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Commodity Derivatives & Risk

Management
Dr. Prabina Rajib
Professor
Vinod Gupta School of Management
IIT Kharagpur, 721302
prabina@vgsom.iitkgp.ernet.in

1 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Crude Oil
A century ago, petroleum - what we call
oil – was just an obscure commodity;
today it is almost as vital to human
existence as water -- James Buchan

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Crude Oil and Refined Products
 Crude oil means rock oil
 Complex mixture of hydrocarbons of various molecular
compositions, plus other organic compounds and trace metals like
Nitrogen, Oxygen & Sulpher.

Refined Products Volumes from 1 Barrel of Crude Oil ( 42 gallons/ 159


liters)
LPG Petrol Diesel Kerosene Fuel Oil Heating Other
or Oil residue like
Jet Fuel Paraffin Wax
& Asphalt
2 19 10 4 2 1 gallon 7 gallons
gallons gallons gallons gallons gallons
1 Barrel = 42 gallons; 1 gallon = 3.785 Liters. Processing Gain: 3 gallons
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Crude Oil Refining Process
http://wikiminiforchem.blogspot.in/2014/10/what-are-side-products-of-petroleum.html

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Major Crude oil Refiners of the world
http://www.wikiwand.com/en/List_of_oil_refineries

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List of Refineries in India

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Crude Oil Refining
 Nelson complexity index
 Measures the capability of a refinery to alter the product-mix in response
market demand as well as change in the type and quality of crude oil input
(heavy/light, sour/sweet crude).
 Higher the nelson complexity index, higher is the capability of a refiner to
achieve desired product mix.
 A refinery's level of complexity is often based on how much secondary
conversion capacity it has. The Nelson Complexity Index is one measure
of refinery complexity. This index was developed in the 1960s by W.L.
Nelson in a series of articles for the Oil & Gas Journal. The index
measures the complexity and cost of each major type of refinery
equipment.
 Index for Indian refineries during 2015
 IOC Paradip Refinery: 12.2
 Essar Oil's Vadinar refinery: 11.8
 RIL’s Jamnagar refining complex : 11.3
 BPCL's Bina refinery: 9.1

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Crude Oil Variants
 International Crude Oil Market Handbook, 2010 of Energy
Intelligence Group, there are 160 odd varieties of crude oil in
terms of their origin of production and quality grade.
 Only 3-4 are known as oil markers or marker crudes
 North America West Texas Intermediate (WTI),
 North Sea Brent Crude,
 OPEC Reference Basket
 UAE Dubai Crude.
 Quality of crude oil is measured by API(American Petroleum
Institute) gravity
 API gravity measures the relative density of crude oil against
water.
 Higher API, better is quality of crude oil.
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Crude Oil Variants
 Crude oil variants based on API
 Light ( API > 31.1o)
 Medium (22.3o < API< 31.1o )
 Heavy (< 22.3o)
 Crude oil variants is also based on Sulpher content
 Sweet <0.5 % Sulpher
 Medium Sour> 0.5% to <1%
 Sour > 1% Sulpher
 Light Sweet Crude is the best crude oil
 Requires lesser refining cost.
 Commands a price premium
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Sweet/ Medium Sour/Sour, Light /Medium/Heavy
https://www.eni.com/docs/it_IT/eni-com/azienda/fuel-cafe/WOGR-2017.pdf

10 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Crude Oil Markers
API Gravity and Sulpher % of Crude Oil Markers

API Gravity Sulpher %


WTI Crude 39.6° 0.24%
North Sea Brent Crude 38.3° 0.37 %
OPEC Reference Basket 32.7o 1.77%
UAE Dubai Crude 31° 2%

The main criteria for a marker crude is for it to be sold in


sufficient volumes to provide liquidity (many buyers and
sellers) in the physical market. Other crude oil is priced
at a premium or discount to these markers depending on
APII gravity and Sulpher %.
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Crude Spot Price
 WTI Spot price: Price of barrel of crude (in USD) for delivery at Cushing, Oklahama,
USA.
 http://www.cnbc.com/2015/03/05/cushing-oklahoma-small-town-is-holding-
illions-in-black-gold.html
 Brent Crude:
 Brent crude is a blend of crude oil from 15 different oil fields located
in the North Sea.
 Spot price for Brent crude is the price for delivery at Sullom Voe oil
terminal near Scotland

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Cushing Oklahoma pipeline terminal map. Source: International Energy Agency

 adsas

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Crude Spot Price
 OPEC Reference Basket
 Organization for Petroleum Exporting Countries (OPEC) reference basket price is the
average of spot prices of crude oil produced by OPEC member countries.
 OPEC reported the price for this reference basket for the first time on
1st January 1987.
 Till 15th June 2005, OPEC’s reference basket used the arithmetic
average of prices of crude oil produced at 7 different countries.
 From 16th June 2005 onwards, represents weighted average of crude
oil prices of 11 different types of crude oils produces by different
countries. The weights are based on production and export volumes.
The new basket incorporates lower quality of crude oil.

 The list of seven : Algeria's Saharan Blend (Algeria), Minas (Indonesia),


Bonny Light (Nigeria), Arab Light (Saudi Arabia), Fateh (Dubai), Tia
Juana Light, (Venezuela) and Isthmus (Mexico).
 https://www.statista.com/statistics/262858/change-in-opec-crude-oil-
prices-since-1960/
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Crude Spot Price
 Dubai Crude Light
 Dubai crude oil is a light sour crude oil extracted from Dubai
region. Dubai crude oil price is used as a benchmark for crude
oil produced at Persian Gulf region. It is the most popular oil
price benchmark in Asia.

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Crude Oil Variants
 Other Crude Oil Benchmark
 Argus Sour Crude IndexTM
 Argus Media
 Volume weighted average price index of medium sour crude
oil trading at US Gulf of Mexico.
 Saudi Arab’s national oil company Saudi Aramco started using
ASCITM prices to price all its crude oil exports to USA from
July 2010 onwards. Prior to July 2010, Saudi Aramco was using
WTI crude oil price as the reference price.
 Japan Crude Cocktail Index
 Petroleum Association of Japan
 It is the monthly average import price of customs cleared
crude oil imported to Japan
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Crude Oil Variants
 International Crude Oil Price for Indian Basket
 Ministry of Petroleum and Natural Gas in India.
 Petroleum Planning & Analysis Cell (PPAC)
 This index considers UAE Dubai Crude price
(sour) and Brent prices (sweet): 65.2 to 34.8
 India imports crude oil mostly from Gulf countries,
Mediterranean countries and West Africa. Sour crude
oil is primarily imported from Gulf countries and
Sweet crude oil is imported from Africa.
 India produces 18% of its crude oil requirement and
imports 82%.
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Crude oil spot price
 Crude oil spot price
 Bloomberg reports: “Brent represents the
Northwest Europe sweet market, but since it's
used as the benchmarks for all West African and
Mediterranean crude, and now for some
Southeast Asia crudes, it's directly linked to a
larger market."

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Swing Producer, Shale oil
 A swing producer that influences prices by raising or
lowering output to balance the market – OPEC is
not playing this role any more.
 Shale oil & gas
 Shale oil is extracted from reserves, held in shales
and other rock formations from which it does not
naturally flow freely. It is also known as “tight
oil”. Shale oil has become more accessible due to
advances in the techniques of horizontal drilling and
hydraulic fracturing or "fracking“.
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Shale Oil
 Shale oil is a substitute for conventional crude oil and the
USA has abundant Shale oil. Extracting shale oil from oil
shale is costly than the production of conventional crude oil.
USA investment boom in shale oil and shale gas extraction
caused a boom in supplies during 2012.

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Shale Oil & Guar Gum
 Shale vs crude: Why oil prices are on a free
fall even as Opec members suffer
 Guar Gum is used in fracking process
 It is used as thickening agent to push fluids
sideways in the hydraulic fracturing or “fracking”
process
 In 2011, guar gum export was the India’s largest
agricultural export to the United States at $915
million, USDA report
 https://www.reuters.com/article/us-india-shale-guar/shale-energy-triggers-
bean-rush-in-india-idUSBRE84R07820120528
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Indian Crude Oil and Refined Product Market
 Upstream as well as downstream(Refining and Retailing) activities
are controlled by Government of India (GoI).
 Upstream
 Exploration and production (E&P) sector
 ONGC Ltd. and (GAIL), RIL and Cairn India etc. are also involved
in upstream activities.
 Downstream
 IOCL, HPCL,BPCL,NRL, MRPL,BRPL and RIL and Essar
Oil Ltd.
 BPCL, HPCL, and IOCL are also major
distributors/marketers (Oil Marketing Companies)

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Understanding Petrol Pricing in India
https://factly.in/understanding-petrol-pricing-in-india/

23 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Factors influencing crude oil prices
• Crude oil prices have strong correlation with geopolitical activities
http://www.eia.gov/finance/markets/spot_prices.cfm
• Crude oil prices are influenced by supply and demand conditions.
 Growth in population & economic activities important driver of
demand
 Financialization of crude oil with oil futures, options contracts
 Lots of geo
 UNCTAD November 2015 report mentions “. with the volumes
of exchange-traded derivatives on commodity markets now being
20 to 30 times larger than physical production, the influence of
financial markets has systematically transformed these real markets
into financial markets”

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Factors influencing crude oil prices
 Crude oil price and US dollar index have negative relationship.
 US Dollar index measures the value of US Dollar relative to some major
currencies. Base year for the index is 1973 with base value of 100.
When US Dollar strengthens against other currencies, the index
increases. Higher index is associated with lower crude price.

 Available inventory
 Lots of information is available at
http://www.opec.org/opec_web/en/76.htm
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Crude Oil Contracts
 CME (Chicago Mercantile Exchanges)
 Both futures, regular options and Asian Options and many
other variants trade at CME.
 Futures contract specification at CME
 Futures Contract Specification at MCX
 https://www.mcxindia.com/market-data/market-watch
CME and MCX
 Hedging energy commodity price risk by Indian companies.
 The State of Airline Fuel Hedging and Risk Management in
2013- Mercatus Energy Advisors

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Crude oil inventory & spot price
 WTI price and Cushing inventory. Lower crude price is
associated with high inventory.

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WTI and storage cost
 Storage cost and contango trade -- buy physical crude oil
today; pay storage cost and sell the futures contract for 6
or 12 months at a higher price; and then wait. When your
futures contract is due, deliver the oil.
 In a contango market,
 Theoretical futures price ( spot oil cost associated with
storage, cost of pumping in and out, cost of fund etc.) <
Actual futures price < then it is beneficial for traders to
buy futures on crude oil.
 LOOP(Louisiana Offshore Oil Port) Crude Oil Storage
Futures Contract Specs
 Loop fact card
 https://www.loopllc.com/Services/Cavern-Storage

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Seasonality in spot/futures contact
 Why Gasoline (Petrol) is more expensive in summer than winter
months?
 Gasoline sold during summer months are different than winter
months in USA ( summer grade gasoline is different than winter
grade).
 The switch started in 1995 as part of the Reformulated Gasoline
Program (RFG), established as part of 1990 Clean Air Act
Amendments. The Environmental Protection Agency (EPA) started
the RFG program in order to reduce pollution and smog during
the summer ozone season, which occurs from June 1 to Sept. 15. n
order to reduce pollution, summer-blend fuels use different
oxygenates, or fuel additives
Dr. Prabina Rajib, VGSOM, IIT Kharagpur
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Crude Oil Risk Management
Hedging Instruments used by
Crude Oil Production & Refining Companies
Haushalter 1992-1994 Survey Mercatus Energy Advisor
Group 2009 Survey

Swaps 50.8% Swaps 63%


Fixed price forward 40.4% Collar 62%
contracts
Futures 37% Fixed price forward contracts 22%
Options 10.5% Futures 15%
Volumetric production 9.8% Volumetric production 11%
payments payments

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Purchase of Crude oil

 IOC Purchases crude oil through spot tender

31 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Fixed Price Contracts
 Long-term contracts
 Bilateral contracts for the delivery of a series of oil shipments over
a specified period of time, (1 or 2 years).
 Agree on the volumes of crude oil / refined product to be
delivered, the delivery schedule, the actions in case of default and
method of calculating the price of an oil shipment.
 Price agreements are based on method of formula pricing based on
market (spot) price. ( based on marker crudes & refined product
benchmark prices)
 Agreement on premium/discount to spot price to accommodate
quality differential.

32 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Swaps
 In a swap contract, two parties exchange a series of cash flow based
on a notional quantity of crude oil/ refined product
 One party pays fixed and another party pays floating ( based rate
marker crudes/ refined product benchmark)
 Buyer of the swap pays fixed rate.
 The notional quantity is used to calculate the swap payoff only and not
exchanged between the counterparties.
 Refiner (interested to buy crude oil and anticipating price increase)
will buy a swap ( agree to pay fixed)
 A crude oil producer ( interested to sell crude oil and anticipating
decline in price) will sell a swap ( agree to receive fixed).

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Swaps
 A refiner enter into swap contract on crude oil price with a
counterparty. Duration of the contract is for 3 years.
Notional volume of crude oil is 10,000 barrel of oil for every
2 months. On every second month during the contract
period, the refiner will pay fixed price of USD 89 per barrel.
 The counterparty will pay the Brent crude oil spot price
prevailing on the last calendar day of the month.
 The refiner is paying fixed and receiving floating rate.
 Irrespective of crude oil price , the refiner will pay USD 89
per barrel.
 The refiner can enter into swap for receiving fixed rate for
its refined product and pay floating rate.
 According Mercatus Energy Advisors report on fuel
hedging by Airlines, majority of companies surveyed ( 37%)
use swaps.
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Swap Contracts

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Extendable Swap
 Both parties agree to extend the tenure of swap based on certain
conditions.
Business Snapshot 5.1
 Alston Energy Inc. of Canada and Extendable Swap
 Alston Energy Inc. of Canada, in January 2013, entered into an OTC
contract as an extendable swap agreement with a counterparty. Under the
agreement, Alston (seller of swap) and the counterparty agree to swap
100 barrels of crude oil per day at a fixed amount of USD 98.5 per day
against a floating price based on simple average of daily settlement
price per barrel of WTI Light Sweet crude oil for the same period.
Swap agreement period spans from February 1 2013 to December 31,
2013. The contract is extendable at the option of the buyer of the
swap (the counterparty to Alston) for one more year ending
December 31, 2014 for 150 barrels per day at the same fixed price.
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Participating Swap

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Continuous Oil Backwardation Swap

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Futures and Options
 Exchange trading on crude oil and refined
product contracts are the most liquid
contracts.

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Collars
 Crude oil producers /refiner producing refined products b(long
on assets)
 Long put position at a strike price (K1)
 short call position at a higher strike price (K2).
 Buyers of crude oil/ consumers of refined oil take ( short on
assets)
 Short put position at a strike price (k1)
 long call position at a higher strike price (K2).

Sasol Limited of South Africa entered into zero cost collars for 30%
of its last quarter production of crude oil of 456 million barrels for
the year 2011. Sasol took long put option at USD 85 per barrel. The
exercise price for short call option was USD 127.77.
40 Dr. Prabina Rajib, VGSOM, IIT Kharagpur
Exercise (Collar)
 An airline company takes a short put option on ATF
at a strike price of USD 4.1 (K1) per gallon and a
long call position at USD 4.6 (K2) on notional
volume of 20,000 gallon for every month. The short
put premium is equal to the long call premium. Find
out the payoff and also plot a graph for this collar
strategy for spot price ranging from USD 3.6 to
USD 5.0.

41 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Volumetric production payment (VPP)
 Variation of Swap Contract
 In this contract, the seller of the VPP
contract (fixed price receiver) is the crude
oil producer. The seller receives the present
value of fixed payment on day 0. In return,
the crude oil producer delivers the physical
asset to the buyer over some specific time
period.
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Chesapeake Energy Corp (CEC). of USA’s VPP Deal with
Barclays Capital

 Barclays Capital and CEC signed a deal in May 2011. The deal
was for 10 year, USD 850 million VPP
 Over the 10 year period, CEC agreed to deliver 180
bcfe(billion cubic feet equivalent) of natural gas at USD 4.82
pe mcfe to Barclays.
 Barclays became the fixed rate payer and floating rate receiver.
Basically Barclays can sell the natural gas in the spot market
and realize the floating price.
 Instead of keeping the VPP deal in its balance sheet (by paying
USD 850mn upfront to Chesapeake), Barclays Capital split its
future cash flow into two separate pools/trusts.
 These two are known as Glenn Pool Oil and Gas Trusts I and II.
 Moody’s VPP rating details
43 Dr. Prabina Rajib, VGSOM, IIT Kharagpur
Crack Spread Futures Contracts
 Standalone oil marketing companies are exposed to crude oil and
refined product price risk. These entities take long futures on
crude oil and short futures on refined products to protect their
margins.
 Crack spread measure the price difference between the refined
product and crude oil http://www.cmegroup.com/tools-
information/calc_crack.html
 Crack spread contracts can be (1:1), (2:1:1), (3:2:1), or (5:3:2)
Table 5.8: Types of Crack Spread Futures Contracts
Contract Type Description
1:1 1 crude oil contracts, 1 gasoline ( or any other refined
product) contract
2:1:1 2 crude oil contracts, 1 heating oil and 1 diesel contract
3:2:1 3 crude oil contract, 2 heating oil and 1 diesel contract
5:3:2 5 crude oil contract: 2 heating oil contract and 2 diesel
44 contract.
Crack Spread ( Exercise)

 The petrol spot price is USD 2.30 per gallon


and heating oil spot price is USD 2.14 per
gallon and crude oil spot price is USD 82.5
per barrel. Find out the 3:2:1 crack spread
margin when the refiner is producing gasoline
and heating oil in the ratio of 2:1.

45 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Crack Spread
Table 5.9: Crack Spread Futures Contracts
Long position in refined product futures
Long spread
Short position in crude oil futures
Short position in refined product futures
Short spread
Long position in crude oil futures

46 Dr. Prabina Rajib, VGSOM, IIT Kharagpur


Key Questions
 On what basis crude oil is categorized as light/medium/heavy ,
sweet/sour ?
 How the spot price of different variety of crude oil is arrived ?
 What is nelson complexity index?
 What is the role of OPEC in crude oil price?
 What factors predominantly influence the crude oil price?
 How exchange traded contracts as well as OTC contracts have
been used to mitigate price risk ?
 How crack spreads can be used by integrated oil companies to
mitigate price risk?

47 Dr. Prabina Rajib, VGSOM, IIT Kharagpur

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