Hedging and Financial Contracts
In this Supply & Trading in Oil and Gas lesson, we discuss financial hedging of crude oil and products through futures, derivatives, and more.
The Arab oil embargo of 1973, and the subsequent nationalization of significant reserves previously controlled by a handful of large, private companies, ushered in a new era of price instability.
To help the industry manage volatility, in 1978 the New York Mercantile Exchange (NYMEX) launched a heating oil futures contract, followed by a crude oil futures contract in 1983.
Today, the NYMEX crude contract is one of the most actively traded physical futures contracts in the world. Every day billions of dollars of energy products, metals and other commodities are bought and sold on the floor of the NYMEX.
Oil companies, oil traders and speculators hedge their activities with energy derivatives. This is the term used for financial contract instruments (also often called paper) that derive their value from the underlying commodity (most often crude oil, natural gas or refined products).
This lesson presents an overview of the basic building blocks of the derivatives most applicable to crude oil and refined products, including:
- Futures contracts: Standardized agreements, traded on an exchange or electronic forum, which provide for the sale or purchase of an asset on a specified date in the future
- Forwards: A contract usually negotiated between two oil and gas companies or traders with similar interests. They are not traded on an organized exchange
Spec trading is the term used for those who take a position in financial derivatives with no offsetting position, either physical or financial. Spec traders have no intention of delivering or accepting the physical commodities.
Futures contracts are standardized agreements, traded on an exchange or electronic forum, which provide for the sale or purchase of an asset on a specified date in the future. The specified terms of the transaction are:
- Delivery location
- Delivery period
- Settlement date
The purchaser of a futures contract has a long position (agreement to buy in the future), and
The seller of a futures contact has a short position (agreement to sell in the future).
Example of Application:
For example, in a futures agreement to deliver a specified quantity of crude oil (or gasoline or heating oil) at a specified place, on a specified future date, at a specified price -the seller agrees to make the delivery; the buyer agrees to take delivery. In reality, most futures traders usually don’t contemplate physical movement of crude.
- Suppose a crude oil trader plans to buy a cargo of crude oil at Ras Tanura, Saudi Arabia, and wants to sell it on the spot market in Japan . The problem for the trader is time – the 23-day transit period during which market events might destroy the economics of the deal and cause a heavy loss. The risk of financial loss can be eliminated if time can be taken out of the equation.
- A futures contract enables the crude to be sold at the price expected at receipt in Japan. It is set as soon delivery is taken in Ras Tanura instead of 23 days later.
The vast majority of oil and gas traded on NYMEX and ICE is never delivered. Instead, the trade is closed, or liquidated, by assuming an equal and opposite position in the market. What’s left is a profit or loss on the cost and value of the paper transaction.
A standard energy contract can take the form of a monthly, quarterly, or calendar-year contract.
Futures contracts on the NYMEX or ICE trade with monthly expirations. In order to price longer-term deals at a single price with a single execution, traders often employ quarterly or annual “strips”.
A strip is quoted as an average price for equal contracts per month of all of the months within the quoted time period. Strips can be customized in the OTC market to match the hedging needs of a particular physical deal.
A forward contract is an agreement made today for a trade that will take place at some point in the future. A forward is usually negotiated between two oil and gas companies or traders with similar interests. They are not traded on an organized exchange.
The components outlined in a forward contract are specific to the underlying commodity, including:
- quality and grade (for crude oil and products),
- delivery price,
- notional amount (or quantity) and
- settlement date.
There is much more flexibility in structuring a forward agreement to a specific business (refiner’s) situation, than use of the standard futures contracts.
Example of Application:
Oil Producer A agrees to deliver 500,000 barrels of crude oil to Refiner B three months from today for $120/barrel.
Once this agreement is made, the receiver of the oil is considered to be long the underlying crude oil while the party obligated to deliver the crude is considered to be short.
At the settlement date, the forward contract’s value will be determined by the difference between the spot market crude value and the contract delivery price, multiplied by the contract quantity, i.e.:
Quantity (Delivery Price – Spot Market Price) = Value at Settlement
Forward position exposure can be hedged against fluctuations in the spot market with a parallel futures contract of similar quantity and tenure.
Options have been one of the fastest growing (20%/yr) energy derivatives since their introduction in the late 1980’s. Most options are applied to crude oil.
An option contract is the right, but not the obligation, to buy or sell a commodity at a fixed price – the strike or exercise price – during a specified period. In simple terms:
- A call option is a right to buy the commodity
- A put option is the right to sell the commodity.
Like stock trading, one advantage of an option is that the risk of the transaction is limited to the cost of the option, called the option premium.
Crude and products option trading is much more complex than futures trading. For any particular delivery month (expiration date), the options trader must make an assumption about:
- the direction of the market and
- how fast the market will move up or down.
Then, an option trader must take into account the current market price, the strike price (exercise price) of the option and the remaining time left for the option.
As shown on the chart, three terms are common in describing an options value:
- If an option has value, it is known as an in the money option.
- If the current market price and an option’s strike price are exactly the same, the option is referred to as at the money.
- If an option has no intrinsic value, it is known as an out of the money option.
Note that the at the money option is usually the most actively traded.
Option traders use a mathematical model, called the Black-Scholes model, to determine how these factors interact and affect the value of an option. Fortunately, computer programs are available for option evaluation. Although most option traders will never have to calculate option equations on their own, it is important to understand the factors that influence option pricing.
The Black-Scholes (1973) option pricing formulas was originally designed for a stock that does not pay a dividend or make other distributions.
When used for crude & products, there are two types of options – both traded globally:
- European style, where the option can be exercised only on the expiration date.
- American style, where the option can be exercised at any time up to the expiration date.
Values for used in the Black-Scholes option formula include the:
- price of the underlying commodity,
- option strike price,
- continuously compounded risk free interest rate,
- time until the expiration of the option, and
- implied volatility for the underlying commodity.
Another standard way that traders, brokers and other specialists estimate volatility for a given commodity is to use the price of an option on that commodity to derive a factor called the implied volatility for the commodity.
Example of Application:
Suppose a call option on crude oil is actively quoted. The option price is readily obtainable and by applying a suitable option pricing formula, the volatility can be derived or “back-calculated.
This derived factor is what is called the implied volatility for the crude oil.
The implied volatility can then be used to price other, similar options — perhaps options that are not actively traded or those where prices are not readily available.
There are four additional instruments available to crude oil and product traders to help limit exposure.
To limit exposure to increases in the price of crude oil, a refiner can purchase a cap covering a specified period. A cap, is a call option, giving the refiner a right to purchase crude oil at the specified strike price, regardless of how much the market price increases.
To limit exposure to decreases in the price of crude, the producer selling to the refiner can purchase a floor. A floor is a put option, giving the producer a right to sell crude oil at the specified strike price, regardless of how much the market price decreases.
Some middlemen who match buyers and sellers simply want predictable prices. To lock in a specified price range, they purchase a collar. A collar is the combination of a cap and a floor. Other traders purchase collars to reduce or eliminate the transaction costs of a cap or floor.
A swap is an agreement to exchange forward obligations. The most common arrangement is to swap floating prices for fixed prices.
Using the basic building blocks of futures, forwards, options and swaps, oil companies and oil traders have devised a collection of specific industry transactions to help implement a given supply strategy.
The most common instrument examples are now described in detail:
- Crack Spread Hedge: A typical spread is the difference between the futures price of crude and that of one or more petroleum products.
- WTI – Brent Arbitrage Contract: commonly termed Arb, is defined as the differential between these two crude contracts, measured in the same time period.
- Exchange for Physical Contract: An off-exchange transaction that allows holders of a futures position to exchange the futures for a physical position of equal volume
Example of Application: Crack Spread Hedge
Traders try to profit within a single exchange from various spreads. A typical spread is the difference between the futures price of crude and that of one or more petroleum products.
Increasingly in crude oil and products, it is also possible to hedge with contracts that cover the price spread between two (or more) commodities. For example, the crack spread hedge contract is available for the differential between the price of crude oil and the price of a set of specific refined products.
Crack spreads are different for each market region and are highly dependent on crude sources and refinery location. Trading the crack spread on an exchange allows for the execution of both the crude and the product hedge as a single transaction. The two main crack spreads traded in crude and products are:
- the Heat Crack (Heating Oil – Crude) and
- the Gas Crack (RBOB – Crude), where RBOB is the term for Reformulated Gasoline Blend Stock for oxygenated gasoline.
Crack spreads typically trade as a one-to-one ratio between crude and the underlying product. However, different ratios can be used to better reflect the trader or refiner’s position.
If a refiner felt that the plant profitability was going to go down because the price of products was not increasing at the same rate as the cost of crude, a 3-2-1 crack spread hedge could be purchased to guarantee or lock-in a range of profitability.
So-called “paper refiners” can approximate refining margins in the physical market with futures contract portfolios proportionate to average refining yields.
The US is by far the world’s largest importer and consumer of petroleum products. Crude oil imports currently average 9.0 MMbd or 61% of US refining requirements.
Heavy reliance on foreign crude sources means that price differences between two key internationally recognized crude oil price benchmarks play a large part in determining if the US will be balanced, starved, or flooded with crude oil. The key benchmarks used are:
- The NYMEX light sweet West Texas Intermediate (WTI) crude oil futures contract and
- The International Continental Exchange (ICE) North Sea Brent futures contract
The WTI – Brent Arbitrage, commonly termed Arb, is defined as the differential between these two crude contracts, measured in the same time period.
This price differential is not a stable relationship. To move crude oil to the US, the differential must be enough to cover the cost of the crude, shipping, insurance, interest cost, taxes and tariffs, and any premiums for delivering Brent on a NYMEX contract. In this case, an open Arb market exists.
This widely followed, liquid market allows speculation on the widening or narrowing of the differential itself – even if a physical cargo is not part of the decision
Example of Application: WTI – Brent Arbitrage
The Arb contract can be traded as a future or swap in the OTC market. The Arb is calculated using a straight differential between the two contracts of the same time period.
July WTI (Nymex) contract price minus the July Brent (ICE) contract price = July Arb
Q2 WTI (Nymex) contract price minus the Q2 Brent (ICE) contract price = Q2 Arb
Historically WTI trades at premium to Brent are due to its premium as a light, sweet grade, but this is not always the case. (WTI maintained an average of $1.30/barrel premium over Brent from 1990-2000.)
Exchange for Physical (EFP)
An EFP (Exchange for Physical) is an off-exchange transaction that allows holders of a futures position to exchange the futures for a physical position of equal volume by submitting notice to the exchange.
There are advantages to using an EFP to initiate and liquidate positions on both the futures and physical sides of the transaction:
- There is flexibility in the negotiation of timing, delivery location, and grade of product on the physical side of the transaction, as opposed to adhering to NYMEX or ICE contract delivery rules.
2. The posting of an EFP allows for a futures position to be either initiated or liquidated in a single transaction and at a single, pre-determined price.
3. Executing an equivalent transaction on the open market could involve many smaller transactions at various prices; and loss of value is a risk in any/all of those related transactions.
Example of Application – Use of EFP:
A producer is long 500,000 barrels of crude and has hedged against a falling market price by shorting 500 futures contracts.
A refiner needs (is short) 500,000 barrels of crude and has hedged against a rising market price by purchasing 500 futures contracts. Their opposite positions in the market can be perfectly offset in a single EFP transaction. The producer sells the crude to the refiner at a negotiated price. The producer then buys the 500 futures from the refiner to unwind its futures hedge position. The refiner agrees to buy the crude and sell 500 futures contracts. This transaction leaves both parties flat in both their physical and futures positions.
There are four major ways to execute crude oil and refined product derivative contracts. Use:
- Organized exchanges: Allow commodity buyers and sellers to make a market for a certain product.
- Electronic Trading Forums: Internet-based marketplaces which trade futures and over-the-counter (OTC) energy and commodity contracts as well as derivative financial products.
- Broker markets: Match anonymous sellers and buyers, and serve as the transaction counterparties. They actually manage a portfolio of sale and purchase obligations.
- Over-the-Counter (OTC) markets. Transactions executed where oil companies and traders simply pick-up the phone and transact directly with a counterparty.
Similar to other stock and financial markets, crude and product trading occurs on organized global commodity and derivative exchanges. An organized exchange allows commodity buyers and sellers to make a market for a certain product. You must be a member of the exchange to process transactions on an exchange, called an Exchange Member Firm.
The key benefit of organized exchanges is that company transactions are with the exchange itself which mitigates counterparty credit risk. On any given trading day, energy and non-energy companies alike can buy and sell energy commodities without even knowing, much less qualifying, the partner or counterparty in the transaction.
However, exchange contracts are standardized and there is limited ability for a company to tailor a contract to its specific business needs.
In March 2008, CME and the major NYMEX shareholders agreed to merge. The merger means that a high percentage of all US futures would trade on the CME/NYMEX.
Today, it is possible to trade futures and options contracts for crude oil and certain petroleum products, plus the non-petroleum fuel – ethanol. It is also possible to trade in electricity and three key power generation fuels – natural gas, uranium and coal.
This chart depicts the flow of futures, options and swaps as they are placed – either directly on an exchange or through a broker, called Exchange Member Firm in the diagram. There is still a mix of electronic transactions and floor executed transactions on the NYMEX. Whether the floor transactions will disappear in the future is anyone’s guess
When an order comes into the Exchange, it is time-stamped and hand-delivered to the floor broker at the earliest possible moment. When the broker receives the order, he signals his offer and, upon acceptance, records it and his counterpart’s code description, as well as the price. This information, together with quantity and month, which are already on the order, are fundamental to recording and processing orders.
An Exchange Member Firm trades for customers (or on its own behalf) on commodity exchanges, charging a commission for its service.
Exchange Member Firms with a seat on the Exchange can also provide clearing services – the daily matching and reconciliation of literally thousands of buys and sells.
Clearing members must meet strict financial and capital requirements and accept primary financial responsibility for all trades cleared through them, and ultimately share in the responsibility for liquidity of the Exchange.
All firms in the US are subject to the rules of the Commodity Futures Trading Commission (CFTC), and the rules of other various exchanges of which it can also be a member.
IntercontinentalExchange (NYSE: ICE) operates Internet-based marketplaces which trade futures and over-the-counter (OTC) energy and commodity contracts as well as derivative financial products.
ICE was established, in May 2000, by some of the world’s largest energy traders. The company’s stated mission was to transform OTC trading by providing an open, accessible, multi-dealer, around-the-clock electronic energy exchange. The new exchange offered the trading community better price transparency, more efficiency, greater liquidity and lower costs than manual trading.
In June 2001, ICE expanded its business into futures trading by acquiring the International Petroleum Exchange (IPE). which operated Europe’s leading open-outcry energy futures exchange.
Since 2003, ICE has partnered with the Chicago Climate Exchange (CCX) to host its electronic marketplace.
In April 2005, the entire ICE portfolio of energy futures became fully electronic.
Headquartered in Atlanta, ICE also has offices in Calgary, Chicago, Houston, London, New York and Singapore, with regional telecommunications hubs in Chicago, New York, London and Singapore.
Broker Markets / OTC
In the broker markets, companies execute transactions through a broker.
Like the organized exchanges, brokers match anonymous sellers and buyers, and serve as the transaction counterparties. They actually manage a portfolio of sale and purchase obligations, rather than matching them on a one-to-one basis.
Brokers may tailor contracts to meet the specific timing and volume needs of the trading parties, at least to the extent that they can contract with a counterparty that is willing to take the other side of the transaction (called an offsetting position).
Some of the more familiar energy derivative brokers, ranked by annual turnover in billions of dollars are:
- Amerex, part of the GFI Group, New York
- TFS Energy, part of Compagnie Financiere Tradition (CFT), Paris
- ICAP Energy, Louisville, Kentucky
- Tullett Prebon Group Ltd, London
Despite the systems, exchanges, and brokers; companies can simply pick-up the phone and transact directly with a counterparty. When executing these transactions, companies are said to be transacting in the OTC (Over-the-Counter) market.
The OTC market allows companies to enter into very unique transactions that can specifically meet their business needs with few, if any, transaction costs.
These direct transactions (also referred to as bilateral transactions) make-up the majority of energy contracts executed in today’s marketplace.
However, the OTC markets are inherently risky, and a significant infrastructure is required to measure, monitor, and manage the business.