In the previous lesson, we learned that NYMEX energy contracts represent the actual right to buy or sell energy commodities. So, for the commercial market participants, these provide both a market for production and a source of supply. For instance, producers of natural gas, crude oil, or refined products such as heating oil and gasoline, can sell financial contracts, thus guaranteeing that they will have a firm market in the future at a fixed price. Conversely, consumers of these same products can buy contracts to ensure that they will have a firm supply source in the future at a set price. Utilizing financial contracts to reduce price and/or commodity risk is known as "hedging." In this lesson, we will discover the ways in which commercial players in energy use the financial markets for hedging their risks.
At the successful completion of this lesson, students should be able to:
This lesson will take us one week to complete. There are a number of required activities in this module. The chart below provides an overview of the activities for Lesson 9. For assignment details, refer to the location noted.
All assignments will be due Sunday, 11:59 p.m. Eastern Time.
REQUIREMENT | LOCATION | SUBMITTING YOUR WORK |
---|---|---|
Reading Assignment: Chapter 5 Errera & Brown | Errera & Brown | No submission |
Hedge Examples | Steps in a Financial Energy Hedge page | No submission |
Lesson Activity: On-going Trading Simulation & Financial/Physical Price comparisons | Lesson Activity page | Submitted through OTIS; Post blog |
Lesson 9 Quiz: Hedge Problems | Summary and Final tasks page | Submitted through ANGEL |
If you have any questions, please post them to our Questions? discussion forum (not e-mail), located under the Communicate tab in ANGEL. 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.
Reading Assignment:
Read Chapter 5 - Errera & Brown
Key Points of Emphasis for Reading Assignment
In Lesson 7, we defined an energy futures contract and the function of the NYMEX. We also identified the two (2) main participants in financial energy markets as “commercial” and “non-commercial” players.
Commercial entities have an interest in the commodity itself due to the particular business they are in. For example, an oil refinery not only needs actual crude oil but also has a stake in the future price of oil. This is the basic feedstock for all of the refined products they produce, and therefore, their profitability is impacted by the purchase price of crude.
In addition, refiners sell products such as gasoline, heating oil, and diesel fuel, all of which are traded in the financial markets. So, the refiner’s profit, or “spread,” is dependent on the feedstock price for crude and the market price for what it produces.
On the other hand, exploration and production companies need to know the future market price for the crude oil they will extract from their wells.
The same holds true for natural gas. In some cases, natural gas is a component of manufacturing costs in such industries as fertilizers and food processing. In the power industry, the price of natural gas impacts the cost of generating electricity. And for midstream processors, natural gas is the main component for the extraction of valuable natural gas liquids (NGLs).
E&P companies that produce natural gas can also see the future market prices for their production.
Keeping in mind that futures contracts are legally binding obligations to buy or sell a commodity, they guarantee a market for producers and a source of supply for consumers. They also guarantee a set or “fixed” price, thereby reducing price risk as well.
When commercial parties enter the financial energy marketplace to reduce their supply and/or price risk, it is known as “hedging.” This is much the same as one who bets on the “favorite” in a horserace but “hedges” that bet by also placing bets on another possible winner. They hope to mitigate their losses should the favored horse not win.
In order to hedge supply and price risk correctly, physical players must take a financial position which is opposite to their physical position. For instance, a producer has a commodity and needs a market. (They are said to be “long” the commodity.) In the futures market, they will sell contracts and thus create a future market for their natural gas, crude, etc. This guarantees that a counterparty will take their production and will do so at a known, fixed price.
Consumers of energy do not have the commodity. (They are said to be “short.”) Therefore, they must buy contracts in the futures markets. For them, this guarantees that a counterparty will provide the commodity and will do so at a known, fixed price.
In Lesson 7, we also said that less than 2% of all futures contracts actually go to delivery, that is, the physical commodity does not usually change hands as a result of the financial transactions. (Think about the non-commercial players. They neither have, nor want, the actual physical commodities. They are just trading price.) So, how does this “hedging” work?
Futures prices, for any commodity, are deemed to represent the “market” as it is known at the moment. (We also addressed, in Lesson 7, the idea of the “price discovery” that futures markets provide.) So for instance, at the time of this writing, December 2012 crude oil on the NYMEX is trading $87.00 per barrel. As far as anyone is concerned, that is the December price until it changes. A producer is considered to have sold “at market” at the time they enter into futures contracts. But we know that prices will change between the time this deal was transacted and the time the commodity changes hands. This fluctuation will impact the perception of the actual cash price until the delivery month arrives and the “real” price is established through physical, cash, trading (as reflected in the cash price "postings" we spoke about in Lesson 6).
Let's look at some simple examples of hedges for Producers and Consumers of natural gas.
Exxon-Mobil, the largest producer of natural gas in the US, wishes to sell some of its production for January, 2013 at the current market levels since those prices help them meet earnings targets. To hedge the price risk that can occur between now and January, they will sell the financial NYMEX contracts. Thus, they are guaranteed a market at Henry Hub at a fixed price when the January production month comes around. And, they can do this for any months up to the 144 months that the Natural Gas contract trades.
My company, Superior Pipeline Company, is a natural gas midstream company engaged in the gathering and processing of natural gas. Our profit depends on the "spread" between the price of natural gas that is our feedstock and the natural gas liquids (NGLs) that we produce. Let's say we are concerned about rising natural gas prices this winter. We can buy January, 2013 contracts and thus, be guaranteed supply at Henry Hub at a fixed price when the January production month comes around.
In each of the above cases, the counterparty to the contracts will be responsible for delvering or taking the natural gas at the Henry Hub. Per the NYMEX contracts, this is legally binding. That is what guarantees both the supply & market as well as the price.
Now, let’s take this line of thinking one step further and examine the steps in an actual financial energy hedge.
A crude oil Producer wishes to hedge its December, 2012 price. The current futures market price is $87.00 based on NYMEX trading. The Producer decides to sell December, 2012 crude oil contracts (the opposite of the physical position). Their price is now set at $87.00 for the sale of December, 2012 West Texas Intermediate Crude Oil at the Cushing, OK Hub.
However, at the end of November, all December future contracts must be financially settled according to the rules of the Exchange. So, the Producer must now buy back the contracts in order to balance their financial position.
So, what happens to the price that the Producer will receive when they actually sell their crude oil in the December cash market? Since the futures pricing represents the “market,” the December prices rose and fell as the contracts traded.
Based on the concept of "convergence" (Errera), the Final Settlement price for the December, 2012 crude oil contract on the NYMEX would represent the cash market price for that month.
That means that both the value of the futures contracts that the Producer sold, as well as the cash price (market), fluctuated throughout the life of the December, 2012 contract trading. When the Producer had to buy-back the futures contracts on Final Settlement day, if the contract price had risen, they took a loss on their financial transaction. But what happened in the cash market? Since futures rose, so did cash, thus providing a gain in the physical market for the Producer.
Conversely, if futures prices had fallen by Final Settlement, the Producer would’ve paid less for buying the contracts back and made a profit on the financial transaction. However, since the futures market declined, so did the cash market, thus lowering the actual price the Producer received when the December crude oil production was sold in the physical market.
In both of these scenarios, the gain or loss in the financial market is offset by a corresponding and opposite gain or loss in the physical, cash market. We refer to this as a “perfect” hedge where there is a 1:1 correlation between the financial and physical markets.
This spreadsheet illustrates how this is calculated in a rising and falling financial market.
(Spreadsheet can be found in the Resources Folder in ANGEL. "EBF-301 Lesson 9 simple hedge.xls")
This process can be performed many times over by Producer and Consumer as desired. Thus, suppliers and end-users can establish a fixed-price and insure themselves a market or supply for energy commodities that are financially traded. And theoretically, they can do so for as many future months as the particular contact allows (this is dependent on the number of market participants willing to trade that far out).
Keep in mind that, for the purposes of this lesson, the energy commodities are being physically delivered at their respective contract points. We will address how to figure pricing for locations other than the financial “hubs” in a later lesson.
If one wishes to enter into a contract for underground storage capacity, this transaction can be hedged as well.
Let’s look at an example. The April 2013 NYMEX natural gas contract is trading $3.75 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. Now, we need a market for when we wish to withdraw these same volumes. January, 2014 is trading at $4.35, so we would sell the January, 2014 futures contracts in the same amount as we bought in April, 2013. This creates a “spread” of $0.60. After the respective monthly storage fees and fuel 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.
(Spreadsheet can be found in the Resources Folder in ANGEL. "EBF-301 Lesson 9 simple hedge.xls")
These simple, “fixed-price” hedges are the basic building block for more complex financial derivative hedges.
In Lesson 6, you looked-up some cash prices at various hubs in the US using the link for Natural Gas Intelligence,
"http://intelligencepress.com/features/intcx/gas/ [1]". Using those same cash hubs, compare the most recent prices to the NYMEX Settlement price for natural gas for December, 2012. Use the CME website to find the most recent Settlement price.
Calculate the difference as follows: Cash price minus NYMEX. Post your answers on the course blog. These results represent what is known as the "actual Basis" relationship between the NYMEX Henry Hub contract and other physical delivery points in the US.
In Lesson 10, we will explore other, more advanced, financial derivatives that can also be used for hedging. Among these are Swaps, Spreads and Options. They are mostly traded in the "over-the-counter" markets, that is, non-exchange traded. "OTC" encompasses electronic trading platforms as well as "voice" Brokers where transactions occur over the phone.
You have reached the end of Lesson 9. 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. (To access the next lesson, use the link in the "Course Outline" menu at left.