Commodity Risk Management

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Commodity Risk Management
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Physical Contracts

• Volume Types
• Firm - seller or buyer has legal recourse if
  volume not
• delivered or taken
• Interruptible or Swing - seller nor buyer
  obligated
• Key Terms of Contract
• buyer
• seller
• price
• quantity
• receipt/delivery point/title transfer point
• time
• terms and conditions

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• Energy components of floating prices or fixed
  prices
• Index Reference Point such as NYMEX Henry Hub
  for Natural Gas
• WTI (West Texas Intermediate-Cushing)
• or Brent for Crude Oil
• plus
• Basis or Location Differential from Index Pricing
  Point
• Any or all components can be fixed or floating.

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Financial Market Terminology

• Derivative
• A Trading Instrument Value is determined from
  one or more physical commodities and/or financial
  securities underlying the derivative.
• Underlying Commodity or Security
• The physical commodity or financial security
  from which a derivative obtains its value.

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• Leverage
• The effect of magnifying the outcome of an
  investment through use of borrowed funds.
• Example Price at Purchase 100
• Price at Sale Year Later 120
• Equity Gain 20
• Unlevered Gain 20
• If borrowed 50 at 10 Interest
• Gain 120 - 100 - 5 15
• Original Equity Investment 50
• Equity Gain 30

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• Hedging
• In general, the term hedging is used when
  describing entering a transaction with the intent
  of offsetting risk from another related
  transaction.
• Examples
• insurance for fire, business interruption
• In commodities and securities markets, a hedge
  is a transaction entered into for the purpose of
  protecting the value of a commodity or security
  from adverse price movement by entering an
  offsetting position in a related commodity or
  security.

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• Futures Contracts
• Standardized Each contract represents the same
  quantity and quality of the underlying physical
  commodity, valued in the same pricing format to
  be delivered and received at the same delivery
  location.
• The date of delivery and receipt is the same for
  all contracts traded.
• Futures contract is a tradable document which
  entitles the buyer of the contract to claim
  physical delivery of the commodity from the
  seller at the contract delivery point at a
  specified date in the future, and entitles the
  seller to deliver the physical commodity to the
  buyer under the same conditions.

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• Value
• Because a futures contract is a tradable, (can
  be bought and sold in the open market), its value
  changes as the supply and demand for the futures
  contract changes. The price of a futures
  contract is derived from the price of the
  underlying commodity which it represents and thus
  is a derivative.

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• Exchange
• No cost swap of physical commodity from one
  physical location to another location without
  actually moving the commodity.
• Futures Liability
• Unlimited upside or downside.

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Financial Swaps
Fixed Price
Buyer
Seller
Floating Price

• Buyer trades fixed receives floating.
• Seller trades floating receives fixed.
• At the time of the trade, the two positions are
  considered to be of equal value.
• Used frequently for currencies, commodities and
  interest rates.

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• Futures Swaps
• Performs almost the same function as a futures
  contract with the exception that, after
  expiration of the futures contract, there is a
  financial settlement for futures swaps (exchange
  of payment), as opposed to a physical settlement
  (making or taking delivery if an open position is
  held through expiration) in the case of actual
  futures contracts.

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Options

• American Option
• Tradable contract between two parties giving the
  buyer of the option the right, but not the
  obligation, to purchase or sell a given commodity
  or security at a specified price at any time up
  to and including the expiration of the option
  contract.
• European Option
• Identical to American except may only be
  exercised at expiration of contract.

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• Option Contracts Two Types
• Calls (American)
• Grants the buyer of the option the right, but
  not the obligation, to buy the underlying
  commodity or security from the seller of the call
  option at a specified price (called the strike
  price) at any time up to and including the
  expiration of the option.
• The seller of a call option is obligated to sell
  the underlying commodity or security to the buyer
  of the call option, at the strike price, at any
  time, up to and including the expiration date.

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• Put Option (American)
• Grants the buyer of the option the right, but
  not the obligation, to sell the underlying
  commodity or security to the seller of the put
  option at the strike price at any time up to and
  including the expiration of the option.
• The seller of the put option is obligated to buy
  the underlying commodity or security from the
  buyer of the put option, at the strike price, at
  any time, up to and including the expiration date.

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Buying a Call
Profit
Strike Price
Cost ofCall
Price of Underlying Commodity or Security
Buyer of Call Option Profits if Prices Rise
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Selling a Put
Profit
PutPremiumReceived
Strike Price
Price of Underlying Commodity or Security
Seller of Put Option Loses if Prices Fall
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• Costless Collars
• The simultaneous selling of a call option at an
  above market strike price and the buying of a put
  option at a below market strike price such that
  the premium received on the sale of the call
  option equals the price paid for the put option.
• Has the effect of locking in a range of prices
  with a floor and ceiling in which you are
  guaranteed to receive for your commodity or
  security at expiration.

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• Option Risk and Liability
• The buyers risk is limited to what it paid for
  the option (option premium), but the sellers
  liability is theoretically unlimited for the
  duration of the options life.

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• Exercising an Option
• Process where the buyer of an option (either a
  put or a call) elects to execute its given right
  to either buy (call) or sell (put) the underlying
  commodity or security from or to the option
  seller at the strike price.

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• Option Valuation
• The price of an option is called its premium.
• Option Premium is paid by the buyer to seller at
  time option contract is written.
• Option Premium Two Components
• Intrinsic Value Positive difference, if any,
  between the strike price of the option, and the
  price of the underlying commodity or security for
  which option is based on.
• Time Value Remaining Value other than intrinsic.

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• An option which has intrinsic value is called an
  in the money option.
• An option which has no intrinsic value is called
  an out of the money option.

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• Black Scholes Valuation
• Used to Value Options Quantified probability
  that the strike price of the option will be in
  the money at expiration.
• Four Main Valuation Parameters
• 1. relationship between the strike price of
• the option and the current price
• 2. time remaining until option contract expires
• 3. level of interest rates and dividend (if any)
• 4. estimated volatility of the underlying
• commodity or security

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• Volatility
• Price change movement measured as a percentage
  of stock price based upon the standard deviation
  of historical prices.
• If a commodity or security is extremely
  volatile, the probability is higher that an
  option with an out of the money strike price will
  expire with intrinsic value (in the money).