientation, often called trading-for-profit, will have higher limits.
Once these maximum hedging exposure limits are established, they are often related to key events in the upcoming business planning horizon. For example,
- The need to get external financing for a new production platform in an upstream company, or
- The need to enter into a (very) long term crude supply contract for a downstream company.
Finally, the hedging limits are translated to each trader. The objective is to balance the need for trading flexibility, with the need to carefully monitor trader limits because each trader uses his/her specific skills, techniques (and magic!) to maximize trading effectiveness.
A properly designed system of measurement and internal control is essential to ensure the effectiveness and appropriateness of any hedging program
To control the operation of firms engaged in complex trading activities, the risk manager will often divide the organization into a series of similar positions, called a book. At the lowest level, the book consists of all of the positions under the scope of a particular trader’s responsibility.
For a crude and products trader, this includes both physical trades as well as all of the financial positions put on as hedges in the physical transaction.
For a risk manager, the company’s book includes the aggregate of all individual trader books, as shown in the chart.
Another measurement term often used in measuring risk is Value at Risk or VAR. Value at risk is the maximum potential loss in a portfolio over a specific period of time given a certain probability. The great feature of VAR is that the technique works across asset classes. It is most often used to asses the risk of a portfolio of assets.
Related Resources:
What is the difference between Upstream and Downstream?
Drilling Wells for Oil and Gas and Offshore Drilling