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Oil Futures Market

Hedging & Price Management

April 10, 2023

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OutlineOutline

Types of Financial Instruments

Jargons

Usages of Financial Instruments

Trading Failures

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Types of Financial InstrumentsTypes of Financial Instruments

Forward Contract Futures Contract Derivatives

1. Options Calls Puts

2. Swaps

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Forward ContractForward 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.”

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Future Contract 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.”

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Futures Contracts - CharacteristicsFutures Contracts - Characteristics

Regulated Small lots Monthly quote Price transparent Clearing house Margin money required Not always physical

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OptionsOptions

“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 one-time premium payment.”

Call : the option to buy Put : the option to sell

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Where are They Traded ?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

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JargonsJargons

Contango vs. Backwardation

Long vs. Short

Bull vs. Bear

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ContangoContango

If at any point in time…

Market prices RISE through future months…

Then the market is in CONTANGO

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BackwardationBackwardation

If at any point in time…..

Market prices FALL through future months…

Then the market is in BACKWARDATION

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IPE Gasoil CurveIPE Gasoil Curve

100120140160180200220240260

1st

Mth

2nd M

th

3rd

Mth

4th

Mth

5th

Mth

6th

Mth

7th

Mth

8th

Mth

9th

Mth

10t

h Mth

11t

h Mth

12t

h Mth

$/to

nn

e

3-Aug-98

1-Aug-00

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Pay Out Diagram – Long PositionPay Out Diagram – Long Position

Buy AXL @ 30$/bbl

-4-3-2-101234

27 28 29 30 31 32 33

Market Price

Profits as Market rises

Losses as Market falls

$/bbl

Profits $

Losses $

27 28 29

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Pay Out Diagram – Short PositionPay Out Diagram – Short Position

Sell AXL @ 30$/bbl

-4-3-2-101234

27 28 29 30 31 32 33

Market Price

Profits $

Losses $

Profits as Market falls

Losses as Market rises

$/bbl31 32 33

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Use of Financial InstrumentsUse of Financial Instruments

1. Speculation

2. Hedging

3. Price Management

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SpeculationSpeculation

Outright position taking

Pure paper traders

Directional price movement

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A Speculative MarketA Speculative Market

IPE Brent Crude futures Total Traded Volume January 1998 - October 2000

0

2000040000

6000080000

100000

120000140000

160000

1/2/

98

3/2/

98

5/2/

98

7/2/

98

9/2/

98

11/2

/98

1/2/

99

3/2/

99

5/2/

99

7/2/

99

9/2/

99

11/2

/99

1/2/

00

3/2/

00

lots

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HedgingHedging

Definition:

Taking an opposite position on futures to that on physical to remain…

“PRICE NEUTRAL” Objective:

“TO REDUCE RISK”

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Hedging - ExampleHedging - 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.

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Hedging – Example (continue)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

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Hedging – Example (continue)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

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Hedging – Example (continue)Hedging – Example (continue)

Physical $/ton Futures $/ton

FOB

Purchase

-270 Sell on

Oct. 29th

+291

Fright -15 Buy on

Nov. 9th

-278

CIF Sale 280

Net -5 Net 13

Accounting

OVERALL NET = +$8/TON

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Price ManagementPrice Management

Definition:

Using futures and forward markets as a vehicle to…

“CATCH THE MARKET” Objective:

“LOCKING IN A PRICE”

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Price Management - ExamplePrice 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 physical is priced

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Why Do You See Trading Failures?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

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Crude Oil PricesCrude Oil Prices

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0

5

10

15

20

25

30

35

40$/BBL Dubai Brent WTI

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Crude Oil Price VolatilityCrude Oil Price Volatility

4-Mar3-Mar

18-Feb

23-Mar

10-Mar

9-Mar

24-Feb

17-Mar

11.0

11.5

12.0

12.5

13.0

13.5

14.0

14.5

15.0

15.5

16.0

16-Feb-99 23-Feb-99 2-Mar-99 9-Mar-99 16-Mar-99 23-Mar-99

WTI ($/BBL)

OPEC Meeting (Vienna)

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SummarySummary

Many financial instruments Three motives to use financial instruments. There is a distinct difference between

hedging and speculation Hedge to reduce risk Trading Failures