In Lesson 7, we focused on “futures” markets and how simple hedges can be accomplished using exchange-traded contracts. Those provide the "building blocks" for the more advanced hedging tools. Here, we will address the “over-the-counter,” non-exchange traded markets, or “forward” contracts. Keep in mind that NYMEX Exchange contracts are referred to as “futures.” We will also cover financial “spreads” whereby traders take advantage of price differences based on location, time, or inter-commodity relationships. Finally, we will deal with financial options, which are a simpler and less costly form of hedging vs. the financial derivative contracts themselves.
At the successful completion of this lesson, students should be able to:
This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.
If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.
Seng - Chapter 7, 8, and 9
Errera & Brown - Chapters 4 & 6
This text is available to registered students [1]via the Penn State Library. [2]
Swaps represent exchanges of payments between two parties. They are financially settled, and no physical commodity is delivered or received by either party. They represent a substitute for the futures contracts but rely on NYMEX pricing to establish the financial arrangement for the swap contract. Similar to a NYMEX contract, the elements of a swap contract include the commodity, location, date, and price.
We use the phrase “fixed-for-floating” swap to signify the prices agreed to by both parties in the contract. The “fixed” price is always the current market price. It is the price known at the time the deal is struck. The exchange of payments will occur when the NYMEX settlement price is known. We refer to this settlement price as the “floating” one, since it is not known until the contract’s last trading day and “floats” with each day’s trading until then. The difference between the two represents the amount of payment due to one party or the other.
For example, as of this writing, the December 2019 NYMEX crude oil contract is trading $62.69. If I bought a swap, I would be setting my contract price at $62.69. On November 20th, 2019, this contract will settle, and the difference between my $62.69 and the NYMEX Final Settlement price that day, will be the amount exchanged between me and my counterparty. If the contract settles at $63.19, since I bought the swap, I would be selling it back at that price for a profit of $0.50 per contract and, my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $62.19, I would be selling the contracts back at a loss of ($0.50) and I would pay my counterparty $0.50 per contract, or $500. The calculations are the same as those shown in Lesson 7's hedging spreadsheet.
As we learned in previous lessons, Futures contracts are standard contracts. However, swaps can be customized. This is another advantage of swaps that make them popular. The advantage of using swaps for hedging is that you can achieve the same price protection without actually having to buy or sell NYMEX contracts. And you can work with brokers either by phone ("Voice" Brokers) or through an electronic trading platform such as "The Intercontinental Exchange (ICE)".
In a previous lesson and in the textbook, we discussed the fact that physical entities wishing to hedge must take a position in the financial market which is the opposite of their physical position. For instance, a crude oil producer is "long" the commodity. Therefore, in order to execute a proper hedge, they must go "short" in the financial derivative they choose. In Lesson 7, I presented how the physical and financial prices interact in a hedge. The same applies to swaps as to the NYMEX contracts themselves.
The following mini-lecture is a summary of the points presented above (3:37 minutes).
“Spread” trading can be used for hedging purposes or purely for trading (“arbitrage”). Spread trading involves taking a long position in one futures contract and simultaneously taking a short position in another, related futures contract. Thus, spread consists of two equal and opposite futures positions. In spread trading, futures or forwards can be used to achieve the desired results. A buy/sell is offset by a corresponding sell/buy. Spread trading involves using price differences in futures or forwards based upon inter-market (time differences, locational differences) and inter-market commodity relationships.
Examples of the types of spreads are:
In addition to traders who are merely interested in price movement to make money, commercial entities can use spreads to hedge their price risk. For example, as mentioned above, a crude oil refiner can buy crude contracts (hedge price of feedstock) and sell heating oil and unleaded gasoline contracts (refined output) to establish a profit margin or “crack” spread. This hedge is illustrated in the spreadsheet, "EBF-301 Lesson 10 refinery hedge.xls" found in Canvas Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options Module.
The following mini-lecture summarizes the points presented above (6:10 minutes).
If one wishes to enter into a contract for underground storage capacity, this transaction can be hedged as well using the time spread.
Example of Time Spread:
Let’s look at an example. The April 2020 NYMEX natural gas contract is trading $2.65 at the time of this writing. We can buy these contracts and that will represent the supply that we would inject into storage in April 2020. Now, we need a market for when we wish to withdraw these same volumes. January 2021 is trading at $3.98, so we would sell the January 2019 futures contracts in the same amount as we bought in April 2020. This creates a “spread” of $0.33. After the respective monthly storage fees are taken-out, we are left with the “net” spread on our storage transaction. This is also known as a “time spread” since it involves a purchase and sale of the same commodity in differing months.
These simple, “fixed-price” hedges are the basic building blocks for more complex financial derivative hedges.
Car insurance is a good example of an option, specifically, a "call" option. A premium is paid and the insured has the right to “call” their insurance agent in the event of an accident. The “price” they will have to pay for the damages is limited to the amount of the deductible (“strike price”). The term is usually one year, and if no claim is made, the “option” expires worthless (i.e. – no payout is made by the insurance company since no claim was made). The insured’s maximum exposure is the deductible, thereby establishing a “ceiling price.” And, the premium is calculated using complicated mathematical models (actuarial tables, statistics & probabilities).
Energy options are very similar in nature. As with most financial derivatives, they can be used for hedging price risk or for outright trading. One key difference is that options represent the buyer’s right, but not the obligation, to buy or sell futures/forwards contracts. The options contracts themselves are not futures or forwards contracts but rather a right to buy or sell those contracts. They are traded on the exchange as well as over the counter. And, the buyer is under no obligation to purchase or sell the underlying commodity contracts if the pricing makes no sense.
Here are some common terms in option contracts:
Call [3]: An option contract that gives the holder the right to buy the underlying security (futures) at a specified price for a certain fixed period of time.
Put [4]: An option contract that gives the holder the right to sell the underlying security (futures) at a specified price for a certain fixed period of time.
Holder [5]: The purchaser of an option.
Premium [4]: The price of an option contract, determined in the competitive marketplace, which the buyer of the option pays to the option writer for the rights conveyed by the option contract.
Strike Price [6]: The stated price which the underlying security (futures) may be purchased (in the case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract.
Expiration date [7]: The day on which an option contract becomes void.
Intrinsic value [8]: The value of an option if it were to expire immediately with the underlying commodity at its current price; the amount by which an option is in-the-money. For call options, this is the difference between the underlying commodity price and the striking price, if that difference is a positive number, or zero otherwise. For put options, it is the difference between the striking price and the underlying commodity price, if that difference is positive, and zero otherwise.
In-the-money [8]: A term describing any option that has intrinsic value. A call option is in-the-money if the underlying security (commodity) is higher than the striking price of the call. A put option is in-the-money if the security (commodity) is below the striking price.
Out-of-the-money [9]: A call option is out-of-the-money if the strike price is greater than the market price of the underlying security (commodity). A put option is out-of-the-money if the strike price is less than the market price of the underlying security (commodity).
Time Value [10]: The portion of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. Time value is whatever value the option has in addition to its intrinsic value.
While watching the following mini-lecture (16:13 minutes), keep in mind the following key points regarding energy risk hedging using options contracts:
Now watch the following two videos for more details. (9:20 and 6:50 minutes)
The components of an options contract are:
Option types are:
The buyer of an option’s exposure is merely the cost of the option, i.e., the premium. They will never pay more than that. On the other hand, the seller, or “writer,” of an option bears all the risk and is exposed to any price movement above the strike price of the call option, and below the price of the put option.
One of the main advantages is that, since only a premium is paid up front, the buyer of the options can control a large amount of contracts for a small price. For example, with a call option, they are not buying the underlying contracts outright, but are buying the right to purchase them at a set price (“strike price”) if necessary. The buyer could have the right to buy 100 contracts and only have to pay the premium for the option and not pay the total cost of 100 contracts.
So, who would use options contracts for hedging? Let’s take a crude oil refiner as an example. The company is concerned about rising crude oil prices. But rather than go out and buy hundreds of futures contracts and lock-in the price now, they decide to purchase a call option at a strike price that limits their exposure to rising prices. In doing so, they establish a maximum, or “ceiling,” price. So, for December 2018, they buy a crude oil call option at a strike price of $70.00 since the current price is $65.00. If December prices remain below $65.00, the refiner does nothing and is out only the premium. However, should December prices exceed $70.00, the refiner calls the option seller and requests the number of crude oil contracts agreed upon at the $70.00 strike price (or, they could ask for payment of the price difference in the market). In this scenario, the refiner will never pay more than $70.00 for their crude supply. And, they capture all the downside of prices should the market fall.
On the flip side, let’s consider the crude oil producer who is worried about falling prices, so they enter into a put option to establish a “floor” price. For December, they choose a $60.00 strike price, thus establishing the lowest price at which they will have to sell their crude oil. Should prices fall below that level, they will contact the options seller and request their right to sell the underlying financial contracts at $60.00. Should prices remain above $60.00, the producer would do nothing and be out only the price of the option (premium). In this way, the producer can reap all the benefits of higher prices, regardless of how high they go.
If not exercised, options expire worthless, and, options are time-sensitive. The closer to the expiration date, the less value the option has (less risk exposure with less time remaining).
There are numerous mathematical models that are used to determine options premium values. The most well-known is the Black-Sholes model. It is an extensive algorithm that only needs a few inputs to calculate an option’s value.
A spreadsheet with the Black-Sholes model and sample inputs can be found in the Canvas Modules under Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options.
In the next section, we will discuss the need for risk controls in energy commodity trading. Given your understanding of the complexities of financial derivatives, you should now realize how important a system of "checks-and-balances" is for any energy trading company. However, if the controls put in place are not followed, catastrophic losses can occur......Enron.
You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.
Links
[1] http://ebookcentral.proquest.com/lib/pensu/detail.action?docID=3385319
[2] https://ebookcentral.proquest.com/lib/pensu/detail.action?docID=3385319
[3] https://www.cboe.com/optionsinstitute/glossary/#glossary-c
[4] https://www.cboe.com/optionsinstitute/glossary/#glossary-p
[5] https://www.cboe.com/optionsinstitute/glossary/#glossary-h
[6] https://www.cboe.com/optionsinstitute/glossary/#glossary-s
[7] https://www.cboe.com/optionsinstitute/glossary/#glossary-e
[8] https://www.cboe.com/optionsinstitute/glossary/#glossary-i
[9] https://www.cboe.com/optionsinstitute/glossary/#glossary-o
[10] https://www.cboe.com/learncenter/glossary_s-z.aspx#t