The Crude Oil Market. Risks and Opportunities


Term Paper, 2017
14 Pages, Grade: 84,0 %

Excerpt

Contents

List of Figures

Introduction

Definitions
Cost of carry
Basis Risk
Contango and Backwardation

Main Body

Recommendation

Reference List

List of Figures

Figure 1 – Variation of basis over time (Hull, 2017, p. 77)

Figure 2 - Futures Price of a Contract Going Forward in Time (Harper, n.d.)

Figure 3 - Multi-year strips of NYMEX crude oil futures prices, $/barrel, for four different dates. (McDonald, 2013, p. 183)

Figure 4 - Crude Oil Prices: West Texas Intermediate (WTI) from 28/11/2012 until 27/11/2017 (FRED)

Introduction

Companies that deal in future markets of commodities like the Crude Oil market are confronted with divers problems, which will be described and analysed in the following pages. There are many numerous factors that must be taken into consideration like the ‘cost of carry’, the basis risk, the importance of Contango and Backwardation and the costs and benefits associated with the utilization of options in general. In this concrete case an important client of our major consultancy firm has asked for an assessment of their current risk management policies, because they are primarily concerned with their exposure to rising energy cost including unexpected costs in managing their futures and forwards hedges in the Crude Oil market in the past two to three years. My task in the following paragraphs is to describe the problems and risks of futures, especially in the Crude Oil market, but also mention the chances implied with this market and the way to deal with it. At best, it will be possible for me to help our client to understand their past decisions and what was wrong with them, and to give them a recommendation for the future how they may improve their overall hedging strategy. Nevertheless, there does not exist any market that is safely predictable, thus there will not be a 100 percent safe prediction that guarantees profit, caused through for instance environmental disasters, political crises, or many more. This is another point I will show an interest in later by analysing the futures price, how it is developed, and the potential risks are included.

Definitions

For an easier understanding of the following analysis it is essential to define the used terms concretely so that misunderstandings can be eliminated and to make it transparent and comprehensible for the client. Within these definitions we will become familiar with the principles that are used in the analysis of the issue.

Cost of carry

“The relationship between futures prices and spot prices can be summarized in terms of the cost of carry.” (Hull, 2017, p. 145). In general, the futures price differs from the current spot price of a certain commodity or a stock because of the expectation how the share will develop over the period. The end date of this period is fixed by the date when someone wants to buy the asset, e.g. you intend to buy an asset on the 5th of April, this is your end of the period and the expected futures prices on this day is compared with the spot price. The futures price can be created with an easy formula, which is influenced by the financing cost , also known as riskless rate, the storage cost , the income (in case of a consumption commodity) or the dividend yield (if it is a financial commodity) and the convenience yield . The financing costs exist because there must be someone who stores the commodity during the period until the maturity, probably this person need to fund that money or borrow it, the storage costs are justified by the fact that commodities must be stored. The convenience yield is any other benefit, tangible or intangible, to owning or holding or carrying the commodity asset, so you do not have to worry about a shortage e.g. in the crude oil market (Hull, 2017, pp. 144-145). The formula for the futures price is as follows: We also apply continuous compounding at the time equal to of the four forces, is the futures price, stands for the spot price of the commodity (Harper, 2008). So, the cost of carry is the difference between current the spot price and the futures price. Are those prices equal and “The forward contract, unlike the stock, requires no investment and makes no payouts and therefore has a zero cost of carry.” (McDonald, 2013, p. 138).

Basis Risk

“The basis in a hedging situation is as follows: ” (Hull, 2017, p. 77). If the spot price and the futures price are equal, the basis of the asset to be hedged is zero. This should be the case at the maturity of the futures contract.

Abbildung in dieser Leseprobe nicht enthalten

Figure 1 – Variation of basis over time (Hull, 2017, p. 77)

As you can see in Figure 1 the spot price and the futures price get closer to each other with the time, finally, a brief time after , they are equal. The fact that the prices are not equal at , can be caused through the basis risk. If, in this case, is the date when you must decide whether the futures contract is closed or dismissed, there will be a certain risk for the hedger because he does not know what will happen with the asset’s price in the following days before its delivery. In general, “The more the basis fluctuates, the more basis risk there is, and the more uncertain will the investor be about the net value of the position at the close-out date.” (Nader, 1998, p. 3). Regarding to the crude oil market, which will be analysed more accurately later, “Basis risk is a generic problem with commodities because of storage and transportation costs and quality differences.” (McDonald, 2013, p. 186). These quality differences can also occur in problems and risks for the producer, potential customers could insist on a discount because they did not receive the ordered grade of oil (Hull, 2017, p. 799).

Contango and Backwardation

The terms contango and backwardation are used to point out the relation between the futures price in the contract and the future spot price. As demonstrated in the previous paragraphs, the futures price for commodities is an expectation how the asset will develop until the maturity. Of course, it is not possible to predict the futures price exactly and with a probability of 100 percent, so usually there is a difference between the futures price and the expected future spot price (boerse.de, n.d.). Accordingly, there are the following possibilities: Either the expected futures spot price is below, or it is above the futures price. “When the futures price is below the expected spot price, the situation is known as normal backwardation; and when the futures price is above the expected future spot price, the situation is known as contango.” (Hull, 2017, p. 148). For a better understanding it is helpful to illustrate this with a short example. We assume that we have a futures contract which we bought in June for 500€. One month later this futures contract could still be at 500€, but also higher or lower. If the expected future spot price increased, for example to 520€, we have a backwardation situation; and if the future spot price decreased we have a contango situation (Harper, n.d.). The following figure will illustrate these facts more precisely.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2 - Futures Price of a Contract Going Forward in Time (Harper, n.d.)

Evidently the contango graph is above the linear expected future spot price line, so the futures contract price is higher than the expected price. The closer we come to the maturity, the closer gets the contango graph to the future spot price. The backwardation graph runs inverse to the contango graph, it is below the expected future spot price and increases or gets closer to the linear graph with the time. “[…] On the maturity date, the futures price must equal the spot price. If they don’t converge on maturity, anybody could make free money with an easy arbitrage.” (Harper, n.d.).

Main Body

The main body can be divided up into two parts: the problem statement of this case and the subsequently some approaches to resolve the issues. The consultancy firm’s client is primarily concerned with their exposure to rising energy costs and serious difficulties in managing their future and forwards hedges in the Crude Oil market, thus in the following the focus is set on these issues.

At the beginning some basic facts about the crude oil market, how the oil is generally traded and hedged, and the risks involved. “Two important benchmarks for pricing are Brent crude oil (which is sourced from the North Sea) and West Texas Intermediate (WTI) crude oil.” (Hull, 2017, p. 799). Crude oil is naturally occurring and can be refined into various consuming products such as gasoline or heating oil. Unlike natural gas, oil is easier to transport and store, so the price of oil is relatively independent to seasons, it is more affected through supply and demand. Regarding the disadvantages of oil, the main factor is ecological. Oil is one of the main reasons of global warming and there are also risks of poisoning, e.g. the explosion on the drilling platform “Deepwater Horizon” in the Gulf of Mexico in 2010. This disaster entailed the leakage of more than 780 million litres oil into the ocean; a great many plants and fish were killed (Lohmann & Podbregar, 2012, pp. 77-80). Futures and forwards prices of commodities underlie the expectation of the futures spot price, therefore the prices for futures contracts in a market with rising prices will also rise with its maturity.

Abbildung in dieser Leseprobe nicht enthalten

Figure 3 - Multi-year strips of NYMEX crude oil futures prices, $/barrel, for four different dates. (McDonald, 2013, p. 183)

Figure 3 illustrates the futures prices in four different years. In 2004, the price was expected to decline; in 2010, the price was expected to rise. If these predicted futures prices would always correspond with the actual spot price at the maturity date, there will not be any problems or risks. However, there is always the risk of contango; but also, the chance of backwardation in the market, which would be equal with profit. Backwardation situations are wanted by the hedgers, in this case, they make a profit in the amount of the difference of futures price and spot price. The main reason for companies and distributors to use futures in the crude oil market is to hedge and fix the price. The spot price of crude oil is influenced by several factors; thus, it fluctuates a lot. In these contracts, quantity, price, date of delivery and maturity date are free to negotiate. Consequently, the potential buyer knows, how much he must pay for a certain amount of oil at a certain date; he reduces the risk to pay more in case of a rising oil price. After paying a premium, the buyer can also long a call option. With this call option, he gets the right to buy the determined amount of oil at the determined date for the determined price, but not the obligation. In case of rising prices, the buyer is happy that he only must pay the premium additional to the futures price; in case of a falling market, he can decline the right to buy and use the spot market to supply his demand (Zündorf, 2008, pp. 261-270). The risk is reduced.

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Details

Title
The Crude Oil Market. Risks and Opportunities
College
Dublin Business School
Grade
84,0 %
Author
Year
2017
Pages
14
Catalog Number
V412886
ISBN (eBook)
9783668640429
ISBN (Book)
9783668640436
File size
747 KB
Language
English
Notes
Feedback comments: well structured assignment showing clear understanding of the issues
Tags
crude, market, risks, opportunities
Quote paper
Max Flöter (Author), 2017, The Crude Oil Market. Risks and Opportunities, Munich, GRIN Verlag, https://www.grin.com/document/412886

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