The Role of Oil Futures In Risk Management

Leena Qunaibi ID: 13313144

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Table of Contents Cover Page..1 Contents Page..2 Executive Summary....3 Introduction..4 Fundamentals of futures contracts6 Advantages & Disadvantages of futures contracts7 Hedging Strategies.9 Conclusion.12 References.13 Appendix.14

Executive Summary

This report looks at the general details of oil futures and the different types of futures contracts used by companies as a means of diversifying and eliminating risk in their risk management process. The fundamentals of futures contracts, as well as their advantages and disadvantages are also discussed in this report. It examines the two types of hedging strategies, while setting examples for further illustration.

Introduction The increasing demand for energy has made oil one of the most important commodities in the world. Practically, all the major industries run on the energy acquired from oil, where every sector from transportation to agriculture depends on oil. Oil prices are determined by many different factors, with supply and demand being the main key drivers for the pricing of oil, as well as the type and quality of the oil being sold, and as most of the worlds crude oil is priced in dollars, the value of the U.S dollar has a large effect on the price of oil.

Commodities like oil could be traded in spot transactions or in special contracts called futures. According to John Hull (2005), futures contracts are highly uniform and wellspecified commitments for a carefully described good (quantity and quality of the good) to be delivered at a certain time and place at an acceptable delivery date, in a certain manner, and the permissible price fluctuations are specified (minimum and maximum daily price changes). Two of the worlds most important markets for trading in crude oil futures are the New York Mercantile Exchange (NYMEX), and the Intercontinental Exchange (ICE). They are similar to forwards contracts, where in a forward contract an agreement between two parties (counterparties) for the delivery of a physical asset i.e. oil and gold at a certain time in the future for a certain price that is fixed at the inception of the contract, John Hull (2007). However, futures contracts are much more liquid because the obligation to buy or sell can be removed before the expiry of the contract, by making an opposite transaction. Whether futures contracts are being used by hedgers, to hedge the price risk of futures on the spot market, or by speculators that usually enter into a futures market with the hope of benefiting from positive price trends, or arbitrageurs looking to gain their profit from the price difference between two related commodity futures contracts. Futures are used as control
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techniques to aid in the risk management of the transactions, and as the main rule of finance is diversification, companies such as airlines use futures contracts as a way of spreading their risk. By locking into a futures contract, both the buyer and the seller can secure themselves from the risk of any dramatic changes in oil prices.

Fundamentals of futures contracts

Each future contract has standardized terms. These terms are quantity, quality, expiration months, delivery terms, delivery differentials, delivery dates, minimum price fluctuation, daily price limits, and trading days and hours. The types of futures contracts are for a physical commodity, foreign currency interest-earning asset, stock index, and individual stocks. There are two types of organizations responsible for sustaining the process of futures trading, exchange and clearinghouse. The exchange organizations are non-profit organizations that offer standardized futures contracts for physical commodities, financial products and foreign currency, whereas clearinghouse organizations are agencies that deal with the delivery and settlement of the trade and are responsible to guarantee the fulfilment of the obligations of the futures contract by all the parties involved. In order to enter into a futures contract, the trader needs to pay an initial margin in the form of a deposit before making the trade. His position would then be tracked on a daily basis in the case that if his account makes a loss, the trader would receive a daily variation margin that requires him to compensate and pay the losses.

There are many types of futures contracts, where each contract is characterized by the type and quality and the region where the commodity is being traded. Futures contracts include energy, metals, food, and chemicals in international trade, and the components making up the spot price of oil are the base price based on a market indicator, plus or minus a quality adjustment and can be expressed in this formula:

P=A+D
For example, crude oil that is sold into the U.S Gulf Coast, delivered at Cushing, Oklahoma would have the base price of the West Texas Intermediate crude oil and the crude oil sold into South East Asia would be tied to the base prices in Dubai. However, the quality of the
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crude oil would be added to the base price, where the denser the crude oil, the lower the quality and consequently the lower are its price.

Likewise, contracts for products between suppliers and bulk consumers are priced in a similar way to international crude oil, except that the base price is adjusted to other factors such as volume, rather than being adjusted for quality.

The types of oil futures contracts traded on the New York Mercantile Exchange are light sweet crude oil, and are the most heavily traded contracts in the world while the other type of oil futures, Brent Crude Oil, are traded on the Intercontinental Exchange (ICE). Brent crude oil is a North Sea crude oil that is widely used to determine Crude oil prices in Europe and other parts of the World. Together the light crude futures contract and Brent crude are used as the basis for virtually every physical crude oil transaction.

Advantages and Disadvantages of using futures contracts The use of futures contracts comes with certain advantages and disadvantages. Being traded in the central market gives futures contracts their liquidity quality. Due to the presence of the three types of traders; the hedger, speculator and arbitrageurs, it means that for every seller theres a buyer, thus a trader may easily buy or sell futures. The ease of entering and exiting a futures market makes it a much more desirable technique than the forwards market. Leverage is also an advantage of futures contracts, where a trader takes on a large position with only a small initial deposit. Furthermore, as the futures contract nears the expiration date, the futures and spot prices tend to meet and become equal on the day of expiration. This equality in price is brought about by the activities of arbitrageurs who would go in to profit if they observe price difference between the futures and the spot price, where they buy in a cheaper market and sell in a higher priced one.
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On the other hand, the legal obligations tied to the futures contracts may sometimes lay constraints on the trading community, and as futures contracts have standardized features, perfect hedging may be impossible to achieve and as a result, some part of the spot transactions may have to go without hedging. In addition, the initial and daily variation margins can cause cash flow inconveniences for traders as they would have to pay up any losses due to the daily variation margins.

Hedging strategies

If a company decides to engage in oil futures, their goal should be to hedge the risk. There are two types of hedging strategies, long hedge and short hedge. For example, a WTI crude oil producer knows that it will gain $100,000 for each 1 cent increase in the price of WTI crude oil over the next, lets say 3 three months. And it also knows that it will lose $100,000 for each 1 cent decrease in the price of WTI crude oil during the same period. To reduce the effect of this risk by futures contract, it means that futures positions should result in a loss of $100,000 for each 1 cent increase in the price of WTI crude oil over the next month and a profit of $100,000 for each 1 cent decrease in the price. This means that when the price goes down, the profit on futures market can compensate the companys loss on the spot market, and when the price goes up, the profit on the spot market can compensate the loss on the futures market.

Long hedge Long hedges refer to taking long positions in futures contracts. They are used by traders that want to lock the price of oil at the present as they know that they are going to purchase some specific assets in the future. This is beneficial in the case of an increase in crude oil prices at the time of purchase. For example, on 1st June, the Gulf price of WTI crude oil is $120 per barrel. The refiner knows that they will buy 100,000 barrels of crude oil on 15th August. Therefore, supposing that the price of light sweet crude oil futures contract is $130 in August on NYMEX, the refiner takes ten long positions of the futures contracts to hedge the price risk. By the application of this strategy, the refiner can lock in the price of $130 per barrel and minimizing any losses he would have incurred without the aid of this strategy.
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Futures contract Price on $120 Spot date Futures contract selling price Profit from futures $130 $10

Considering a scenario where the refiner was to buy 100,000 barrels of crude oil and assuming that the spot price increases from $120 to $125 on 15th August, this rise in price would cost them $12,500,000 ($125*100,000). And as mentioned earlier, when the contract becomes nearer to the expiration or the delivery date, the spot price and the futures price start to get closer and more equal. In this scenario, it would mean that the light sweet crude oil futures contract should be close to $125 per barrel. However, by balancing his future positions, the buyer could gain $3 dollars per barrel in profit ($125-$122). Moreover, if in the case that on 15th August crude oil spot price falls to $118 per barrel, the refiner can buy 100,000 barrels of crude oil with $11,800,000. Unfortunately, this means that he will experience a loss of $400,000 [($122-$118)*100,000] by equalizing his futures positions.

Short hedge Short hedges refer to taking long positions in futures contracts. They are mainly used by traders wishing to sell their commodity on the spot market, i.e. oil producers. The benefit of using short hedges is that they allow the seller to lock their selling price to a profitable level. For example, if on 1st May, an oil producer was to sign a contract to sell 100,000 barrels on 15th September, and the price will be tied to the spot price of the crude oil on 15th September. Assuming that the spot price of the oil is $120 per barrel on 1st May, and the light sweet crude oil futures contract on NYMEX is $122 dollars per barrel in September. The oil producer can then hedge his price risk by shorting 100 futures contracts (where each contract represents 1,000 barrels) and lock the selling price to $122 per barrel.

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However, if the spot price of crude oil was to fall to $119 per barrel on 15th September, the company can take in $11,900,000 if it sells the crude oil it promised. As the delivery month of the futures contracts is September, the contracts price should be almost equal to the spot price, and by offsetting its future positions the company can gain profit, which is around $3 dollars per barrel. As a result, the amount of money that the oil producer receives is $12,200,000. If the spot price of WTI crude oil is increases to $123 per barrel rather than drops to $119 per barrel on September 15th, the company can realize 12,300,000 dollars by selling crude oil on spot market. But the company will suffer a loss of $1(123-122) per barrel by offsetting its futures positions on futures market. So, the total money the realized from futures market and spot market is still 12,200,000 dollars or $122 per barrel.

Looking at the examples above, it is clear to see that whether there is an increase or a decrease in the price of crude oil, the oil producer can still sell the crude oil he promised at a locked price. This method entirely hedges the price risk and is one of the reasons why oil futures play an important role in risk management.

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Conclusion

As in any scenario, traders want to buy at a low price and sell at a high price. Futures contracts not only serve as a financial mechanism in managing risk to hedge oil prices, but can also serve as a way to make a profit from fluctuating oil prices. Futures contract is considered a kind of standard contract when compared to oil forward contracts and are only traded on exchange, as it has standardized features such as, the quality of the oil being traded, delivery months, and delivery locations etc. There are three types of traders in oil futures, hedgers, speculators and arbitrageurs. The main advantages of using futures contracts are run due to their liquidity feature and ease of entry and exit. There are two kinds of hedging strategies, short hedge and long hedge. The decision to use a short hedge or a long hedge depends on the traders position on the spot market. Ultimately, when a company decided to engage in a futures contract, it is attempting to eliminate its risk, which is the most important factor for risk management. Despite the emergence of alternative forms of energy, oil remains a crucial and essential commodity and will be so for a long time to come.

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References
Alquist, Ron and Lutz Kilian. 2010. What Do We Learn from the Price of Crude Oil Futures? Journal of Applied Econometrics 25(4), 539-573. Energy Pulse, 2004. The Marginal Price of Oil. [online] Available at: http://www.energypulse.net/centers/article/article_print.cfm?a_id=886 [Accessed 6 November 2011]
Infinity Trading, 2010. Crude Oil Futures and Options. [online] Available at: http://www.infinitytrading.com/futures/energy-futures/crude-oil-futures [Accessed 6 November 2011]

John Hull, Options, Futures, and Other Derivatives, Prentice Hall, 2005. Litzenberger, Robert and Nir Rabinowitz. 1995. Backwardation in Oil Futures Markets: Theory and Empirical Evidence. Journal of Finance 50(5), 15171545. Manmohan S. Kumar, The Forecasting Accuracy of Crude Oil Futures Prices, International Monetary Fund, Vol. 39, No. 2. (Jun., 1992), pp. 432-461 Neely, Christopher J. 2009. Forecasting Foreign Exchange Volatility: Why is Implied Volatility Biased and Inefficient? And Does It Matter? Journal of International Financial Markets, Institutions and Money 19(1), 188-205. Trading Oil, 2008. Oil Commodity Futures Trading or Investing. [online] Available at: < http://www.tradingoil.net/Oil-Commodity-Futures-Trading-Or-Investing.html> [Accessed 5 November 2011] Trading System Lab, 2006. Crude Oil Trading Hedge Strategy. [online] Available at: < http://www.tradingsystemlab.com/files/CRUDE%20OIL%20Hedge.pdf> [Accessed 10 November 2011]

Tu, X., 2008. The Study Of Risk About International Oil Future Market. International Journal of Business and Management.

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Appendix 1

Example of Crude oil futures contract:

NYMEX Crude Oil Futures Contract Specifications

Crude Oil Futures
Product Symbol Venue CL CME Globex, CME ClearPort, Open Outcry (New York) Sunday - Friday 6:00 p.m. - 5:15 p.m. New York time/ET (5:00 p.m. - 4:15 p.m. Chicago Time/CT) with a 45-minute break each day beginning at 5:15 p.m. (4:15 p.m. CT) Sunday Friday 6:00 p.m. 5:15 p.m. (5:00 p.m. 4:15 p.m. Chicago Time/CT) with a 45-minute break each day beginning at 5:15 p.m. (4:15 p.m. CT)

CME Globex Hours (All Times are New York Time/ET)

CME ClearPort

Open Outcry Contract Unit Price Quotation Minimum Fluctuation 1,000 barrels

Monday Friday 9:00 AM to 2:30 PM (8:00 AM to 1:30 PM CT)

U.S. Dollars and Cents per barrel

$0.01per barrel

Termination of Trading

Trading in the current delivery month shall cease on the third business day prior to the twenty-fifth calendar day of the month preceding the delivery month. If the twenty-fifth calendar day of the month is a non-business day, trading shall cease on the third business day prior to the last business day preceding the twenty-fifth calendar day. In the event that the official Exchange holiday schedule changes subsequent to the listing of a Crude Oil futures, the originally listed expiration date shall remain in effect. In the event that the originally listed expiration day is declared a holiday, expiration will move to the business day immediately prior. Crude oil futures are listed nine years forward using the following listing schedule: consecutive months are listed for the current year and the next five years; in addition, the June and December contract months are listed beyond the sixth year. Additional months will be added on an annual basis after the December contract expires, so that an additional June and December contract would be added nine years forward, and the consecutive months in the sixth calendar year will be filled in. Additionally, trading can be executed at an average differential to the previous

Listed Contracts

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day's settlement prices for periods of two to 30 consecutive months in a single transaction. These calendar strips are executed during open outcry trading hours. Settlement Type Physical Trading at settlement is available for spot (except on the last trading day), 2nd, 3rd and 7th months and subject to the existing TAS rules. Trading in all TAS products will cease daily at 2:30 PM Eastern Time. The TAS products will trade off of a "Base Price" of 0 to create a differential (plus or minus 10 ticks) versus settlement in the underlying product on a 1 to 1 basis. A trade done at the Base Price of 0 will correspond to a "traditional" TAS trade which will clear exactly at the final settlement price of the day. (A) Delivery shall be made F.O.B. at any pipeline or storage facility in Cushing, Oklahoma with pipeline access to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing storage. Delivery shall be made in accordance with all applicable Federal executive orders and all applicable Federal, State and local laws and regulations. For the purposes of this Rule, the term F.O.B. shall mean a delivery in which the seller: provides light "sweet" crude oil to the point of connection between seller's incoming and buyer's outgoing pipeline or storage facility which is free of all liens, encumbrances, unpaid taxes, fees and other charges; in the event of the buyer's election to take delivery by interfacility transfer ("pumpover") to either TEPPCO, Cushing or Equilon Pipeline Company LLC, Cushing, from seller's delivery facility, bears the lesser of the pumpover charge applicable for pumpover from seller's delivery facility to TEPPCO or Equilon Pipeline Company LLC; retains title to and bears the risk of loss for the product to the point of connection between the buyer's outgoing and the seller's incoming pipeline or storage facility. Delivery (B) At buyer's option, such delivery shall be made by any of the following methods: By interfacility transfer ("pumpover") into a designated pipeline or storage facility with access to seller's incoming pipeline or storage facility. By in-tank transfer of title to the buyer without physical movement of product; if the facility used by the seller allows such transfer, or by in-line transfer or book-out if the seller agrees to such transfer. (C) All deliveries made in accordance with these rules shall be final and there shall be no appeal. (C) Transfer of title-The seller shall give the buyer pipeline ticket, any other quantitative certificates and all appropriate documents upon receipt of payment. The seller shall provide preliminary confirmation of title transfer at the time of delivery by telex or other appropriate form of documentation. Grade and Quality Please see rulebook chapter 200

Trading at Settlement (TAS)

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Specifications Position Limits Rulebook Chapter NYMEX Position Limits

200

Exchange Rule

These contracts are listed with, and subject to, the rules and regulations of NYMEX.

Source: http://www.infinitytrading.com/futures/energy-futures/crude-oil-futures

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Appendix 2

Source : Spread using historical data from Bloomberg

Brent Crude Oil figures using Bloomberg

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