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Oil Futures Market Hedging & Price Management August 13, 2017 1 Outline Types of Financial Instruments Jargons Usages of Financial Instruments Trading Failures 2 Types of Financial Instruments Forward Contract Futures Contract Derivatives 1. Options Calls Puts 2. Swaps 3 Forward Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price on a specified future date. Payment in full is due at the time of, or following, delivery.” 4 Future Contract “A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price at a specified location.” 5 Futures Contracts - Characteristics Regulated Small lots Monthly quote Price transparent Clearing house Margin money required Not always physical 6 Options “a right – but not an obligation- to buy or sell an underlying asset at a fixed price during a specified time period in exchange for a onetime premium payment.” Call Put : the option to buy : the option to sell 7 Where are They Traded ? NYMEX (US) IPE (London) Light sweet crude (WTI) Brent Heating oil (No 2) Gasoil Gasoline Natural Gas SIMEX (Singapore) Fuel Oil 8 Jargons Contango vs. Backwardation Long vs. Short Bull vs. Bear 9 Contango If at any point in time… Market prices RISE through future months… Then the market is in CONTANGO 10 Backwardation If at any point in time….. Market prices FALL through future months… Then the market is in BACKWARDATION 11 2n th d M t 3r h d M th 4t h M th 5t h M t 6t h h M t 7t h h M th 8t h M th 9t h M 10 th th M 11 th th M 12 th th M th tM 1s $/tonne IPE Gasoil Curve 260 240 220 200 180 160 140 120 100 3-Aug-98 1-Aug-00 12 Pay Out Diagram – Long Position Buy AXL @ 30$/bbl Profits $ 4 3 2 1 0 -1 -2 -3 -4 Profits as Market rises 27 27 Losses $ 28 28 29 29 30 31 32 33 $/bbl Losses as Market falls Market Price 13 Pay Out Diagram – Short Position Sell AXL @ 30$/bbl Profits $ 4 3 2 1 0 -1 -2 -3 -4 Profits as Market falls 31 27 Losses $ 28 29 30 31 32 32 33 $/bbl 33 Losses as Market rises Market Price 14 Use of Financial Instruments 1. Speculation 2. Hedging 3. Price Management 15 Speculation Outright position taking Pure paper traders Directional price movement 16 A Speculative Market IPE Brent Crude futures Total Traded Volume January 1998 - October 2000 lots 3/2/00 1/2/00 11/2/99 9/2/99 7/2/99 5/2/99 3/2/99 1/2/99 11/2/98 9/2/98 7/2/98 5/2/98 3/2/98 1/2/98 160000 140000 120000 100000 80000 60000 40000 20000 0 17 Hedging Definition: Taking an opposite position on futures to that on physical to remain… “PRICE NEUTRAL” Objective: “TO REDUCE RISK” 18 Hedging - Example It is October 29th. A trader loads a gasoil cargo ex-Yanbu. The FOB price is $270/ton. His freight cost is $15/ton. He also has agreed to sell it CIF to a buyer in Rotterdam at Platts 0.2%S CIF on arrival. Vessel is due Rotterdam November 9th. Today, Platts 0.2%S CIF price is $293/ton IPE December Futures price for gasoil is $291/ton. The trader intend to make $8/ton in profits. 19 Hedging – Example (continue) Hedging plan (Part I) When the physical is priced in, he should sell futures (October 29th) Action: 1. Buy physical @ $270/ton 2. Sell Futures @ $291/ton 20 Hedging – Example (continue) Hedging plan (Part II) When the physical is priced out, he should buy futures (November 9th) On November 9th, Platts CIF Cargoes price is $280/ton IPE December Futures price is $278/ton Action: 1. Sell physical @ $280 2. Buy Futures @ $278 21 Hedging – Example (continue) Accounting Physical FOB Purchase Fright $/ton -270 CIF Sale 280 Net -5 -15 Futures Sell on Oct. 29th Buy on Nov. 9th $/ton +291 Net 13 OVERALL NET = +$8/TON -278 22 Price Management Definition: Using futures and forward markets as a vehicle to… “CATCH THE MARKET” Objective: “LOCKING IN A PRICE” 23 Price Management - Example It is November 1st A Japanese refinery is due to load Dubai crude on December 15th As usual, price will be determined 5 days around B/L Buyer fear that crude prices are increasing next month and would like to lock current price Action: 1. Buy Dubai futures now 2. Sell Dubai futures at time 24 physical is priced Why Do You See Trading Failures? Failure to understand risk & exposure Poor organizational structure Excessive speculation No position tracking Absence of controls Extreme market volatility 25 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 Crude Oil Prices 40 $/BBL 35 38 Dubai Brent WTI 30 25 20 15 10 5 0 26 Crude Oil Price Volatility 16.0 WTI ($/BBL) 23-Mar 15.5 15.0 10-Mar 14.5 14.0 9-Mar 13.5 13.0 24-Feb 12.5 4-Mar 3-Mar 17-Mar OPEC Meeting (Vienna) 18-Feb 12.0 11.5 11.0 16-Feb-99 23-Feb-99 2-Mar-99 9-Mar-99 16-Mar-99 23-Mar-99 27 Summary Many financial instruments Three motives to use financial instruments. There is a distinct difference between hedging and speculation Hedge to reduce risk Trading Failures 28