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ENERGY DERIVATIVES
Econ 3385 –
Economics of Energy
S. Gürcan Gülen, Ph.D.
Cash Markets
Conduct Normal Business Activity
Face Risks
Price Risk Management Using Derivatives
OTC
Forwards
Options - Swaps
Organized Exchanges
Futures - Options - Swaps
Markets
•Price
an indicator of the relative balance between the supply of and
the demand for a particular product or commodity.
•Commodity
a product over which the producer has lost control of the
price.
•Derivative
a product whose price is derived from the price of
something else, which is referred to as the underlying commodity.
Markets
Spot Market
• Immediate Physical Delivery
and immediate payment
Derivative Markets
• Deferred Physical Delivery
• Financially Settled Arrangements
Economic Purpose
• Hedging
• Price discovery
Coal Prices
F.O.B Minem outh
30.00
25.00
$ /t o n
20.00
15.00
10.00
5.00
0.00
1940
1950
1960
1970
1980
1990
2000
Crude Oil Prices
Wellhead / First Sale
35.00
30.00
$/ Bbl
25.00
20.00
15.00
10.00
5.00
0.00
1940
1950
1960
1970
1980
1990
2000
Gasoline Prices
Retail
140.0
c e n ts / g a l l o n
120.0
100.0
80.0
60.0
40.0
20.0
1940
1950
1960
1970
1980
1990
2000
Natural Gas Prices
Wellhead
3.00
$ /M M B tu
2.50
2.00
1.50
1.00
0.50
0.00
1940
1950
1960
1970
1980
1990
2000
Electricity Prices
Composite Retail
7.0
c ents / k W h
6.0
5.0
4.0
3.0
2.0
1.0
1940
1950
1960
1970
1980
1990
2000
Risk and Risk Management:
Strategic Implications
What is risk management?
Active identification and unbundling of the risks (exposures) a company faces in order to
profit from exposures a company is well equipped to handle and mitigate potential losses
from other risks.
What is strategic risk management?
Use of risk management to alter fundamentally a company’s equity valuation through
optimizing capital structure, enhancing risk/return profile of company’s businesses and
facilitating profitable pursuit of new opportunities.
Derivatives
A set of tools- forwards, futures, options, swaps and enhanced vehicles - that allow
management to keep and add to those risks it seeks, and to shed those risks it chooses
not to bear. These tools, which are traded in financial markets, allow management to
focus on its core competencies in pursuit of its principal goal - maximizing returns while
minimizing the variance of those returns. They are only part of the risk management
tool set, along with operational efficiencies, competitive strategy, and so on.
Markets
Requisites for a Futures Market
Characteristics of the underlying cash commodity
• Price Volatility
• Active market
• Open market
(no government controls)
Jun-98
Nov-97
Apr-97
Sep-96
Feb-96
Jul-95
Dec-94
May-
Oct-93
Mar-93
Aug-92
Jan-92
Jun-91
Nov-90
Apr-90
Sep-89
50.00
Feb-89
Jul-88
Dec-87
May-
Oct-86
Mar-86
Aug-85
$/Bbl
Crude Oil Futures Price - NYMEX
August 1985 - August 1998
40.00
30.00
20.00
10.00
0.00
Aug-98
Feb-98
Aug-97
Feb-97
Aug-96
Feb-96
Aug-95
Feb-95
Aug-94
Feb-94
Aug-93
Feb-93
Aug-92
Feb-92
Aug-91
Feb-91
Aug-90
Feb-90
Aug-89
Feb-89
Aug-88
Feb-88
Aug-87
Feb-87
Aug-86
Feb-86
Aug-85
¢/Gallon
Gasoline Futures Prices - NYMEX
August 1985 - August 1998
1.20
1.00
0.80
0.60
0.40
0.20
0.00
Aug-98
Feb-98
Aug-97
Feb-97
Aug-96
Feb-96
Aug-95
Feb-95
Aug-94
Feb-94
Aug-93
Feb-93
Aug-92
Feb-92
Aug-91
Feb-91
Aug-90
Feb-90
Aug-89
Feb-89
Aug-88
Feb-88
Aug-87
Feb-87
Aug-86
Feb-86
Aug-85
¢/Gallon
Heating Oil Futures Prices - NYMEX
August 1985 - August 1998
1.20
1.00
0.80
0.60
0.40
0.20
0.00
A
pr
A -90
ug
D 90
ec
A 90
pr
A -91
ug
D 91
ec
A 91
pr
A -92
ug
D 92
ec
A 92
pr
A -93
ug
D 93
ec
A 93
pr
A 94
ug
D 94
ec
A 94
pr
A -95
ug
D 95
ec
A 95
pr
A -96
ug
D 96
ec
A 96
pr
A -97
ug
D 97
ec
A 97
pr
A -98
ug
-9
8
$/MM Btu
Natural Gas Futures Prices - NYMEX
April 1990 - August 1998
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Price Theory
Forward Curve
The price of a commodity over time.
Two different shapes:
•
Contango
•
Backwardated
Price Theory
Futures v. Cash Prices
If the futures price is greater than the cash price,
then:
Futures Price = Cash Price + Storage
Price Theory
Contango
Price
time
• Forward prices are successively higher over time
• Today’s price is the lowest
• Current supply exceeds demand
Price Theory
Futures v. Cash Prices
If the cash price is greater than the futures price,
then:
Futures Price = Cash Price + Storage
- Convenience Yield
Price Theory
Backwardation
Price
time
Forward prices are successively lower over time
• Today’s price is the highest
• Current demand exceeds supply
NYMEX Crude Oil Prices
Forward Curve on February 3, 1997
25
24
$ /B b l
23
22
21
20
19
Mar-97
Aug-97
Jan-98
Jun-98
Nov -98
Apr-99
Dec-2001
NYMEX Electricity Prices (COB)
Forw ard Curve on February 3, 1997
20
18
$/M W H r
16
14
12
10
8
Mar-97 May-97 Jul-97 Sep-97 Nov-97 Jan-98 Mar-98 May-98 Jul-98
NYMEX Organization
816 seats, 749 individual members
Board
NYMEX Membership
of
Directors
COMEX Membership
772 seats, 663 individual members
Chairmen of the
Board
Executive
committee
President
Planning &
Compliance
Clearing
development
Market
Surveillance
Financial
surveillance
Trade
Surveillance
Strategic
Planning
Research
Marketing
Banking &
Delveries
Position
processing
Futures Exchange
Characteristics:
•Liquidity
•Safety
•Flexibility
•Ingenuity
Futures Exchange
Forward
A bilateral commitment to buy or sell an agreed upon asset for
a predetermined price on a specific future date.
Futures
A standardized forward contract which is traded on an
organized futures exchange.
Futures Exchange
Standard Contract Terms
•
Size
•
Quality
•
Point of Delivery
•
Time of Delivery
•
Payment
•
Disputes
Futures Exchange
Variable Contract Terms
•
Price
•
Number of contracts orders
•
Delivery Month
Futures Exchange
Rules of Operation
•
•
•
•
•
•
•
Times and days of business
Position limits
Daily price limits
Margin requirements
Delivery procedures
Payment
Disputes
Natural Gas Futures - NYMEX
April 1990 - August 1998
1,800,000
1,600,000
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
M
ay
No 90
vM 90
ay
No 91
vM 91
ay
No 92
vM 92
ay
No 93
vM 93
ay
No 94
vM 94
ay
No 95
vM 95
ay
No 96
vM 96
ay
No 97
vM 97
ay
-9
8
Number of Contracts
1,400,000
Volume
Open Interest
p
M -85
ay
Ja 86
nSe 8 7
pM 87
ay
Ja 88
nSe 8 9
p
M -89
ay
Ja 90
nSe 9 1
pM 91
ay
Ja 92
nSe 9 3
p
M -93
ay
Ja 94
nSe 9 5
p
M -95
ay
Ja 96
nSe 9 7
p
M -97
ay
-9
8
Se
Number of Contracts
Heating Oil Futures - NYMEX
August 1985 - August 1998
1,200,000
1,000,000
800,000
600,000
400,000
200,000
0
Volume
Open Interest
Volume
Open Interest
Jul-98
Dec-97
May-97
Oct-96
Mar-96
Aug-95
Jan-95
Jun-94
Nov-93
Apr-93
Sep-92
Feb-92
Jul-91
Dec-90
May-90
Oct-89
Mar-89
Aug-88
Jan-88
Jun-87
Nov-86
Apr-86
Sep-85
Number of Contracts
Gasoline Futures - NYMEX
August 1985 - August 1998
900,000
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
p
M -85
ay
Ja 86
nSe 8 7
pM 87
ay
Ja 88
nSe 8 9
p
M -89
ay
Ja 90
nSe 9 1
pM 91
ay
Ja 92
nSe 9 3
p
M -93
ay
Ja 94
nSe 9 5
p
M -95
ay
Ja 96
nSe 9 7
p
M -97
ay
-9
8
Se
Number of Contracts
Crude Oil Futures - NYMEX
August 1985 - August 1998
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
Volume
Open Interest
97%-98% OF ALL FUTURES ARE NOT DELIVERED
in other words:
ONLY 2%-3% OF THE CONTRACTS TRADED ARE DELIVERED!
EXAMPLE:
IN 1990: 719,000 CRUDE OIL NYMEX CONTRACTS WERE ACTUALLY
DELIVERED OUT OF 23 MILLION: ABOUT 3.126%
QUESTION: WHAT DOES THIS MEAN?
ACTIVITIES IN THE FUTURES MARKETS ARE MOSTLY FOR
PURPOSES OTHER THAN PURCHASE AND SALE OF COMMODITY:
FINANCIAL GOALS AND RISK MANAGEMENT GOALS.
QUESTION: HOW IS IT POSSIBLE FOR 98% OF
EXISTING CONTRACTS TO DISAPPEAR?
ANSWER:
THE CLEARINGHOUSE REGULATION AND
ACCOUNTING METHODS.
THE CLEARINGHOUSE
A NON-PROFIT MEMBERSHIP CLUB. THE CLEARINGHOUSE IS THE
OMNIPOTENT GUARANTOR OF ALL CONTRACTS.
* CLEARINGHOUSE GURANTEE:
TO THE LONG - NO DEFAULT ON THE SELLING SIDE.
TO THE SHORT - NO DEFAULT ON THE BUYING SIDE.
* THE CLEARINGHOUSE DOES NOT GURANTEE THE MARKET !
* THE CLEARINGHOUSE NEVER TAKES A POSITION.
* THE CLEARINGHOUSE MAKES SURE THAT ALL TRADES MATCH.
I.E., THAT ALL THE POSITIONS MUST ADD UP TO ZERO EVERY
TRADING DAY.
Clearinghouse
Exchange
Corporation
Exchange Members
Clearing
Members
Futures
Commission
Merchants
(FCMs)
Nonclearing
Members
FCM Customers
Futures Exchange
Types of Positions
• Long - a commitment to buy; benefits if prices rise
• Short - a commitment to sell; benefits if prices fall
Buyer
Member
Firm
Seller
Buying
Floor
Broker
Selling
Floor
Broker
Member
Firm
Trading Ring
Buying:
floor broker
confirms
purchase
Member
firm
Confirms
purchase
Buyer
now long
1 contract
Orders executed by open
outcry by buying and selling
floor brokers, recorded and
placed on ticker
Reports
purchase
Reports
sale
Clearinghouse
1
1
obligation
obligation
long
short
Total open interest: 1 contract
Selling:
floor broker
confirms sale
Member
firm
Confirms
sale
Seller
now short
1 contract
Seller - long with obligation
to pay for and take delivery
Member
Firm
Buyer - short with obligation
to deliver
Selling
Floor
Broker
Buying
Floor
Broker
Member
Firm
Trading Ring
Selling
floor broker
confirms purchase
Member
firm
Confirms
sale
Buyer has
offset obligation
by sale – no
market position
Orders executed by open
outcry by buying and selling
floor brokers, recorded and
placed on ticker
Reports
sale
Reports
purchase
Clearinghouse
1 Obligation
1 Obligation
or short purchased
or long sold
canceling sell
canceling
obligation
buy obligation
Total open interest: 0 contract
Buying
floor broker
confirms sale
Member
firm
Confirms
purchase
Seller has offset
obligation by
purchase no market
position
Futures Exchange
Delivery Procedure
Short
Long
Intention to
Accept Delivery
Intention to
Make delivery
Clearinghouse Matches
Seller with Buyer
Delivery
Seller
Deposits margin
Clearing
Broker
Payment
Buyer
Deposits full margin
Clearing
Broker
Futures Exchange
Margins
• Initial Margin
A cash deposit
• Variation Margin
A margin call
Outside Customers
...
A
B
FCM a
C
FCM b
Clearing
member 1
D
FCM c
E
...
Customer
margins
Clearing
member 2
Clearing
margins
Clearinghouse
B
Clearinghouse
A
Futures Exchange
Initial Margin Requirements
NYMEX
Crude Oil
Heating Oil
Gasoline
Natural Gas
Electricity
$/Contract
2,200
2,000
2,000
6,300 * / 4,000
1,900
+ Effective January 7, 1997
* for the Feb and Mar contracts only
Futures Exchange
•Marking-to Market
The process that realizes all
gains and losses.
•Settlement Price
The benchmark against which all
accounts are marked-to-market.
Futures Exchange
Marking-to-Market
Example:
Commodity
Gasoline
Heating Oil
Gasoline
Crude Light
Electricity
Transaction Settlement
Price
Price
Change
64.00
58.00
66.00
25.60
21.00
65.50
56.00
65.50
25.50
19.90
1.50+
2.00+
0.500.101.10+
JUNE WTI FUTURES (1,000 bbls PER CONTRACT)
DATE
PARTY
NUM
PRICE
Th.5.16
A:LONG
10
$20
CH
C:LONG 25
$21
CH
5.16
5.16 SETTLE
Fr.5.17
E:LONG 10
5.17 SETTLE
Mo.5.20 D:LONG 25
5.20
B:LONG 10
5.20 SETTLE
Tu.5.21
F:LONG 10
5.21 SETTLE
We.5.22 F:LONG 10
5.22 SETTLE
*
PARTY
NUM
PRICE
OI*
B:SHORT 10
$20
10
D:SHORT 25
$21
35
$21
$22
$21
CH
A:SHORT 10
$22
$22
35
$22
$22.5
CH
F:SHORT 25
$22.5
35
$21.5
CH
C:SHORT 10
$21.5
25
$21.5
$21
$21.5
CH
E:SHORT 10
$21
$20
$20
OI = Open Interest
$21
15
$21
CH
C:SHORT 10
$20
$20
5
CLEARINGHOUSE ACCOUNTING
A: LONG 10; SHORT 10 : OUT
B: SHORT 10; LONG 10 : OUT
C: LONG 25; SHORT 10; SHORT 10
C remains
LONG 5.
D: SHORT 25; LONG 25 : OUT
E: LONG 10; SHORT 10 : OUT
F: SHORT 25; LONG 10 : LONG 10
F remains
5.23
SHORT 5.
F DECIDES TO DELIVER 5 FUTURES
C ACCEPTS DELIVERY OF 5 CONTRACTS.
The actual delivery is now scheduled for June 23.
CLEARINGHOUSE PROFIT/LOSS = ZERO*
LONG
PRICE
SHORT
PRICE TOTAL PROFIT
A
10
$20
10
$22
$20,000
B
10
$21.5
10
$20
-$15,000
C
10
$21
10
$21.5
10
$20
-$10,000
$5,000
D
25
$22.5
25
$21
-$37,500
E
10
$22
10
$21
-$10,000
F
10
$21
25
$22.5
10
$20
$15,000
$25,000
TOTAL
C TAKES DELIVERY 5 PAYS $21 :
F DELIVERS 5 RECEIVES $22.5 :
TOTAL
*
-$7,500
-$105,000
$112,500
$7,500
0
This calculation accounts for buying and selling only. It does not account for cash
movements resulting from the daily marking-to-market process.
The following exhibits illustrate the activity in the margin account of each of the traders
focusing only on cash flow resulting from the daily marking-to-market process. Thus,
possible margin calls are ignored.
PARTY
A:
DATE ACTION
5.16
LONG 10
PRICE
SETTLE
CASH FLOW POSITION
$20
Initial margin LONG 10
+$10,000
LONG 10
+$10,000
0
$20,000
$21
5.17
SHORT 10
$22
TOTAL
A’s profit is = $20,000
PARTY
B:
DATE ACTION
5.16
5.17
5.20
SHORT 10
PRICE
SETTLE
$20
$21
$22
LONG 10
$21.5
TOTAL
CASH FLOW POSITION
Initial margin
-$10,000
-$10,000
+$5,000
-$15,000
B’s loss is = $15,000
SHORT 10
SHORT 10
SHORT 10
0
PARTY
C:
DATE ACTION
5.16
5.17
5.20
5.21
5.22
5.23
LONG 25
PRICE
SETTLE
$21
$21
$22
CASH FLOW POSITION
Initial margin
+$25,000
SHORT 10 $21.5
-$5,000
$21.5
-$7,500
$20.5
-$15,000
SHORT 10 $20
-$5,000
$20
-$2,500
TAKE DELIVERY OF 5,000 BARRELS
for $20/bbl
-$100,000
LONG 25
LONG 15
LONG 15
LONG 5
0
C’s total loss up to and and including 5.22 is $10,000.
Note that the 5 contracts that were delivered has accumulated the following amount over the period:
5.17
5.20
5.21
5.22
5.23
(5,000)($1) = $5,000
(5,000)(-$.5) = -$2,500
(5,000)(-$1) = -$5,000
(5,000)(-$.5) = -$2,500
(5,000)(-$20) = -$100,000 Payment upon delivery
TOTAL………….-$105,000
The five contracts have accumulated total payment of $105,000 (Note: $105,000/5,000 = $21/bbl).
PARTY
D:
DATE ACTION
5.16
SHORT 25
PRICE SETTLE CASH FLOW POSITION
$21
$21
Initial margin SHORT 25
0
SHORT 25
$22
$22.5
TOTAL
-$25,000
-$12,500
-$37,500
5.17
5.20
LONG 25
SHORT 25
0
D’s total loss is = $37,500
PARTY
E:
DATE ACTION
5.17
5.20
5.21
LONG 10
PRICE SETTLE CASH FLOW POSITION
$22
$22
$21.5
SHORT 10
$21
TOTAL
Initial margin
0
-$5,000
-$5,000
-$10,000
E’s total loss is = $10,000
LONG 10
LONG 10
LONG 10
0
PARTY
F:
DATE ACTION
5.20
5.21
5.22
5.23
PRICE
SETTLE CASH FLOW POSITION
SHORT 25 $22.5
SHORT 25
Initial margin
$21.5 +$25,000
LONG 10 $21
+$5,000
$20.5 +$15,000
LONG 10 $20
+$5,000
$20
+$2,500
DELIVER 5,000 BARRELS
for $20/bbl
+$100,000
SHORT 15
SHORT 5
0
F’s total profit up to and including 5.22 is $52,500.
Note that the 5 contracts that were delivered has accumulated the following amount over the period:
5.20
5.21
5.22
5.23
(5,000)($1)
(5,000)($1)
(5,000)($.5)
(5,000)($20)
= $5,000
= $5,000
= $2,500
= $100,000 Payment upon delivery
TOTAL…………..$112,500
The five contracts that F delivers accumulated a total of $112,500 (Note: $112,500/5,000 = $22.5/bbl)
Futures Trading
The Trading Participants
•
Hedgers
•
Speculators
•
Arbitrageurs
Futures Trading
Speculation
• A transaction whose sole purpose is to achieve gain.
A speculative transaction can be consummated in any
market.
Speculators (scalpers, day traders, position traders)
•
Volatility sensitive
•
Many transactions
•
Short-term trades (seconds to days)
Futures Trading
Example of Speculation (long and short)
Outright Position
Price
Action
.
Pe up
long 10 Mar COB
Pr down
short 10 Mar COB @ $10.25
@ $11.00
loss $0.75 / MWHr
Pe up
short Apr PV
@ $16.00
Pr down
long 50 Apr PV
@ $14.25
profit $1.75 / MWHr
Futures Trading
Example of Speculation (long and short)
Spread Position
Price difference either widens or narrows:
Price
Action
.
Pe widened
long 25 Dec NG
short 25 Jun NG @ $0.35
Pr widened
short 25 Dec NG
long 25 Jun NG @ $0.45
Pe narrow
short 10 May HU
long 10 May HO @ 2.00 cpg
Pr widened
long 10 May HU
short 10 May HO @ 2.75cpg
Hedging
Primary Goals:
• reduce or eliminate price risk
• lower expected transaction costs
• reduce the probability of bankruptcy
• reduce expected tax liabilities
•signal to creditors that the firm is safer
Hedger
•
Price level sensitive
•
Few transactions
•
Long-term trade (weeks or months)
Hedging
Types of Hedge Positions
Long Hedge
A long derivative position ( benefits if prices rise )
Short Hedge
A short derivative position ( benefits if prices fall )
Hedging
Long Hedge
Action
now
later
P
P
Cash
Sell cash
buy cash
LOSS
GAIN
Futures
long futures
short futures
GAIN
LOSS
Hedging
Long Hedge - Anticipatory
Action
now
later
P
P
Cash
nothing
buy cash
0
0
Futures
long futures
short futures
GAIN
LOSS
Hedging
Long Hedge - Fixed Price
Prices
Prices
Action
Increase
Decrease
sales price
$ 28.00
$ 28.00
establish long hedge
25.00
25.00
conclude physical purchase
29.00
24.00
close hedge position
29.00 -
24.00 -
Effective Purchase Cost
Margin
Gain or loss on futures
Gain or loss on cash
$
$
$
$
25.00
3.00
4.00
1.00 -
$
$
$
$
25.00
3.00
1.00 4.00
Hedging
Long Hedge - Floating Pric
Prices
Action
establish long hedge
Increase
Prices
Decrease
$ 25.00
$ 25.00
conclude physical purchase
26.00
24.00
close hedge position
26.00-
24.00-
Effective Purchase Cost
$ 25.00
Gain on Futures
$ 1.00
Loss on Futures
$ 25.00
$
1.00
LONG HEDGE
LDC PERSPECTIVE
An LDC has to buy 10,000 MMBtu a day or 300,000 MMBtu a month to supply residential customers and is concerned
about rising natural gas prices. Therefore, the LDC decides to hedge its purchases by buying natural gas futures to lock in
the purchase price of December natural gas or execute a LONG HEDGE.
Note: 10,000 MMBTU = 1 NYMEX contract for natural gas  300,000 MMBTU = 30 contracts
Step 1:
In August, it buys 30 contracts of December natural gas futures at an average price of $2.662 per MMBtu. The
LDC now has a long position of 30 contracts.
Step 2:
In late November, the LDC buys 300,000 MMBtu of natural gas from a marketer for $2.83 an MMBtu to meet
its December demand.
Step 3:
Simultaneously, the LDC liquidates the futures hedge or offsets the long position by selling futures. (The hedge
was originally initiated by buying futures) The LDC sells 30 contracts on NYMEX for an average price of $2.83 since prices
have risen as the LDC anticipated.
FUTURES:
($2.662)
2.380
0.168
Long hedge average price per MMBTU
futures sold at current price
hedge gain
PHYSICAL:
$2.83
-( .168)
2.662
purchase price per MMBTU
futures gain
Final adjusted price to the LDC
LONG HEDGE
UTILITY PERSPECTIVE:
A utility in the west who uses natural gas to produce electricity is notified by its supplier that due to a pipeline
maintenance outage in July, alternate routing will be needed to deliver the gas at an increased cost. This renders natural
gas uneconomic as power generation fuel. The utility’s trader decides to buy from Power Marketer X a 25 MW block of
firm, on-peak (“6-by-16”) electrical energy in order to meet its anticipated load requirements, but naturally is very
concerned about rising electricity prices. Therefore, the utility decides to hedge this purchase by buying July futures, or
executing a long hedge, to lock in the purchase price of the electricity.
Jul power purchase = 25 MW *26 on-peak days * 16 on-peak hours per day = 10,400 Mwh
1 NYMEX contract = 736 Mwh  Contracts to hedge = 10,400 / 736 = 14.1 or 15 contracts
STEP 1 : Utility buys 15 Jul. futures contracts at an average price of $28.50 per Mwh. Utility now has a long position of
15 contracts.
STEP 2 : Utility now buys 10,400 Mwh of physical electricity from “X” Power Marketer for $28.80 per Mwh. Now, the
utility needs to liquidate (or close out) the futures hedge (or long position) by selling futures. (Remember, the hedge
was initiated by buying futures). Utility sells 15 contracts on exchange for average price of $28.80 Mwh, as prices have
risen as anticipated by the trader. What is the utility’s final adjusted price?
FUTURES
$28.50 Long Hedge futures average price
- $28.80 futures sold at current price
$ .30 Futures or hedge gain
PHYSICAL
$28.80 Purchase from Power marketer
- .30 hedge gain ( see above )
$28.50 Final adjusted price for utility
LONG HEDGE
REFINER PERSPECTIVE:
A refiner has to buy 3,000 barrels a day or 90,000 barrels a month of crude oil every
month to run the refinery and naturally is very concerned about possible increases in the
price of crude oil, especially during the winter months. Therefore, the refiner decides to
hedge its purchases for December’s runs by buying crude oil futures to lock in the
purchase price of December crude oil or executes a long hedge.
EXAMPLE:
1,000 barrels = 1 NYMEX futures contract for light sweet crude oil
90,000 barrels = 90 contracts
STEP 1:
In October, the refiner buys 90 contracts for future delivery (December) at
an average price of $19.50 per barrel. The refiner now has a long position
of 90 contracts.
STEP 2:
In late November, the refiner buys 90,000 barrels of crude oil from a
producer for $19.80 a barrel to meet its December demand.
STEP 3:
At the same time as step 2, the refiner liquidates its futures hedge or offsets
the long position by selling futures contracts. The refiner sells 90 contracts
on the exchange for an average price of $19.80 a barrel since prices have
risen as anticipated by the refiner.
FUTURES
$(19.50)
19.80
$
.30
long hedge futures average price
futures sold at current price
futures gain
PHYSICAL
$19.80
.30
$19.50
purchase from the producer
futures gain
final adjusted price for the refiner
Hedging
Short Hedge
Action
now
later
P
P
Cash
buy cash
sell cash
GAIN
LOSS
Futures
short futures
long futures
LOSS
GAIN
Hedging
Short Hedge - Anticipatory
Action
now
later
P
P
Cash
nothing
sell cash
0
0
Futures
short futures
long futures
LOSS
GAIN
Hedging
Short Hedge - Fixed Price
Action
purchase price
Prices
Prices
Increase
Decrease
$ 22.00
$ 22.00
establish short hedge
25.00 -
25.00 -
conclude physical sale
29.00 -
24.00 -
close hedge position
29.00
24.00
Effective Sales Price
Margin
Gain or loss on futures
Gain or loss on cash
$
$
$
$
25.00
3.00
4.00 7.00
$ 25.00
$ 3.00
$ 1.00
$ 2.00
Hedging
Short Hedge - Floating Price
Prices
Action
Prices
Increase
Decrease
$ 25.00 -
$ 25.00 -
conclude physical sale
26.00 -
24.00 -
close hedge position
26.00
24.00
Effective Sales Price
$ 25.00
$ 25.00
Loss on Futures
$ 1.00
establish short hedge
Gain on Futures
$
1.00
SHORT HEDGE
PRODUCER PERSPECTIVE:
A natural gas producer has production of 10,000 MMBTU?D or 300,000 MMBTU
monthly and naturally is very concerned about declining prices. Therefore, in order to
lock in December sales price for natural gas, the producer sells December’s production in
the futures market or executes a short hedge.
EXAMPLE:
10,000 MMBTU = 1 NYMEX futures contract for natural gas
300,000 MMBTU = 30 contracts
STEP 1:
In August, the producer sells 30 contracts for future delivery (December)
at an average price of $2.662 per MMBTU. The producer now has a short
position of 30 contracts.
STEP 2:
In late November, the producer sells 300,000 MMBTU of natural gas to an
LDC for $2.43 an MMBTU for physical delivery.
STEP 3:
At the same time as step 2, the producer liquidates its futures hedge or
offsets the short position by buying futures contracts. The producer buys
30 contracts on the exchange for an average price of $2.43 per MMBTU
since prices have declined as anticipated by the producer.
HEDGE ANALYSIS
$2.662
( 2.43)
$ .232
sells 30 Dec. contracts
buys 30 Dec. contracts
hedge gain
PHYSICAL
$2.43
- .232
$2.662
sold gas to an LDC
hedge gain
final adjusted price
SHORT HEDGE
INDEPENDENT POWER PRODUCER PERSPECTIVE:
The bulk power sales manager has excess power for the next two months and is concerned about falling prices in the forward
market. The current futures market price would provide a profitable return for power plant operations. After reviewing
sales commitments and forecasted operating conditions with her schedulers, the sales manager realizes there is available
capacity. Therefore, in order to lock in the current price of the electricty, the independent power producer decides to sell the
excess power equivalent in the futures market by executing a short hedge. If the forward price for power continues to fall,
the futures hedge will be offset as needed when the physical power is sold.
736Mwh = 1 futures contract  7,360Mwh = 10 futures contract
STEP 1 : Sell 10 Palo Verde futures contracts at an average price of $24.50 per Mwh. Producer now has short position of 10
contracts.
STEP 2 : Producer now sells 7,360Mwh of its excess power of to Wooly Navel Citrus Juice Company for $24.10 per Mwh.
Now, the producer needs to offset, or liquidate, the short hedge by buying futures. Remember -- the producer is hedged with
a short futures position. Producer buys 10 futures contracts at the average price of $24.10 per Mwh as prices have fallen as
anticipated by the bulk power sales manager.
FUTURES
$24.50
Short Hedge futures average price
- 24.10
Futures purchased at current price
$ .40
Futures or hedge result
PHYSICAL
$24.10
Sale to Customer
+ .40
Hedge result ( see above )
$24.50
Final adjusted price for power producer
SHORT HEDGE
PRODUCER PERSPECTIVE:
A producer has production of 3,000 barrels a day or 90,000 barrels a month of crude oil and is
very concerned about possible decreases in the price of crude oil, e.g., because of a mild winter.
Therefore, in order to lock in December sales price for crude oil, the producer sells December’s
production in the futures market or executes a short hedge.
EXAMPLE:
1,000 barrels = 1 NYMEX futures contract for light sweet crude oil
90,000 barrels = 90 contracts
STEP 1:
In October, the producer sells 90 contracts for future delivery (December) at an
average price of $19.50 per barrel. The producer now has a short position of 90
contracts.
STEP 2:
In late November, the producer sells 90,000 barrels of crude oil to a refinery for
$19.10 a barrel.
STEP 3:
At the same time as step 2, the producer liquidates its futures hedge or offsets the
short position by buying futures contracts. The producer buys 90 contracts on the
exchange for an average price of $19.10 a barrel since prices have fallen as
anticipated by the producer.
FUTURES
$19.50
(19.80)
$ .40
short hedge futures average price
futures purchased at current price
futures gain
PHYSICAL
$19.10
sale to refinery
HEDGE
$19.10
+
.40
$19.50
sale of production to the refinery
futures gain
final adjusted price for the producer
Hedging
Hedging - Spreads
• Calendar Spreads
• Intermarket Spread
Hedging
Intermarket Spreads
• Crack Spread (gasoline, heating oil and
crude oil)
• Spark Spread (electricity and natural
gas)
NYMEX SPARK SPREAD
•
A specialized form of intermarket spread between natural gas and
electricity
•
Involves the simultaneous purchase and sale of natural gas and
electricity futures contracts
•
Protects or “locks in” a margin for current or future generation.
Options
Option
• A contingent claim.
Two Types of Options
•
•
Calls
Puts
Options
Option Buyer (holder or long)
In exchange for making a payment of money (the
premium), the owner (buyer) of an option has the
right, but not the obligation, to buy (call option) or
to sell (put option) a specified quantity of the
underlying commodity at a specified price at a
specified time in the future.
Options
Option Seller (writer or short)
In exchange for receiving a payment of money
(the premium), the writer (seller) of an option
has the obligation to provide (call option) or
receive (put option) a specified volume of the
underlying commodity at a specified price at a
specified time in the future.
Options
Buyer of a call option
. . .
expects the price of the underlying
commodity to increase during the period of the
option contract.
Options
Seller of a call option
. . . expects the price of the underlying
commodity to either remain at the current
level or to decline during the period of the
option contract.
Options
Buyer of a put option
. . . expects the price of the underlying
commodity to decrease during the period of the
option contract.
Options
Seller of a put option
. . . expects the price of the underlying
commodity to either remain at the current
level or to increase during the period of
the option contract.
Options
Types of Options
• American Option
exercisable any time before expiration
• European Option
exercisable only on expiration date
• Average Rate Option
price of underlying set by an averaging procedure
Options
At-the-money
Whenever the price of the underlying is the
same as the strike price of the option.
In-the-money
Whenever the price of the underlying is above
the strike price of a call option or below the strike
price of a put option.
Out-of-the-money
Whenever the price of the underlying is the
below the strike price of a call option option or
above the strike price of a put option.
Options
Option Price = Premium
Two Components
Intrinsic Value - The amount by which an
option is in-the-money.
Time Value - The amount by which the price of
an option exceeds its intrinsic value.
Options
Option Variables
•
•
•
•
•
•
Premium
Strike Price
Underlying Commodity
Time Until Expiration
Volatility
Interest Rate
=E
=U
=T
=
=
Options
Put-Call Parity
C - P = U - E
where:
C =
P =
U=
E =
Call Premium
Put Premium
Price of the Underlying commodity
Exercise or Strike Price of the Option
Options
Synthetic Options
Call Put +
Call Put -Put -Call +
Put
Underlying
Underlying
Call
Underlying
Underlying
=
=
=
=
=
=
Synthetic Long
Synthetic Call
Synthetic Put
-Synthetic Short
-Synthetic Call
-Synthetic Put