Price Risk ManagementDr Abdelatif AbadaBP - Structured Products

Algeria 2006Algeria 2006

Africa Oil & Gas Trade & Africa Oil & Gas Trade & Finance Finance

Algiers - April 2006Algiers - April 2006

NOT AN OFFICIAL UNCTAD RECORD

DisclaimerThis 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.

Content

• Context & Back to Basics• What is Price Risk

Management• Various type of Solutions

– Tools and derivative instruments– Structures & hedging strategies

• Summary

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

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

Types of trading1. Speculation: taking risky positionsrisky 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

2. Hedging: trading activity intended to reduce the riskinessreduce 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

3. Arbitrage: trading activity resulting in a riskless profitriskless 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.

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

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

Types of marketsExchange

FuturesStandardised options

• Volumes are regulated• Indices are restricted

(Brent, WTI, etc)• Delivery and settlement

dates are regulated• “Clearing houses”• IPE, NYMEX, ICE, CBOT,

SFE…

Over The CounterSwapsExotic optionsPackages 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

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)

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

Swap: Application

Refinery Seller

Fuel Oil

V (tons)Customer

0.7

*V (

ton

s)

FOn($)

bpriskmanager

V (tons)

Fixed($)

Fuel Oil

FO

n($

)

P0(

$)

• Decision made to:

• fix the price of Fuel Oil;

• for the next 1 year;

• in US$ or other (e.g., €)

• 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

Net Margin for Seller on a given month: 30% × (Fixed – FOn) + 70% (Fixed – P0)

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”

Option: Application

bBrentabtuP nn )/($

Buyer Supplier

Gas

V (tons) bpriskmanagerV×a (bbls)

Brentn($)

K= $40

• Decision made to:

• protect against prices ≤ $40/bbl;

• for the next 10 years;

• on 100% of the volumes

• 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

Net price to receive for LNG for next 10 years: Pn($) = [a × Max(40, Brentn) + b] - p

$$-premium

Option: Applicationa = 0.1; b = 0premium= $5/bbl

LNG Price Formula ($/Ton)

0

1

2

3

4

5

6

7

8

9

10

0 10 20 30 40 50 60 70 80 90 100

Brent ($/bbl)

Ne

t L

NG

pri

ce

@ d

eli

ve

ry

Do Nothing Put Protection

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

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

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

Hedge and Physical Transactions

bpriskmanager

Refinery

Fixed = $10/bbl Floating: Monthly average of Margin

Settlement Amount = Monthly Volume * ($10 – Margin)Settlement Amount = Monthly Volume * ($10 – Margin)

Settled by either party on, say, 5 business days after end of Settled by either party on, say, 5 business days after end of each month each month

Physical market

Floating: Monthly average of Margin

Physical crude and product

Hedging Crack Spread: ExampleWhat happens at each settlement?

Physical Transaction

Crack Spread Swap outcome to Refinery: $10.0 - Margin

Net Effect: Achieved Margin = $10.0

Secure Payment of $5MM / month

Crud

e Pr

ice

($/b

bl)

Jet price ($/bbl)

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)

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.

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

THANK YOU

Abdelatif.Abada@bp.com

+65 9835 3118

+65 6371 8201

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

BP’s Customers

Marketing (bpriskmanager):London, Chicago and Singapore

Products•Gasoil•Jet•Gasoline•Naphtha•Fuel Oil

Crude Oil Gas & Power & Emissions

Shipping Freight

Metals •Non/precious

Forex & MoneyMarkets

StructuredProducts

Options

Quantitative Analysis

OilMarket

Analysis

StructuredFinancing

OTC

BP’s Trading Books

Context within BP Trading