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Price Risk Management

NOT AN OFFICIAL UNCTAD RECORD. Algeria 2006 Africa Oil & Gas Trade & Finance Algiers - April 2006. Price Risk Management. Dr Abdelatif Abada BP - Structured Products. Disclaimer.

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Price Risk Management

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  1. NOT AN OFFICIAL UNCTAD RECORD Algeria 2006Africa Oil & Gas Trade & Finance Algiers - April 2006 Price Risk Management Dr Abdelatif AbadaBP - Structured Products

  2. Disclaimer This presentation and any services described in it are intended only for Market Counterparties or Intermediate Customers as those terms are defined by the UK Financial Services & Markets Act 2000 and the FSA Handbook, or only for Eligible Contract Participants as that term is defined in the U.S. Commodity Exchange Act. This presentation and its contents have been provided to you for informational purposes only. This information is not advice on or a recommendation of any of the matters described herein, whether they consist of financing structures (including, but not limited to senior debt, subordinated debt and equity, production payments and producer loans), investments, financial instruments, hedging strategies or any combination of such matters and no information contained herein constitutes an offer or solicitation by or on behalf of BP p.l.c. or any of its subsidiaries (collectively "BP") to enter into any contractual arrangement relating to such matters. BP makes no representations or warranties, express or implied, regarding the accuracy, adequacy, reasonableness or completeness of the information, assumptions or analysis contained herein or in any supplemental materials, and BP accepts no liability in connection therewith. The actual terms and conditions of any contract or specific arrangement that may be entered into between you and BP may differ from the arrangements described in this presentation. BP deals and trades in energy related products and may have positions consistent with or different from those discussed herein. There is no assurance that the structure described herein will hedge risks the recipient may incur in the operation of its business. Prior to dealing in any investment or financial instrument or entering into any risk management product arrangement, you should obtain your own tax, legal and other advice as they may expose you to inappropriate financial risk.

  3. Content • Context & Back to Basics • What is Price Risk Management • Various type of Solutions • Tools and derivative instruments • Structures & hedging strategies • Summary

  4. Context: Energy Risk • World events and growth have thrown a spotlight on security of energy supply, energy costs and price volatility • Energy costs & revenues are a significant source of uncertainty for budgeting purposes • They feed directly through to a company’s bottom line • The need to understand energy market risk has never been greater

  5. Who are the players? Types of energy traders • Producers • Oil and gas producers • Renewable power generators • Transformers • Power generators • Oil refiners • Chemical refiners • Resellers • End Users • Air, land and sea transport companies • Commercial and industrial users • Domestic users • Governments

  6. Types of trading • Speculation: taking risky positions in a market with the intention of exploiting market price movements. • Frequent In & out of the Market looking for potential gain opportunities • View driven • Take a bet on the future direction of a market • Want price volatility (uncertainty) to increase • Will enter into deals and set limits when to exit • Hedging: trading activity intended to reduce the riskiness of a portfolio. • Reduce/eliminate the risk faced from potential future price movements • In & out of the Market only when there is a (strategic) business • Business objective driven • Reduce/”hate” exposure to volatility of the business • Want certainty at the cost of sacrificing away potential upside • No surprise approach • Arbitrage: trading activity resulting in a riskless profit, usually arising from participants exploiting inefficiencies in a market or mis-pricing of derivatives. The forces of supply and demand usually ensure these price mismatches subsequently disappear as a result of the trade being executed.

  7. Some Definitions: What is risk? • Most dictionary definitions of risk relate to hazard, exposure to misfortune, or other quite negative meanings • Definition for our purposes:Risk:Exposure to an uncertainty • Risk Management or Hedging:is about transforming an “unknown” (uncertain) future cash flow to a “known” (certain) one

  8. Risk management objectives Use of Price Risk Managment Tools to meet the following objectives: • Costs and revenues stabilisation • Secure positive margins • Elimination of price risk to ensure budget predictability • Competitive advantage • Strategic hedged-based finance

  9. Exchange Futures Standardised options Volumes are regulated Indices are restricted (Brent, WTI, etc) Delivery and settlement dates are regulated “Clearing houses” IPE, NYMEX, ICE, CBOT, SFE… Types of markets Over The Counter Swaps Exotic options Packages and structured Products • No restriction on volumes • All indices/products are traded • Delivery/Settlement dates are agreed upon • Hedging structures are designed to meet exact exposure

  10. Types of risk management tools • Linear instruments • Fixes the future price at a level agreed today (forwards, futures, swaps) • Non-linear instruments • Right of achieving a maximum or a minimum protection price (options and derivatives) • Structured products • Tailored package (combination of above) • Interaction between different risk factors (physical commodities, FX, interest rates, freight, etc)

  11. Swap contracts • A purely financial (paper) transaction between two parties who agree to make regular payments to each other in the future • Allows the exchange of a variable or floating price for a schedule of fixed price payments • Swaps can pay out on the basis of differing notional volumes month-by-month • Need to agree: • Floating price index • volume • time period • fixed price • No premium outlay

  12. Swap: Application Fuel Oil Fuel Oil Refinery Seller Customer V (tons) V (tons) FOn($) Fixed($) P0($) 0.7*V (tons) FOn($) • Buy a Swap on FO: • Monthly cash settled; • pay a fixed price P0($); • receive the floating price FOn($) • for the next 12 months; • Volumes (tons) per month = 0.7*V • Decision made to: • fix the price of Fuel Oil; • for the next 1 year; • in US$ or other (e.g., €) bpriskmanager Net Margin for Seller on a given month: 30% × (Fixed – FOn) + 70% (Fixed – P0)

  13. Option instruments • Options are derivative instruments that provide the holder with the right, but not the obligation, to pay or receive some quantity of cash or commodity, at an agreed strike price • Options come in many different flavours, and have a whole language associated with them • A call option provides the holder with the right, but not the obligation, to receive the underlying at some agreed strike price, an operation known as exercising • A put option provides the holder with the right, but not the obligation, to exercise by selling the underlying at the strike price • Options are asymmetric, they guarantee their holder needs never exercise unless market prices are in their favour • Since there is no such thing as a free lunch, the option purchaser needs to pay an option premium for this “insurance”

  14. Option: Application Gas K= $40 Supplier bpriskmanager Buyer V×a (bbls) V (tons) $$-premium Brentn($) • Buy a Put Option on Brent: • Monthly cash settled; • pay a premium p upfront, or • as part of settlement; • receive: Max (0, $40 – Brentn) per bbl; • for the next 10 years; • Volumes (bbls) per month = a×V • Decision made to: • protect against prices ≤$40/bbl; • for the next 10 years; • on 100% of the volumes Net price to receive for LNG for next 10 years: Pn($) = [a × Max(40, Brentn) + b] - p

  15. Option: Application a = 0.1; b = 0premium= $5/bbl

  16. Option prices • Option premiums are impacted by: • Current market price (Forward prices) • Strike price • Time to expiry • Risk-free interest rates • Volatility of the underlying market • Volatility is the most important “unobservable” market data. • It is a measure of the uncertainty/instability of future prices

  17. Hedging Refinery Crack Margin • Consider a refinery of 55kbd • Consider that the refiner needs to meet some fixed payments during next 2 years to service a $120MM loan. I.e. $5MM per month* • Consider the Jet Fuel yield is 30% (i.e. 16.5kbd) • Market Forward price for Crude and Jet Fuel are such as the margin for next two years is: $10/bbl *Ignore interest effect

  18. Hedging Crack Spread: Example Solution to secure repayments: • Refiner Sells a Swap • Underlying: Refining margin Jet/Crude • Volume: 16.5kbd (i.e. ~500kbbls/month) • Period: 2 Years • Starts: July-06 • Ends: June-08 • Settlement: end of each Calendar month • Fixed price: $10/bbl *Ignore interest effect

  19. Hedge and Physical Transactions bpriskmanager Fixed = $10/bbl Floating:Monthly average of Margin Refinery Physical crude and product Floating:Monthly average of Margin Physical market Settlement Amount = Monthly Volume * ($10 – Margin) Settled by either party on, say, 5 business days after end of each month

  20. Hedging Crack Spread: ExampleWhat happens at each settlement? Crude Price ($/bbl) Jet price ($/bbl) Physical Transaction Crack Spread Swap outcome to Refinery: $10.0 - Margin Net Effect: Achieved Margin = $10.0 Secure Payment of $5MM / month

  21. Another Mitigation Solution:Indexation • Refinery can buy Crude on a price linked, e.g., to gasoil price: • Crude Oil price ($/bbl) = a* Gas Oil price + b • a & b two constant parameters • Or, • Refinery enter into a “reference swap” (i.e. financial hedge) where Crude oil price is swapped to a Gas Oil price (formula as above)

  22. Summary • An ENERGY player can add value to its business through: • Understanding the Risk Management solutions that exist to manage price exposure; • Being able to enter into the most appropriate solution when needed, after defining the business model of the company (how much exposure to hedge? How far in time? And other corporate considerations); and • Transact when a decision is made to hedge. • Once it executes the appropriate hedge, one becomes indifferent to prices movements during the hedged period.

  23. Something to remember... • Price Risk Management is not Speculation • It is about reducing risk to future market movement • It is about Margin & Return On Investment stabilisation/Protection • It is about seeking certainty in an uncertain world

  24. THANK YOU Abdelatif.Abada@bp.com +65 9835 3118 +65 6371 8201

  25. bpriskmanager Services • bpriskmanager is a core part of BP’s Integrated Supply and Trading Organisation • We offer cross-commodity and cross-currency hedging service to BP and to external counterparties • Our activities comprise derivatives marketing, commodity options trading, financial FX, Money Market & Metals trading, and structured products • bpriskmanager works with its partners to help them understand their risk exposures, and explains the range of hedging tools available to them, including in-house financially-engineered structures. It then prices and transacts the hedge selected by the customer

  26. Context within BP Trading BP’s Customers Oil Market Analysis OTC Options Marketing (bpriskmanager): London, Chicago and Singapore Structured Financing Quantitative Analysis BP’s Trading Books Crude Oil Gas & Power & Emissions • Products • Gasoil • Jet • Gasoline • Naphtha • Fuel Oil Shipping Freight • Metals • Non/precious Forex & Money Markets Structured Products

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