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Hoya Investments Oil Investment Strategy Karim Anchassi Diego Bacci Claudia Casiano Karine Milhomens Business Problem • We are an Investment Management firm that focuses on the Energy Sector • We serve long-term investors with a moderate risk appetite. Our executives embrace a hybrid strategy of long-term investments while having the capacity to take advantage of short-term opportunities • Our analysts have analyzed the downward trend in the price of oil over the past six months and the more recent steep fall of crude oil prices • Current position is short ~US$10mn in crude oil futures maturing March 2015 (CLH5), equivalent to 147 contracts. Further discussion will follow • Contract: 1,000 barrels currently @ US$67,580 Overview – Crude Oil Futures • West Texas Intermediate (WTI) and North Sea Brent crude oil are the major benchmarks for the world’s oil • The main futures exchanges are the New York Mercantile Exchange (NYMEX) for WTI and Intercontinental Exchange (ICE) for North Sea Brent; they trade “light-sweet” crude oil • Crude oil options are the most widely traded energy derivative in the NYMEX and ICE • The underlying of these options is not actually crude oil itself, but crude oil futures contracts • Trading on these options ends three business days before the termination of trading in the underlying futures contract Market Overview – Oil in the News • The Nymex WTI front-month dropped $8.70 or 9.3% over the month of October to average $84.34/b, its lowest value in more than two years. • Expectations of tighter US monetary policy boosted the value of the dollar, with potential decreasing oil demand impacts for nondollar economies since oil is priced in USD on the world market • Oil producers and market makers hedging in both the ICE and NYMEX crude options markets have reinforced the price drop • The Central Bank of China’s announcement to cut interest rates created a temporary rise in crude oil prices in the week of November 21, 2014 by igniting hopes in oil demand • On November 27, 2014 the OPEC decided to maintain current output levels, confirming that oil supply will remain high and pushing oil prices further down View: Direction CLH5 Price Performance To Date Source: Bloomberg Moving Forward - Direction • We expect the price of oil in the near future to continue to have a downward trend, with a limited downside • As the graph on previous slide shows: during the past 6 months the price of oil has had a decreasing trend • WTI is now down 37.8% from its June 2014 peak • As mentioned in OPEC’s July 2014 Oil Market Report, production of non-OPEC countries in Latin America, the U.S. and Canada will continue to drive production of oil up without intervention from OPEC • As inventories increased, the risk of shortages was reduced, which began to drive prices down Moving Forward - Direction Historical World Oil Production vs. Consumption 100000 Thousands of Barrels Daily 90000 80000 70000 60000 50000 40000 30000 20000 10000 - Total World Oil Production Total World Oil Consumption *Source: BP Statistical Review of World Energy 2014 • As seen on the graph above, historically, production levels and consumption levels have followed a very similar trend • We believe that this trend will hold true in the future: even at higher supply levels, customers will eventually begin to consume more, which will ultimately help stabilize price View: Volatility CHANGE TO HVG Source: Bloomberg Moving Forward - Volatility *Source: BP Statistical Review of World Energy 2014 • Alternative sources of energy like natural gas (production up 48.76% in the past 28 years) have increased and become more available • The increased availability of energy alternatives will contribute to higher levels of volatility in oil prices Moving Forward - Volatility • Ongoing unrest in Libya, Ukraine, and the Middle East produces fear of disruption in exports • Given increasing volatility levels of approximately 820bp in the past 6 months, we expect volatility for Oil prices to be high in the near future • The market instability in OPEC countries like Iraq or Venezuela have and will keep oil price volatility high • LINK to Direction: Our view on direction is a downward trend, but given the volatility, we see potential fluctuations on both sides, although limited Business Risk • Position: We are short 147 crude oil futures maturing March 2015 (CLH5) • We do not consider that the price of oil will decrease significantly from the current levels, given the recent steep decline • However, we still perceive a potential small decline from the current March 2015 futures price. We can generate income from putting a cap to our position beyond certain prices Risk Management • Total exposure: -F US$10 million -147F • We want only a 5% chance of losing more than a US$500,000 loss limit equivalent to a 1.65 standard deviations move up • • • • 0F.25 = US$67.56 (Source: CME; Dec 3 2014) 0R.25 = 0.2346% (3-month LIBOR rate) Volatility = 18.426% Source: CLH5 HVG Vol Chart Dec 3 Bloomberg Risk Premium (RP) = 17.9747% – Jul 1959 – Dec 2004 RP: 20.67% – RPH Adjustment: 5.61% • Based on Bloomberg CL 2004 – 2014 prices Critical price = US$77.4303 Risk Management Decision Given our analysis of the loss associated to the critical price of US$77.43, for the underlying risk, we should hedge our position by buying ~66% forward futures and leave a maximum of 34% unhedged to meet out risk management guidelines • Current position of -147F • Hedge: US$6.6 million @ US$67.56k/contract; BUY ~98 contracts • Given Keep Ratio of 34% (~49 contracts short) Price Value at Risk Current Position: Unhedged –F • • • • Position: -147F short 147 contracts; @67,560/contract Name: Short Forward View: Down, Sure Purpose: Trading (T) Option Prices • The team has explored the following options as it considers there is potential for small fluctuations • Not hedging may result in losses if prices up or forgone opportunity for profits if prices do not change a lot Call Put Strike Price Premium Strike Price Premium More OTM $69.50 $2.9369 $65.00 $2.7966 OTM $68.50 $3.3879 $66.00 $3.1774 ATM $67.50 $3.8891 $67.50 $3.8390 ITM $66.00 $4.7411 $68.50 $4.3301 More ITM $65.00 $5.3525 $69.50 $4.8814 Premiums reported in Future Value Source: Daily Information Bulletin PDF CME Group 3 Dec 2014 Recommended Position: Syn Short Butterfly • • • • • Position: -147F +294C -147Cotm -147Potm View: vol trade, < straddle Purpose: Trading (T), Income (Y), Insure (I) Maximum Loss: -US$282.9K ✔ Complies with our Risk Management parameters Upside: US$75.7K if prices down; US$2.2K if prices up Alternative Hedging Strategies: Overview View: vol view, small fluctuations Syn Long Strangle Short Butterfly Syn Long Put Syn Long Straddle Synthetic Bear (Put) Spread View: limited downside potential, unsure Position 1: Synthetic Long Put • • • • Position: -130F + 130C We had to cut to -130F to comply with Risk Mgmt View: Down, Unsure Purpose: Trade (T), Insure (I) Maximum Loss: -US$497.8K ✔ Complies with our Risk Management parameters • Upside: positive if prices down Position 2: Synthetic Long Strangle • • • • • Position: -87F + 87Citm + 87Cotm We had to cut to -87F to comply with Risk Mgmt View: vol trade, < straddle Purpose: Trade (T), Insure (I) Maximum Loss: -US$498.5K ✔ Complies with our Risk Management parameters Upside: positive both if price very down or up Position 3: Synthetic Long Straddle • • • • • Position: -65F +130C We had to cut to -65F to comply with Risk Mgmt View: vol trade, neutral on direction Purpose: Trade (T), Insure (I) Maximum Loss: -US$497.8K ✔ Complies with our Risk Management parameters Upside: positive both if price down or up Position 4: Synthetic Bear (Put) Spread • • • • Position: -147F +147Cotm -147Potm View: limited down, worry big up Purpose: Trade (T), Income (Y), Insure (I) Maximum Loss: -US$305.8K, with prices up ✔ Complies with our Risk Management parameters • Maximum Upside: US$355.7K, with prices down Maximum Loss and Upside Comparison Position Maximum Loss Upside Syn Short Butterfly* -US$282.9K US$75.7K if prices down US$2.2K if prices up Syn Long Put -US$497.8K Positive if prices down Syn Long Strangle -US$498.5K Positive both if price very down or up Syn Long Straddle -US$497.8K Positive both if price down or up Syn Bear (Put) Spread -US$305.8K US$355.7K, with prices down • All of the alternative hedging positions meet the risk management parameter of a loss limit of -US$500K • It coincides that the position that best fits our view also has the smallest downside Rationale for Recommended Strategy • Despite the Short Butterfly does not exactly fit a view of down unsure, it enables us to benefit from small changes around the current levels. As stated before, we consider it is more likely that the price will decrease slightly, but we still see potential for fluctuations on both sides • The Short Butterfly fits our view of a low likelihood for large fluctuations. Since we consider that the price will not go beyond certain levels, we can profit by putting a cap through an out-of-the-money put and call on both sides of the position • Given our recommended position, we consider that the expected direction and volatility increase the likelihood that the expected future price will be ITM significantly • The maximum loss on this position (-US$282.9K) is within our loss limit of -US$500K