Oil and Gas Market and Price Risk Management

Prof. Kabir Tahir Hamid, B.Sc., MBA, PhD. (BUK), M.Sc. (ABU),
CNA, ACS, ACSI, FCIFC, FIDRP, ACTM, CPA

Department of Accounting, Bayero University, Kano-Nigeria

[email protected]
[email protected]
08028376563
08168743809

12th May, 2023

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Objectives of the Presentation
At the end of the presentation, it is expected that the
participants will understand the following:
Nature of the oil and gas market.
The factors affecting oil and gas price.
Causes of oil and gas price volatility.
Impact of oil and gas price volatility on oil upstream
firms.
Strategies for oil and gas price volatility risk
management.
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Outline of the Presentation
Introduction
Oil and gas market
Oil and gas price risk management
Conclusion
Questions and Answers

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Introduction
 Petroleum is a mixture of hydrogen and carbon atoms that were formed from
the remains of plants and animals that decayed and decomposed over million of
years ago.
 It reservoirs in small connoted pore spaces of some underground sedimentary
rocks.
 There are four different types of functions or segments in the petroleum
industry, namely exploration and production (E&P), storage and transportation
(ST), refining and hydro processing (RHP), and marketing and distribution (MD).
 These activities or functions are further grouped into three sectors, namely
upstream (E&P), midstream (ST & wholesale MD) and downstream (RHP and
retail MD).
 The trading environment of the oil market is inherently unstable, due to a
number of risks including price risks.

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Introduction… Cont’d
 Since petroleum is a non-standard commodity, the industry choose a small
number of reference crude oil to serve as the basis for the financial market.
 Oil is the most active international trade commodity that attracts foreign
exchange in the world accounting for about 10% of the global trade.
 Seven Sisters (SS) of the world (coined by CEO of Italian oil company
Enrico Mattei in 1950’s) dominated the global petroleum industry
from 1940’s- 1970’s. These include Anglo-Iranian/Persian Oil Co.
(BP), Gulf oil (now part of Chevron), Royal Dutch Shell, SoCal (now
Chevron), Esso (later Exxon, now part of Exxonmobil), Socony (later
mobli, now part of Exxonmobil), Texaco (later merged into Chevron).
 ExxonMobil, Chevron and Europe’s BP and Royal Dutch Shell replaced
the old SS in 1990’s.

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Introduction… Cont’d
 The industry is now dominated the by new Seven Sisters. These are
Saudi Aramco, Russia’s Gazprom, CNPC of China, NIOC of Iran,
Venezuela’s PDVSA, Brazil’s Petrobras and Petronas of Malaysia.
 The oil industry classifies crude oil by the location of its origin (e.g. West
Texas Intermediate or Brent, Bonny light) and often by its relative weight
(light, intermediate, or heavy).
 Refiners may also refer to it as “sweet” which means it contains relatively
little sulfur, or as “sour”, meaning it contain more sulfur.
 The quality of petroleum is determined by different factors including API
gravity, boiling point, sulphur content and characterization factor (K-
factor), etc.

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Introduction… Cont’d
 API gravity categorizes crude oil into light, medium and heavy.
 The K-factor categorizes crude oil into paraffinic, naphthenic,
intermediate or aromatic nature.
 Crude oil is named based on its source of origin and there are
more than 50 types of crude oil products depending on the
different physical and chemical properties of crude.
 While oil is measured in barrels, gas is measured in cubic feet.
 The standard unit of measurement of crude oil is a barrel of 42 US
gallons (or 35 British gallons) at a temperature of 60°F.
 A barrel of oil contain 6 million BTUs while a cf of gas contain
1million BTUs.

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Introduction… Cont’d
 Oil and gas (O&G) companies’ earnings are substantially
affected by the price fluctuations of crude oil, natural gas and
refined products, which induce these companies to find ways to
minimize price risk exposure.
 Almost all O&G companies use derivative instruments, like
swaps and options, to share price risks with other counterparties.

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Oil and Gas Market
 A market is any arrangement that bring buyers and sellers together
with a view to transacting a business.
 Crude oil is a global commodity that trades in markets around the
world, both as spot oil and via derivatives contracts.
 Many economists view crude oil as the single most important
commodity in the world, as it is currently the primary source of energy
production.
 As the petroleum market developed, it transformed from a primarily
physical market into a financial market, attracting many participants
such as banks and hedge funds managers.

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Oil and Gas Market… Cont’d
 Crude oil futures on the New York Mercantile Exchange (NYMEX) are
the world's most actively traded futures contract on a physical commodity.
 In 1983, crude oil futures joined the New York Mercantile Exchange
(NYMEX) and was traded like other commodities. Natural gas futures
became available on NYMEX in 1990.
 Crude oil and natural gas are two of the most important energy
commodities in the world.
 Crude oil prices are determined by global supply and demand.
 Economic growth is one of the biggest factors affecting petroleum product
—and therefore crude oil—demand.
 Growing economies increase demand for energy in general and especially
for transporting goods and materials from producers to consumers.
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Oil and Gas Market… Cont’d
 Crude oil prices keep falling amid fears of recession, demand-supply dynamics,
among other reasons
 Crude oil is traded in the futures markets. A futures contract is a standard contract to
buy or sell a specific commodity of standardized quality at a certain date in the
future.
 If oil producers want to sell oil in the future, they can lock in their desired price by
selling a futures contract today
 The price of oil is primarily moved by the relationship between supply and
demand. When there is a demand for oil that outstrips its supply, the price of oil will
rise. But if demand falls and supply floods the market, the price of oil will fall.
 Before the Industrial Revolution, agricultural staples like corn and wheat ruled the
commodities market. Today, however, crude oil and derivatives are most actively
traded commodities in the world.
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Oil and Gas Market… Cont’d
 What are Commodities? Commodities are raw materials used to
create the products consumers buy, from food to furniture to
gasoline or petrol.
 Commodities include agricultural products such as wheat and
cattle, energy products such as oil and natural gas, and metals
such as gold, silver and aluminum.
 These futures are traded in the New York Mercantile Exchange
(or NYMEX), as well as the International Petroleum Exchange.
Commodity trading has been getting bigger than ever in recent
years as a response to the dot-com crash of the early 2000s.

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Oil and Gas Market… Cont’d
 countries that use the most oil are US, China, India, Japan.
 Countries that are the top producers of oil are USA, S/Arabia,
Russia and Canada.
 Venezuela has the largest amount of oil reserves in the world with
more than 300 billion barrels in reserve.
 Saudi Arabia has the second-largest amount of oil reserves in the
world with 297.5 billion barrels.
 In the maritime industry, a group of six companies that control the
chartering of the majority of oil tankers worldwide are together
referred to as "oil majors". These are: Shell, BP, ExxonMobil,
Chevron, TotalEnergies and ConocoPhillips.
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Oil and Gas Market… Cont’d
 The four major factors that can impact oil supply and demand are as
follows:
 The influence of OPEC
 Global economic performance
 Oil storage
 The push for alternative energy sources
 Countries in OPEC produce a large share of worldwide oil supply. The
group sets production levels to meet global demand, and can influence the
price of oil by increasing and decreasing output.
 During the 2020 Covid-19 pandemic, OPEC and its allies agreed to cut
production rates to stabilize prices. But a disagreement with Russia – a non-
OPEC country but large exporter – caused a sheer drop in the price of oil.

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Oil and Gas Market… Cont’d
 The four major factors that can impact oil supply and demand are as
follows:
 The influence of OPEC
 Global economic performance
 Oil storage
 The push for alternative energy sources
 Countries in OPEC produce a large share of worldwide oil supply. The
group sets production levels to meet global demand, and can influence the
price of oil by increasing and decreasing output.
 During the 2020 Covid-19 pandemic, OPEC and its allies agreed to cut
production rates to stabilize prices. But a disagreement with Russia – a non-
OPEC country but large exporter – caused a sheer drop in the price of oil.

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Oil and Gas Price Risk Management
Price Risk Management without Derivatives
Diversification
Investing in a variety of activities in different locations. For example
Royal Dutch Shell plan to invest up to $3bn a year on renewable
energy often in different locations.
Long-term Fixed-Price Contracts
The owner of a firm that invests in a natural gas combined-cycle plant
could simply sign a long-term contract with a gas supplier. For example, in
January 2020 it can lock in gas price of $52.59 per thousand British
thermal units (BTU), $52.92 for 2023, and so on.
However, such a hedging strategy still would leave some risk.

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Price Risk Management without Derivatives
 If the spot market price for natural gas in 2023 turned out to be only
$52.70 as opposed to $52.92, power from the firm’s plant might not be
competitive, because other plant owners could purchase natural gas at $52.70
 Conversely, if natural gas prices in 2023 rose to $75.00, the seller might
choose to default on the plant’s gas supply contract.
 Insurance Contracts
 Insurance can also be used to manage risk. For example, if there is some
probability that the natural gas plant in the previous example might
malfunction and take time to be serviced.
 The owner of the plant could purchase an insurance contract that would
provide compensation for lost revenue (and perhaps for repair costs) in the
event of an unplanned outage.

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Price Risk Management without Derivatives… Cont’d
 The insurance would essentially shift the risks from the owner of the
plant to the “counterparty” of the contract (in this case, the insurance
provider).
 The counterparty would accept the risk if it had greater ability to pool
risks and/or were less averse to risk than was the owner of the plant.
 Storage
 The plant owner could also reduce the risk of adverse movements in
future natural gas prices by purchasing the fuel in the current period
and storing it as inventory. If prices fell, the firm could buy the fuel
on the open market; if they increased, it could use the inventory.
 However, this could be an expensive way to manage risk, because
storage costs could be considerable.
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 Price Risk Management with Derivatives
 The world’s first futures market was likely the Dojima Rice Market set up in Osaka,
Japan, in 1730 (Irwin, 2013).
 New York Mercantile Exchange (NYMEX) is the world’s largest physical commodity
futures exchange. It has two principal divisions, NYMEX and Commodity Exchange
(COMEX), which were once independent but are now merged.
 Chicago Mercantile Exchange (CME) in Chicago is also renown for futures contract.
 The most general exchanges for crude oil futures trades include NYMEX, International
Petroleum Exchange, also known as Intercontinental Exchange (ICE) London and
Multi Commodity Exchange India (WiseGeek, 2014).
 There are different types of crude oil futures contracts traded such as Brent Crude Oil
Futures, Heating Oil Futures and Gasoil Futures.
 The most common one is Light Sweet Crude Oil (WTI) futures, due to its high demand
thus has the advantage of liquidity and transparency (CME Group, 2014).
 WTI is included in one of the New York Mercantile Exchange’s commodity futures
contract (Investopedia, 2014).

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 Price Risk Management with Derivatives… Cont’d
 Nevertheless, WTI is widely used in United States’ domestic market and later on
adopted by the world and became international benchmark for crude oil prices as a
result of its high quality graded crude oil (WiseGeek, 2014).
 WTI or Brent is remarkably referred to as benchmarks due to the reasons that there are
almost no particular market prices set out for physical oils and are quoted in a daily
basis with reference to not the spot prices of oil but the prices of nearest maturity
futures contracts instead (Investopedia 2014).
 Thus, oils are traded in the futures market instead of the spot markets (Investopedia
2014).
 The price volatility of oil futures can be driven by some important factors such as
speculators, high demand from emerging countries, oversupply or undersupply of
petroleum products and shortage or surplus of crude oil etc.
 The high crude oil prices driven by high level of speculation activities are supported by
empirical studies.

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Price Risk Management with Derivatives… Cont’d
 Derivatives are contracts, financial instruments, which derive their value from
an underlying asset.
 Unlike a stock or securitized asset, a derivative contract does not represent an
ownership right in the underlying asset.
 For example, a call option on IBM stock gives the option holder the right to
buy a specified quantity of IBM stock at a given price (the “strike price”).
 The option does not represent an ownership interest in IBM (the underlying
asset).
 The right to purchase the stock at a given price, however, is of value. If, for
instance, the option is to buy a share of IBM stock at $40, that option will be
worth at least $60 when the stock is selling for $100.
 The option holder can exercise the option, pay $40 to acquire the stock, and
then immediately sell the stock at $100 for a $60 profit.

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Price Risk Management with Derivatives… Cont’d
 The asset that underlies a derivative can be a physical commodity (e.g., crude oil or wheat),
foreign or domestic currencies, treasury bonds, stock indices, a service, or even an intangible
commodity such as a weather-related index (e.g., rainfall, heating degree days, etc).
 What is critical is that the value of the underlying commodity or asset be unambiguous;
otherwise, the value of the derivative becomes ill-defined.
 When used prudently, derivatives are efficient and effective tools for reducing certain risks
through hedging.
 The OTC derivatives market exists primarily to meet the needs of customers who are
interested in particular commodities—at particular locations and times—that are not
available on exchanges, hence the market tends to change quickly.
 The most commonly used derivatives in the oil and gas industry are forward contracts,
options (basic instruments) futures and swaps (hybrid instruments).
 Derivatives have a long history. Futures markets date back to the Middle Ages, while
options markets date back to 17th century Holland.
 Traders for derivatives are hedgers, speculators and arbitrageurs.

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Oil Reference Used in the World Exchanges
 The four main oil reference used in the old are:
(1) West Texas Intermediate (WTI), which is also known as Texas sweet light,
used as a benchmark in oil pricing in New York Mercantile Exchange’s oil
futures contract, for delivery in Cushing, Oklahoma.
(2) Brent crude which comprised of 15-oils from fields in the Brent and the east
Shetland basins of North sea. It is light and sweet crude oil, but not like WTI.
(3) Dubai used as a benchmark for Middle East oil flowing to Asia Pacific.
(4) OPEC Reference Basket (ORB), which is the arithmetic average of OPCEC
member countries crude oil.
 While the traded global benchmarks for natural gas are Henry Hub and
JCC.

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Forward Contract
 A forward contract is an agreement between two parties to buy (sell) a specified
quality and quantity of a good at an agreed date in the future at a fixed price or
at a price determined by formula at the time of delivery to the location specified in
the contract.
 This price is called the delivery price.
 Trades in the OTC market and settled at maturity only..
 OTC contracts are customized to the needs of the contracting parties, privately
negotiated, and are offered directly by dealers to end users.
 Forward contract must specify delivery locations, the length of delivery period,
delivery conditions, properties of the delivered commodity, payment dates etc.
 A long position is an obligation to purchase the asset, and a short position is an
obligation to sell the asset.

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Forward Contract… Cont’d
 For example, a natural gas producer may agree to deliver a billion cubic feet
of gas to a petrochemical plant at Henry Hub, Louisiana, during the first week
of July 2021 at a price of $3.20 per thousand cubic feet.
 Forward contracts have problems that can be serious at times.
 First, buyers and sellers (counterparties) have to find each other and settle on
a price. Finding suitable counterparties can be difficult. Discovering the market
price for a delivery at a specific place far into the future is also daunting.
 Second, when the agreed-upon price is far different from the market price, one
of the parties may default (“non-perform”).
 Third, one or the other party’s circumstances might change. The only way for a
party to back out of a forward contract is to renegotiate it and face penalties.

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Futures Contract
 Future contract can be defined as a contract that obligates the holder to buy or sell
an assets at a predetermined delivery price during a specified future time period.
 A futures contract is an exchange between a buyer and a seller indirectly as the
counterparties are unaware of individual identities and therefore futures contracts
are standardised in the form of size, quality, possible delivery dates and locations
being covered.
 This price is called the futures price.
 It is exchange traded and its terms are standardized.
 Crude oil futures were first introduced on the New York Stock exchange in 1974.
 Unlike a forward contract, buyers and sellers of futures contract deal with an
exchange, not with each other.

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Futures Contract… Cont’d
 For example, a producer wanting to sell crude oil in December 2020 can sell a futures
contract for 1,000 barrels of West Texas Intermediate (WTI) to the NYMEX, and a
refinery can buy a December 2020 oil futures from the exchange.
 The December futures price is the one that causes offers to sell to equal bids to buy, i.e.
demand for futures equals the supply.
 The December futures price is public, same as the volume of trade.
 If the buyer of a December futures finds later that he does not need the oil, he can get out
of the contract by selling a December oil futures at the prevailing price.
 Since he has bought and sold a December oil futures, he has met his obligations to the
exchange by netting them out.
 Futures exchanges not only allow buyers and sellers to interact and make agreements,
but also prevent defaults to happen from either party such as margin requirements with
deposit funds to be settled.

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Table 1. Example of an Oil Futures Contract

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Table 1. Example of an Oil Futures Contract… Cont’d
 Table 1 illustrates how futures contracts can be used both to fix a
price in advance and to guarantee performance.
 Suppose in January a refiner can make a sure profit by acquiring
10,000 barrels of WTI crude oil in December at the current December
futures price of $28 per barrel.
 One way he could guarantee the December price would be to “buy” 10
WTI December contracts.
 The refiner pays nothing for the futures contracts but has to make a
good-faith deposit (“initial margin”) with his broker.
 NYMEX currently requires an initial margin of $2,200 per contract.
 During the year the December futures price will change in response to
new information about the demand and supply of crude oil.
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Table 1. Example of an Oil Futures Contract… Cont’d
 In the example, the December price remains constant until May, when it falls to $26 per
barrel.
 At that point the exchange pays those who sold December futures contracts and collects
from those who bought them.
 The money comes from the margin accounts of the refiner and other buyers.
 The broker then issues a “margin call” requiring the refiner to restore his margin account
by adding $20,000 to it.
 This “marking to market” is done every day and may be done several times during a single
day.
 Brokers close out parties unable to pay (make their margin calls) by selling their clients’
futures contracts.
 Usually, the initial margin is enough to cover a defaulting party’s losses. If not, the
broker covers the loss. If the broker cannot, the exchange does.


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Table 1. Example of an Oil Futures Contract… Cont’d
 Following settlement after the first change in the December futures price,
the process is started a new, but with the current price of the December
future used as the basis for calculating gains and losses.
 In September, the December futures price increases to $29 per barrel, the
refiner’s contract is marked to market, and he receives $30,000 from the
exchange.
 In October, the price increases again to $35 per barrel, and the refiner
receives an additional $60,000.
 By the end of November, the WTI spot price and the December futures price
are necessarily the same, for the reasons given below. The refiner can either
demand delivery and buy the oil at the spot price or “sell” his contract.
 In either event his initial margin is refunded, sometimes with interest.

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Table 1. Example of an Oil Futures Contract… Cont’d
 If he buys oil he pays $35 per barrel or $350,000, but his trading profit is
$70,000 ($30,000 + $60,000 - $20,000). Effectively, he ends up paying $28 per
barrel [($350,000 - $70,000)/ 10,000], which is precisely the January price for
December futures.
 If he “sells” his contract he keeps the trading profit of $70,000.
 Several features of futures are worth emphasizing.
 First
 A party who elects to hold the contract until maturity is guaranteed
the price he paid when he initially bought the contract.
 The buyer of the futures contract can always demand delivery; the
seller can always insist on delivering. As a result, at maturity the
December futures price for WTI and the spot market price will be the
same.

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Table 1. Example of an Oil Futures Contract… Cont’d
 If the WTI price were lower, people would sell futures contracts
and deliver oil for a guaranteed profit.
 If the WTI price were higher, people would buy futures and
demand delivery, again for a guaranteed profit.
 Only when the December futures price and the December spot
price are the same is the opportunity for a sure profit eliminated.
 Second
 A party can sell oil futures even though he has no access to oil.
 Likewise a party can buy oil even though he has no use for it.
 Speculators routinely buy and sell futures contracts in anticipation
of price changes.

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Table 1. Example of an Oil Futures Contract… Cont’d
 Instead of delivering or accepting oil, they close out their
positions before the contracts mature.
 Speculators perform the useful function of taking on the price
risk that producers and refiners do not wish to bear.
 Third
 futures allow a party to make a commitment to buy or sell
large amounts of oil (or other commodities) for a very small
initial commitment, the initial margin.
 An investment of $22,000 is enough to commit a party to buy
(sell) $280,000 of oil when the futures price is $28 per barrel.

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Table 1. Example of an Oil Futures Contract… Cont’d
 Consequently, traders can make large profits or suffer huge losses from
small changes in the futures price. This leverage has been the source of
spectacular failures in the past.
 Futures contracts are not by themselves useful for all those who want
to manage price risk. Futures contracts are available for only a few
commodities and a few delivery locations. Nor are they available for
deliveries a decade or more into the future.
 There is a robust business conducted outside exchanges, in the over the-
counter (OTC) market, in selling contracts to supplement futures
contracts and better meet the needs of individual companies.

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Options
 An option is a contract that gives the buyer of the contract the right to buy (a call
option) or sell (a put option) at a specified price (the “strike price”) over a specified
period of time.
 This price is called the strike price.
 The option buyer pays the seller a sum of money called the option price or
premium.
 Traded in the OTC market or on an exchange.
 American options allow the buyer to exercise his right either to buy or sell at any
time until the option expires.
 European options can be exercised only at maturity.
 Whether the option is sold on an exchange or on the OTC market, the buyer pays for
it up front.
 For example, the option to buy a thousand cubic feet of natural gas at a price of
$3.60 in December 2020 may cost $0.73.

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Options… Cont’d
 If the price in December exceeds $3.60, the buyer can exercise his option and buy the gas
for $3.60.
 More commonly, the option writer pays the buyer the difference between the market
price and the strike price.
 If the natural gas price is less than $3.60, the buyer lets the option expire and loses
$0.73.
 Options are used successfully to put floors and ceilings on prices; however, they tend to be
expensive.
 NYMEX started trading energy options in 1986, and it has grown due to successful
launch of an OTC market and extreme volatility in oil pries in 1990 due to Iraq’s
invasion of Kuwait.
 In contrast, OTC options are generally cash settled. Their value at settlement is generally
based on the average price over a period of time.

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Options… Cont’d
 Cash settlement options work well in the oil market, as it could be very
expensive to exercise the option and then resell the product to capture the
increase in value.
 For example a refiner may hold an exchange traded call option on crude oil
as a protection against a rise in crude oil prices.
 Selling this option at an acceptable price is always a possibility, but if the
option market is not liquid, then the refiner might need to exercise the
option by taking delivery at the underlying future position at the strike price.
 However, the refiner might prefer to buy his crude oil from another source
or for a different delivery date that than the crude controlled by the future
contract.
 Then he will need to resell it in order to capture the increase in value beyond
the strike price.

39
Options… Cont’d
 This might result in an additional commission to pay, or the market might move
unfavourably before the future position is disposed of.
 One of the main advantages of cash settlement options is that many clients favour
settlement based on average prices.
 Compared to settlements based on a single point in time, they can provide a better hedge
for non-specific “cash type” exposure.
 For example an oil trader buying and selling cargoes of oil can use large lumps of futures
to hedge the large lump of oil.
 Matching of hedge is easy, because when the trader buys cargo and wants to hedge he can
sell an equal quantity of futures to unwind his hedge.
 For this operation, the futures are sold at a specified amount and bought back at a specified
moment within the timing constraint of the ship’s voyage.

40
Options… Cont’d
 Options are also increasingly used to hedge cross-market risks.
 Cash settlement is significantly cheaper in this kind of hedge, because in
most cases the buyer is nor interested in the underlying commodity of
the options, he is merely interested in the price protection that the
option provides.
 For example, a refiner can buy an option on gasoline as a cross market
hedge against a rise in the price of crude oil.
 In this case, the option buyer is not at all interested in acquiring the
underlying asset, he just wants to price hedge the value, which is highly
correlated with his underlying price exposure.

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Swaps
 Swaps (also called contracts for differences) are the most recent innovation in
finance.
 Swaps were created in part to give price certainty at a cost that is lower than
the cost of options.
 A swap contract is an agreement between two parties to exchange a series of
cash flows generated by underlying assets.
 No physical commodity is actually transferred between the buyer and seller.
 The contracts are entered into between the two counterparties, or principals,
outside any centralized trading facility or exchange and are therefore
characterized as OTC derivatives.
 Because swaps do not involve the actual transfer of any assets or principal
amounts, a base must be established in order to determine the amounts that will
periodically be swapped.

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Swaps… Cont’d
 This principal base is known as the “notional amount” of the contract.
 For example, one person might want to “swap” the variable earnings
on a million dollar stock portfolio for the fixed interest earned on a
treasury bond of the same market value.
 The notional amount of this swap is $1 million.
 Swapping avoids the expense of selling the portfolio and buying the
bond.
 It also permits the investor to retain any capital gains that his portfolio
might realize.
 Figure 1 illustrates an example of a standard crude oil swap. In the
example, a refiner and an oil producer agree to enter into a 10-year
crude oil swap with a monthly exchange of payments.
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Figure 1. Illustration of Crude Oil Swap Contract Between an Oil
Producer and a Refiner

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Swaps… Cont’d
 The refiner (Party A) agrees to pay the producer (Party B) a fixed price of
$25 per barrel, and the producer agrees to pay the refiner the settlement
price of a futures contract for NYMEX light, sweet crude oil on the final day
of trading for the contract.
 The notional amount of the contract is 10,000 barrels.
 Under this contract the payments are netted, so that the party owing the
larger payment for the month makes a net payment to the party owing the lesser
amount.
 If the NYMEX settlement price on the final day of trading is $23 per barrel,
Party A will make a payment of $2 per barrel times 10,000, or $20,000 to
Party B.
 If the NYMEX price is $28 per barrel, Party B will make a payment of
$30,000 to Party A.

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Swaps… Cont’d
 The 10-year swap effectively creates a package of 120 cash-settled forward
contracts, one maturing each month for 10 years.
 So long as both parties in the example are able to buy and sell crude oil at the variable
NYMEX settlement price, the swap guarantees a fixed price of $25 per barrel,
because the producer and the refiner can combine their financial swap with physical
sales and purchases in the spot market in quantities that match the nominal contract size.
 All that remains after the purchases and sales shown in the inner loop cancel each other
out are the fixed payment of money to the producer and the refiner’s purchase of
crude oil.
 The producer never actually delivers crude oil to the refiner, nor does the refiner
directly buy crude oil from the producer.
 All their physical purchases and sales are in the spot market, at the NYMEX price.

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Swaps… Cont’d
 Figure 2 shows the acquisition costs with and without a swap contract.
 Many of the benefits associated with swap contracts are similar to those
associated with futures or options contracts.
 That is, they allow users to manage price exposure risk without having
to take possession of the commodity.
 They differ from exchange-traded futures and options in that, because they
are individually negotiated instruments, users can customize them to suit
their risk management activities to a greater degree than is easily
accomplished with more standardized futures contracts or exchange-traded
options.

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Figure 2. Crude Oil Acquisition Cost With and
Without a Swap Contract

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Swaps… Cont’d
 So, for instance, in the example above the floating price reference for crude oil might
be switched from the NYMEX contract, which calls for delivery at Cushing,
Oklahoma, to an Alaskan North Slope oil price for delivery at Long Beach, California.
 Such a swap contract might be more useful for a refiner located in the Los Angeles
area.
 Although swaps can be highly customized, the counterparties are exposed to higher
credit risk because the contracts generally are not guaranteed by a clearing house as are
exchange-traded derivatives.
 In addition, customized swaps generally are less liquid instruments, usually requiring
parties to renegotiate terms before prematurely terminating or offsetting a contract.

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Table 3. Petroleum and Natural Gas Price Risk
Management Strategies

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Conclusion
 Foreign exchange and commodity price risk are two distinctive features
of the oil and gas industry.
 Risks are managed in the oil and gas industry using either non-derivative
or derivative-based instruments, or a combination of the two.
 Derivatives are financial instruments (contracts) that do not represent
ownership rights in any asset but, rather, derive their value from the value
of some other underlying commodity, indices, security or other assets.
 When used prudently, derivatives are efficient and effective tools for
“hedging” to reduce exposure to risk.
 The most commonly used derivative contracts in the oil and gas industry
are forward, futures, options, and swaps.

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52
Question and Answer Session

 Questions
 Comments and Clarifications

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THE END

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