Before you begin this course, make sure you have completed the Course Orientation
(see the Orientation [1] menu).
As the saying goes, “the only constant is change.” This statement can be used to describe the energy industry over the past few decades. “Booms” and “Busts” have occurred numerous times as prices rose and then fell back again. Companies have come and gone. Enron shook the very foundation of energy trading. Investigations of supply and price manipulation have occurred, resulting in fines and imprisonment. The new exploration("3-D & 4-D"seismic), drilling (directional & horizontal), and completion techniques (so called “fracking”) have not only led to a substantial increase in the production of crude oil and natural gas, but have also led to great controversy and new regulation over the methods themselves. The abundance of natural gas is leading to the exportation of liquefied natural gas (LNG), making the US a major player in that global market.
The “how” and “why” these occurred will be presented throughout the course, and you will come to understand the ever-changing landscape that is the energy industry in the United States.
This course will be focused largely on the five fossil fuels that are traded both physically and financially in energy markets. These are natural gas, crude oil, unleaded gasoline, heating oil, and natural gas liquids (NGLs). These fuels, along with coal, comprise the “non-renewable” energy sources. They are so named since their supply is seen as finite over the long-term.
Each of these products has a profound affect on the United States and global economies. Billions and billions of dollars of infrastructure and hundreds of thousands of jobs are involved in the exploration, production, transportation and distribution of these forms of energy. And, price volatility for these commodities has increased dramatically over the past several years going back to the historic run to $147 per barrel (Bbl) for oil in 2008. Since that time, crude oil has been recognized as a truly global commodity with a host of new factors influencing price. And, once again, in 2014, prices fell from $100 in June to less than $50 by December, caused largely by Saudi Arabia flooding the market with cheap crude. It was said they feared a loss of market share to the new shale oil in the US.
However, before we proceed into the details of these fossil fuels, we need to understand how these fit into the overall profile of energy production and consumption in the United States. In order to do this, we must also include the various other forms of energy produced and consumed in the United States known as “alternative” and “renewable” energy. This is the only lesson regarding alternative and renewables.
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 1. 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 |
---|---|---|
Mini-lecture: Alternate and Renewables | Course website - Mini-Lecture: Alternate and Renewables page | No submission |
Lesson 1 Activity | Course website - Lesson 1 Activity page | Canvas discussion forum |
Discussion forum participation | Canvas | Canvas discussion forum |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
“Non-renewable” energy sources, as well as “renewable” energy and “alternative fuels” help to satisfy the nation’s energy needs. Coal, a non-renewable fossil fuel, plays a large role in the generation of electricity as well as in industrial processes such as the manufacturing of steel. Nuclear, hydro, solar, wind, biomass, and geothermal are all considered “renewable” forms of energy and comprise varying levels of supply in this country. They are classified as renewables since their source is seen as being virtually unlimited. Of these, solar, wind, biomass, biodiesel, and geothermal are all considered “alternative” energy sources since they are not the “traditional” kind (fossil fuels, nuclear and, hydro).
Figure 1 below shows the break-out of fuel sources used in the generation of electricity. As you can see, the single largest fuel is coal, although this is changing as historically low natural gas prices are causing some “fuel switching.” This is followed by natural gas, nuclear, hydro, and “other.” This final category is comprised of energy sources such as fuel oil (a crude distillate), wind, solar, biomass, and geothermal. Note the very small percentage currently represented by all of these combined. It will literally take decades for alternative fuels to make a substantial contribution to the energy portfolio in the United States. Thus, there is a need to continue to use fossil fuels and nuclear power to “bridge” the gap. How the former are delivered to market and how they are priced is the main focus of this course.
The following chart illustrates the various types of energy in the US and the corresponding consumption types. Again, note that the current contribution of renewable energy sources is very small.
Now that we have clarified the difference between renewable and non-renewable sources of energy, let’s have a look at the production and consumption of energy in the United States on a macro level.
The United States is the world’s largest consumer of energy in general and of oil and refined products in particular. However, our current, and forecasted, energy production and consumption balance is improving towards a position of declining imports and more efficient use of all energy sources. The vast new supplies of oil and natural gas coming from domestic shale are radically altering our outlook for eventual self-sustainability. And, the continuing development of “renewable” and “alternate” energy sources will decrease our reliance on traditional “fossil” fuels. We will now take a look at the current state of energy production and consumption in the US followed by a brief examination of the renewable and alternative energy sources.
Figure 2 illustrates the history of actual energy consumption in the United States from 1775 to 2012. Note the forecasted decline in the use of both petroleum and coal, while natural gas and nuclear consumption are expected to increase. The increase in natural gas consumption has much to do with the following: the current historically low prices resulting from the huge amount of new shale gas being produced, and new tighter emissions standards being imposed on coal-fired power plants. The rise in nuclear-generated electricity is a result of the increased number of permits issued for new plants for the first time in decades.
Figure 3 indicates current and projected United States energy consumption overall by source. Notice the increase in renewables and liquid bio-fuels. These alternative energy sources will continue to grow as long as economically feasible, and especially if government subsidies are available to support their production (e.g. – ethanol). However, realize that the EIA (Energy Information Administration) is projecting only a modest increase of 4% by 2035. There is a general misconception that this category, which includes wind and solar power, will eventually contribute a substantial portion of our energy needs. Clearly, such is not the case.
Nuclear production is shown as being stable, however, we know that new plants are being permitted, and with the negligible emissions they produce, look for an increase in power output from this source.
As far as natural gas goes, an increase is indicated. The residential use of heating oil and propane is steadily declining as conversions to natural gas steadily continue. (50% of US homes use natural gas for space heating and hot water.) Add to that the retirement of coal plants, or the outright switching from coal to natural gas, and growth in the consumption of natural gas will naturally occur.
The future consumption of oil and “other liquids” will be interesting to observe as well. With automobile efficiency improving and electric cars gaining in popularity, this segment should decline. Also, there are decades-old power plants, mostly in the Northeastern US, that use fuel oil. These, too, will become obsolete or convert to natural gas. (The Northeast US is also the world’s largest consumer of heating oil.)
There should also be a more dramatic decline in the use of coal than is shown above as emissions restrictions and lower natural gas prices make coal less economic to use.
The fuels we will study in-depth, natural gas and “oil and other liquids,” comprise 57% of the projected total US energy consumption profile, thus making it crucial to understand the logistics and “value chain” of these fuel sources.
In Figure 4, we see the energy sources matched-up with their respective categories of consumption. Both petroleum and natural gas are used in each sector of consumption, while coal is utilized in only industrial, residential (this would have to be a very small amount), and power generation. Nuclear energy is strictly used for electric power generation, and renewables can be consumed in all categories but contribute very little to each on a percentage basis.
The sources and uses of energy are important for the overall understanding of the impact of supply, demand and pricing on the macro-economic environment. Everything depends on energy, and understanding these interrelationships can help us manage our supply needs and price exposure.
So, what are the “renewables and alternate” sources of energy? As previously mentioned, “renewable” energy sources are those which can be replenished over and over again, such as nuclear, solar, hydro, wind, biomass, biofuels, and geothermal. “Alternate” energy sources are those which are not the traditional fossil fuels or nuclear power. These include the renewables hydro, wind, solar, biomass, biofuels, and geothermal.
As stated previously, renewable and alternate energy sources will take a long time to make a significant dent in the US’ reliance on fossil fuels. In the interim, the fuels we will study, primarily natural gas and crude oil, will continue to be produced and consumed in substantial quantities. Natural gas, as the cleanest burning of the fossil fuels, represents the “bridge” fuel until renewable and alternate energy can be produced in sufficient quantities to wean us of our dependence on fossil fuels.
The following "mini-Lecture" will cover Alternate and Renewable energy sources in more detail. Mini-Lectures such as this will be provided in most Lessons and will supplement the textual lesson or, be the lesson itself. The slides can be found in the Modules under Lesson 1: The Energy Industry - Overall Perspective in Canvas.
For our first lesson activity, you're going to do something simple but important: introduce yourself and get to know some of your classmates while researching a topic in the course. Getting to know each other now will help us collaborate and benefit from each other.
Now is the time where we will use L1 Activity forum to submit a Learning Activity.
Post your introduction in the Lesson 1 Activity.
Your entry should consist of two paragraphs.
First paragraph
In the first paragraph try to answer the following questions.
Despite the reference to alternative & renewables energy sources in the course description, we will spend very little time discussing them. This course focuses on oil, natural gas, gasoline, heating oil and natural gas liquids (NGLs). The reason for this is that these energy commodities are heavily traded in financial futures markets. Understanding how these financial markets work is the primary goal of this course.
Second paragraph
There is considerable debate as to the economic viability and benefits of developing and using “alternative” fuels. Conduct some cursory research on alternative fuels (all of them) to evaluate the “pros and cons” of each of those presented in Lesson 1. Specifically, your post should address each of the following, with citations to the research that you did.
After Part I has been completed, posts from all students will be available. Read through entries by about 10 other students to get some understanding for who else is in the class. Pick two of these students to respond to with comments on their entries. Pick students whose entries do not already have a comment on them. If all of the entries already have comments, then pick students whose entries only have one comment on them. Also, pick students whose entries are interesting to you for any reason.
Post a comment on the two entries you have chosen. Briefly introduce yourself. Then respond to their entries in some way. You might also explain why their entries caught your interest, or say something else that comes to your mind. What you say does not need to be sophisticated in any way. The only requirement is for you to be polite and respectful.
Length: Use your own discretion, as long as you address all of the prompts in the assignment above.
Value: 20 points, as per the EBF 301 grading scale on the course syllabus.
This assignment should be completed by posting an original entry in the Canvas discussion forum no later than Sunday, at 11:59 p.m., Eastern Time Zone. Your entry should begin with your name. Don't forget to read other students' entries and comment in order to receive full credit! If you are having difficulties accessing the Canvas discussion forum, please contact your instructor immediately for technical support.
Energy consumption in the United States takes many forms. The traditional “fossil fuels,” such as coal, oil, natural gas, gasoline and other refined products and, natural gas liquids, do not have a limitless supply.
Renewables, however, such as, hydro, wind, solar, biomass, biodiesel and geothermal, are self-replenishing.
Alternative fuels comprise the group outside of the “traditional” energy nuclear and fossil fuel sources. They represent the smallest amount of energy consumed in the US and are not expected to expand greatly over the next (20-25) years. And, for many alternative fuels, government subsidies are essential for them to be produced economically.
In the interim, fossil fuels such as natural gas and crude oil will continue to grow in usage and importance. Their supply, demand, and pricing, will have a great impact on the US economy for decades to come.
Now that we have examined production and consumption in the United States as well as the energy “mix,” we will focus on the fuel sources that comprise over 57% of the energy used in this country. Crude oil, with refined products, and natural gas and related natural gas liquids (NGLs), make-up this large sector. The factors that influence their supply and demand are varied and ever-changing. Besides the obvious impact of weather, the economy, US dollar and the global geo-political conditions can all influence energy commodities and affect their prices.
You have reached the end of Lesson 1. 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 "Lessons" menu.)
In mid-2008, crude oil shocked energy markets as it reached an all-time High of $147/barrel (Bbl.) on the New York Mercantile Exchange. (See Figure 1 below.) Within four months, prices had sunk to $50 per barrel. Then, again in 2014, prices hit a High of about $100/Bbl in June only to fall to under $50/Bbl by December. How could this happen and what were the factors causing this level of price volatility? We will be exploring these questions in Lesson 2.
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 2. 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: Oil & Gas Basics Video Viewing Assignment: Understanding the Drilling Process Reading Assignment: Fracturing Operations |
Lesson 2 Reading Assignment page | No submission |
Lesson 2 Activity: "Fundamental" Factors exercise | Lesson 2 Activity page | Submit through Canvas |
Lesson 2 Quiz | Summary and Final tasks page | Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Before we begin our discussion of the logistics and value chain for natural gas and crude oil, we need to have at least a cursory understanding of the “upstream” processes for the exploration, drilling, fracturing, and production of these fossil fuels. The following readings and video support this learning.
Oil and Gas Basics
Go to the PetroStrategies web site [3], click on the section marked "Oil and Gas Basics" and read the following sections:
Understanding the Drilling Process
The focus of this course involves the sectors of the oil and gas industry known as “midstream” and “downstream.” These occur after the exploration and production, or “upstream” processes. In these videos, you will view this aspect of the energy industry and see how the drilling, completion and production of an oil and/or gas well is accomplished from start to finish. This will give you a cursory understanding of how oil and gas is developed. The midstream and downstream activities start once the oil and gas has risen to the top of the well and is ready to be produced.
Fracturing Operations
Go to the PetroStrategies web site [4], click on the section marked "Fracturing Operations" and read the following sections:
Economists have long recognized that we are truly a global society and all of our economies were intrinsically tied-together. Growth or recession in one region of the world could have a ripple effect on other regions. China and India were emerging as large-scale industrial countries with vast exports of manufactured goods. Both were consuming new, higher levels of energy, and most specifically, crude oil. News of increasing crude imports by both countries sparked buying of the financial commodity contracts.
The so-called “speculators” were blamed for a lot of the price increase that year, but there was a whole new set of players who greatly influenced the market. Investment funds and private investors, both domestic and international, saw the crude market as a “safe harbor” from the ups-and-downs of the stock market and the US dollar. When the stock market fell, they bought crude oil contracts. And when it rose, they sold those same contracts. The dollar is a little more complicated. When the value of the US dollar falls relative to foreign currency, overseas investors have more “buying power,” that is, they can buy more crude with their currency than those holding US dollars. So to some extent, it is true that “traders” had a major influence on oil prices that year. But the definition of “trader” had changed from the stereotypical “day trader,” who wreaks havoc on markets, to sophisticated investors and real demand from emerging nations.
Today, the economic health of various countries still impacts the volatility in oil prices, and the US dollar and crude prices have a very high but inverse correlation. Concerns over the stability of Portugal, Ireland, Spain, and Greece (not so politely known as the “PIGS”) impact the perception of world demand for oil on a daily basis as the collapse of even one of them could create a “domino effect” across other economies. Various economic reports on growth, manufacturing, etc. are monitored continuously.
And, geopolitical conflicts involving oil-producing countries and regions always cause concern over potential supply disruptions.
US oil production has risen steadily over the past (10) years and currently stands at about 9.0 million Bbl. per day. This represents a +13% increase from 2013 to 2014 alone and now stands at a 30 year high. Production for 2015 & 2016 is forecasted to remain slightly over 9.0 million Bbl/d. Current production represents only about 53% of consumption, with the remainder coming in the form of imports. However, as Figure 2 shows, imports continue to decline as domestic crude supplies increase.
The rise in domestic oil production is mostly attributed to the new, “unconventional”, sources found in shale formations. Advances in seismology (“3-D”), directional drilling (“horizontal”) and, fracturing methods (“fracking”), have made this once inaccessible resource common place today. Contrary to some beliefs, the number one source of imported crude oil in the US is not the Middle East but, Canada. Oil from tar sands in their Western Provinces is shipped via pipeline into the US.
Figure 1 shows the upward trend in oil production over the past (6) years with projections to 2016. (Based upon the latest completed study by the Energy Information Agency of the US Department of Energy.) Figure 2 shows the downward trend in oil imports for the same time period.
Many, many factors can influence the price of crude oil either directly or, indirectly. Some of the major factors influencing US crude oil prices are:
The following video goes into greater detail for the factors which can influence crude oil prices. (The lecture notes can be found in Modules under Lesson 2: Supply/Demand Fundamentals for Natural Gas & Crude Oil in Canvas.)
In contrast to crude oil, natural gas is almost strictly a domestic North American commodity* whose price is more influenced by weather and the health of the US economy. Other factors, such as the level of US natural gas inventory, impact prices on a weekly basis. While US economic indicators, such as the stock market, employment figures, housing and, manufacturing indexes, are deemed to be indicative of demand for natural gas, global economies and the US dollar do not have much affect on pricing in this country.
Natural gas is used in more than 50% of US homes for space heating and hot water. In addition, it is the second largest source of energy for electrical generation behind coal (Figure 1) and is widely used in commercial and industrial industries. Figure 2 illustrates the break-down by consuming sector.
The main sources of natural gas supply in the US are domestic production, imports and, Liquefied Natural Gas (LNG). Canada again represents the largest source of imported natural gas, with Mexico contributing a minor amount. Additionally, there are export points into Canada and Mexico. The map below indicates the major import/export and, LNG import points in the US.
Domestic production in the US has grown dramatically in recent years due to the same advanced technologies that have allowed crude oil production to increase: “3-D” seismology, horizontal drilling and new “fracking” methods. All contribute to successful recoveries from hard formations such as the new “shales.” Figure 7 illustrates the growth in production of the currently active shale basins in the US.
Among the major factors influencing US natural gas prices are:
The following video goes into greater detail for the factors which can influence natural gas prices.(The lecture notes can be found in the Modules under Lesson 2: Supply/Demand Fundamentals for Natural Gas & Crude Oil in Canvas.)
As we explore pricing for crude oil and natural gas in a later lesson, we will consider the major influential factors for each and define their individual impact. We will also have a weekly activity about the market prices for crude oil and natural gas and the factors we believe affect them.
*In a future lesson, we will discuss the plans for exporting natural gas in the form of LNG. That will make North American natural gas a global commodity similar to crude.
You may wish to print this page to circle each corresponding decision (bearish, bullish, neutral) as you work through the scenarios.
Read each of the factor examples and scenarios given below for crude oil and then for natural gas. For each scenario, determine whether it could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price. When you are finished with the scenarios, synthesize them in your own mind to generate a recommendation to buy or sell the commodity.
Keep in mind, these are actual energy commodity contracts and not "stocks". So, you are buying or selling the actual commodity using the financial contracts. These decisions are also about trading for a profit. That is, if you think prices are going to rise, you want to buy contracts now and sell them later when prices do rise to make a profit. Conversely, if you think prices are going to fall, you would sell contracts now and buy them back later when prices do fall to make a profit. Buying or selling a commodity contract now is called "taking a position" and then offsetting that with a sell or a buy at a later date is called "closing a position." In the Fundamental Factors activities that follow in the weeks ahead you will be asked to take and close a position in crude oil and natural gas each week. For this week, however, we will warm up by focusing on understanding the various factors influencing crude oil and natural gas prices.
Read through these factor examples to help you with the scenarios that follow.
Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.
Given all of these, would you Buy crude oil contracts (you think prices will rise, i.e., "Bullish") or Sell crude oil contracts (you think prices will fall, i.e., "Bearish")?
Read through these factor examples to help you with the scenarios that follow.
Determine whether each scenario could have a “bearish” (lower prices), “bullish” (raise prices), or neutral impact on the commodity price.
Given all of these, would you Buy natural gas contracts (you think prices will rise, i.e., "Bullish") or Sell natural gas contracts (you think prices will fall, i.e., "Bearish")?
Please answer the following two questions:
This Fundamental Factors activity will be worth 30 points, as per the EBF 301 grading scale described in the syllabus. You will earn two points for each of the crude oil and natural gas factors that you interpret, and 2 points for each buy/sell recommendation that you include and explain in your response. Each factor has to be explained individually, how it is going to affect the market and prices. You will also earn two points for each of the trading questions that you answer correctly and completely. Your trading suggestion should be based on the overall evaluation.
Submit a single word processed document with your responses to the Crude Oil/Natural Gas Scenarios and the Trading questions to the Lesson 2 Fundamental Factors Activity in Canvas.
Now that we have examined production and consumption in the United States as well as the energy “mix,” we will focus on the fuel sources that comprise over 57% of the energy used in this country. Crude oil, with refined products, and natural gas and related natural gas liquids (NGLs) make-up this large sector.
Complete the Lesson 2 Quiz
You have reached the end of Lesson 2. 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.
In 2008, the price of crude oil on the New York Mercantile Exchange (NYMEX) hit an all-time high of $147 per barrel. And, within (6) months, the price had fallen to about $35. Again, in 2014, oil was over $100/Bbl in June only to fall to below $50/Bbl by December. While many factors led to these "peaks and troughs, the nature of futures trading and the Exchange itself made this possible. The New York Mercantile Exchange has been around since the late 1800s here in the US, and it is still the most influential financial energy commodities exchange in the world. In this lesson, we will explore the history of the Exchange, how it functions, the participants, and the commodities traded.
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 3. 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 1&2 -Errera & Brown; Bloomberg article. | Errera & Brown, Canvas | No submission |
Mini-Lecture: NYMEX Contracts | Mini-Lecture: NYMEX Contracts page | No submission |
Mini-Lecture: Cushing-NYMEX Crude Oil Hub | Mini-Lecture: Cushing-NYMEX Crude Oil Hub page | No submission |
Lesson 3 NYMEX Prices Activity | Lesson Activity page | Submit through Canvas |
Lesson 3 Quizzes 1 & 2 | Summary and Final tasks page | Submit through Canvas |
Fundamental Factors (on-going) | Summary and Final tasks page | Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
The following lecture will take you through the history of the NYMEX, the type of trading that occurs ("pit" vs. electronic), the major players, the commodities traded, and futures contract specifications.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The lecture slides can be found in the Modules under Lesson 3: The New York Mercantile Exchange (NYMEX) & Energy Contracts in Canvas.
Financial energy commodity contracts are traded on the New York Mercantile Exchange. The picture at the left side of the slide here, the actual building with the reflection of the sun on it, is the New York Mercantile Exchange building on the Hudson River in New York City. To the right is an actual picture taken with the traders trading in the pits, as they yell and scream back and forth at one another, placing the orders.
The New York Mercantile Exchange started in the 1800s. There were scattered markets for the goods in large cities. You can picture a city like New York City and agricultural products being brought in and sold in various parts of it. So some entrepreneurial businessmen decided that they needed a central exchange. So in 1872, it was founded as the Butter and Cheese Exchange. In 1880, it was changed to the Butter, Cheese, and Egg Exchange. And then finally in 1882, it was changed to its present name of the New York Mercantile Exchange.
Later products would include yellow globe onions, apples, potatoes, plywood, and platinum. Platinum is the only product which is still traded today on the New York Mercantile Exchange. So today, it trades crude oil, heating oil, gasoline, propane, natural gas, platinum, and palladium.
Futures contract. The definition given by the New York Mercantile Exchange is a legally binding obligation for the holder of the contract to buy or sell a particular commodity at a specific price and location at a specific date in the future. The key word here is future. These are known as futures. We are buying and selling energy commodities at a future date and time. And again, this is a legally binding obligation. This is what makes exchanges a sound place to conduct business. If you fail to perform under a contract obligation with the New York Mercantile Exchange, there are both financial and legal ramifications.
The components of a standard NYMEX energy contract. First, we name the commodity-- crude oil, natural gas, heating oil, unleaded gasoline. The price, which is what most times we are most interested in. The location-- each of the energy commodities on NYMEX has a different delivery location. And then the date. What the future point in time do we wish to buy or sell the energy commodity?
The trades on the New York Mercantile Exchange between the counterparties are conducted under the International Swaps and Derivatives Association, or ISDA, 2002 Master Agreement. This is a standardized contract under which all financial energy commodity contracts are traded.
One of the primary functions of energy contracts on the New York Mercantile Exchange is that they provide us price discovery. We can establish a price for crude oil, natural gas, heating oil, and unleaded gasoline for any future point in time. Years back, prior to the advent of the New York Mercantile Exchange, no one could really tell what the price was at any point in time. Most trades were conducted over the telephone. But now, with the New York Mercantile Exchange, at any point in time, you can look up the live trading. The New York Mercantile Exchange is owned by the Chicago Mercantile Exchange, or the CME Group. If you go to cmegroup.com, you can see the commodity prices. There are some links to that on the home page of the course module here.
In addition, this allows us to perform what we call hedging. Hedging is to reduce risk in a transaction. In the case of the futures contracts, it helps us to reduce our price and/or physical risk. We may be concerned about high prices if we're a consumer of energy commodities. We may be concerned about low prices if we are a producer of energy commodities. We may also be concerned about receiving physical supply or having to guarantee physical market. The New York Mercantile Exchange contracts guarantee that.
Some of the common terms used by NYMEX. An ask-- an ask is a motion to sell at a specific price. It's the same as an offer. So ask and offer are interchangeable. It's your asking price. What do you wish to get in the marketplace for your commodity? And notice this is a motion, because they're addressing the idea of the physical trading that takes place in the pits, the movement of hand gestures back and forth as traders buy and sell. A bid, then, is the opposite. It's a motion to buy at a specific price. What is your bid for the energy commodity?
A bull-- in this case, we're talking about a person. It's one who anticipates prices will increase or volatility in the market will increase. They're the opposite of a bear. A bear is one who anticipates a decline in price or the volatility in the marketplace. Obviously, the opposite of a bull.
This is a picture of the New York Mercantile Exchange trading floor. It just so happens in the foreground is the natural gas trading pit. Off to the left, barely seen, is the crude oil trading pit. Notice the various colors of jackets around the floor. I will identify who some of those are in a minute. But the yellow jackets, for the most part, those are NYMEX compliance personnel. The multi-colored jackets, the blues, the burgundies, some of the other colors, represent brokers, what are known as clearing brokers on the floor of the New York Mercantile Exchange. They have posted credit, and they have licenses to trade on behalf of their clients.
So we have the floor brokers, which I mentioned. We have locals. These are the individuals and firms and in some cases funds that have a large amount of money and wish to trade. They are speculators. They're not interested in the physical commodities whatsoever. They're interested in price movement, and wherever price is moving, that's where they want to be.
Ring reporters and ring chairmen-- we'll drop back here a second, and I will show you. The ring reporters are in the yellow jackets near the trading rings themselves. There is a podium, if you can tell, situated above the natural gas pit with some personnel in yellow jackets. Those are the ring chairmen. Their primary responsibility is to oversee the activity of the pits and to resolve any disputes. Since we have people who are yelling orders back and forth to one another and using paper slips, sometimes mistakes can be made, and if there's a disagreement over the actual details of a trade, the ring chairman is supposed to step down and resolve that trade between the two counterparties.
We have floor committee members. Those are basically NYMEX committee members. The New York Mercantile Exchange also has compliance people. And the Commodity Futures Trading Commission is the regulatory body for energy financial derivative trading. They have their own personnel on the floor as well. And then there are hundreds of line staff from the New York Mercantile Exchange.
We'll now talk about each one of the specific contracts for energy commodities. The first is crude oil. Symbol is CL. We refer to this as West Texas Intermediate, or WTI crude. It is low sulfur, and so therefore is given the nickname sweet crude. The NYMEX contract for crude oil was initiated in 1983. Every contract represents 1,000 barrels, which is the equivalent of 42,000 gallons of oil. Price quotes on the New York Mercantile Exchange are all US dollars and cents, in this case per barrel. A minimum price fluctuation-- that is, the amount that the price has to move for a trade to take place-- is a penny, or $10 a barrel.
The delivery point for crude oil under this contract is what's known as FOB, or free on board, or delivered to the seller's facilities at Cushing, Oklahoma and to any pipeline or storage facility with access to Cushing Storage, TEPPCO, or Equilon pipelines. So if you buy or sell crude oil contracts on NYMEX for a particular month, you are obligated to either receive the crude oil or deliver the crude oil at Cushing, Oklahoma.
Deliveries are to be made uniformly across the month. This is the contractual obligation. The idea here is to make all parties deliver as equally as possible. The actual obligation-- for instance, if I sold 30 contracts for the month of September, that means 30,000 barrels of crude oil-- the Exchange would like me to deliver that at 1,000 barrels a day. However, if I cannot, my real legal obligation is 30,000 barrels for the month.
The trading hours on NYMEX for what we consider to be the open outcry or pit trading, the general session where the traders are in the pits yelling orders back to one another, run from 9:00 AM to 2:30 PM Eastern Standard Time. The Chicago Mercantile Exchange also has an electronic trading platform known as Globex, and this is virtually 24 hours a day, seven days a week. It starts at 6:00 PM on Sunday evenings and ends at 5:45 PM on Friday, Eastern Time.
Crude oil can be traded for up to nine years. And then we also have products that are known as strips. These are available for terms of 2 to 30 consecutive months. In essence, strips amount to an average price. If I wanted to buy six months worth of crude, rather than go out and have my broker quote me one month's price at a time, they'll just give me an average price across the six months. Therefore, I am purchasing a six month strip of crude oil.
The last trading day, every contract expires. Again, we are talking about future contracts. So currently, the closest future contract is September. The crude oil contract, then, settles three business days prior to the 25th of the month. So just in case the 25th is a non-trading day, either a weekend day or a holiday, the settlement occurs three business days prior to the business day that is prior to the business day ahead of the 25th. I know that sounds very confusing. I can't quite figure it out myself half the time.
Margin requirements. This is a big issue here. You can see that if you want to buy or sell crude oil contracts, for every single contract that you wish to enter into, you have to have $5,100 in a margin account. That's a safety net against losses that you could incur. This protects your clearing broker and protects the New York Mercantile Exchange from default by you as a counterparty.
This also discourages a lot of traders from just jumping in and trying to trade contracts. For example, if a trader wanted to speculate on 10 crude oil contracts-- that's only 10,000 barrels-- that's not a lot of volume, per se. They would have to put $51,000 in a margin account before they could even get started.
Here is the symbol breakdown. When you look at futures screens, or if you see the prices reported in the Wall Street Journal or any other type of publication, you'll see these funny symbols. The first two letters of the symbol represent the energy commodity themselves. So CL represents crude oil. The second letter is the actual month of delivery. For example, U equals September. The final symbol is the number that corresponds to the year. In our example, 2. So the September 2012 contract for crude oil on the NYMEX is expressed as CLU2.
Other symbols that represent energy commodities-- NG for natural gas, HO for heating oil. RBOB represents unleaded gasoline, and then PN for propane. And then here's the breakdown of the symbols for the months that they use. Feel free to use this as a cheat sheet if you ever run across those quotes and can't remember what they mean.
When you look at futures screens, you're going to see column headers that will use these types of terms. When you see the open, that's the opening price at the opening bell. When you see people on television ringing the bell for the open of whatever market it might be-- stock market, the NYMEX, the Chicago Mercantile Exchange-- as soon as the bell goes off, the very first trade that is consummated, that price is registered as the open for the day.
The high is the highest price that traded that day, including the after hours electronic trading. The low is the lowest price that traded for that day, including after hours electronic trading. That gives us the range on the day-- what was the entire range of pricing that day.
When you see last, that's the last trade that just occurred. In other words, what was the last trade that had occurred? The net would be the change in price from that last trade to the one prior to it. So are we going up or are we going down as we're trading currently? And then change-- the change is the change in price from the trade that just occurred, from that last trade, versus the prior day's settlement. What was the final price for the energy commodity the day before, and where do we sit relative to that today? That's what change represents.
We refer to futures contract trading as a zero sum game. For every buyer, there is a seller. I can't buy crude oil contracts without someone being willing to sell them to me, nor can I sell them without a market. And believe it or not, less than 2% of all the contracts traded actually go to physical delivery. In other words, less than 2% of the contracts will actually be energy commodities exchanged between counterparties. Now, on the one hand, that may sound like a small number, but with each crude oil contract representing 1,000 barrels, and you can trade between 50,000 and 100,000 contracts a day, it does amount to a substantial amount of physical energy commodities being exchanged.
This is what a typical futures screen would look like. These are the headers that I mentioned to you. On the day that I printed this off, you can see the last trade was $92.68 and, represented a drop of $0.19 from the prior day's settle of $92.87 in the far right corner there. We had the opening price of $93.25, and a high and low on the day as well. And the very far right column is the time at which the trade occurred.
Natural gas futures contracts. The contract unit is 10,000 MMBtus-- that is, 10,000 million British thermal units. Prices are quoted in US dollars and cents, and the minimum fluctuation between trades has to be 1/10 of a penny or what we refer to as a tick. Trading hours are exactly the same, but the trading months for natural gas-- you can actually trade natural gas out 12 years if there was in fact a need to buy or sell for that long of a period of time.
Last trading day for natural gas contracts, the futures, is the third business day prior to the first calendar day of the delivery month. We do trade options in energy futures contracts. In the case of natural gas, those expire one day prior to the actual contract itself.
The delivery point for buying and selling under NYMEX natural gas contracts is a place known as the Henry Hub in Erath, Louisiana. Texaco has their Henry plant in Erath, Louisiana. Sabine Pipeline Company runs the hub on behalf of the New York Mercantile Exchange. And again, the delivery period is to be uniform across the month of production for which the contracts were exchanged.
This is a schematic of the pipelines going in and out of the Henry Hub. There are various sources of natural gas coming offshore, onshore. There is gas moving to the Northeast, the Southeast, the Upper Midwest, as well as from Louisiana back into Texas. So it made an ideal market hub for indicating various supply and demand.
Settlement price. Every day, the New York Mercantile Exchange will put together a final price for that day's trading. The settlement price is the weighted average of all the trades that occur during the last two minutes of trading in that regular session. Now, when the closest future month, or what we call the prompt month, when that contract expires, they're going to take the total number of trades in the last 30 minutes to come up with a weighted average, and that will be the price for that month. And that month rolls off, as we say, and it's in the history books.
Margin requirements for natural gas are substantially less than crude oil, but the value is substantially less, so there's only $2,100 margin requirement per contract.
This is what a natural gas futures screen would look like. If you ever see one of these on a trading floor or somewhere else, perhaps on someone's screen who trades in these contracts, this is what it would look like.
We're now going to talk about unleaded gasoline, referred to as RBOB. RBOB stands for Reformulated Blend for Oxygenated Blending. What we get at the gas pump-- you usually have the opportunity to get 100% unleaded in very few places. Mostly, it's a 90/10-- that is, it's 90% gasoline, 10% ethanol or some other type of blending component. In some cases, you hear about E85, which is 85% unleaded, 15% of some other additive, normally something like ethanol.
So what's traded on the New York Mercantile Exchange is actually the 100% unleaded. It becomes a feed stock for unleaded, because it's only 90% of what we get at the pump unless we're buying 100% unleaded. So it's reformulated blend for oxygenated blending. They're going to blend oxygenators into the unleaded gasoline.
The oxygenators are seasonal in nature, depending on the regions. Again, oxygenators help to burn the gasoline more efficiently and therefore reduce the emissions. Oxygenators are things such as ethane, ethanol, butane, isobutane, and natural gasolines.
Every RBOB contract is 42,000 gallons. US dollars and cents, and the minimum fluctuation is 1/1000 of a penny per gallon. The delivery point is free onboard or delivered into the petroleum products terminals in New York Harbor. Margin requirements-- $8,100 per contract.
Last but not least, heating oil, or HO. It's sometimes referred to as number two fuel oil. Every contract is 42,000 gallons. We are still dealing with US dollars and cents per barrel. Minimum price fluctuation is 1/1000 of a penny per gallon. The delivery point is the same as for RBOB, and that is free onboard or delivered to the petroleum products terminals in New York Harbor. Everything else pretty much remains the same under the standardized NYMEX contracts.
The delivery point for the NYMEX Crude Oil contract is the Cushing Hub in Cushing, OK, USA. It is the world's largest crude oil storage facility and represents 16% of the US capacity. It has been in the news over the last few years as Transcanada seeks approval for its Keystone XL pipeline and, as the excess supply at Cushing looks for new outlets to the Gulf of Mexico refineries.
While watching the following mini-lecture, please keep in mind the following key points:
The lecture slides can be found in the Modules under Lesson 3: The New York Mercantile Exchange (NYMEX) & Energy Contracts in Canvas.
In the last lesson, we talked about Cushing as the New York Mercantile Exchange crude oil hub for the buying and selling of physical crude products under the New York Mercantile Exchange contracts. We're going to talk a little bit about this. But I want to spend some time on it only because it's made the news a few times in the past year. There are certainly some issues related to pricing of crude oil, which again impacts the price of unleaded gasoline throughout the United States, involving Cushing and a surplus of crude oil that happens to be there.
Here are some aerial pictures of Cushing itself. It is a pipeline and above ground crude oil storage hub in Oklahoma. It is a pipeline hub. Hub-- we use the term whenever we're really talking about intersection of multiple pipes where any type of crude, natural gas liquids, natural gas can be exchanged or moved from one pipe to another.
They also have, as the previous picture showed, it's a crude oil storage tank farm as well. It's the world's largest crude oil storage facility. The companies of TEPPCO, Equilon, and TransCanada have crude oil pipelines that run to and away from Cushing.
It has 46 million barrel storage capacity that represents 16% of the total US crude oil storage capacity. It's designed to receive Gulf Coast and Midwest crude, to store it, and then transport it to refineries in Oklahoma and throughout the upper Midwest. Some of the key companies that are participants and owners of facilities of Cushing are Enbridge, BP, SemGroup, ConocoPhillips, Sunoco, Plains All American, and TEPPCO.
Here in the last couple years, there have been historically high inventory levels. In fact, they're running out of storage capacity for crude. There's no incremental storage capacity at present. In part, this is due to the dramatic increase in domestic production of crude oil from the shale plays.
The most recent ones are the Bakken Shale in North Dakota and the Mississippian Lime play in central or northern Oklahoma. The Canadian imports continue to increase. The Keystone XL pipeline received some press earlier this year. But a lot of people do not know that TransCanada already has a pipeline in place known as the Keystone pipeline. So there are shipments of Canadian crude oil entering the United States coming to Cushing as we speak.
One of the biggest issues, though, is that we can't get the surplus crude oil to the Gulf Coast. So as a result, Gulf Coast refiners-- that's the largest petrochemical refining area in the United States-- are having to pay more for crude oil than the WTI price. They're having to import more.
And so it's a price that is above WTI. It's not quite the North Sea Brent crude pricing that occurs in Europe. But it's more than they should have to pay because we can't get this excess supply down to them.
A couple of solutions to this problem, this bottleneck or this glut of supply, is to reverse the Seaway pipeline. The Seaway pipeline has been in existence for several decades. It originally was a crude oil pipeline that brought crude that was offloaded from tankers near Houston in the Ship Channel and Beaumont-Port Arthur areas of eastern Texas, right there on the Gulf. And the pipeline shipped it up to Cushing from there. In the late '80s, early '90s, it was actually a natural gas pipeline, taking natural gas from the mid-continent down to the Houston Ship Channel petrochemical and refining corridor, and was later converted back to crude oil. And it currently would bring crude oil to Cushing.
However, the demand is actually in the Gulf of Mexico. So Enbridge and Enterprise bought this pipeline from ConocoPhillips. It's 500 miles, runs from Freeport, Texas, up to Cushing, Oklahoma. And they have already reversed the flow.
currently by, in essence, redirecting the pumps along the pipeline. They're able to push 150,000 barrels a day of crude oil from Cushing down towards the Gulf Coast refiners. They're working on a project to expand the pipeline. And hopefully by next year, they'll be able to ship 400,000 barrels a day southbound to the Gulf Coast refineries.
The Keystone XL project is the one that has received some press in this past year. It's TransCanada Pipeline Company's proposed two phase crude oil pipeline. The objective is to move tar sands, crude oil, from Canada's Alberta province all the way down to Texas.
Phase one would run from Alberta, Canada, to Cushing, Oklahoma, approximately 1,180 miles. Phase two would run from Cushing, Oklahoma, to Nederland, Texas, on the Gulf Coast. And that segment is about 435 miles.
This is a picture of the Seaway pipeline, as you can see running from Cushing all the way down to Freeport, Texas. And in fact, the flow on this has been reversed. And here's the Keystone XL project,
the yellowish dotted lines, and, the existing Keystone pipeline, is in orange. And so you can see that TransCanada plans phase one to hook up with a portion of the existing Keystone pipeline. But phase two would run from Cushing on down to both the Houston Ship Channel and Port Arthur, Texas.
Some of the project issues, as I've already mentioned, Seaway pipeline. It's already reversed their pump stations. And it's flowing southward again already as we speak.
Keystone XL, phase one, requires a presidential permit for the international border crossing. Back in February, this was delayed by the US State Department because the pipeline route was going to go through a sensitive environmental area known as Sandhills in Nebraska. The TransCanada Keystone project's parent is investigating alternate routes, and in fact I believe has refiled for the permit to get the international border crossing.
Phase two, the section from Cushing, Oklahoma, down to Texas, is going to proceed. TransCanada has already received most of the regulatory approvals that they need. As a crude oil pipeline, they can only receive common carrier status. They are not a utility. And so they will have to negotiate with landowners the entire way.
There is a new project that ONEOK, out of Tulsa, Oklahoma, has announced. They're going to build a crude oil pipeline, which will run from the Bakken Shale area in North Dakota all the way to Cushing. It's estimated to be somewhere between $1.5 to $1.8 billion and 1,300 miles of pipeline. And they hope to have it in service in approximately three years' time.
The NYMEX is actually owned by the Chicago Mercantile Exchange (CME Group). Links to their energy commodity prices (Henry Hub Natural Gas Futures and Light Sweet Crude Oil (WTI)) can be found in the course "Resources" box on the Main course page, not Canvas. Using those links, look-up the prices for both crude oil and natural gas futures for delivery in the closest month to the present time. Although you won't see this terminology on the NYMEX web site, the futures contract for delivery in the closest month to the present calendar month is called the "front month" contract. Report the "Last," "Change," and "Prior" prices, and also report the volumes for both the crude oil and natural gas front month contracts. Please include a screen shot of the NYMEX web site that you used for crude oil, and a screen shot for the NYMEX web site you used for natural gas.
This activity is worth 20 points, as per the EBF 301 grading scale in the syllabus.
Part of the overall objective of this course is to have you understand how the market functions in terms of determining price and how it trades in general. To truly appreciation this, you have to begin to think like an energy commodities Trader. To do so, you must consider the market factors that they research before making any Buy/Sell decisions.
In Lesson 2, you were presented with a number of “fundamental” factors that can influence the price of crude oil and/or natural gas.
Beginning this week continuing until further notice, you will submit Fundamental Factors assignments in the respective Lesson in Canvas each week by 11:59 p.m., Eastern US Time, on Sundays. Instructions for the Fundamental Factors assignments [8] can be found under the "Resources" section of the EBF 301 web site.
You are to submit ALL of the same fundamental factors for both crude and natural gas shown in Lesson 2 and give your opinion on how they impact prices for oil and natural gas. Fundamental Factors assignments should be submitted to the Fundamental Factors Drop Box on Canvas for each week.
A detailed grading rubric [9] for the Fundamental Factors activities is available under the "Resources" section of the EBF 301 course web site.
An example of a complete answer would be:
Natural Gas
The Energy Information Agency’s Weekly Natural Gas Storage Report (http://ir.eia.gov/ngs/ngs.html [10]) showed an injection of +50 Bcf. This was below the expectation of +60 Bcf, therefore, it was seen as “bullish” since less supply was put into storage implying that demand was higher than expected. Prices would increase under this scenario. Total gas in storage now stands at 1.5 Tcf which is below the 5-year average as well as, last year at this time.
Pricing Activity: Submit your findings as a single word processed document to the Activity Drop Box in Canvas.
Fundamental Factors: Submit your work as a single word document and to the Lesson 3 Fundamental Factors Activity in Canvas.
Now that we are familiar with the workings of the Exchange and futures contracts, we will walk through the precise steps in placing a buy or sell trade on the Exchange. The words used and timing of the process are very important to successful completion and settlement of the trades.
You have reached the end of Lesson 3. 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.
All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner where each party involved is fully aware of the details of the transaction.There are specific nuances in the flow of the orders themselves. As legally-binding agreements, non-performance under a futures contract can have severe financial, and legal, consequences. Therefore, most phone conversations are recorded to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized Order Forms are used on the floor of the NYMEX during order execution. Daily "check-outs" occur between Brokers and their clients for verification of all trades conducted that day. In this lesson, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed-price for a 12-month period ("strip"). In addition, electronic trading is becoming the main way in which these transactions are executed these days and the traditional "pits" are quickly becoming a thing of the past. In addition, "High Frequency Traders" (HFT) are using super-computers with complicated algorithms to trigger thousands of trades in mere nano-seconds. They have only added to the volatility in the marketplace.
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 this lesson. 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 3 Video on High Frequency Trading |
Errera & Brown Mini-lecture page |
No submission |
Mini-lecture: NYMEX Order Flow | Mini-lecture: NYMEX Order Flow page | No submission |
Lesson Activity: "Trading Places" video | Lesson Activity page/Canvas | Submit to activity in Canvas |
Lesson Quiz Fundamental Factors (on-going) |
Summary and Final tasks page Summary and Final tasks page |
Submit through Canvas Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Errera & Brown - Chapter 3
All orders placed on the NYMEX to buy or sell contracts are done in a very precise manner with each party involved fully aware of the details of the transaction.As legally-binding agreements, non-performance under a futures contract can have severe financial, and legal, consequences. Therefore, most phone conversations are taped to ensure the accuracy of the orders placed as well as the results of the execution of those orders. Standardized Order Forms are used during order execution and daily "check-outs" occur between Brokers and their clients for verification of all trades conducted that day. In this lesson, we will follow a natural gas futures contract trade from the beginning to end for a producer and end-user wishing to lock-in a fixed price for a 12-month period.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The lecture slides can be found in the Modules under Lesson 4: NYMEX Order Execution & Electronic Trading in Canvas.
As mentioned in the introduction to this lecture, we're going to walk through the specific steps of executing a buy and sell order on the floor of the New York Mercantile Exchange. We're going to be doing this during the regular session where there are active traders in the pits doing what they call the open outcry trading. In order to understand what's going on, there's two key terms here that we're going to need to understand.
One is a bid. And it's a motion to buy a futures contract at a specified price. The opposite of that is an offer. Again, a motion to sell a futures contract at a specific price. And that's also known as the asking price. And we use the word motion because the traders are using various hand signals to communicate to one another across the, pits if they're buyers or sellers, what volume, and what price.
So the example we're going to use in this case is a 12 month price, a 12 month "strip" average of $3.50. As mentioned in lesson seven, you can go out and you can buy or sell contracts at an average price as opposed to having to buy or sell at each individual month's price. In this case, we're looking at 12 months out. So currently, this 12 more strip is running $3.50. And there's a producer out there who would like to lock this price in, or better, if he or she can get that. So the producer's going to call a trader at the energy company and tell them that they're interested.
So the trader will turn around then and they'll ask the personnel on the fixed price desk to call New York and find out where the market currently is, where are the bids, where are the offers, for this 12 months strip for natural gas. Energy trading companies that have financial derivative trading, they will have a fixed price desk. These are the personnel mostly responsible for dealing with the New York Mercantile Exchange.
So the fixed price desk calls their broker on the floor of the New York Mercantile Exchange to find out the current market quotes and both the bid and offers. Now the person that they're talking to is the clearing broker and, specifically, the phone clerk. If you recall the picture of the floor of the Mercantile Exchange from lesson seven, you can picture those phone banks. So this is where that phone call is going to.
The fixed price desk person turns around then and gives the trader the current market quote. The producer then gets that bid and offer from the trader. And given that the market is still in the $3.50 range, the producer decides that he or she would like to lock in the price of $3.50 or better for the next 12 months, if in fact it can be executed. The trader now takes the order from the producer and passes it along to the fixed price desk.
Now at this point in time, the producer is obligated to perform under this contract. In other words, the producer realizes that the energy trading company's going to have to enter into the legally binding contracts on the New York Mercantile Exchange to obtain this fixed price for them. So the producer is going to have to perform by giving the physical gas when the time comes to the energy trading company.
So the trader gives that order, the sell order, to the fixed price desk. The fixed price desk then calls New York again and, tells the phone clerk with the clearing broker on the floor of the NYMEX that they would like to sell the one month strip $3.50. The phone clerk immediately stamps the ticket that they have, indicating when the order was received from the fixed price desk at the energy trading company.
The phone clerk will then walk over to the pits and hand a copy of that ticket to their broker who is trading in the pits themselves. That pit broker then offers out the 12 month strip into the market at $3.50. Another broker, who has received a buy order from another customer, decides to go ahead and lift the offer on the 12 months strip at $3.50. So keep in mind that, as we mentioned in the prior lesson, it's a zero sum game. For every buyer, there is a seller.
So in this case, the producer is having the trading company sell contracts for them. There has to be a buyer across the pit willing to buy those contracts in order for the deal to be consummated. So in this case, there happened to be an interested party on the other hand. And for our purposes, we'll go ahead and assume that it's an end user who's interested in buying the natural gas at $3.50 for the next 12 months.
So once the counterparty across the pit has gone ahead and lifted the order, the broker now hands the order back to their phone clerk. And the pit brokers also then have an official form that they have to fill out for the New York Mercantile Exchange, which includes the details of the transaction. So the phone clerk now time stamps the ticket, as in they've had it timestamped when the order was received, and it again is stamped with the time when the order is actually filled.
So phone clerk calls the trader's fixed price desk. The trader's fixed price desk receives the fill from the floor of the NYMEX and repeats the fill verbally to ensure that there's no error. So the clearing broker phone clerk and the trading company's fixed price desk repeat the details of the transaction so that there's no mistake as to exactly what has occurred. And as mentioned in the prior lesson, the phones are also recorded.
So if there's any dispute at the end of the day when it comes to check out the trades between the energy trading company and their broker, they can pull the tapes, as we say, if there's a discrepancy and have it resolved that way. OK. The fixed price desk, now having confirmed the order, passes along the fill to the trader. The trader now passes along the completed order to the producer.
So the producer has gotten done what the producer wanted. So the producer is now what we call hedged if natural gas prices decline below $3.50 across the next 12 months. So they can't get a price any lower than $3.50. However, because of that, they give up any upside. In other words, the producer you cannot get a price higher if the market does move up. But in this situation, the producer liked $3.50. And they wanted to make sure that prices didn't fall on them.
Here's some more terms that are frequently used in terms of New York Mercantile Exchange trading. We already covered the ask and the bid. A bull, a lot of you have already heard this term. But it's actually someone. It's a person who anticipates an increase in price or an increase in volatility. (Volatility is a measure in the magnitude of price change, as well as the frequency of the change in price). And they are the opposite of a bear. A bear, again, is a person who anticipates a decline in price or volatility. And they are the opposite of a bull.
Backwardation. It's a market situation in which the futures prices are lower in each succeeding delivery. It's also known as an inverted market. It's the opposite of contango. So let's take, for instance, the September crude oil contract. If right now it was the highest price, and October was lower than September, and November was lower than October, and so forth, we would have a backward- dated market. Because the normal situation is, the prompt month or near month, and for several months going out, prices do rise.
A broker. A broker is a party or company which is paid a fee for transactions in the financial and physical markets. Brokers do not take title to the contracts. They do not take title to the commodity being traded. They simply join counter parties together and they extract a fee for doing so. They are truly middlemen. The cash market is the market for a cash commodity where the actual physical product is traded.
So we've mentioned a couple of times, we differentiate between financial and physical or cash marketplaces. When I talked about the pricing publications, they cover the cash market. The CFTC, that's the Commodity Futures Trading Commission. This is the federal agency responsible for the oversight of all commodities trading, not just energy commodities. The contango market. This is the opposite of the backward dated market. It's a market situation which the prices are higher in succeeding delivery months than in the prompt month.
To cover. We use that term to talk about a trader or company who happens to be short futures or options positions. In other words, they've sold contracts in anticipation of prices falling. And so that open position is known as a short position until such time as they buy those contracts back and cover that open position. A derivative is a financial instrument derived from a cash market commodity, a futures contract, or other financial instrument
The New York Mercantile Exchange contract for natural gas is derived from natural gas itself, the commodity. And the same applies to the other energy commodities on the NYMEX. The last trading day. It's the last day of trading for the prompt month contract. Currently for natural gas, it's three working days prior to the next calendar month. We covered the deadlines for each of these in lesson seven.
Long. This is a market position based on owning contracts which must be sold, or the delivery of the underlying commodity must be accepted. It's the opposite of short. So a trader or a company who takes a long position, they're buying contracts in anticipation of prices rising. And then they will sell those contracts hopefully at a profit. The offer, we mentioned already. We talked about what an offer is.
Open outcry is the name given to the pit trading. OK. For NYMEX purposes, it's a method of public auction for making verbal bids and offers for contracts in the trading pits or trading rings of commodity exchanges. It is totally different than electronic trading platforms. The short. This is a market position based on selling contracts which must be bought back or the delivery of the underlying commodity must be made. It is the opposite of long.
So again, this is where traders are selling contracts in anticipation of prices falling. They'll buy them back and make a profit. We mentioned earlier the idea that when they are short, they'll have to cover those positions by buying the contracts back. Strike price. We will get more into this when we talk about options. But it's the price at which the underlying futures contract is bought or sold in the event that an option is exercised. It's also called an exercise price.
The video is located in Lesson 4 under Modules in Canvas.
This movie was released in 1980. Although it is old, it still does a great job of illustrating what goes on in the "pits" of commodity exchanges. In this movie, the Duke brothers are rich commodity brokers. Dan Akroyd works for them and Eddie Murphy is a street bum. The brothers have a bet about one's genetics or their environment shaping their future. To test their theories, they ruin Akroyd's life and put Murphy in his place. When Eddie (William) discovers the bet he tells Akroyd and they plan to ruin the Dukes. They manage to find out that the Dukes are getting the Department of Agriculture's report on the orange crop before it is released to the public. Akroyd and Murphy steal the report from the Duke's man and replace it with a false one. The two then go to the NYMEX and out-trade the Dukes. The Dukes think their report, when released, will show crop damage and that will make FCOJ futures rise.
Several concepts of futures trading can be learned from this one clip....."going long", "going short", fundamental information (the crop report), "Locals" (the traders who jump into the action started by the Dukes), margin calls. You can also see the prices posted as the trades occur...."Open", "Last", etc.
Answer the following questions about the movie clip.
This activity is due at 11:59 pm on Sunday and is worth up to 20 points on the EBF 301 grading scale. Each question is worth 2 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Video Activity: Submit your answers as a word document to the "Trading Places Video Activity" in Canvas.
Fundamental Factors: Submit your work as a single word document o the Lesson 4 Fundamental Factors Activity in Canvas.
Now that we have studied the NYMEX, financial derivative contracts, and the order execution, we will learn how prices are determine and reported in the cash market place. Later, we will explore the methods used by producers and end-users to reduce their price and supply risk, otherwise known as "hedging."
Log into Canvas and complete the Lesson Quiz. The quiz covers Chapter 3 Errera & Brown and this lesson.
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.
Energy is being consumed at every hour of the day everywhere on earth. Thus, energy commodities are being bought and sold constantly to fill this demand. When we are talking about prices for the actual physical production and consumption of natural gas and crude oil, we are talking about the "cash" market. In this lesson, we will explore the ways in which cash prices are established in the physical marketplace, historical pricing, the main publications that report these prices, and the methodologies they use to collect the data.
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 this lesson. 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 |
---|---|---|
Lesson Quiz | Modules > Lesson 5: Energy Commodity Logistics - Crude Oil | Submitted through Canvas |
Mini-lecture: Pricing - Physical Natural Gas & Crude Oil | Mini-lecture: Pricing - Physical Natural Gas & Crude Oil page | No submission |
Lesson Activity | Lesson Activity page | Submitted through Canvas |
Fundamental Factors (on-going) | Lesson Activity page | Submitted through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Even though the prices of energy "futures" influence the physical markets, prices are negotiated outside the infamous and chaotic trade floors of the exchanges. Buyers and Sellers, looking at their supply and demand situations, make pricing decisions daily and actually buy and sell the physical commodities. The results of these trades are reported in industry publications and become market indicators for the physical "cash" market.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The lecture slides can be found in the Modules under Lesson 5: Energy Commodity Logistics - Crude Oil.
Familiarize yourself with one of the industry publications that reports physical, cash prices for natural gas. Inside FERC, Gas Daily and, OPIS do not allow their publications to be copied unless you have a subscription and receive prior permission. However, you can access natural gas cash prices from the Natural Gas Intelligence website [11]. These come directly from the electronic trading platform The Intercontinental Exchange (ICE). They are actual transactions for physical natural gas trades at the specified locations. ICE is based in Atlanta, GA. and they also own the ICE Futures Europe in London.
You might not be able to access the latest natural gas cash prices through NGI. In that case, use the sample prices provided in the NGI website and include a screenshot in your submission.
The cash hubs that you might see in the report are:
Please chose four of these hubs. Report the following information for the selected four hubs plus the national average (last row):
Please also include a screen shot or PDF printout of the Natural Gas Intelligence website to verify your reported prices. Do not simply submit a screen shot of the web site. You must submit both the screen shot and a typed response with your reported prices.
The Natural Gas Intelligence website is a great resource for when you work on your weekly Fundamental Factors for natural gas. You can indicate where cash prices are trading, and that may help you with your trading decisions.
This activity, due at 11:59 pm on Sunday, is worth up to 20 points on the EBF 301 grading scale.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Cash Price Activity: Submit your work as a word processed document to the Lesson 5 Cash Price Activity in Canvas.
Submit your work as a single word processed document to the Lesson 5 Fundamental Factors Activity in Canvas.
While copyright laws prohibit me from reproducing copies of their reports, here are the website links so you can see the data and, in some cases, view a sample report.
Platt's Gas Daily - http://www.platts.com/IM.Platts.Content/ProductsServices/Products/gasdaily.pdf [12]
Platt's Inside FERC - http://www.platts.com/IM.Platts.Content/ProductsServices/Products/gasmarketreport.pdf [13] (pages 6 & 8)
OPIS - http://www.opisnet.com/Images/ProductSamples/NAmericanLPGReport-sample.pdf [14]
ARGUS - http://www.argusmedia.com/Crude-Oil [15]
In this lesson, we addressed the physical cash marketplace that, for the most part, deals with the "here and now." In the next lesson, we will delve into the financial "futures" markets, whereby commodity prices can be obtained for future months and years.
Log onto Canvas and complete the Lesson Quiz.
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.
The term “logistics” has become more and more popular to define the process whereby goods move from the point of manufacturing and production to the point of sale and consumption. UPS® and FedEx® are no longer just in the package shipping business. They now provide a full range of services, from receiving parcels to transporting them via truck, rail and plane, to storing them in warehouses and ultimately, distributing them to their final destinations. All the while, they are tracking packages throughout the entire process, which can also be done by their customers.
The delivery system for energy commodities is no different, as products—either from the wellhead, plant, or refinery—are transported using various methods, stored, and ultimately distributed to places of final consumption. As we explore the ways and methods in which energy commodities are delivered to market, you will see this same basic theme consistently applied.
Additionally, we will learn the “value chain” for energy commodities. That is, what are the costs and revenues along this delivery path?
This graphic illustrates the various steps in the "wellhead-to-burnertip" logistical path for oil and natural gas:aggregation (gathering), the "cleaning" of the raw stream and production of valuable natural gas liquids (NGLs) and, the steps for getting crude oil and natural gas from the wells all the way to market. As you can see, there is processing of natural gas or refining of crude, the transportation and storage and, finally, the distribution and retail delivery to the various end-users. As you will see, each step along this "path" will have some costs associated with it and most will represent an opportunity for generating revenue. These will add to the total profit that can be derived from the initial wellhead production.
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 this lesson. 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: Crude Oil Refining Process |
Lesson6 Reading Assignment page |
No submission |
Mini-lecture: Crude Oil | Mini-Lecture: Crude Oil page | No submission |
Mini-lecture: Crude Oil Refining | Mini-Lecture: Crude Oil Refining page | No submission |
Lesson 6 Activity 1 | Lesson 6 Activity page | Submit through Canvas Discussion |
Lesson 6 Quiz | Summary and Final tasks page | Submit through Canvas |
Fundamental Factors | Lesson 6 Activity Page | Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
The refining of crude oil is a complex process. In preparation for this topic, please complete the reading assignment below. My lecture will closely follow the steps in refining as outlined here.
Crude Oil Refining Process
Go to HowStuffWorks: "How Oil Refining Works" [17] and read pages 1 through 6 in preparation for the mini-lecture on Crude Oil Refining. As you read the sections, keep these questions in mind:
The following mini-lecture traces the flow of crude oil from the wellhead to the refinery using various forms of transportation. We also discuss the two global standards for crude oil, West Texas Intermediate, and Brent North Sea. The major supply/demand districts in the US are presented, as well as supply and demand statistics.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The following mini-lecture presents each phase of the crude oil refining process and the various products that are extracted from each barrel of oil.
While watching the Mini-Lecture, keep in mind the following key points and questions:
You will be graded on the quality of your responses. This question is worth up to 20 points on the EBF 301 grading scale; each question is worth up to 10 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Petroleum Products Activity: Submit your work as a word processed document to the Petroleum Products Activity on Canvas.
Fundamental Factors: Submit your work as a single word processed document to the Lesson 6 Fundamental Factors Activity in Canvas.
Log onto Canvas and complete the lesson quiz
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.
This graphic illustrates the various steps in the process of getting crude oil and natural gas from the wells all the way to market. As you can see, there is wellhead aggregation (gathering), the "cleaning" of the raw stream, and production of valuable natural gas liquids (processing or refining), the transportation and storage, and finally, the distribution and retail delivery to the various end-users. As you will see, each step along this "path" will have some costs associated with it and most will represent an opportunity for generating revenue. These will add to the total profit that can be derived from the initial wellhead product.
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 this lesson. 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: Natural Gas - From Wellhead to Burner Tip | Reading Assignment page | No submission. |
Mini-lecture: Production and Gathering | Mini-lecture: Production and Gathering page | No submission. |
Mini-lecture: Processing and Natural Gas Liquids | Mini-lecture: Processing and Natural Gas Liquids page | No submission. |
Mini-lecture: Transmission Pipelines | Mini-lecture: Transmission Pipelines page | No submission. |
Mini-lecture: Storage | Mini-lecture: Storage page | No submission. |
Mini-lecture: End-Users Mini-lectue: LNG |
Mini-lecture: End-Users page Mini-lecture: LNG page |
No submission. |
Energy CommoditiesActivity | LessonActivity page | Submit to Canvas |
LessonQuiz | Summary and Final tasks page | Submit to Canvas |
Fundamental Factors | (on-going) | Submit to Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
From Wellhead to Burnertip
While reading each of these short descriptions, try to visualize the movement of the natural gas through each stage and what exactly is occuring. We will go into more detail for each of these steps in the mini-lectures.
Go to NaturalGas.org [18] and read over each section in “Natural Gas – From Wellhead to Burnertip." Sections to read are:
Please also download and review the American Association of Petroleum Landmen Form 610 - 1989 [19] before proceeding.
The first step in the movement of natural gas from the “wellhead-to-burnertip” is to determine the "deliverability," or sales volume of the well and then get it connected to a pipeline. This is normally done by midstream companies who gather wells together and deliver the gas to processing plants or directly into transmission pipelines.
The following mini-lecture explains these concepts in detail.
While watching the Mini-Lecture, keep in mind the following key points and questions:
The final step in the logistics chain for natural gas is delivery to the burner-tip. This can be accomplished by Local Distribution Companies (“gas companies”), or pipelines can deliver gas directly to connected end-users. We generally classify the end-users as utility, residential, commercial, and industrial.
The following lecture explains the function of Local Distribution Companies (LDCs) and presents various other natural gas end-user groups.
While watching the Mini-Lecture, keep in mind the following key points and questions:
Once the raw natural gas stream has been processed, it is now “commercial grade,” or “pipeline quality,” natural gas. The outlet, or residue, side of the processing plant delivers the gas to the transmission pipelines. The primary function of transmission pipelines is to move the gas from the producing basins to the market areas.
The following mini-lecture will illustrate the function and operation of the transmission pipeline systems.
While watching the Mini-Lecture, keep in mind the following key points and questions:
Natural gas storage facilities provide the industry with flexibility. During times of “peak” demand such as harsh winters or extremely hot summers, utilities can rely on supplies stored beneath the ground. Likewise, during times of low demand, excess supplies can be stored for when they are needed. For savvy marketers, storage capacity can be used to take advantage of the price fluctuations in the market. There are three main types of natural gas storage facilities: depleted oil & gas reservoirs, salt caverns, and aquifers.
The following lecture covers the types of natural gas storage, traditional and current uses, and the industry players who use storage capacity and why.
While watching the Mini-Lecture, keep in mind the following key points and questions:
Now we have gathered the gas. We have processed it. We have put it in the transmission pipelines. Before we take it on to the local distribution companies and ultimate end users, there is an incremental step-- which may or may not occur-- and that is the underground storage of natural gas.
Here, again, is the energy commodity logistics and value chain. You can see that the fourth step in our process here is that of storage. Here's a cutaway of what a potential storage facility could look like. Again, it's really just, in most cases, a depleted oil and gas reservoir. So you treat it the same as you would a typical oil or gas well.
Here we have some vertical wells and one horizontal well. This is a good example of what a horizontal well looks like. You can see that by cutting across the reservoir horizontally you can extract more production than the straight, vertical holes that come down in traditional wells.
This is an above ground shot of a storage facility. You don't see the caverns. You just see what's above ground. In this particular case, there is a pipe being laid that's going to connect a power plant directly to this storage facility.
Traditional uses for storage-- mostly by local distribution companies or gas companies in the winter time, when there was high demand and there was not enough wellhead gas to meet the demand. And so gas had been stored, mostly in the summertime, and was utilized for what we refer to as peaking supply, that is when demand peaks due to unforeseen changes in the weather.
The summertime-- low demand for natural gas, because again it was mostly a winter fuel. Also, prices tended to be lower in the summer than the winter time, because of lower demand. Also, pressure relief-- as we saw in those photos as to what can happen when the pipeline pressure gets too high, when the pipeline pressure is in fact high, pipeline companies can put some of that gas in the ground and reduce the pressure. Also price opportunity-- when prices dip, one can buy some natural gas at those lower prices, stick it in the ground, and save it for when demand may go up and prices can be higher.
Probably, though, the number one utilization of underground storage by gas companies is for emergency deliverability. We mentioned that term deliverability in talking about the well head, the amount of gas that can be pulled out on a given day. We have seen harsh winters just two years ago, the winter of 2010, 2011, was fairly harsh. And so local distribution companies, your gas company, can rely on gas in storage to supplement the wellhead gas that they're receiving otherwise.
In the Gulf Coast region, if there is in fact an active hurricane that enters the Gulf, a lot of the offshore rigs are going to be evacuated and shut down. There's a substantial amount of natural gas that is then curtailed. Well, supply in underground storage facilities can supplement the loss of that natural gas deliverability.
Traditional operators and users of natural gas storage facilities-- mainly the pipeline companies in both the supply and market areas, and then local distribution companies in the market areas themselves.
Types of natural gas storage-- there are mainly three types. Depleted oil and gas reservoirs being the most common. Why? Because you're taking what used to be an oil or gas well, and you're now going to put natural gas down in it. So we already know the characteristics of the wells. We know how much natural gas they can hold.
There are also terms, permeability and porosity. These are geologic terms. The permeability is how much natural gas can actually be held in the formation. And then the porosity, the types of little pores in the formation itself as well. Those two combined can give us a determination of the deliverability of that particular reservoir. That would allow us to determine whether it would make a good store facility or not.
We can inject gas from the transmission pipeline. If the pressure's high enough, the gas will freely flow into the formation. As we add natural gas to the formation, and the pressure increases, we may actually need to use compression to draw the gas from the transmission pipeline, and shove it down into the reservoir.
Conversely, when it's time to utilize the gas, we can withdraw it. If the pressure is high enough, that is if it's higher than the downstream transmission pipeline, it'll free flow. At such point in time, as the reservoir pressure meets or is less than the downstream transmission pipeline, we'll use compressors to boost the pressure up from the reservoir.
Oil and gas reservoirs converted to storage take approximately 50% of the capacity to be filled first before they can utilize it. We refer to this as the cushion, or base, gas. So, for example, a one billion cubic foot natural gas reservoir that we would like to convert to storage, is going to take 500 million cubic feet of natural gas to be put in place first. The tier above that is what we refer to as the working gas. It is the usable space. It is the recoverable gas. This factor itself is one of the reasons why developing storage facilities can be so expensive, because that initial 50% of natural gas will have to be purchased and cannot be sold until the end of the life of the storage facility when it's extracted.
Another type, and these are very much used along the Gulf Coast, these are salt domes, or salt caverns. There are literally a large, impermeable hole. When the natural gas, or natural gas liquids, are put into salt caverns, they do not escape. If you find a salt formation, it's very easy to form one of these.
High pressure water carves out the reservoir. Then you inject gas into the cavern. And free flow it in or compress it, just as you will with the oil and gas reservoirs. The converse process of withdrawing, again, can also be free flow or compression. These actually have very high deliverability. They can be cycled numerous times. That means gas can be injected one day, withdrawn the next day, and so on. And so they make a very, very worthwhile type of storage facility.
Aquifers, these are water formations that are utilized for storage. You generally see these only in the upper-Midwest market areas, where they are used for emergency supply. You're pushing gas into the aquifer, the water comes out. When you need the natural gas, you push water back in and take the gas out.
Now, these are the least desirable types of storage facilities. There's a high development cost, because there is no pre-existing facility in place. The aquifer reservoir characteristics are literally unknown. The boundaries of an oil & gas reservoir, or the boundaries of a salt cavern, can be determined, but not an aquifer.
The base gas requirements-- we talked about an oil & gas reservoir requiring about 50% of base gas. In the case of an aquifer, you need 90% base gas to hold back the water. So you only have about 10% of capacity that you can utilize. And then you're going to have to use gas compression to force the gas into the aquifer, or water injection, when you wish to remove the gas.
We have a couple of classifications of storage. We have what we call seasonal, and these are mostly the depleted oil and gas reservoirs. We inject gas in what is normally the lower demand, lower price period of April through October. And then we withdraw the gas in what we refer to as the winter months of November through March.
Now these time-frames are very key to the industry. Pricing for natural gas, when we talk about seasonal pricing, we use the terminology summer and winter. They are not the typical summer and winter periods that we're accustomed to. There are no four seasons within the natural gas marketplace. We talk about summer being April through October, because it corresponds to the injection period for natural gas storage. And we talk about the winter as being November through March, because it is the typical withdrawal period for natural gas storage.
High deliverability classification of storage are your salt caverns and your enhanced depleted oil and gas reservoirs. Has there been additional compression added to the oil and gas reservoir storage facility? Do we have horizontal wells? Both of those will increase the deliverability of the oil and gas reservoir. Salt caverns by themselves have high deliverability characteristics.
Current users-- we see pipelines still using these to provide what we refer to as market-responsive services. Seasonal storage, as well as cyclable storage-- cyclable storage meaning that you can inject or withdraw at any point in time during the term of the contract that you have with the pipeline and their storage affiliate. Park and loans-- this is a short-term service that pipelines can provide. If you have excess gas, they allow you to store it in their facility for a short period of time. If you find yourself short of supply relative to demand, you can also borrow some gas from the pipeline for a certain fee. But you will actually give them the molecules back upon the repayment time.
Local distribution companies, again your gas companies-- traditional storage usage. They're going to use the storage for short-term peaking of services. These days, however, what they pay for storage is going to be regulated by the respective public utility commission in the state where the LDC operates.
The largest group of current users are your marketing and trading companies. We will talk briefly later on about the deregulation of the industry. But there are third-party marketing and trading companies that are now providing services that were once provided by the pipelines and LDC's. We call this the re-bundling of those services. So they can provide peaking gas. They now provide same-day gas. That is, if the utility or end-user needs gas today, for some reason, because they have storage capacity they can sell them gas today.
In other situations, they can provide gas on demand. A marketing and trading company with cyclable storage can literally allow a electric utility, for example, to draw gas from them as they need it. Each one of these services commands a premium. And this is really where marketing and trading companies make their money on these added value services. They cannot provide these added value services, however, without storage.
Storage facilities also allow them to respond to changes at the markets. Price volatility, that is the movement of price up and down, as well as the speed at which price changes occur. Those represent opportunities for savvy marketers to buy and sell. And they can do this because they have storage facilities that will allow them to store the gas when prices are lower, and to sell gas when prices are higher, both in the physical cash market, as well is in the financial market on the New York Mercantile Exchange, which we will talk about in both lessons seven and eight.
The final step in the logistics chain for natural gas is delivery to the burner-tip. This can be accomplished by Local Distribution Companies (“gas companies”), or pipelines can deliver gas directly to connected end-users. We generally classify the end-users as utility, residential, commercial, and industrial.
The following lecture explains the function of Local Distribution Companies (LDCs) and presents various other natural gas end-user groups.
While watching the Mini-Lecture, keep in mind the following key points and questions:
This activity, due on Sunday at 11:59 pm, is worth up to 20 points on the EBF 301 grading scale. Each question is worth up to 10 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Lesson Activity: Submit your work as a word processed document to the Lesson 7 Logistics & Value Chain Activity in Canvas.
Fundamental Factors: Submit your work as a single word processed document to the Lesson 7 Fundamental Factors Activity in Canvas.
All pipelines are regulated by the Federal Energy Regulatory Commission, which has rules for how they conduct business. The services that pipelines provide and the rates they charge must be posted on their websites. These requirements came about after years of heavy regulation, which eventually led to de-regulation of the industry and a more competitive environment.
Log onto Canvas and complete the Lesson 7 Quiz.
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.
Over the years, many industries have been regulated by the federal government. But one by one, they became "de-regulated" over time. The banking and airline industries were once heavily regulated, as was the telephone business. In exchange for federally-approved rates of service and a set return on investment, companies were given exclusive franchises, or service territories. Today, the de-regulation of formerly regulated businesses has spurred-on competition and stimulated new products and services. The natural gas and crude oil businesses followed behind but eventually became de-regulated as well. Thechain of events leading up to that, and the current regulatory status of these industries, is presented in this lesson.
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 this lesson. 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: | Reading Assignment Page | No submission |
Mini-lecture: Pipeline Regulations & Rates - Crude Oil | Part I | No submission |
Mini-lecture: Pipeline Regulations & Rates - Natural Gas | Part II | No submission |
Lesson Calculation Activity | Lesson Activity Page | Submit to Canvas |
Lesson Quiz | Summary and Final tasks page | Submit to Canvas |
Lesson Fundamental Factors | (on-going) | Submit to Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Go to NaturalGas.org [18] and read the section on "The History of Regulation." Also, see "A Brief History of Energy Regulations" [22] and read the "Overview" and "Oil Market Policies."
The history of regulation for crude oil and liquids pipelines goes back to the first regulation of the railroads in the 1800s. A fear of a monopoly by the few railroads in existence prompted the US government to form the Interstate Commerce Commission. The body was later given jurisdiction over interstate crude oil pipelines based upon the same monopoly fears. Today, that responsibility lies with the Federal Energy Regulatory Commission (FERC).
Under federal regulations, pipelines must file “just and reasonable” rates and provide access to any shipper requesting space, if available.
The following mini-lecture provides a brief summary of the history of regulation in the crude oil pipeline industry.
We talked about the value chain along the well head to burnertip path a couple of times now. One of things we have to consider are the actual rates of service that the pipeline companies and storage owners charge for performing that service. And these are a function of the regulation of the respective industries both crude oil and natural gas. So here, we'll discuss the regulation and the transportation services and rates of crude oil.
The federal regulation of crude oil pipelines began with the Hepburn Act of 1906. They put the oil pipelines under the jurisdiction of the Interstate Commerce Act of 1887 which was established initially to regulate railroads. However, there was a concern that oil pipeline companies could have a monopoly similar to what the railroads had. And so, they were designated as an Interstate common carrier for all transportation of oil by pipeline.
The Interstate Commerce Act of 1887 required that railroads and now crude oil pipelines file rates and charges that were reasonable and just with the federal government. They would also have to outline their terms of service, that is the rules and regulations regarding the transportation of crude oil. They would have to show the form and content of their tariffs, tariffs being the rules of the game, so to speak, as well as the rates, the method of accounting, the type of reporting that they would do both to customers and the federal government. And then, disclosure of shipper information. They were going to have to let everyone know who the shippers were on their pipelines.
The Federal Energy Regulatory Commission, basically Congress, in 1995 abolished the Interstate Commerce Commission, the entities subject to the ICC were now under FERC jurisdiction. They were still known as common carriers. Crude oil pipelines are not considered utilities. Natural gas pipeline companies were granted utility status under the Natural Gas Act of 1938.
Therefore, crude oil pipeline companies have no guaranteed franchises, that is no guaranteed market regions. They don't have the right of eminent domain. That basically means that they don't serve in the public interest. And so, if they're in a dispute with a landowner over building pipeline, they have no fallback. They have to negotiate with the landowners to lease their surface rights to put the pipeline through there. However, they are required to file just and reasonable rates, and they have the same reporting requirements as natural gas pipeline companies.
Here's a sample of a crude oil pipeline tariff that Shell Pipeline Company in Houston, Texas uses. You can see in the case of this pipeline, since it's entirely within the state of Texas, the Texas Railroad Commission has jurisdiction. You can see the type of pipeline is a petroleum product. Getting down to the rates there, the unit of measure is in cents per barrel.
And at the very bottom, you can see that the rates for the first tier which is set on volume. The rate is $0.164 per barrel. The more that you ship on Shell's pipeline, the cheaper the rate becomes. So anything above approximately 66,000 barrels, the rate reduces to $0.082 per barrel.
While watching the Mini-Lecture, keep in mind the following key points and questions:
This activity, due at 11:59 pm on Sunday is worth up to 20 points on the EBF 301 grading scale. Question 1 is worth 13 points and Question 2 is worth 7 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Rate Calculation Activity: Submit your answers in a spreadsheet file via the Rate Calculation Activity in Canvas.
Fundamental Factors: Submit your work as a single word processed document to the Lesson 8 Fundamental Factors Activity in Canvas.
The services and rates that pipelines charge represent a component of the value chain for crude and natural gas, but how the actual wellhead and delivered prices are determined will be examined in the next lesson.
Log onto Canvas and complete the Lesson 8 Quiz
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.
We've 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 afixed price. Conversely, consumers of these same products can buy contractsto 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 the energy industry 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 this lesson. 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: Financial/Physical Price comparisons | Lesson Activity page | Submit through Canvas |
Lesson 9 Quiz: Hedge Problems Fundamental Factors (on-going) |
Summary and Final tasks page Summary and Final tasks page |
Submit through Canvas Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Errera & Brown - Chapter 5
In Lesson 3, 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 and heating oil,both 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” the commodity.) 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 3, 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 3, the idea of the “price discovery” that futures markets provide.) 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 actual 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 5). (The fluctuation of cash and futures throughout the life of the contract is known as, "parallelism.)Cash and futures prices tend to approximate one another at the "Settlement" of the financial contracts thus, allowing them to move "in sync". This concept, called "convergence", is covered in Errera.
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 December, 2015 at the current market levels since those prices help them meet earnings targets. To hedge the price risk that can occur between now and December, they will sell the financial NYMEX contracts. Thus, they are guaranteed a market at Henry Hub at a fixed price when the December production month comes around. And, they can do this for any months up to the 118 months that the Natural Gas contract trades.
In the case of a natural gas midstream company engaged in the gathering and processing of natural gas, their profit depends on the "spread" between the price of natural gas that is their feedstock and the natural gas liquids (NGLs) that they produce. Let's say they are concerned about rising natural gas prices. They can buy December, 2015 contracts and thus, be guaranteed supply at Henry Hub at a fixed price when the December production month comes around.
In each of the above cases, the counterparty to the contracts will be responsible for delivering or taking the crude oil at Cushing, OK or, the natural gas at Henry Hub, LA. 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, 2015 price. The current futures market price is $45.00 based on NYMEX trading. The Producer decides to sell December, 2015 crude oil contracts (the opposite of the physical position). Their price is now set at $45.00 for the sale of December, 2015, West Texas Intermediate Crude Oil at the Cushing, OK, Hub.
However, at the end of Novembe 2015, all December futures 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 futures prices rose and fell as the contracts traded. Based on the concept of "convergence" (Errera), the Final Settlement price for the December, 2015 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 2015 futures 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 futures 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 Canvas Modules under Lesson 9: Basic Energy Risk “Hedging” using Financial Derivatives. "Lesson 9 simple hedge worksheet.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 ensure 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 2016 NYMEX natural gas contract is trading $2.40 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, 2016. Now, we need a market for when we wish to withdraw these same volumes. January, 2017 is trading at $2.95, so we would sell the January, 2017 futures contracts in the same amount as we bought in April, 2016. This creates a “spread” of $0.55. 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.
(Spreadsheet can be found in the Canvas Modules under Lesson 9: Basic Energy Risk “Hedging” using Financial Derivatives.. "EBF-301 Lesson 9 simple hedge worksheet.xls")
These simple, “fixed-price” hedges are the basic building blocks for more complex financial derivative hedges.
In Lesson 5, you looked-up some natural gas cash prices at various hubs in the US using the link for Natural Gas Intelligence [11]. Using those same cash hubs and the high price for the day on which you accessed the web site, compare the most recent prices to the NYMEX daily Settlement price for front-month natural gas. Use the Henry Hub Natural Gas Futures [24] web site to find the Settlement price.
Natural gas intelligence has stopped posting all the cash prices listed below. In completing the Lesson 9 Activity, please report the five cash prices that you see on the natural gas intelligence website. Please report the high price traded on the day and include a screen shot.
As a reminder, the cash hubs that you might see in the report are:
Please chose five hubs. Calculate the difference as follows: Cash price minus NYMEX. Post your answers in the Canvas Activity. These results represent what is known as the "actual Basis" relationship between the NYMEX Henry Hub contract delivery point for natural gas in south Louisiana and other physical delivery points in the US.
Please also include a screen shot or PDF printout of the Natural Gas Intelligence website to verify your reported prices, as well as a screen shot of the NYMEX natural gas futures site to verify your Settlement price. Do not simply submit a screen shot of the web site. You must submit both the screen shot and a typed response with your reported prices and basis calculations.
This activity is worth up to 20 points on the EBF 301 grading scale. You will earn up to 4 points for each basis calculation correctly reported. TAKE NOTE!!! SUBMISSIONS THAT DO NOT INCLUDE SCREEN SHOTS FROM THE NYMEX AND NATURAL GAS INTELLIGENCE WEB SITE WILL RECEIVE NO CREDIT!!!
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Basic Energy Risk Hedging: in Canvas. Submit your work as a single word processed document to the Lesson 9 Hedging Activity in Canvas.
Fundamental Factors: Submit your work as a single word processed document to the Lesson 9 Fundamental Factors Activity in Canvas.
In the next lesson, 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.
Price exercise (previous page)
Log onto Canvas and complete the Lesson 9 Quiz.
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.
In Lesson 9, we focused on “futures” marketsand 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. There are a number of required activities in this module. The chart below provides an overview of the activities for this lesson. 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: Chapters 4 & 6 - Errera & Brown | Errera & Brown | No submission |
Mini-lecture:FinancialEnergySwaps | Mini-lecture: Financial Energy Swaps page | No submission |
Mini-lecture: Financial Energy Spread Trading | Mini-lecture:Financial EnergySpread Trading page | No submission |
Mini-lecture: Financial Energy Options Contracts | Mini-lecture:Financial EnergyContracts page | No submission |
Lesson Activity: Black-Sholes Model Exercise | Lesson Activity page | No submission |
Lesson 10 Quiz Fundamental Factors (on-going) |
Summary and Final tasks page Summary and Final tasks page |
Submit through Canvas Submit through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Errera & Brown - Chapters 4 & 6
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 one party or the other.
For example, as of this writing, the December, 2015 NYMEX crude oil contract is trading $44.85. If I bought a Swap, I would be setting my contract price at $44.85. On November 20th, 2015, this contract will settle, and the difference between my $44.85 and the NYMEX Final Settlement price that day, will be the amount exchanged between me and my counterparty. If the contract settles at $45.35, since I bought the Swap, I would be selling it back at that price for a profit of $0.50 and, my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $44.35, 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 9's hedging spreadsheet.
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 9, 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.
“Spread” trading can be used for hedging purposes or purely for trading (“arbitrage”). This involves using price differences in futures or forwards based upon time differences, locational differences and inter-commodity relationships.
In spread trading, futures or forwards can be used to achieve the desired results. A buy/sell is offset by a corresponding sell/buy. 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 the Canvas Modules under Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options.
The following Mini-Lecture summarizes the points presented above.
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.
While watching the Mini-Lecture, keep in mind the following key points and questions regarding Energy Risk Hedging Using Options Contracts:
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, 2015, they buy a crude oil Call Option at a Strike price of $50.00 since the current price is $45.00. If December prices remain below $45.00, the refiner does nothing and is out only the premium. However, should December prices exceed $50.00, the refiner calls the Option Seller and requests the number of crude oil contracts agreed upon at the $50.00 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 $50.00 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 $40.00 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 $40.00. Should prices remain above $40.00, 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 Canvas, under Lesson 10, you will find a spreadsheet called the Lesson 10 Options Model. It will give you a sense as to how the different inputs affect the put and call prices for an option. Please play around with a couple of examples (you can use commodities and/or stock options)). No need to submit anything.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Black-Sholes Model Exercise: No need to submit anything.
Fundamental Factors: Submit your work as a single word processed document to the Lesson 10 Fundamental Factors Activity in Canvas.
Over the past few weeks, you have been researching various Fundamental Factors that can be used to aid in making trading decisions. The other type of information, used by "Day Traders," is "Technical Analysis." In the next lesson, we will get an elementary overview of TA.
Log onto Canvas and complete the Lesson 10 Quiz
Submit your weekly Fundamental Factors
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.
Thus far, we have addressed the fundamental factors that influence energy prices. And we established that there are two main groups that trade in the financial energy commodities markets, commercial and, non-commercial. The latter group represents the “pure” Traders or “speculators." These participants are only interested in price movement. The type of commodity does not matter to them. In order to make trading decisions, they use Technical Analysis as opposed to Fundamental Analysis.
Technical Analysis involves the use of charts to track price movement, establish the current market trend, and to determine the probability of prices moving in one direction or another. Simply put, technical or “day” Traders are interested in market activity as illustrated by the resulting prices.
Since the prices that occur in the market are the result of human decision-making, Technical Analysis really examines the behavior of market participants. As such, patterns emerge that have a high probability of recurring. It is precisely these events that technical Traders are looking for. But, make no mistake; fundamental events cause Traders to react emotionally, the results of which are also reflected in the price action.
In Technical Analysis, Traders must first establish what the current price trend is, up or down. Then, they must determine the probability of the trend lasting or changing direction. It is this information that guides their buy/sell decisions.
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 this lesson. 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: Errera & Brown - Chapter 8 | Reading Assignment page | No submission |
Lesson Activity: Technical Chart Analysis | Lesson Activity page | Submit through Canvas |
Lesson 11 Quiz | Canvas | Canvas |
Fundamental Factors (on-going) | Summary and Final Tasks | Submi through Canvas |
If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), 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.
Errera & Brown - Chapter 8
There are several types of charting methods, but three of them are the most popular.
1) “Bar Chart” – a vertical line is shown for each time increment selected. In the chart below, a “daily” chart is used to show the September NYMEX contract for natural gas. Each bar shows the price results for that day’s trading. The mark to the left of the bar represents the first trade of the day, or the “Open.” This is the price of the first trade that occurs right after the bell rings to start trading. The vertical line itself represents the full range of prices for the day, that is, the High and Low prices. And the mark to the right of the bar represents the final closing, or “Settlement” price for the day.This is often referred to as the "OHLC" chart (Open/High/Low/Close).
2) “Close Only” – this type of chart shows only the daily market settlement price. It provides much less information than the Bar Chart and is mainly used for longer-term trend analysis. The chart below shows the same September natural gas contract in this form.
3) “Candlestick” – these charts were developed by the Japanese centuries ago. They provide information similar to the Bar Chart but also indicate “up and down” days. That is, they clearly show the direction the market took on a daily basis. The top end of the “candle” still represents the High for the day, and the lower end represents the “Low,” but the “body” indicates the Open and Closing prices in relation to one another. For example, if the Open is higher than the Close, the Open price is at the top of the “body” of the candle and represents a day where prices fell (solid "body"). Conversely, if the Close is found on the top of the “body,” it represents an “up” day, and on the chart below, appears with a hollow “body.” As you can now see, the up-and-down days are easily visible on the Candlestick Chart. By counting these, we can determine the current trend. For Traders, the question is, when will it reverse course?
Trendlines can be used to identify both long- and, short-term price trends. They are also used to indicate Support and Resistance prices and Channels (covered later). A trendline only has significance if it touches at least two price points. The chart below shows an obvious long-term downtrend going back one year.
This next chart illustrates two short-term trendlines, one up and one down.
When one trendline connects two or more price points and another trendline connects two or more price points in parallel fashion, they form a “Channel,” as shown below. Channels have significance in that traders look for prices to move above or below the confines of the Channel. This is referred to as a “breakout,” and depending on the number of days that form the Channel, this can occur with good momentum, resulting in a large price move in that direction.
1) Volume - One of the simplest clues to the strength of price movement is that of the Volume of contracts traded. If a price shows a large range or change in direction on a particular day, looking at the volume of contracts traded indicates how well supported that move was by the market participants. A $0.10 movement up or down in natural gas is not very significant if a low volume of contracts traded. On the other hand, when large volumes trade, that definitely reinforces the price action for the day. It’s as if those trading have agreed on the price outcome. The chart below is a Daily Bar Chart with Volume for natural gas. Notice that on August 9th, prices traded in a $0.25 range and a very large amount of contracts exchanged hands, solidifying the move. Then, on August 10th, prices fell and the second-highest Volume for the contract traded. Both of these Volumes add legitimacy to the price action for those days
2) Moving Averages – For those of you who have had statistics, you should be familiar with the term “reversion to the mean.” For those of you who have not, the concept hinges on the idea that all prices will eventually return to their average despite dramatic movements up or down. I have found this to be especially true for energy commodities, at least in the short-term. Therefore, tracking commodity moving average prices can be a good signal for a change in the direction of a trend. For instance, the chart below shows that the Moving Average for September, 2012, crude oil over a 30-day period was $95.69 while prices had risen to as high as $97.50. This means there is a good probability that they will eventually fall towards $95.69. It may be a gradual decline which also means the average will change, but as long as the MA is lower, prices will gravitate towards it. The exact opposite occurs when prices fall below the MA. The chart below illustrates this principal with the September, 2012, crude oil contract. Note that the timeframe for the MA is set to the particular Trader’s needs. I have set the MA at 5 days, as that represents a full week of trading (regular session, pit trading only occurs on weekdays). See how the prices, while moving above and below the MA, ultimately return to it. This is a key sign for making buy/sell decisions.
3) Relative Strength Index - Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, RSI is considered overbought when above 70 and oversold when below 30. RSI can also be used to identify the general trend. (Technical Indicators and Overlays - ChartSchool [25]) Understanding the exact RSI calculation is not necessary to understand how to use this indicator. The next chart is a Daily Bar Chart with Volume, MA and now, the RSI study. Note that the current RSI is over "70" which is considered “overbought. This could, therefore, be a signal to "Sell."
As with trend analysis and market indicators, there are several types of price signals. We will deal with a few of the ones that are more common and easy to use.
1) Support & Resistance: As prices move up-and-down, Traders make decisions as to when to continue to buy in an uptrend and when to sell in a downtrend; that is, they try to determine when the current trend will exhaust itself and change direction. One way to do this is to look at the “Support” and “Resistance” price levels. Support represents a price level at which Buyers will step back into the market after a period of selling. This interest establishes a “floor” price. Traders find value at this level and start to buy-up the contracts again. In some cases, Traders who have been selling contracts during the downtrend may be buying them back to take some profits. Resistance is the price level at which the market is no longer interested in buying contracts. The price is deemed to be too high and Sellers re-enter the market, thus establishing a "ceiling" price.
So, how do we establish these pricing points? As the chart below shows, when we draw upper and lower trendlines, the lines continue through price points on the right, vertical axis. Where the upper trendline crosses the right axis is the Resistance point while the price where the lower trendline crosses the right axis is the Support point. Theoretically, then, these represent both the maximum the market is willing to pay as well as the minimum at which is it willing to sell.
This chart indicates that Resistance is about $97.20 and, Support is about $95.00. Traders will now look to see if prices can trade above, or below, these levels. If they do, there will be a flurry of activity in the direction of the move.
2) “Tops & Bottoms.” Since we are on the subject of Support and Resistance, we can discuss price signals related to those concepts. As we have said, Traders are interested solely in price movement. And Support and Resistance levels represent buying and selling interest. So what happens when the Buyers or Sellers step-in to halt the moves higher or lower? They are testing the points of Support and Resistance. If the Sellers can’t break-through Support, it is a result of Buyers stepping-in. As mentioned above, that sets a “floor” or “bottom” price on that day. Likewise, if Buyers test the Resistance price and Sellers step in to prevent a breach of that level, a “ceiling” or “top” is established.
While a one-day occurrence of these events is not a very strong indicator of a change in direction, the more a “bottom” or “top” is tested and holds, the more significant that price level becomes. Think about it this way. Let’s say crude oil Traders are trying to sell September contracts and push the price down to the $95.00 Support level on the chart above. Buyers step in at that price and the sell-off fails. The next day, Sellers again attempt to push prices down to $95.00, and again, the move fails. The market now begins to see $95.00 as a stronger Support price. We refer to this as a “double-bottom.” While this is still a good indicator of price levels, a third day, or “triple-bottom” is a very strong indicator that prices will rally higher. Traders have no choice but to recognize the buying interest at $95.00 and thus will buy contracts until the Resistance, or “top” is tested. The same holds true for Resistance levels, but in reverse. The more “tops” are established, the stronger the level at which Sellers will step-in and sell contracts.
The September, 2012, natural gas chart below clearly illustrates this point. On August 15th, prices reached a High of $2.84. The next day, this level was tested by Buyers and "held," resulting in a “double-top” at $2.84. After that, the market reversed direction and tested new Lows. But, $2.68 held for 3-consecutive days, forming a "triple-bottom." This caused prices to rally the next day.
3) “Head-and-shoulders” reversal patterns: These are identifiable, 3-day price patterns that signal a change in direction and can be used for long-term or short-term trend analysis. This consists of three consecutive trading days where the middle day’s High, or Low, is higher or lower than that of the other two days. The first day then represents the “left shoulder,” the second day is the “head,” and the third day is the “right shoulder.” Using the chart below without all the trendlines, we can see that on July 31st, the High for the day was higher than the 30th. We are now looking for the completion of the pattern the next day. And on August 1st, the High for the day was lower than the prior day. Now you can see the pattern whereby the 30th is the “left shoulder,” the 31st is the “head,” and the 1st is the “right shoulder.” The right shoulder “leans” in the direction of the price change. In this case, prices reversed from an uptrend to a downtrend. There are also “reverse” head-and-shoulders patterns. These occur in an upside-down fashion and signal a move from a downtrend to an uptrend. Looking at August 6th, we see that the day’s Low was lower than that on the 3rd. Then on the 7th, the pattern was completed as that day’s Low was higher than the 6th. Since the “right shoulder” is leaning upward, the trend is now upwards.
4) “Consolidation” patterns: when upper and lower trendlines are drawn and are parallel to one another and perpendicular to the Y axis, they form a rectangular shape. The upper trendline does represent Resistance, with the lower trendline indicating Support. In this pattern, prices will move up-and-down within the rectangle. This “consolidation” is indicative of market indecision. Traders are not really sure what direction prices should take. It is a battle between Buyers and Sellers. The key here is the number of days this pattern continues to exist. The longer Traders battle, the more momentum builds-up for when prices break-out of this range. Think of it as a spring that winds tighter and tighter for each day prices stay within the consolidation range. That means a very large price movement will occur in the direction of the breakout. A good illustration of this is the September, 2012 natural gas contract, shown below. Starting on June 25th, the contract bounded by a Low of $2.70 for sixteen straight days. The High was $2.91 with the exception of three attempted "break-outs" that failed as prices returned to the Channel. But on July 18th, prices broke-out to the upside with good momentum and hit a 6-month High.
These are but a few of the methods in Technical Analysis used to try to determine when a greater probability exists of prices moving in one direction vs. another. Once determined, Traders enter or exit the market at those price levels.
Using what you have learned in this lesson, answer the following questions regarding the chart below and submit your answers in the Canvas Activity.
This activity, due at 11:59 pm on Sunday, is worth up to 20 points on the EBF 301 grading scale. Each question is worth up to 2 points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Technical Chart Analysis Activity: Submit your answers to the Lesson 11 Technical Chart Activity.
Fundamental Factors: Submit your work as single word processed document and screen captures to the Lesson 11 Fundamental Factors Activity in Canvas.
In addition to my explanations, the definitions of terminology used in Technical Analysis can be found at:
Technical Indicators and Overlays - ChartSchool [25]
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.
On December 2, 2001, Enron Corp., at the time the world's largest energy trading company, declared bankruptcy, causing a loss of $11 billion dollars for its shareholders and billions morefor its trading counterparties. At the time, it was the largest bankruptcy filing in US history. As events unfolded and the investigations took place, it was revealed that there were several "off-sheet," "paper" companies churning-out false earnings. These were "mark-to-market," unrealized earnings, that had no cash gains associated with them. Ultimately, it was a lack of controls, or a failure to adhere to them, that allowed this to occur. Top executives at Enron were convicted and sent to prison, and their outside auditors, Arthur-Andersen, would go out of business.
In this lesson, we will learn about other famous cases where financial disasters took place due to a lack of controls and oversight. We will explore concepts such as "mark-to-market," and "Value at Risk," both financial risk measures that are mandatory for today's publicly-traded energy companies who deal in financial derivatives.
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 this lesson. 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: Case Studies | Reading Assignment page | No submission |
Mini-Lecture: Risk Control | Mini-Lecture: Risk Control page | No submission |
Lesson Activity: Baring's Bank Case Study Analysis | Lesson Activity page | Submit through Canvas |
Lesson 12 Quiz Fundamental Factors (on-going) |
Summary and Final tasks page Summary and Final tasks page |
Submit through Canvas Submit through Canvas |
Read each of the following case studies (on the following pages) before viewing the lecture.
In February, 1995, Nick Leeson, a “rogue” trader for Barings Bank, UK, single-handedly caused the financial collapse of a bank that had been in existence for hundreds of years. In fact, Barings had financed the Louisiana Purchase between the US and France in 1803. Leeson was dealing in risky financial derivatives in the Singapore office of Barings. He was the lone trader there and was betting heavily on options for both the Singapore (SIPEX) and Nikkei exchange indexes. These are similar to the Dow Jones Industrial Average (DJIA) and the S&P500 indexes here in the US.
In the early 90s, Barings decided to get into the expanding futures/options business in Asia. They established a Tokyo office to begin trading on the Tokyo Exchange. Later, they would look to open a Singapore office for trading on the SIMEX. Leeson requested to set-up the accounting and settlement functions there and direct trading floor operations (different from trading). The London office granted his request and he went to Singapore in April, 1992. Initially, he could only execute trades on behalf of clients and the Tokyo office for "arbitrage" (Lesson 10) purposes. After a good deal of success in this area, he was allowed to pursue an official trading license on the SIMEX. He was then given some "discretion" in his executions meaning; he could place orders on his own (speculative, or "proprietary" trading).
Even after given the right to trade, Leeson still supervised accounting and settlements. And there was no direct oversight of his "book" and he even set-up a "dummy" account in which to funnel losing trades. So, as far as the London office of Barings was concerned, he was always making money because they never saw the losses and rarely questioned his request for funds to cover his "margin calls" (Lesson 3). He took on huge positions as the market seemed to "go his way." He also "wrote" options, taking-on huge risk (Lesson 10).
He was, in fact, perpetuating a "hoax" in his record-keeping to hide losses. He would set the prices put into the accounting system and "cross-trade" between the legitimate, internal, accounts and his fictitious "88888" account. He would also record trades that were never executed on the Exchange.
In January, 1995, a huge earthquake hit Japan, sending its financial markets reeling. The Nikkei crashed, which adversely affected Leeson's position (remember, he had been selling Options). It was only then that he tried to hedge his postions, but it was too late. By late February, he faxed a letter of resignation, and when his position was discovered, he had lost ($1.4 billion USD). Barings, the bank which financed the Louisiana Purchase between the US and France, became insolvent and was sold to a competing bank for $1.00!
(If you are interested in more details regarding this infamous case, you can read "Rogue Trader" by Nick Leeson himself. There is also a movie of the same name starring Ewan McGregor which should be available for rent in DVD format.)
The following two cases are brief descriptions of similar, catastrophic losses by traders with little, or no, oversight.
Robert Citron was the Treasurer for Orange County, California, in the early 90s. He was solely responsible for investing several of the county’s funds which totaled about $7.5 billion USD. Despite having no background in trading financial instruments, he decided to invest in risky interest rate swaps that were tied to the US Treasury Department’s rates.
Citron was a County Tax Collector with no college degree who was later elected to the position of Orange County Treasurer. In this capacity, he was able to push for California legislative approval for county treasurers to increase their use of financial instruments for investment and fund management.
He was attempting to artbitrage the difference between short-term and long-term interest rates. His position was sound and he could make money so long as short-term rates remained low. During his tenure, the average return on county investments was a healthy 9.4%, but interest rates had been low for that long.The position he took would lose money if interest rates rose. And, he inflated the county’s volumetric position by entering into other derivatives that would also be negatively impacted by higher interest rates.
Beginning in February, 1994 the Federal Reserve Board made the first of six consecutive interest rate hikes. Between February and May of that year, the County had to produce $515 million in cash (margin) to cover its position. Further margin calls would occur throughout year, leaving the County's cash reserves at only $350 million by November, 1994.
When word got out about the County's troubles raising cash, investors sought to retrieve their money, and by December 6, 1994, the County declared bankruptcy and lost ($1.64) billion.
MG was a huge, German industrial conglomerate that decided to open an energy trading office in the US in the early 90s.
The original plan was threefold:
When the strategy was first implemented in 1992, current physical prices were lower than the futures prices. So the sales contracts were set at those higher future prices. And it meant that purchasing the "near" month futures contracts would be profitable. So MG developed a strategy whereby they would cover the long-term, fixed-price sales by buying contracts in these few, near months. As each month "rolled-off," they would merely buy contracts in the next month. It was their intent to continue this process until the physical product sales contracts expired in (10) years. This strategy worked as long as the futures market was "backwardated," whereby each successive month is lower than the prior one (Lesson 3).
One of the major flaws in this approach, however, was the volume of contracts being traded since they were "loading-up" on closer month contracts. Add to that the fact that they would not get paid for the product sales for years out, and you begin to have a cash flow problem where margin calls are concerned. Their position in the Fall of 1993 was estimated to be between 160 to 180 million barrels stretched-out over the following (10) years.
In 1993, prices fell as the market received a "bearish" signal from OPEC on production quotas. This lowered futures prices and reversed the market from "backwardated" to "contango," whereby each successive month's price is higher than the prior one (Lesson 3). Faced with this position, MG management was changed and the new team was directed to close all positions. This resulted in losses on the futures purchases totalling almost ($1.5) billion USD. The had to seek bailout funds from one of their banks, and in return, had to sell-off several divisions.Today, the German industrial giant no longer exists having been bought-out by a competitor.
There were some common themes that ran through each of these cases.
These events, along with others, prompted the financial industry to institute ways to monitor, track and stay on top of, financial derivative trading. These same methods would later have to be adopted by publicly traded energy companies in the US.
Using the information presented in this Lesson, evaluate the Baring's Bank case to determined where the flaws were in the risk controls.
This activity is worth up to 20 points on the EBF 301 grading scale. Each question is worth up to 4 possible points.
The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [9] for additional information and grading rubric.
Case Study Activity: Submit your findings to the Lesson 12 Case Study Activity in Canvas.
Fundamental Factors: Submit your work as a single word processed document Lesson 12 Fundamental Factors Activity in Canvas.
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.
Links
[1] https://www.e-education.psu.edu/ebf301/44
[2] http://www.eia.gov/forecasts/ieo/world.cfm
[3] https://web.archive.org/web/20150930155519/http://www.petrostrategies.org/Learning_Center/oil_and_gas_basics.htm#What%20are%20Crude%20Oil%20and%20Natural%20Gas?
[4] https://web.archive.org/web/20150930215323/http://www.petrostrategies.org/Learning_Center/fracturing_operations.htm
[5] http://www.eia.gov
[6] http://www.bing.com/videos/search?q=This+Is+Nymex&&view=detail&mid=9DE87C62F2EEDD5F38939DE87C62F2EEDD5F3893&FORM=VRDGAR
[7] http://web.archive.org/web/20121002065446/http://www.rbnenergy.com/henry-the-hub-i-am-i-am-understanding-henry-hub
[8] https://www.e-education.psu.edu/ebf301/node/680
[9] https://www.e-education.psu.edu/ebf301/680
[10] http://ir.eia.gov/ngs/ngs.html
[11] http://intelligencepress.com/features/intcx/gas/
[12] http://www.platts.com/IM.Platts.Content/ProductsServices/Products/gasdaily.pdf
[13] http://www.platts.com/IM.Platts.Content/ProductsServices/Products/gasmarketreport.pdf
[14] http://www.opisnet.com/Images/ProductSamples/NAmericanLPGReport-sample.pdf
[15] http://www.argusmedia.com/Crude-Oil
[16] https://www.e-education.psu.edu/
[17] http://science.howstuffworks.com/environmental/energy/oil-refining3.htm
[18] http://www.naturalgas.org
[19] https://www.e-education.psu.edu/ebf301/sites/www.e-education.psu.edu.ebf301/files/1989%20JOA%20%28Clean%29.pdf
[20] https://www.e-education.psu.edu/ebf301/498
[21] https://www.e-education.psu.edu/ebf301/473
[22] http://www.downsizinggovernment.org/energy/regulations
[23] http://webapps.elpaso.com/PortalUI/DefaultKM.aspx?TSP=NGPL
[24] http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html
[25] http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators
[26] https://www.e-education.psu.edu/ebf301/sites/www.e-education.psu.edu.ebf301/files/images/lesson11/lesson11_Activity_Chart.jpg
[27] https://www.e-education.psu.edu/ebf301/569
[28] https://www.e-education.psu.edu/ebf301/570
[29] https://www.e-education.psu.edu/ebf301/571