Published on EBF 301: Global Finance for the Earth, Energy, and Materials Industries (https://www.e-education.psu.edu/ebf301)

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Lesson 9 - Basic Energy Risk “Hedging” using Financial Derivatives

Lesson 9 Introduction

Overview

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.

Key Learning Points – Energy Risk Hedging

  • Producers and Consumers of energy can reduce both theirphysical (marketor supply)and price risk using financial derivatives such as futures and forwards.
  • Futures are exchange-traded contracts such as the NYMEX energy commodities: crude, natural gas, heating oil and unleade gasoline.
  • “Over-the-counter,” or “OTC” contracts, are known as “forwards.” These are non-exchange traded and can either involve an electronic trading platform or “voice” Broker.
  • Hedgers are not speculators.
  • In a hedge, Commercial participants in financial markets take the opposite position from what they have in the physical markets.
  • Financial positions must be settled monthly.
  • Storage capacity can be hedged through buying one month and selling a future month.

Learning Outcomes

At the successful completion of this lesson, students should be able to:

  • Understand how price risk reduction can occur through the use of basic financial derivatives
    • NYMEX contracts
    • “Basis Swaps”
  • Understand how commodity risk can be reduced
  • Demonstrate a simple “hedge” structure for:
    • Energy commodity Producers
    • Energy commodity Consumers
    • Storage

What is due for this lesson?

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.

Lesson 9 Requirements
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

Questions?

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.

Reading Assignment: Lesson 9

Reading Assignment:

Errera & Brown - Chapter 5

Key Points of Emphasis

  • Hedging reduces both physical and financial risk.
  • Hedging is performed by commercial entities; it is not "trading."
  • Hedgers have two positions, one in financial and one in physical.
  • Hedgers must take an opposite position in the financial market to the one they have in the physical market.
  • Commodity producers are "long" the physicals and must sell the financials.
  • Commodity consumers are "short" the physicals and must buy the financials.
  • Multi-month hedges or, "strips," can be obtained.

Reducing Commodity Risk

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.

Simple Hedging

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.

Steps in a Financial Energy Hedge

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.

Lesson Activities

Physical (cash) prices vs. Financial Settlements for natural gas Activity

In Lesson 5, you looked-up some natural gas cash prices at various hubs in the US using the link for Natural Gas Intelligence [1]. 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 [2] web site to find the Settlement price.

Important Note

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:

  • EAST - "Transco Z6 (NY)" - this is the price of gas delivered to NYC.
  • GULF/TEXAS - "Henry" - this is the physical delivery point for financial natural gas futures contracts (Lesson 3)
  • GULF/TEXAS - "Houston Ship Channel" - this is the price of gas delivered to the huge petrochemical refining corridor east of Houston (Lesson 3).
  • MIDCONTINENT - "NGPL Midcont" - this is the price for gas in Western OK and the Texas Panhandle. It is also the area we used in Lesson 5 as an example for transportation costs.
  • WEST - "SoCal Border" - this is the price of gas delivered to the border of California for Southern California Gas Company ("SOCAL"), the country's largest LDC.
  • WEST - "Waha" - this is a major pipeline "hub" in West TX (recall the national pipeline grid which shows pipes intersecting one another), which reflects Texas demand as well as demand in NM, AZ and CA.
  • WEST - "Kingsgate" - this is an import point for Canadian gas.

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.

Grading Criteria

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!!!

Fundamental Factors

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 [3] for additional information and grading rubric.

Submitting Your Work

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.

Summary and Final Tasks

Key Learning Points: Lesson 9

  1. The financial derivative contracts for energy commodities provide actual supply and market for commercial players.
  2. Fixed prices for the commodities can be established as well.
  3. Utilizing financial derivatives to reduce one’s price and supply/market risk is known as “hedging.”
  4. Commercial entities must take a financial position that is the opposite of their physical position in order for the hedge transaction to be successful.
  5. Producers of the commodity are said to be “long” the physical product and therefore, must be Sellers in the financial market (sell contracts).
  6. Consumers for the commodity are said to be “short” the physical product and therefore, must be Buyers in the financial market (buy the contracts).
  7. Companies that lease storage capacity can hedge their price, supply, and market risk through buying contracts in one month and selling contracts in a subsequent month. This is known as a “time” or “storage” spread.
  8. By taking these opposite positions, price changes in one market are offset by price changes in the other market. When these occur on a 1:1 basis, it is referred to as a “perfect” hedge.
  9. These are known as “simple, fixed-price” hedges and represent the “first layer” of any more complex hedge transaction.

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.

Activities

Price exercise (previous page)

Quiz

Log onto Canvas and complete the Lesson 9 Quiz.

Reminder - Complete all of the lesson tasks!

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.


Source URL: https://www.e-education.psu.edu/ebf301/node/530

Links
[1] http://intelligencepress.com/features/intcx/gas/
[2] http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html
[3] https://www.e-education.psu.edu/ebf301/680