crude oil price risk management report final

Royal Melbourne Institute of Technology

Crude Oil Price Risk Management

Assignment 1

Authors

Mohnish Avinash Gulati (s3179685)

Nick Jonker

Mia

Alisa

Jenny

4/10/2014

Crude Oil Price Risk Management 2014

Executive Summary

The aim of the report is to analyse and develop techniques to manage crude oil price risks

analyse its volatility impacts on World Financial Markets. The report also aims to find

suitable hedging techniques for investors in order to mitigate risks and maximise profits. The

report introduces the factors that affect crude oil prices and the level of correlation between

the factors and the price fluctuation. The report also analyses different financial instruments

such as options, futures, forwards and other derivative combinations that can be utilised by

crude oil investors and producers to undertake investments.

Based on the analyses it is concluded that

Macro-economy affects crude oil prices and vice versa. The degree of effect

depends on the correlation on each other.

Supply and demand factors affect prices significantly. The demand for oil is very

seasonal and is dependent on major economical factors. A large proportion of

supply is controlled through OPEC cartel and records are kept secretive. Supply is

also restricted by major economies to profit from higher prices.

The type of substitute and investments in alternative sources helps to control future

oil prices. Stricter Government regulations on ethanol and high risk on returns in

alternative projects hinders large scale investment

Entrepreneurs are a major cause of crude oil fluctuations. Cartel by OPEC nations

and different profit goals and competitive behaviour makes it difficult to find a win-

win (Nash Equilibrium) situation for all players. Politics, Government embargoes

and refining capacity all affect prices. Future expectations and historical volatility

heightens pessimism and optimistic behaviour leading to bubbles and bursts.

A combination of call and put options with futures is found to reduce volatility risk

and protect producers from downside losses. Options on futures also protect

investors from volatility risks in prices and are more liquid and cheaper at times

than options on other contracts

Future options on interest rates can protect borrowers and lenders from interest rate

risks and helps in project evaluation to a large extent.

The cost of carry model uses arbitrage arguments to derive a futures value of a

commodity or investment asset. The model depends on interest rates, storage costs,

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yields (i.e. convenience yield for commodities), the time to maturity and the spot

price of the underlying asset.

The cost of carry model results in good estimates of futures oil prices for the 30-day

WTI futures contracts. The maximum daily difference was 0.51% deviation from

the market value of the futures contract under current interest rates and a storage

cost of 2% p.a.

The model appears to work well for oil price futures, which are short dated for

example 30-day oil price futures, however, it may be less reliable for longer dated

futures contracts. The reason for this is that the model is less sensitive to interest

rates and storage costs over a short term to maturity than a long term to maturity.

Trading strategies to take advantage of the mispricing of the WTI oil futures

contracts based on the cost of carry model may not result in profits, but losses. The

strategy resulted in only a 52% correct profit trading decision, which is just as good

as flipping a coin. Alternative models were estimated using R-studio based on

econometric techniques. These models appear to not be very useful, however, a

weak relationship with the S&P daily returns was observed.

Basis risks exist for either long or short hedge thus hedging is not always perfect

(Pelletier 2006) where the risk is equal to the spot price of the commodity deducted

by the future price of the commodity.

Based on the conclusion it is recommended that

Investors and producers should make use of different financial instruments to

protect themselves from risk. An investor must also consider holding the underlying

asset during volatility times when derivatives are selling at a premium.

The fundamentals such as macroeconomic factors, substitutes, supply and demand

growth rates, refining capacity and politics between players must be closely

followed to estimate prices. Regression models on the level of dependence on

individual factors and investor attitude towards these changes should be developed

to profit from price changes.

Long term investment in oil prices is suitable as the prices have been found to

follow an upward trend.

A risk-averse investor must refrain undertaking large scale investments during

volatility times as prices seem to follow a random walk and is majorly controlled by

market speculation

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Synthetics with high maturity dates should be considered by an investor to reduce

Value at Risk (VaR) and increase profit probability due to large scale fluctuations.

Long straddle and strangle strategies should also be considered due to high

variations.

Long calls in substitute assets during bullish crude oil times can be considered by

investors as substitutes price increases are causally related with crude oil price

increases with a lag. The lag period can be calculated by analysing historical lags.

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Table of Contents

1. Introduction........................................................................................................................6

1.1 Impact of oil price volatility on world financial market............................................16

1.2 Group Organisation...................................................................................................18

2. What are the available hedging techniques?....................................................................18

2.1 Oil Futures.................................................................................................................19

2.2 Oil Options (caps, floors, collars, captions)..............................................................23

2.3 Swaps and Swaptions................................................................................................29

2.4 Oil Forwards..............................................................................................................36

2.5 Option on Futures/Futures Options...........................................................................40

3. Empirical Testing of Cost of Carry Model......................................................................44

4. Conclusion........................................................................................................................57

5. Recommendation..............................................................................................................59

6. References........................................................................................................................60

7. Appendices.........................................................................................................................0

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Aim

The aim of the report is to analyse and develop techniques to manage crude oil price risks

analyse its volatility impacts on World Financial Markets. The report also aims to find

suitable hedging techniques for investors in order to mitigate risks and maximise profits.

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1. Introduction

Oil is a naturally occurring yellow-to-black liquid found in the geological formations beneath

the earth’s surface. It is an organic hydrocarbon and is formed by the decaying of dead

organism and plants buried underneath sedimentary rock and subjected to high pressure and

heat. Crude oil is commonly refined to different types of fuels depending on purity and is

useful to man in many different ways ranging from driving an automobile to generating

electricity (EIA, 2013). Due to its wide variety of uses in different areas it is significantly

related to the Gross Domestic Product (GDP) of many nations. The different substitutes of

crude oil are coal, nuclear, natural gas, shale gas and renewable sources of energy such as

wind, tidal etc. The demand for crude oil is found to have increased linearly from the years

2000-2011 due to growth in the developing nations and the rising of emerging economies of

India, China, Brazil and Russia. Its future demand is expected to be stable due to

environmental issues caused by its use and the growing demand of substitutes such as

renewable sources of energy (PR newswire, 2012). The quality of crude oil is assessed by

many different factors such as API gravity, boiling point, sulphur content, characterization

factor etc. The most important ones are the API gravity (American Petroleum Institute

gravity) which measures the relative density of the crude oil with respect to water (Institute of

Petroleum, 1960) and the characterization factor also known as K-factor which is a way of

classifying crude oil according to its molecular structure (Speight, 2007). The API gravity

categorises crude oil into light, medium and heavy. An API gravity of 10 or more indicates

the crude oil is lighter and floats on water and if it’s less than 10 than it will sink (Institute of

Petroleum, 1960). The K-factor categorises the crude oil into paraffinic, naphthenic,

intermediate or aromatic nature. A 12.5 or higher indicates the crude oil has a lot of paraffinic

components (wax like structure) and 10 or lower indicates the crude is more of an aromatic

nature (Speight, 2007). The API gravity and the K-factor share a linear relationship and are

very essential in determining the quality and the costs associated with the transmission of

crude oil (McCain, 1990). There are more than 50 types of crude oil products depending on

the different physical and chemical properties of crude oil (BP, 2014).

Factors affecting Oil Prices

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Oil prices are affected by a lot of factors ranging from political decisions of Governments to

the fundamentals of supply and demand in an economy. The major factors affecting the Oil

economy is stated below

Macroeconomy

Crude oil affects the macro-economy to a large extent as it forms a core product of export in

major nations such as Russia, Saudi Arabia and United Arab Emirates. Also, due to its

diverse uses in different industries such as agriculture, plastics, automotive etc. it is

significantly related to Gross National Product (GNP) of many countries and influences many

factors such as interest rates, inflation and exchange rates. There is no direct evidence to the

extent oil prices affect a macro-economy of the country but there is a consensus that oil price

shocks have resulted in recessions. From research of many econometricians it is found that

the oil prices follow a stochastic trend i.e. the future oil prices are significantly dependent on

the current oil prices. Also, it is the unanticipated changes in the oil prices have a negative

effect on the economy irrespective of the movements. This means if there is an unanticipated

growth or fall in supply the economy will react in a negative manner resulting in a decrease

in real GDP growth. In terms of forecasted changes, the degree of correlation of oil prices

varies from nation to nation. Since profits of nations are determined by supply and demand of

oil prices it cannot be said with certainty an increase or decrease in price will benefit nations

exporting or importing. For USA, a forecasted 1% increase in real oil prices is found to have

a 0.11% decrease in real GDP growth. Similarly a forecasted 1% decrease is found to have a

0.07% increase in real GDP growth (Miller et al, 2011).

Trading Strategies

Due to fluctuations in oil price and the GDP growth of an economy a finance trader in US

market can invest in bonds or purchase put options in equity inversely correlated to oil price

rises to benefit from a price rise in oil. For a trader investing in other markets such as the

Australian stock market or Asian markets who also share a significant amount of correlation

with the US markets a trader can benefit by reacting before the reaction time of other market

participants.

Supply and Demand

Supply and demand are one of the predominant factors that dictate the prices of oil in a

market economy along with market expectations of the purchaser and the entrepreneur.

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Theoretically, the price of oil should only be affected by supply and demand aspects of the

market but since these curves are not known to anyone i.e. real supply and demand they are

only considered to be one of the factors influencing it and not the only factor (Kates, 2009).

A sample supply and demand curve in equilibrium is shown below

Figure 1: Supply and Demand in Equilibrium, Kates 2009

The other factors dictating the prices of oil are political situation, financial situation of the

market participants, US dollar, entrepreneurial capabilities, substitutes, future expectations

and availability of factors of production i.e. land, labour, capital and entrepreneur.

Figure 2: WTI Spot Price – Long Term Trend, EIA 2014

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Oil prices have shown significant increase after the period 2000 peaking before the Global

Financial Crisis (GFC) in 2008. This is mainly due to the supply and demand factors

affecting the prices to rise by a large amount, ceteris paribus. The reasons for changes in the

supply and demand was that after the 1998-1999 oil price collapse the OPEC nations reduced

their crude oil production from the maximum capacity to prevent future losses from oil price

plummet (Takir, 2014). Since nearly 50% of crude oil production is managed by the OPEC

nations which operate as a cartel there was a major reduction in supply (Snow, 2011). The oil

supply reduction was nearly reduced by a million barrels a days which accounts to

approximately 4% of reduced supply (Davis, 2001). At the same time the US economy

reduced crude import and relied on the domestically available production. At the same time

the global demand increased at a rapid rate due to rise in the Asian economies and the growth

of capitalism (Snow, 2011). Thus due to the changes in the supply and demand factors the

short run aggregate supply (AS) and aggregate demand (AD) moved resulting in a higher

price of oil for the same quantity, ceteris paribus. A graph illustrating the impact of the

supply and demand curves is shown below

Figure 3: Changes in Aggregate Supply & Demand

It has been found that after 2003 energy crisis the dependence of oil prices on supply and

demand gradually decreased due to speculation, psychology of market participants and

shortages of people, equipment and skills. This resulted in increased costs of oil production

by approximately 70% for many companies as the projects became more risky due to

volatility (McElligot, 2007). Also due to large amount of volatility caused by infrastructure,

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human resource and speculation new oil rigs investment are slow as return on investment and

future market conditions cannot be determined easily (Shepherd, 2009). Due to these reasons

the spread between the price of oil arising purely from supply and demand and the real price

of oil is increasing continuously. Until 2003 the inflation adjusted oil price was $25/barrel

which rose to $60 in 2005 and peaked to approximately $147 in July 2008 and then fell back

to $30.28 in December 2008 (Shepherd, 2009). This is 488% increase in price which is far

more than the real supply and demand. A graph showing the production of oil is shown below

Figure 4: Crude Oil Production 1997 – 2007, EIA 2014

As you can see from the above graph the oil production had increased in the past 10 years by

approximately 14% but the price increase is 488%. Though the long run average supply curve

(LRAS) for any good is vertical with demand increasing price the price rise of 488% cannot

be said to be justifiable and follow the theory of demand and supply completely.

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Figure 5: Aggregate Supply, Economics Online 2014

Hence supply and demand factors do help in determining oil prices but it is also strongly

governed by behaviour of participants, Governments and future expectations as well.

Trading strategies

A trader can benefit in an oil price trade by understanding the level of dependence of the

estimated supply and demand of the market and the real oil prices. Changes in demand can be

estimated by finding the elasticity coefficient between the price change in oil and the amount

demanded. The formula for elasticity is shown below

If the market is highly elastic there will be a larger change in demand with marginal change

in price. Thus the prices can be expected to rise and fall when considered from purely supply

and demand perspective. Hence stable to bearish strategies for trading should be applied.

Supply can be estimated by approximating the production costs for an entrepreneur (Kates,

2009).

Substitutes

Substitutes play a major role in pricing of commodities. An entrepreneur selling a commodity

which have large number of substitutes will find it difficult to sell it at a higher margin

because consumers will swap over to substitutes when price is raised over their expectations

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limit (Kates, 2009). Crude oil has diverse uses and limited substitutes such as biofuels and

natural gas with solar to a small extent. The main substitute for crude oil is natural gas in

terms of consumption and production as well. Developments in the area of natural gas as

substitute for oil can significantly reduce oil demand and is forecasted to reduce demand for

oil by 3.5m barrels by 2020 (Makan, 2013). The natural gas prices are different in different

countries with prices determined by supply and demand in USA and by contracts linked to

crude oil in Asia. European countries pricing mechanism is a combination of both supply and

demand and contracts. There is a positive stable causal relationship between natural gas and

crude oil with crude oil prices affecting natural gas prices in the long run. The level of

relationship in the European pricing markets is about 17% i.e. increase in $1USD/barrel to

0.17EUR/MWH if the prices are within the 10% level. Both natural gas and crude oil follow

stochastic trend and the short run relationship between them often varies. Also booms and

bursts in the global economy cause disruption in the relationship. Developments in natural

gas and low natural gas prices help to stabilise WTI prices (Obadi et al, 2013). Ethanol is

another substitute of crude oil which when mixed with gasoline can be used in transportation.

An estimated 5% use in ethanol decreases crude oil price by 8% (McPhail, 2011). A crude oil

price range between $40 -$120 and a lower corn price will make ethanol production

profitable and will put a downward pressure on oil prices (Corn and Soybean Digest, 2012).

The production of ethanol is subjected to lot of debate between economists and Governments

as increased production results in higher corn prices due to scarcity and affects the lower

income groups. The impact is significantly higher in developing countries where corn forms

the staple food (Lu, 2011).

Trading Strategies

If the oil market is on a bull run and the price is over $USD 40/barrel the call option for the

oil will be also selling at a premium. A trader instead of buying a call for oil can think of

purchasing a call for corn in USA which might be available at a cheaper price. This is

because higher oil prices will lead to increase in ethanol production for biofuels whose prime

ingredient is corn. This can drive the demand and prices for corn, ceteris paribus. The USA

controls 57% of biofuel production and have increased its usage to suppress oil prices in the

past (McPhail, 2011). Thus, this strategy can be used. A trader can also purchase corn futures

during the boom of oil prices as well. Similarly a trader can benefit by purchasing put

options on oil if there is positive news on natural gas exploration or excavation. An increase

in supply will reduce the prices of natural gas and hence oil due to causality relationship.

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Entrepreneurs (Oil Market Players & Governments)

Entrepreneurs and Governments are another very important factor after supply and demand in

determining oil prices. This is because more than 40% of oil is produced by the OPEC

economies which operate as a cartel. Hence the politics and the role of Government in

determining the prices of oil are significant. Also, the oil market is an oligopoly market

where few major participants (oil companies) control the market and the entry and exit

barriers are difficult in the industry (Shepherd, 2009). The major participants are British

Petroleum (BP), Royal Dutch Shell, Gulf Oil, Saudi Aramco, Gazprom, ExxonMobil,

PetroChina and Chevron (Forbes, 2012). These participants have a significant impact on oil

prices as they control all the major areas of supply chain.

Politics & Volatility Causes

The politics in oil market is that oil producers try to control output in order to attain a position

where marginal revenue (MR) is equal to marginal cost (MC). In order to maximise profits

the OPEC economies closely work together and compete at the same time such that the

behaviour can be considered to be quasi cartel and quasi competition. The total oil output in

the world is given by

(OPEC production) + (Non OPEC production) = Total Supply

The OPEC economies try to estimate non OPEC production and vice versa so that the world

supply is matched and prices don’t fall below a target level (Shepherd, 2009). The trading

price level is predetermined and negotiated in a union by OPEC economies. A price level of

generally $100 is believed to be suited by most countries in the OPEC and is found to be

profitable (Said et al, 2010). The target output is determined by futures price in the market.

This is because any news relating to the increase in output will push downward pressure on

the futures price. The politics behind the production is that each partner in the OPEC

economy has the incentive to cheat by increasing production. The trade-off for this is

everyone in the OPEC economies cheat then excess supply will put downward pressure on

prices and profits will erode. The payoffs of the OPEC economy can be compared with the

Cournot Duopoly model (Eichberger, 1993). Even though there is high transparency between

the OPEC economies and strong measures incidents of cheating has been noted. Also, there is

the aspect of other non OPEC economies who also try to estimate production levels.

Developing countries like Venezuela and Brazil face severe losses if the oil price is below

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$70 whereas OPEC nations reduce profits if the oil price is too high (Shepherd, 2009). Thus

due to varying payoffs there is production cuts and excesses causing high volatility in the

market. Also, world political decisions such as embargo sanctions and gulf wars also create

shortages in supply and increases consumer speculation leading to increased volatility. Even

global economy crashes and low $USD leads to a reduction in supply in order to increase

profit margins.

Refining Capacity and Volatility

Refining capacity is another aspect that affects crude oil price fluctuation. Unrefined crude oil

doesn’t have any significant values as it cannot be used as a direct input in many things. It is

the refined crude oil that has uses in transportation, jet fuel and other automotive areas. The

price volatility due to refining capacity occurs during times when refineries are used to their

full potential. This is because even though everything is stable investors believe that the oil

companies will not be able to serve future demand in case of demand increase as the

refineries are operating at full potential or near full potential (85 - 90%). This leads to an

increase in future prices due to speculation. However, as the future approaches near with

stable supply and demand growth future prices fall rapidly, ceteris paribus (Shepherd, 2009).

Thus refining capacity is a significant contributor to volatility at times.

Investment and Volatility

One of the major causes of price rises in crude oil is the investment problem. Upstream oil

companies face a major problem in undertaking new investment projects to explore and

excavate oil due to problems in calculation of return on investment. Generally, increased

demand provides an incentive to suppliers and oil companies to produce more as more profits

can be reaped through satisfying the needs of consumers (Kates, 2009). The problem with

investment is oil projects are lengthy and any news about increase in supply leads to a fall in

future prices at most times even when the spot prices are trading at a premium (Shepherd,

2009). This makes ROI calculation hard and oil stocks to fluctuate significantly. Countries

where oil forms a major part of GDP cannot afford price crashes in oil as any such effect may

lead to massive unemployment and stalling of existing projects in other industries especially

infrastructure in case of Middle eastern economies, ceteris paribus. On the other hand higher

oil prices makes infrastructure projects favourable as more money is flowing in the economy

which can be spent towards employment and infrastructure development (Henny Sender,

2007). On the other hand there is a major trade-off tension if oil prices continuously rise

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because firstly it will lead to increase investments in substitutes such as renewables sources

of energy and biofuels. This will hurt future oil prices to large extent and will not be

profitable in the long term (Shepherd, 2009). Also, through empirical studies it has been

found that oil prices are inelastic in short term and elastic in long term. Thus long periods of

higher prices will reduce demand leading to future losses (Li, 2003). Thus due to avoid losses

OPEC and oil companies try to manage supply to find an appropriate position all the time.

Hence due to the trade-off issue between investment and elasticity there are price fluctuations

in crude oil prices, ceteris paribus.

Trading Strategies

At high volatility times one of the trading strategies I believe is to buy oil stocks with a short

– medium term perspective. This is because at high volatility times derivatives will be selling

at a premium and hence profit margins in holding derivatives may be low as compared to

holding stocks. Another incentive to hold oil stocks is generally due to politics and control in

supply the prices will always show an upward trend. Hence the risk of losing money on them

is very low. Another method is to use the techniques of value investing by comparing the

market value of stocks to the fundamental principles of supply and demand, calculate ratios

and undertake company analysis and market analysis. If the stock or derivatives is

undervalued then purchase it and sell it optimistic investors at higher value (Graham, 2003).

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1.1 Impact of oil price volatility on world financial market

The top 10 oil-producing nations in the world produce approximately 2/3rds the entire world’s

supply of oil with the top 25% producing 90% (Snow, 2011). The major importers of oil are

highly developed nations in North America, Europe and Asia and countries with very large

populations, such as India and China. The United States of America is particularly dependent

on oil as it is the largest net importer of oil and the 3rd largest producer of oil. Oil price

volatility (“oil price shocks”) hence impacts the USA to a large extent, which impacts the

global economy. An oil price shock results in higher inflation within the economy, which

causes monitory authorities to increase the interest rates to manage inflation, which results in

higher borrowing costs for firms (SMEs) and eventually lower dividends paid, hence lower

share prices.

Table 1: Top 25 Oil producing nations based on 2012 data, World Fact Book

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Table 2: Top 25 countries oil production, EIA 2013

The WTI Oil Price is plotted against the S&P 500 Share market Index for the USA. The Oil

Shocks of 1991, 2001 and 2008 show large impacts on the stock market. The major oil

shocks of the 1970’s resulted in risk management techniques being developed to hedge

against oil price shocks.

Figure 1: Impact of Oil Prices on S&P Index, (Reference)

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The oil shocks in the 1970’s resulted in the development of many risk management

techniques so as to mitigate the impact of oil shocks in future. This included (i) oil futures,

which allow oil producers to sell oil today for a future price at a future date, (ii) oil options,

which gives the oil producer the right, but not the obligation, to sell oil at a future date at an

agreed price, (iii) oil swaps, which allows the creation of long fixed price contracts via

swapping variable oil prices for fixed oil prices, (iv) oil forwards, similar to the oil futures,

but traded over the counter, and hence terms and conditions are negotiated, (v) oil options on

futures, allows the oil supplier to sell oil today for a future price at a future date, but also

includes the option to back out of the contract if it is not economically viable, hence

protecting against downside risk. Further details are presented in the next chapter. These risk

management tools have greatly reduced the impact of oil shocks on the global economies

since the 1970’s.

1.2 Group Organisation

Meeting Date Agenda

01/05/2014 Project Plan and Report Structure

26/04/2014 Individual Draft Submission (50% complete)

and Review


and Review


and Review

30/05/2013 Conclusion and Recommendation

The group consisted of 5 members and each member contributed equally and fairly. All

members attended meeting on time and followed the plan. Decisions were taken by consensus

of every group member and work was distributed depending on the skill, potential and

interest of individual group members. The overall report is a team effort and every participant

has contributed significantly in the completion of this report.

2. What are the available hedging techniques?

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2.1 Oil Futures

What’s Futures Contract?

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. The world’s first futures market was

likely the Dojima Rice Market set up in Osaka, Japan, in 1730 (Irwin 2013). The largest exchanges

are New York namely New York Mercantile Exchange (NYMEX) and the Commodity Exchange

(COMEX); Chicago Mercantile Exchange (CME) in Chicago. The most general exchanges for crude

oil futures trades also include Intercontinental Exchange (ICE) and Multi Commodity Exchange

(WiseGeek 2014).

Futures exchanges not only allow buyers and sellers to interact and make agreements in other words

an intermediary, but also prevent defaults to happen from either party such as margin requirements

with deposit funds to be settled. It is vital for investors, hedger or speculators to decide which

exchanges to choose from. It then goes to the clearinghouse to ‘clear’ the trade when agreement is

made upon to confirm that there is no inconsistency in terms of prices and quality of the contract

(Irwin 2013).

There are different types of crude oil futures contracts traded such as Brent Crude Oil Futures,

Heating Oil Futures and Gasoil Futures but the most common ones are 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). Nevertheless, WTI is widely used in United States’ domestic market and later on

adopted from 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).

What is driving the oil futures prices?

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. However, there are also other studies against this speculation

supposition.

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The studies that support the view of speculators causing the oil prices to go up states that speculators

trade oil like other assets such as gold or bonds to diversify their portfolio and earn abnormal returns

(Deccan Herald 2014) and there would be no contradictions when no strict regulations are

implemented on this kind of active short term trades on oil futures or investing in commodity related

derivatives as their asset allocation approach (Investopedia, 2014).

On the other hand, studies which against the speculation statements states that fast growing

developing countries such as China with dramatically high demand resulted from rapid

industrialization and rapid income per capita growth along with high growth of commodity intensity

pushes the oil prices up. Indeed that there was a rapid growth in demand for oil between 2003 and mid

2008 which increased faster than global oil production (The National Bureau of Asian Research

2014). Furthermore, it is likely that developing Asia would expand their demand growth for over 85%

for the next twenty years or so (International Energy Agency 2014).

Market manipulation only happens when speculators transform the market into where they can earn

profits from and therefore raising the oil prices. However, there is no clear indication of this sort of

activity since 2003 (CNN 2014).

Pricing of futures contracts

1. Cost of Carry Hypothesis The value of the futures contracts is determined by the value of the underlying assets. The common

cost of carry model summarizes the relationship between the spot price of commodity and future price

of the commodity where for instance the crude oil prices (Futures Prices 2014). Spot price is the price

in the cash market to be paid today to purchase the commodity. Future price is then derived from the

spot price of the expected value of the commodity. The model also depends on the underlying asset to

be hold until the end of agreement. However, it doesn’t take into account the margin requirements,

transaction costs, interest rate differences when borrowing and lending, and short selling restrictions

(Futures prices 2014).

Rules are set out under cost of carry model to restrict on risk free arbitrage opportunities. Firstly, the

spot prices plus the percentage cost to carry the commodity until expiry date should exceed or equal to

the futures prices.

Secondly, the spot prices plus the percentage cost to carry the commodity until expiry date should be

less than or equal to futures prices.

The first and second rules then lead to the final rule of spot prices plus the percentage cost to carry the

commodity until expiry date to be equal to futures prices to prevent investors from exploiting a cash

and carry arbitrage opportunity.

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F 0 , t≤S 0(1+C 0 , t )

F 0 , t≥S 0(1+C 0 , t )

F 0 , t=S 0(1+C 0 , t )


Investors can make risk free arbitrage profits from the price discrepancies between cash and futures

market by buying an underlying asset at a lower price and selling it at a higher price at the same time.

However, arbitrage opportunities only exist when both cash market and futures market are present

(Futures prices 2014). Cash and carry arbitrage or reverse cash and carry arbitrage exists when the

rules listed above are not achieved. The detailed execution is arbitrageur borrowing money to pay off

the loan, pay interest on the borrowings, and buy commodity today and delivery the commodity

against futures contract at time t.

2. Risk premium hypothesis Another model to price futures contract is the risk premium hypothesis where the futures price is

equivalent to expected spot price plus risk premium. The hypothesis has the oil futures prices equal to

the spot prices adjusted with a risk premium, in other words, changes of spot prices at maturity

compared to current spot prices are reflected. Risk premium compensates traders for investing in risky

assets than the risk free ones (Watkins 2001).

From the cost of carry model it is stated that the spot prices should equal to futures prices to avoid

arbitrage opportunities, this is however not the case in risk premium hypothesis due to the risk

premium adjusted future prices (Haseeb 2013). The expected spot prices would be greater than futures

prices and is expected to grow at a faster rate than risk free rate when risk premium is greater than

zero and vice versa (Valuing Futures and Forward contracts 2014).

How to hedge with futures contracts?

Futures contracts’ value arises from the underlying assets thus are seen as derivative contracts. As

discussed earlier, a futures contract consist of two parties where the seller will deliver the underlying

asset with standardized condition such as specific time, price and location whereas the buyer of the

futures contract would agree with the fixed prices that was set out and make the purchase of the asset.

Futures contracts can thus be utilized by buyers or sellers to protect their current positions. For

instance, when the price of the underlying asset increase after the settlement the buyer would become

the winner which in other words at the expense of the seller and the risk of higher prices are reduced

and vice versa (The Option Guide 2014).

Interest rate changes are the major concerns of hedgers, for instance, oil companies might purchase

futures contracts to hedge against rise in oil prices whereas mutual fund managers might hedge

against unfavorable foreign exchange rates movements. The difference between spot prices and future

prices can determine the structure of oil futures contracts although it is difficult to obtain due to the

fact that prices can reflect current performance of the economy as a whole as well as signaling what

future performance of the economy is going to be (Commodity HQ 2014).

21


Different investors have different perspectives on using oil futures contracts. Crude oil hedgers would

protect their profit margins by obtaining a long hedge position to prevent unfavorable price

movements when purchasing crude oil in the future whereas they obtain a short hedging position

when wishing to sell certain commodities (The Options Guide 2014). Long hedge position helps

hedgers to offset the increase in purchasing prices as illustrated in Figure 1 below. Short hedge

position then helps hedgers to offset the decrease in selling prices as illustrated in Figure 2 below.

Crude oil speculators trade for abnormal profits instead of being risk adverse like hedgers. They take

positions in long futures when expected underlying assets price increases and when expected

underlying assets prices decrease short futures positions are obtained. For example, a speculator

bullish on purchase price of crude oil futures at $102.47 per barrel with each crude oil futures

contracts representing 5000 barrels. When the price of crude oil goes up to $102.90 per barrel, the

speculator could earn a profit of (102.90 – 102.47)*5000 = $2150 when exiting the long futures

position (The Option Guide 2014). It is then the opposite execution with short futures positions when

the speculator bearish on the crude oil prices.

Figure 1: Long Futures Hedging Position Figure 2: Short Futures Hedging Position

Illustration

Crude oil futures contracts to hedge against price increase:

In the example of crude oil futures contract, investors or traders can secure their purchasing price

from rising with a long futures contract to buy low and sell high. For instance, current crude oil price

is US$45.20 per barrel and in order to secure the price, 1000 barrels per contract of crude oil futures

contracts are to be purchased leading to the value of US$45,200 of futures contracts. Margin

requirement is then to be settled after locking in oil futures prices. The bullish assumption on oil

prices few weeks later at US$47 per barrel would increase the futures contract value to US$47,000.

22


The loss in cash market can be offset by the gain in futures market (The Options Guide 2014). Profit

of $47,000 - $45,200 = $1800 when existing the long hedge position is earned by selling the futures

contracts at the higher price (The Options Guide 2014).

Crude oil futures contracts to hedge against price decrease:

To secure an oil selling price from decrease, it is to obtain a short hedge position in crude oil futures

contracts to sell high and buy low. The bearish assumption on oil prices few weeks later at US$40.78

per barrel from the current spot price at US$43.80 with 1000 barrels per crude oil futures contract

gives a net profit of ($43.80 - $40.78)*1000 = $3020 earned. Therefore, after closing the short hedge

position by selling oil futures at $43.80 per barrel and buying oil futures at $40.78 per barrel with

1000 barrels per contract, $3020 profit is earned (The Options Guide 2014).

2.2 Oil Options (caps, floors, collars, captions)

The main feature of the commodity options is the price of commodities in the options market

and it is determined by a particular period and situation. Therefore, price of commodities has

definite influence on the pricing and hedging options (Ewald C et al. 2013). Hedging of

derivative securities is a crucial problem in finance. There are scholars and market

researchers who have attempted to study it extensively. Thus, all contingent claims can be

perfectly hedged in the complete market. The hedging problems become more difficult when

there is an incomplete market that derivative securities cannot be entirely hedged. However,

hedging strategies are strongly associated to the oil and gas market’s economic condition. In

oil and gas market, securities with higher investment are tend to use more hedging strategies

such as put options only, mixture of swap contracts with put options or costless collars

(Mnasri M et al. 2013). The higher instabilities and higher future expected prices are related

to the use of put options and collars. While, swap contracts are positively related to higher

spot prices.

Specification of option contracts

Options give buyer the right but without the need of commitment to transact a security at a

predetermined price during an agreed period. Options offer the buyer with protection against

the consequences of unpredictable future price movements in exchange for a fixed payment

that is paid prior to the seller (Kshirsagar K 2013). Consequently, an options contract will

only be executed if market moves in favor of the holder. For instance, crude oil options are

the option contracts in which the underlying asset is a crude oil futures contract. The holder

of crude oil options holds the right to assume a long position or a short position in the

23


underlying crude oil future at the strike price. However, the right will be revoked when the

option expire after, market close on expiration date (Ewald C et al. 2013)

The buyer of a crude oil call options requires a premium payment to the seller; in return,

before or at an agreed date, buyer has the right to buy a specific amount and type of oil at a

fixed price. The buyer of a crude oil put option pays a premium to the seller and, in return,

has the right to sell at a specific amount and type of oil at a fixed price, before or at a given

date. Nevertheless, it is important to remember that the option seller is obliged under contract

to buy or sell should the buyer exercise its right. In return, the option seller receives the

option premium as a non-refundable payment, in which is from the option buyer.

Literally, there are four basic option-trading positions; each of them has different

characteristic profile of risk;

Buy a call, i.e., purchase an option to buy the underlying commodity or asset

Buy a put, i.e., purchase an option to sell the underlying commodity or asset

Sell a call, i.e., write a contract that gives the purchaser the option to buy the

underlying commodity or asset

Sell a put, i.e., write a contract that gives the purchaser the option to sell the

underlying commodity or asset

Call options (Caps)

Buyer has the right but is not required; to buy a specific asset at an agreed quantity by a

certain date for a certain price (strike price) Call options can be made both over the counter

(OTC-trade) or exchange trade. OTC options are settled based on the average monthly price

of the commodity. “Fuel hedging in the Airline Industry” is an example for calls option as

they refuel their aircraft several times a day and the airline company paying an average price

of oil price over a month. However, Airline Company prefers to settle hedges against an

average price (Kshirsagar K 2013). In the options trade, when market liquidity is a concern,

The Call Options are used to hedge cross-market risks particularly. For instance, when crude

oil and heating oil prices changes it will affect the jet fuel prices changes as well. As a result,

an airline may choose to buy an option on heating oil as a cross-market hedge against a rise in

the price of jet fuel. Due to the high volatility in the prices of energy commodities, the

premium that the airline has to pay on the option is expensive and thus it explores the zero-

cost collars (Roubini N & Setser B 2004).

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When hedging, there is two investment positions are in an inverse relationship so that one

"hedges" (protects) the other from great losses. Hedging is often done when the position is

already profitable and you want to protect those profits. For illustration, let us assume that if

bearish on crude oil, we can profit from a fall in crude oil price by buying (going long) crude

oil put options. Such as if interest rate is bullish and on other hand, in futures is bearish in the

market in order to make a profit. Similarly, we can protect the deposit rates. We observed that

the near-month Crude oil futures contract is trading at the price $ 40.30 per barrel. A Crude

oil put option with the same expiration month and a nearby strike price of $40.00 being

priced at $2.6900 per barrel. Since each underlying Crude Oil futures contract represents

1,000 barrels of crude oil, hence, the premium we need to pay to own the put option is

$2,690. Assuming that by option expiration day, the price of the underlying crude oil futures

has fallen by 15% and is now trading at $ 34.25 per barrel. At this price, your put option is

now in the money.

By exercising the put options, we assume to sell 1,000 barrels of crude oil futures at $40.00

on the strike price per barrel on the delivery day. In order to make profit we offsetting long

futures in one contract of the underlying crude oil futures at the market price of $34.26 per

barrel, in which, resulting in a gain of $5.7500 per barrel. Subsequently, Crude oil put option

covers 1,000 barrels and gain from the long put position of $5,750. Then deducting the initial

premium of $2,690 we have paid to purchase the out option, hence, the net profit from the

long put strategy is equal to $3,060.

Gain from Option Exercise = (Option Strike Price - Market Price of Underlying Futures) x Contract Size

= ($ 40.00/barrel - $ 34.25/barrel) x 1000 barrel

= $ 5,750

Investment = Initial Premium Paid

= $ 2,690

Net Profit = Gain from Option Exercise - Investment

= $ 5,750 - $ 2,690

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= $ 3,060

Put options (Floors)

A put option is the right to sell the underlying stock at a predetermined strike price by a

certain date. The buyer has the right but is not required, to sell a specific asset at an agreed

quantity by a certain date for the strike price (Kshirsagar K 2013).

The party that sells the option is called the writer of the option. The option holder pays the

option writer a fee; called the option price or premium. The option writer is obligated to

fulfill the terms of the contract should the option holder choose to exercise the option.The

buyer of a put option either believes it's likely the price of the underlying asset will fall by the

exercise date, or hopes to protect a long position in the asset.The advantage of buying a put

over shorting the asset is that the risk is limited to the premium. Normally, the seller of a put

option does not believe the price of the underlying security is likely to fall. The writer sells

the put to collect the premium.

There is an illustration to hedge the put option, let us assume that if bullish in crude oil, we

can make a profit from a rise in crude oil by buying or going long on crude oil call options.

Such as if the interest rate is bearish and on the other hand, the futures is bullish in the market

in order to make a profit by hedging with buying call on the futures. Similarly, we can protect

the interest rate. We observed that the near-month Crude Oil futures contract is trading at the

price of $ 40.30 per barrel. A crude oil call option with the same expiration month and a

nearby strike price of $40.00 is being priced at $2.6900 per barrel. Since each underlying

Crude oil futures contract represents 1,000 barrels of crude oil, the premium we need to pay

to own the call option is $ 2,690. By assuming that by option expiration day, the price of the

underlying crude oil futures has risen by 15% and it is now trading at $46.34 per barrel. At

this price, the call option is now in the money.

By exercising the call option, we assume to go long in the underlying crude oil futures at the

strike price of $40.00.In order to make a profit, we offsetting short futures position in one

contract of the underlying crude oil futures at the market price of $46.35 per barrel, resulting

in a gain of $ 6.3400 per barrel. Since Crude oil call option covers 1,000 barrels, hence, we

gain from the long call position is $ 6,340. Then deducting the initial premium of $2,690, we

have paid to buy the call option. Therefore, the net profit from the long call strategy is equal

to $3,650.

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Gain from Option Exercise = (Market Price of Underlying Futures - Option Strike Price) x Contract Size

= ($ 46.34/barrel - $ 40.00/barrel) x 1000 barrel

= $ 6,340

Investment = Initial Premium Paid

= $ 2,690

Net Profit = Gain from Option Exercise - Investment

= $ 6,340 - $ 2,690

= $ 3,650

Collars

A collar is when there is a combination of both a call option and a put option. In this, the

purchaser of the commodity sells a put option with a strike price below the current

commodity price and buys a call option with strike price above the current commodity price

(Kshirsagar K 2013). As a result, call option enable the acquisition of the commodity at a

price that will not be greater than the call strike price. The call option provides protection to

the hedger against rising movement of prices and the premium obtained from selling the put

option helps counterbalance the cost of the call option. The price of the commodity thus

changes between the minimum and maximum price and eliminates the risks. However, it is

known as a zero-cost collar if the premium received from the sale of the put option has

entirely offsets the purchase price of the option. The cost of the call option is only partially

counterbalance by the premium received from selling a put option in case of a premium

collar. Typically, a premium collar is used to protect against the rising price movement by

lowering call option strike price. This is so that we can benefit from declining prices by

selling a put option with a lower strike price.

By establishing a collar strategy, a minimum and maximum commodity price is created

around a hedger’s position until the expiration of the options. For an example of airline

27


industry, the net cost of jet fuel in $ per gallon using a collar where a call option is purchased

with a $0.80 strike price and a put option is sold with $0.60 strike price. As shown, the airline

will never pay more than $0.80 for jet fuel no matter how high prices rise, yet will never pay

less than $0.60 regardless of how low jet fuel prices drop. If more protection against upward

price movements is desired (i.e: having a lower call option strike price) or more benefit from

declining prices is desired (i.e; selling a put with a lower strike price), a premium collar is

used. With a premium collar, the cost of the call option is only partially offset by the

premium received from selling a put option. Using a zero-cost collar or premium collar may

appear to be a reasonable hedging strategy for an airline since it involves no upfront cost (or

low upfront cost) and involves no speculative return. However, if jet fuel prices fall

drastically, the airline may pay more for jet fuel than its competitors who did not employ the

collar strategy. Competitors may lower their airfares aggressively as a result. Accordingly,

the zero-cost collar should be more accurately called a “zero-upfront cost” collar (Carter D

et.al. 2013)

However, for other example, instead of buying the futures, buying the $79 puts and selling

the $97 calls, the trader could buy the $79 calls and sell the $97 calls against them. There are

no further losses below $79 and no further gains above $97. The trader could also sell the $97

puts, while buying the $79 puts for protection. Collaring a long futures position, buying a call

vertical spread and selling a put vertical spread all benefit from an upside move and are

positions where the maximum profit and loss in the position is defined. Collaring a long

futures position is a method whereby the trader transforms a naked long position into a

bullish vertical spread (Keegan D 2010).

Captions

A caption is an option to buy or sell an interest rate cap when the holder of option has the

right with no obligation to purchase or sell a cap at an agreed strike rate. A caption is also

known as an interest rate caption (Dontwi I K et al 2010). However, an investor purchasing a

caption would profit if the floating interest rate on a security commodity increases above a

specific level. Or else, investors can simply choose to avoid from purchasing the interest rate

cap. Nevertheless, investors might lose the premium if the caption is not exercised and the

securities have hedged in interest rate risk and as well as volatility risk. For illustration, an

investor could possibly buy an at-the-money six-month cap for 15 basis points when a two-

year cap has a premium of 150-basis point. Factually, cap has to be bought at or before the

28


expiration date when the option’s life ends. Though, if the cap is in-the money at the expiry,

the holder of caption have to purchase the cap for 150 basis points as well as exercise the

option and thus the cap has gained 30 basis point from the amount which the cap is in-the-

money worth for 180 basis points. Moreover, the price that an investors pay against being

able to hedge interest rate risk at a future date is the additional cost that investors incurs

(Dontwi I K et al 2010). Nevertheless, there was directly relationship between the oil price

and ticket price in the airline industry and the aim for hedging was to lock in the cost of

future fuel purchases and hence to protect the company against losses which would arise from

oil price fluctuations (Roubini N & Setser B 2004). The value of hedging is highly depended

on the accuracy of the predictions of the price of oil in the future years, in respect of which

hedging arrangements were to be made. Similarly, the source of income of airline industry is

based on the uncontrollable ticket price fluctuations. Therefore, the company would make a

loss if in the incident that the oil price increased when ticket prices were set at the lower

price. Even so, the cost of hedging would eventually be offset if the price growth were not a

great amount.

Consequently, options are high-risk but provide high-returns when compared to buying the

underlying security. Options become completely valueless once they have expired. Generally,

when the price does not move in the direction that the investor hopes to, in which case the

investor would not gain anything by exercising the options. When buying stocks, the risk of

the entire investment amount getting exhausted is usually quite low.

2.3 Swaps and Swaptions

Introduction

A swap is an agreement between two parties to exchange a series of cash flows over a future

period where one party pays fixed amounts and the other pays variable amounts. The variable

amount, also called “floating”, could be based on any index, commodity price, interest rate,

or other market variable (Hull, 2005). The most common are interest rate swaps often

referenced relative to LIBOR interest rates and the other is exchange rate swaps (or “FX”

swaps) which are referenced relative to a currency, e.g. USD / AUD exchange rate (Hull,

2005). Oil swaps are commodity swaps and exchange cash flows between two companies

based on the oil price (or an oil price index). The figure below illustrates the concept (Hull,

2005), where company A would be the fixed-rate payer (i.e. receive floating) and company B

the fixed-rate receiver (i.e. pay floating).

29


Figure 2: Oil Swap, Hull 2005

In practice, Company A and Company B in the above swap would usually not approach one

another directly, but rather negotiate the swap deal with their respective banks, which act as

intermediaries and market makers (Brown, 1994). Swaps are set up in the over the counter

market and so the contract would be negotiated.

Swap Contract

An example of a commodity swap’s terms and conditions, adapted from Gay &

Venkateswaran (Georgia State University), are:

Commodity: Crude Oil (West Texas Intermediate)

Notional Amount: 100,000 Barrels

Agreed fixed price: $83.02/Barrel

Agreed Oil Price Index: “Oil-WTI-Platt’s Oilgram”

Term: 9 years

Settlement Basis: Cash settlement, Semi-annual

Payment Dates: June 18 and December 18

The commodity is the WTI oil and the price index is based on the Oilgram Price Report

(Platts, 2013). The notional amount determines the size of the swap contract and in this

example it is 100,000 barrels. This contract does not allow physical delivery of oil, but

financial cash settlement. So if the oil price is $103/Barrel on 18 June the fixed-rate receiver

pays the fixed-rate payer 100,000 * (103-83.02)=$1,998,000. The term can vary from a few

years to many years into the future. The advantage of a swap agreement is that no premiums

are paid to enter the contract, however, commission is still paid. The disadvantage of a swap

agreement is that credit risk arises when the swap goes out the money. The company that is

out the money may hence default on the agreement (Fabozzi, 2013).

30


Illustration of hedging Oil Price increases (and decreases) using Oil Swaps

Common uses of oil swaps are:

Companies hedging against decreases in oil prices, e.g. oil producers

Companies hedging against increases in the oil price, e.g. airlines

This allows these companies to transform their liabilities or assets (Fabozzi, 2013)

The figure below provides an illustration of how a swap is set up for an oil producer and an

airline company in order to reduce the impact of oil price volatility on their profit and loss

statements.

Figure 4: Illustration of Hedging using oil swaps

The oil producer

Oil producers, also known as exploration and production (E&P) companies, drill for oil and

sell oil in the market to refinery companies. An example of an E&P company is

ConocoPhillips (NYSE Euronext, 2014). Majority of the oil producer’s revenue is dependent

on the oil price and majority of the oil producer’s costs are fixed. The risk for the oil producer

is that oil prices fall and result in losses for the company placing the company at risk of

bankruptcy. If the oil price increased, the oil producer would not experience stress in this

situation, but rather experience higher profit levels. In order to hedge against the fall in oil

31


prices, the oil producer negotiates a swap contract with its bank (Bank A in the above

diagram) to receive a fixed-rate oil price over a future period.

As an illustration of hedging for the oil producer, assume:

The spot price of oil is $105 today

The 2-year swap rate of $100

Payments every 6 months

If the price of oil decreased to $50 per barrel, the oil producer would receive a

payment of (100-50)*100,000 barrels = $5m during the 6 month period to offset the

reduction in revenue

If the price of oil increased to $150 per barrel, the oil producer would make a payment

of (100-150)*100,000 barrels = -$5m during the 6 month period, however, the

company made the additional profits in revenue.

The price of oil is thus set at $100 for the 2-year period.

The airline

Airlines face the risk of increases in oil prices that is a major component of their variable

costs in jet fuel cost, which is a function of the oil price. An example of an airline is

American Airlines (NYSE Euronext, 2014). In an unhedged situation, in which no swaps are

in place, and oil prices rise unexpectedly, the airline would experience stress on the profit and

loss statement as costs rose unexpectedly, placing the company at risk of bankruptcy.

However if the price of oil fell, the airline would experience lower costs, unchanged revenue

and hence higher profitability. The airline could hedge it’s risks by approaching its bank

(Bank B in the above diagram) and enter into an oil swap agreement to become the fixed-rate

payer. This would result in a reduction in the variability of the airline’s costs and so reduce

the risk of bankruptcy.

As an illustration of hedging for the airline company, assume:

The spot price of oil is $105 today

The 2-year swap rate of $100

Payments every 6 months

If the price of oil increases to $150 per barrel, the airline would receive a payment of

(150-150)*100,000 barrels = $5m during the 6 month period to offset the increase in

costs

32


If the price of oil decreased to $50 per barrel, the airline would make a payment of

(100-50)*100,000 barrels = -$5m during the 6 month period, however, the airline

would have lower variable costs.

The price of oil is thus set at $100 for the 2 year period.

The structure

The swap contracts are negotiated with swap banks, which also act as market makers and

enter into swaps as the counterparty to every deal. Swap contracts are long-term contracts and

hence can result in large credit exposures to the banks. Because swap contracts are a

collection of forward (or futures) contracts with varying terms to maturity, banks can hedge

their risk by entering into a series of short forward or futures contracts (Hull 2005).

Swap Rate Pricing

The price (i.e. swap rate) of an oil swap can be determined from the Oil Price futures traded

on the New York Mercantile Exchange (NYMEX) and Eurodollar futures contracts traded on

the Chicago Mercantile Exchange (Fabozzi, 2013). At the start of a swap agreement the

discounted present values of the expected floating rate payments is set equal to the discounted

present value of the fixed rate payments. The cash flows are based on a notional amount

defined in the contract, for example 100,000 barrels of oil, (Fabozzi, 2013).

The pricing of the above oil swap contract is presented in the table below.

The Eurodollar futures contract has a term of 3 months and the rate is set at the start of the

period with payment made at the end of the quarter (CME, 2014)

The forward discount rate, column (f), is determined from the Eurodollar futures contracts for

each quarter over the nine-year period (Fabozzi, 2013). The formula is for the forward

discount rate is:

Forward Discount Factor= 1(1+ f 1 ) (1+ f 2 ) … (1+f t )

= 1(1+ i )t

where f is the forward rate for each quarter and i is the spot rate for the t periods (the first

quarter’s interest rate is known).

The expected floating rate payments are determined from the WTI oil price futures 6-month

contracts for nine years into the future, see column (g), with cash settlement dates of June 18

33


and December 18 (NYMEX, 2014). The floating rate cash flow is calculated by multiplying

the notional amount by the WTI futures price, i.e. column(h) = 100,000 * column(g). The

expected floating rate cash flow is then discounted to present value, i.e. column(i) =

column(h)*column(f). The swap rate is then calculated using the following equation

(Fabozzi, 2014, p671):

Swap Rate= Present Valueof Floating Rate Payments

∑t

N

Notional Amount × Forward Discount Factor for Period t

where column (j) is the Notional Amount * forward discount factor = 100,000 * column(f).

This leads to a swap rate of USD 83.02 for the 9-year WTI oil swap.

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

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Table 2: Pricing of an Oil Swap

Swaptions

Swaptions are options on swaps and grant the option buyer the right to enter into a swap at a

future date (Fabozzi, 2014). Swaptions are alternatives to deferred swaps, which allow a

company to enter into a swap at a future date (Hull, 2005). The deferred swap has the

advantage of no up-front cost, but has the disadvantage of obligating the company to enter

into the swap agreement. With a swaption, the company is able to benefit from favourable oil

price movement while obtaining protection from unfavourable oil price movements. For

example, the company may buy and option to enter into a 5 year WTI oil swap in 1 year’s

time at the exercise swap rate. If the swap rate in 1 year’s time is less than the exercise swap

rate, the company would let the swaption expire and enter into a WTI oils swap at the market

rate. Alternatively, if the swap rate in 1 year’s time is above the exercise swap rate, the

company would exercise the option.

Conclusion

Swaps are excellent risk management tools to hedge oil price increases for airlines (or oil

price decreases) over a longer time period than other derivatives. Fixed oil price contracts for

10 years have been common for many years, (Fabozzi 2011). Banks are able to price the

swaps with oil price futures contracts.

2.4 Oil Forwards

A forward contract is a contract between two parties to buy or sale given quantity of a crude

oil for an amount of dollars and lock in exchange rate for settlement on a predetermined

future date (maturity date), and historically forward agreements were made by farmers to

permit guaranteed returns at future times when the crop had been harvested, no margin call

payments are required (Geman, 2004). Forwards are quoted as delivery price and it would

fluctuate with market condition such as war, demand and so on. A best example to illustrate

this is an airline can reduce its cost by purchasing the crude oil few months forward by using

the forward contracts. Similarly, oil producer could also hedge by using forward contract in

order to make the interest payment.

Available Hedging Techniques (Illustration)

35


Forward contract usually are traded in the over-the-counter-market (OCT), which means less

transparent and also subject to less regulation. Furthermore, futures contracts are

standardized, thus, difference to futures contracts, forward contracts are riskier in terms of

credit risk (default risk) due to lack of regulation. Because of the fact that forward contracts

are not mark to market, it would be less liquid compare to the future contract. However,

forward contracts may be more prices competitive for all parties since both of them do not

need to pay for margin.

The following example will illustrate how to hedge by using the forward contracts:

Qantas and BP world might agree today to exchange 500,000 barrels of crude oil for USD

$100 a barrel three months from today. The spot price of WTI today is USD $102.61.

In the forward contract there are four variables should be specified:

The notional amount (500,000 barrels)

The delivery price/ Forward Price (USD $100)

The settlement date (3 Months)

The underlie (The quality of the crude oil product)

The total payment of delivered oil is:

500,000 * $100 = USD $50M

At settlement, the forward has a market value given by:

500,000(102.61-100)=1,305,000

As shown above, for Qantas, it pay cheaper than the market price and save up to 1.305

million dollar; for BP world, it has advantage for get the cash one year before it deliver the

oil to Qantas thus can invest on other fields. In addition, the price for WTI crude oil will be

expected boost to USD$ 117/barrel in one year time, in such case, the long party would

benefit in the spread between price today and one year later.

The limitations of forward contracts

Both the forward contracts and future contracts could use to hedge the volatility risk for

trading crude oil. However, forward contracts are an agreement between buyer and seller

whereas future contracts are involved third party (clearing house), that is, forward contracts

36


could be more risker than future contracts due to the counterparty risk (default risk). On the

other hand, future contracts are marked to market, which allow both parties to close positions

before expiration. However, some issue such as the time value of money may ignore by

forward contracts since the long party making the payment today and get the delivery on the

settlement date. Other issues such as liquidity and default would be also a concern to both

parties.

Futures versus Forward Contracts

As described earlier in this chapter, the difference with forward contracts is futures contracts

require marking to market. And if for all maturities the interest rates are remain same, there

should be no difference between the value of an equivalent forward contract and the value of

a futures contract. Furthermore, if the interest rates are very unpredictably, the futures prices

can be different from forward prices. This is because of the reinvestment assumptions that

have to be made for intermediate profits and losses on a futures contract, and the borrowing

and lending rates assumptions that have to be made for intermediate losses and profits,

respectively. The relationship between spot prices and interest rates will lead to the effect of

the interest rate induced volatility on futures prices. For example, under the case with stock

indices and treasury bonds, when spot process and interest rates move in opposite directions,

the interest rate risk will make futures prices greater than forward prices. And if both of them

move together, the interest rate risk can actually counter price risk and make futures prices

less than forward prices. Moreover, because of the futures exchange essentially guarantees

traded futures contracts, so credit risk is also can cause the prices of futures and forward

contracts to deviate. On the other hand, forward contracts can be traded in twenty-four hours,

this trading time is beyond the future exchange-trading hour (Robert & George, 1981).

In addition, when we considering futures and forward contracts, it is important to distinguish

between investment assets and consumption assets. A consumption asset is an asset which is

not held for investment, it is held primarily for consumption, such as copper oil and pork

belies. On the other hand, an investment asset is an asset which is held for investment

purposes certain numbers of investors, but do not have to be held exclusively for investment.

For example, both of bonds and stocks, gold and silver can be classification to investment

assets. However, the difference between futures contract and forward contract is when we use

arbitrage arguments to determine the futures and forward prices of an investment asset from

its spot price and other observable market variables, we can not do this for consumption

37


assets (Hull, 2013). However, in the real world, the difference between forward and future

prices is very small and can be ignored.

A Forward-to-Forward Contract

A forward-to-forward contract is about a swap transaction, which involves the simultaneous

purchase and sale of one currency for another, and both of transactions are forward contracts

at the same time. It allows company without locking on to the spot rate and to take advantage

of the forward premium. The spot rate has to be locked onto before the starting date of the

forward-to-forward contract (Ghosh, 1998). For example, both bank ABC and bank XYZ

under the forward-to-forward contract, ABC forward deposit US $10m to XYZ after 3

months for 6 months, and XYZ will pay interest rate 5% on US $10m for 6months, when

both banks under the forward-to-forward contract, credit risk involved for both side.

Furthermore, if interest rate increase more than 5%, ABC receives less than market, on the

other hand, if interest rate decrease less than 5%, XYZ pays more than market. Based on this

case, a forward-to-forward contract is a commitment on the part of one bank to deposit funds

at an agreed interest rate at some date in the future in another bank, who also agrees to pay

that rate. Thus, the first bank commits itself not only to accepting the deposit rate, but also to

accepting the credit risk of the second bank, whatever the latter’s condition at the future date.

The second bank has locked in not only the rate but also the availability of funds.

Equity forward contract

An equity forward is a contract for the purchase of a stock portfolio, an individual stock or a

stock index at some future date. Equity forward contracts are cash settled in most cass, at

maturity the two counterparties exchange a cash flow equivalent to the difference between

the stock closing price and the strike price. For instance, an equity forward on an individual

stock allows an investor to sell the stock at some future date at a guaranteed prick. If the

guaranteed price is below the market guarantee price, the investor will still receive the

guaranteed price. If the market price is above the guaranteed price, the investor will only

receive the guaranteed price and not be able to participate in any market increase above that

price (Benhamou, 2013). For example, assume that a client owns ABC at US $100 and wants

to sell ABC stock in 6 months to increase cash. The client can enter into an equity forward in

which he will receive a price of US $125. Under this situation, if the price remains at or

below US $125, the client will receive the same amount money US $125 per share in 6

38


months. However, if the stock price is at $130, the client will still have to delivery the shares

to counterparty and will only receive US $125 per share, that will losing US $5 on the

transaction.

Forward contracts on bonds

An equity forward contract is one where the underlying asset is an equity instrument. The

basic characteristics of a forward contract on a bond are very like those of equity, and a bond

pays a coupon very similar to an equity paying a dividend. But the differences are bonds have

a default risk, and bonds mature that means contracts must also mature before the maturity

date. This instrument can either be a single stock, a basket of stocks or a stock index. For

zero-coupon bonds like a T-bill, a forward contract has one party agreeing to buy the T-bill at

a later date, but before its maturity, at a price that is agreed to at the time the contract is made.

For example, there is a 180 day T-bill which selling at 3.5%. The par vale equity to $1, and

assume 360 days is market convention for the number of days in a year, therefore,

1.035(180/360)=0.9825. It will pay to investor $1 if the bond is held to maturity. There are

semi-annual and sell at premium or discount to the bond’s par value for coupon payment

bonds and interest payments. And prices are usually quoted without the interest rate that has

accrued from the last payment but quoted by stating the yield. In addition, forward contracts

call for the delivery of a bond prior to the bond’s maturity where the short pays the long the

agreed upon price (Finance Train, 2014)

2.5 Option on Futures/Futures Options

A futures option gives the holder the right but not the obligation to enter into a futures

contract at a certain futures price by a certain date. The options on futures work similar to the

options as stocks. A call futures option gives the right to enter into a long futures contract at a

certain price and a put futures option gives the right to short a futures contract at a certain

price (Hull, 2005). A call option on a futures contract will be in the money if (Ft – K) > 0

where Ft is the exercise price and K is the strike price. Similarly a put futures option will be

in the money when (Ft – K) < 0 where the strike price K is greater than the exercise price F t.

The profit on the transaction for a call futures option will be (F t – K) – 2*transaction costs

and Pc where Pc is the price of the call option. The profit equation is similar for the put

futures option with strike price K greater than the futures price F t. It must be noted that when

exercising future options contract there is an underlying obligation either to buy or sell the

39


good. An example of a futures option contract will be if you hold a futures call option

contract of corn at strike price X = $10/kg on April 1st with delivery in May 1st. One futures

contract is 1000kg of corn. Suppose the current trading price is $11/kg the futures call option

is in the money. A trader can exercise the option and earn a profit (11-10)*1000 = $1000 and

a long position on futures contract to purchase 1000 kg of corn. If the price of the corn just

before the day of settlement is $15/kg an investor can sell the futures contract and earn an

extra profit of (15-11)*1000 = $4000. The total profit for an investor is 4000 + 1000 = $5000.

Similarly a put futures option is used. The working of options on futures is same as options

on stocks except the fact that futures are contracts with an expiry date whereas shares is an

ownership of an organisation an does not have a maturity date.

Benefits of options on futures

There are several benefits on trading options on futures rather than trading in underlying

asset. The primary benefit is liquidity. Futures contract is more liquid and easier to trade than

the underlying asset. Also, the futures price of an underlying asset is immediately known

from the futures exchange whereas spot prices of assets may not be readily available. An

example will be Treasury Bonds. Futures for Treasury Bonds are more active than the market

for Treasury Bonds. In terms of ease of trade futures contract is far easier because delivery of

future contracts on commodities is easier than the physical delivery of commodities.

Exercising futures options does not necessarily lead to purchase of the underlying asset as the

underlying futures contract is usually closed prior to delivery. Also trading in futures and

futures options occur side by side in the same exchange. One of the primary important

benefits for a trader is that transaction costs on future options are less than spot options. Also,

the market of future options also provides an opportunity for traders to benefit from arbitrage

and undertake hedging and speculation to maximise profits and protect themselves from risks

(Hull, 2005).

Available Hedging Techniques on Commodities

Future options form an excellent tool to hedge against risks in future prices of an asset. The

hedging techniques for crude oil manufactures and producers are:

Case 1: A producer wants to reap the benefits of price increase and protect itself

from a price drop

Short Futures Position and Long Call Option Futures

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This is a strategy used by crude oil producers who wants to reap benefits from a price rise. If

the spot price for crude oil is $100/barrel and futures price is trading at $105/barrel and my

production costs is $70/barrel. I will short a futures contract at $105/barrel. This will help me

to recover my costs of production. However, I am bullish about the market and believe that

the oil prices will rise significantly. To maximise my profits I will purchase call futures

options to maximise my gains.

X (Spot Price) = $100/barrel

1 Futures Contract = 1000 barrels

Y (Futures Price) = $105/barrel

Total barrels for sale = 100,000

1 Call Futures Option = $2/barrel at K = $105/barrel

Time to maturity = 6 months

Total cost of call option futures contract = 2*100,000 = 200,000

In this scenario my loss is minimised and my gain potential is maximised.

Case 2: A trader who wants to purchase oil futures but does not want to risk large

sums of cash

Synthetic Short Put Option Futures and Long Call Option Futures

This is a technique where investors who do not have large sums of money to invest in

commodities can develop positions where their actions are similar to the purchase of futures

position. An investor can develop a synthetic position by selling put futures option and

purchasing call futures option if he believes a bullish view of the market. The profit for an

investor in undertaking the synthetic futures position is as follows

1Call = $10 X = $100/barrel t=3 months

1Put = $5/barrel X =$100/barrel t=3 months

Net premium = 5 – 10 = $-5

41


In this scenario just by spending $5/barrel an investor has entered into a futures option

contract. The transaction is the same as stocks but in this case the investor has to even pay

margin costs as well.

Breakeven point = Price of crude oil futures is greater than $105

Case 3: A producer wants to hedge the risk of incurring losses in futures price

The producer of a crude oil can protect itself from risks by using options contract.

X (Spot Price) = $100/barrel

1 Futures Contract = 1000 barrels

Y (Futures Price) = $105/barrel

Total barrels for sale = 100,000

1 Call Futures Option = $2/barrel at K = $105/barrel

1 Put Futures Option = $3/barrel at K = 105/barrel

Time to maturity = 6 months

A crude oil producer can protect itself from a fall in crude oil prices by purchasing put

options on futures at $105/barrel. If the price of crude oil falls below $105/barrel his losses

will be compensated by exercising the put option. Suppose after 6 months the price of crude

oil is $100/barrel. The gains from put options on futures is 5*100,000 = $500,000 - $300,000

= $200,000. This will compensate his production losses.

Options on Interest Rate Futures

This is one of the most popular financial instruments that are traded by institutions and

traders as it forms a subject of importance to many people in the economy. Options on

interest rate futures are similar to options on commodity futures where the holder of the call

option obtains a long position in the futures contract and vice versa. The payoffs from

holding the call option are the same as options on other future contracts and are given by (F-

K, 0). Interest rates future prices work similar to bonds i.e. when bond prices increase interest

rate future prices increase. This is due to the fall in interest rates basically.

Available Hedging Techniques

42


Case 1: Hedging techniques to protect from borrowed money

Long interest rate futures + Variable rate LIBOR on loans

Suppose a crude oil dealer has borrowed money at variable rate LIBOR to purchase stocks.

The risk of crude oil dealer is that his gains will be minimised if the interest rates goes up

which means he has to pay more for borrowed money. To protect from this risk the dealer

purchases interest rate futures and borrow money at variable interest rate. This means his

losses from borrowed money is compensated by increase in price on interest rate futures

contract.

3. Empirical Testing of Cost of Carry Model

The Cost of Carry Model

Cost of carry model determines the price relationship between futures prices and spot prices

and any deviations from this relationship will be restored in the market through riskless

arbitrage.

The formula for the futures price has stated below:

F t=S t (1+rf +ct−dt )t

where Ft= future price, rf= risk-free rate, St=spot oil price, ct=storage cost, dt=convenience

yield , t=time.

The model assumes no arbitrage and investors have two choices when investing in

commodities, either (1) Buy the commodity in the spot market and pay storage costs or (2) Or

buy a futures contract on a commodity. According to the cost of carry formula, ‘cash and

carry’ arbitrage occurs if futures price is greater than the cost of carry price, the traders in the

market can exploit riskless arbitrage profits by buying the underlying commodity and selling

the futures contracts. Likewise, if futures price is less than the cost of carry priced, a reverse

arbitrage opportunity will be arises. Nevertheless, in most case, cost of carry model futures

contracts should always be greater than the underlying spot price ( Alizadeh, AH & Nomikos,

NK 2002). For an example, crude oil is a commodity that differs from most other

commodities as it is intended for consumption and it needs storage. Further, crude oil storage

costs are basically significant, it has spot prices that alter regionally and its consumption and

production are highly variable. Crude oil has a high consumption rate relative to its inventory,

43


as compared to the same ratio for investment futures such as financials or precious metals

like gold, silver or platinum. It has little collateral value for borrowing and due geopolitical

issues the risk of its supply disruption is relatively high ( Girard,E , Sinha, A & Biswas, R

2009). There are case, however, if future price is too low, the arbitrageur holding the

commodity in inventory could sell on the spot market and buy the futures contract in order to

avoid incurring carrying cost until the maturity of the futures contract. Convenience yield

arises from the benefit from holding the inventories to meet unexpected demand of

commodity. In fact, this follows from the fact that investors prefer to hold physical

inventories of the underlying asset rather than a distant futures contract; as a result, they are

willing to pay a premium in order to hold the physical asset.

Data for testing

The cost of carry valuation model described above uses 4 main inputs (i) the risk free rate, (ii)

the spot price of WTI oil, (iii) the cost of storage, and (iv) the convenience yield (Hull 2005).

The value from the cost of carry model futures price is then compared to the market value of

the futures price.

In order to perform an empirical analysis, the data sources are summarized below.

Model Input Data Source

Risk Free Rate (rf) US Treasury Bills 13-weeks

Spot Oil Price (St) NYMEX WTI Spot Oil Price

Storage Costs (ct) Provided at 2%

Futures Price (Ft) NYMEX WTI Futures price

Convenience Yield (dt) Not observable.

The risk free rate used was the Treasury Bills 13-week interest rate sourced from the Federal

Reserve Website (Federal Reserve, 2014). The Treasury bill rate is considered to be risk free

due to the very good credit rating of the US government. WTI crude oil is a blend of several

US light sweet crude oils and the delivery location is Cushing, Oklahoma. The spot price of

oil is determined by the supply and demand for the oil at Cushing. The U.S. Energy

Information Administration collects and distributes independent statistics and analysis about

energy related produces and commodities from around the world (EIA, 2014). The historical

spot prices were downloaded from the EIA website (EIA, 2014) for 6 months starting from 3

44


September 2013 until 3 March 2014. 30-day futures contracts on WTI oil are traded on the

New York Mercantile Exchange (NYMEX). Contracts are for 1,000 barrels (CME Group,

2014). The historical futures prices were downloaded from the EIA website (EIA, 2014) for 6

months starting from 3 September 2013 until 3 March 2014.

Storage costs are incurred on commodities, such as gold, corn and WTI oil. The assumed

storage cost is 2% p.a. expressed as a percentage per barrel of oil. The convenience yield

defined by Hull, 2005, is “the benefits of holding the physical asset”, for example, crude oil

held in inventory could be used to continue running a production process, or oil in inventory

could be sold at a higher price to take advantage of shortages of supply, Hull 2005. No data is

available for estimating the convenience yield (other than estimating the implied convenience

yield).

Empirical Testing of the model

The cost of carry model was then used to price the 30-day futures contracts. The interest rate

was converted to a monthly rate by dividing the annual rate by 12. The storage cost of 2%

was converted to a monthly rate by dividing by 12. No convenience yield was assumed. The

time variable was expressed as fractions of a month, so if there were 25 days to maturity of

the contract, then t = 25/30. The below table provides an example of the application of the

cost of carry model for 5 days, the remainder of technical calculations are included in the

appendix.

The WTI Futures Price is the market price of the futures contract and the “Futures Value

(Cost of Carry Model)” is the theoretical price using the cost of carry model. For the 5 th

September 2013, the market value was 22c below the theoretical price indicating that the

market value of the futures contract was undervalued, indicating a buy for the contract on that

day.

DateWTI Spot

Price

WTI

Futures

Price

FedFunds

13 Week

Bill Rate

I/R

expressed

monthly

Storage Costs

/ 12t

Futures Value

(Cost of Carry

Model)

Difference

(Market-

Theoretical)

Sep 03, 2013 108.67 108.54 0.02 0.0000167 0.001666667 0.733333333 108.8 -0.26

Sep 04, 2013 107.29 107.23 0.02 0.0000167 0.001666667 0.533333333 107.39 -0.16

Sep 05, 2013 108.5 108.37 0.02 0.0000167 0.001666667 0.5 108.59 -0.22

Sep 06, 2013 110.62 110.53 0.02 0.0000167 0.001666667 0.466666667 110.71 -0.18

45


Sep 09, 2013 109.62 109.52 0.02 0.0000167 0.001666667 0.366666667 109.69 -0.17

The WTI Futures contract specifications under “Trading Ceases” section states “Trading in

the current delivery month shall cease on the third business day prior to the twenty-fifth

calendar day of the month preceding the delivery month. If the twenty-fifth calendar day of

the month is a nonbusiness day, trading shall cease on the third business day prior to the last

business day preceding the twenty-fifth calendar day. In the event that the official Exchange

holiday schedule changes subsequent to the listing of a Crude Oil futures contract, the

originally listed expiration date shall remain in effect. In the event that the originally listed

expiration day is declared a holiday, expiration will move to the business day immediately

prior.”

Our interpretation is that trading stops 3 days before the 25th calendar day in the month and so

the time to maturity on this day is t=0/30.

So for September 5th, the calculation of the futures price is:

F t=108.5(1+ 0.02 %12

+ 2 %12 )

1530=108.59

The spot price of oil, the market price of the futures price and the cost of carry model are

plotted over time in the chart below.

Figure 1 Spot Price, Futures Price and Cost of Carry Model

46


The above chart shows the futures price using the cost of carry model does not deviate

significantly from the market value of the futures price. The relative difference was

calculated each day as (market value – theoretical value)/market value and expressed as a

percentage. The average of these relative differences was -0.01% indicating that the market

price was on average slightly below the theoretical price over the 6 months. The difference

ranged from -0.51% to 0.51% fro market value with a standard deviation of 0.22%. The table

below contains a summary of the statistics.

Statistic (Market value – Theoretical Value)/

Market Value

Mean of difference -0.01%

Standard deviation of

difference0.22%

Minimum difference -0.51%

Maximum difference 0.51%

In order to statistically test the significance of the relationship the market value of the futures

price and the theoretical value from the cost of carry model were plotted against one another

47


in the chart below. Linear regression revealed an R-squared of 99.854% which is highly

significant.

The main reason for this is that the futures price today depends on the spot price today and so

due to this link there is not a very large difference between the model and the market value.

In addition, interest rates are currently at record low levels and the term of the contract is

short, less than 30 days. A sensitivity analysis is conducted later to test the impact of changes

in interest rates and changes in storage costs.

Limitation of the Cost of Carry Model

There are some limitations of the cost of carry model.

The interest rates that are used are assumed to be constant over the term of the contract until

maturity. Interest rates are highly volatile over time and so this is clearly not an appropriate

assumption. A flat yield curve is also assumed, which in practice does not occur very

frequently.The spot price volatility is not taken into account in the model. Futures prices

depend heavily on spot prices and so this would impact on predictive ability of the model.The

convenience yield is not easily measurable for oil futures and so is a limitation of the model.

Dividend yields, which are easily measurable, allow easier application of the model.

Trading Strategies Assessment and illustration

48


In order to assess the ability of the cost of carry model to assist in determining a trading

strategy, an experiment was conducted based on the following strategy. If market futures

price > cost of carry futures price, then sell the futures contract today and sell the following

day in an attempt to make a profit from the mispricing of the futures contract. Alternatively,

if the market futures price for a particular day < cost of carry futures price, then buy the

futures contract today and sell the following day in an attempt to make a profit from the

mispricing of the futures contract.

If the strategy was conducted every day for the 6 month period from 3 September 2013 until

3 March 2014, the cumulative profit would in fact been a loss of -5.1 dollars (per barrel of oil

invested), as can been seen in the figure below. There were runs of good fortune though,

where many days in a row a profit was realized, but in the same manner, there were runs of

multiple days of losses.

The number of days in which the investor would have made a profit was 64 days out of 123

days, or 52%, accuracy on predicting the price movement. This indicates that the model does

not very good for use as a trading strategy.

Sensitivity of the Model

The cost of carry model uses two main inputs that drive the futures price, the interest rates

and the storage costs.

49


In this section we test the sensitivity of the model to changes in these two key parameters

relative to the “base scenario” with current T-bill interest rates and 2% storage cost

assumption.

Two interest rate scenarios were tested:

Increase of 3% per annum on top of current interest rates (scenario 1) Increase of 8% per annum on top of current interest rates (scenario 2)

In addition, two storage cost scenarios were tested:

Increase in storage costs from 2% p.a. to 3% p.a. (scenario 3) Increase in storage costs from 2% p.a. to 5% p.a. (scenario 4)

The table below presents a summary of the daily percentage difference between the market

price of the futures contract and each relevant scenario. The relative difference is calculated

as (Scenario futures price from cost of carry model – market value of futures contract) /

(market value of the futures contract).

The average daily different, standard deviation and minimum and maximum deviations were

calculated.

Base

Cost of Carry

(i/r & 2%)

Scenario 1

Cost of Carry (i/r

+ 300bpts pa &

2%)

Scenario 2

Cost of Carry

(i/r + 800bpts

pa & 2%)

Scenario 3

Cost of Carry

(i/r & 3%)

Scenario 4

Cost of Carry (i/r

& 5%)

Mean 0.01% 0.13% 0.33% 0.05% 0.13%

SD 0.22% 0.25% 0.33% 0.22% 0.25%

Min -0.51% -0.51% -0.51% -0.51% -0.51%

Max 0.51% 0.71% 1.11% 0.57% 0.71%

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The 8% interest rate increase (Scenario 2) has the largest impact on the cost of carry model

and the 5% storage cost (Scenario 4) the second largest impact on the model.

The various scenarios are also plotted against the market value of the futures price below.

Scenario 1

The FedFunds T-bills rate was increased by 3% per annum from current levels, whilst

holding the storage costs unchanged at 2%. The average daily difference between the cost of

carry model and the market value is 0.13% with a maximum difference of 0.71% observed on

a particular day.

Scenario 2

The FedFunds T-bills rate was increased by 8% per annum from current levels, whilst

holding the storage costs unchanged at 2%. The average daily difference between the cost of

carry model and the market value is 0.33% with a maximum difference of 1.11% observed on

a particular day. In addition there are periods of multiple days where the cost of carry model

is above the market value of the futures price.

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Scenario 3

The FedFunds T-bills rate was left unchanged from current levels, whilst increasing the

storage costs from 2% to 3%. The average daily difference between the cost of carry model

and the market value is 0.05% with a maximum difference of 0.57% observed on a particular

day. This change appeared to be relatively insensitive, so in the next scenario we increased

the storage costs to 5%.

Scenario 4

The FedFunds T-bills rate was left unchanged from current levels, whilst increasing the

storage costs from 2% to 5%. The average daily difference between the cost of carry model

52


and the market value is 0.13% with a maximum difference of 0.71% observed on a particular

day. The higher storage costs do have an impact on the cost of carry model.

One of the major limitations of the above sensitivity analysis is that the cost of carry model

was tested on 30-day WTI oil price futures. The short time period of 30 days limits the

impact of time value of money than if a longer time period was considered. This is

considered in the next section.

Sensitivity of the Model over the longer term

The sensitivity of the cost of carry model was tested over a longer time frame of 10 years.

The purpose of this is to further illustrate the sensitivity of the model relative to different

interest rates and storage cost assumptions. Assuming the spot price of oil is USD 100 today

and assuming the 2% storage costs, the futures price would increase over time due to the cost

of borrowing money to finance the purchase of the oil. The higher the interest rate, the higher

the futures price. The futures price in 30 days is not very sensitive to interest rates, however,

the price in 10 years time is very sensitive. The char below illustrates 3 interest rate

scenarios, 0.5%, 2.5% and 5% per annum.

53


Assuming the spot price of oil is USD 100 today and assuming the current T-bill interest

rates, the futures price of oil would increase due to the cost involved in storing the oil. The

higher the storage costs, the higher the futures price. The futures price in 30 days is not very

sensitive to storage costs, however, the price in 10 years time is very sensitive. The figure

below illustrates 4 storage cost scenarios, 2%, 3%, 4% and 5%.

54


An Alternative Models Tested

A few alternative models were tested using R-Studio using econometric techniques (Hill,

2011). The model presented below predicts the natural logarithm of the futures price from the

natural log of the spot price, natural log of the spot price lagged by one day and the natural

log of the futures price lagged by 1 day.

The R-squared of the model is extremely high at 99.99%, but it would not work in practice as

a predictor of futures prices as can only predict the futures price today and not in future.

Estimate Std. Error t value Pr(>|t|) Significance

(Intercept) 0.026242 0.011387 2.305 0.0229 *

Ln(Spot) 0.975376 0.008538 114.244 <2e-16 ***

Ln(Spot) Lag1 -0.791396 0.055429 -14.278 <2e-16 ***

Ln(Futures) Lag1 0.810332 0.056096 14.445 <2e-16 ***

Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

The below model is the same, however, the interesting this is it shows that a weak

relationship could be estimated with the S&P daily return on the S&P index. Again, this is

not very useful.

Estimate Std. Error t value Pr(>|t|) Significance

(Intercept) 0.027845 0.011361 2.451 0.0157 *

Ln(Spot) 0.97129 0.008871 109.491 <2e-16 ***

Ln(Spot) lag1 -0.787933 0.055126 -14.293 <2e-16 ***

Ln(Futures) lag1 0.810602 0.055746 14.541 <2e-16 ***

S&P Daily Return 0.022062 0.013987 1.577 0.1174

Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05 ‘.’ 0.1 ‘ ’ 1

55


56


4. Conclusion

Based on the above factors it is concluded that

Macroeconomy affects crude oil prices and vice versa. The degree of effect depends

on the correlation on each other.

Supply and demand factors affect prices significantly. The demand for oil is very

seasonal and is dependent on major economical factors. A large proportion of

supply is controlled through OPEC cartel and records are kept secretive. Supply is

also restricted by major economies to profit from higher prices.

The type of substitute and investments in alternative sources helps to control future

oil prices. Stricter Government regulations on ethanol and high risk on returns in

alternative projects hinders large scale investment

Entrepreneurs are a major cause of crude oil fluctuations. Cartel by OPEC nations

and different profit goals and competitive behaviour makes it difficult to find a win-

win (Nash Equilibrium) situation for all players. Politics, Government embargoes

and refining capacity all affect prices. Future expectations and historical volatility

heightens pessimism and optimistic behaviour leading to bubbles and bursts.

A combination of call and put options with futures is found to reduce volatility risk

and protect producers from downside losses. Options on futures also protect

investors from volatility risks in prices and are more liquid and cheaper at times

than options on other contracts

Future options on interest rates can protect borrowers and lenders from interest rate

risks and helps in project evaluation to a large extent.

The cost of carry model uses arbitrage arguments to derive a futures value of a

commodity or investment asset. The model depends on interest rates, storage costs,

yields (i.e. convenience yield for commodities), the time to maturity and the spot

price of the underlying asset.

The cost of carry model results in good estimates of futures oil prices for the 30-day

WTI futures contracts. The maximum daily difference was 0.51% deviation from

the market value of the futures contract under current interest rates and a storage

cost of 2% p.a.

The model appears to work well for oil price futures, which are short dated for

example 30-day oil price futures, however, it may be less reliable for longer dated

57


futures contracts. The reason for this is that the model is less sensitive to interest

rates and storage costs over a short term to maturity than a long term to maturity.

Trading strategies to take advantage of the mispricing of the WTI oil futures

contracts based on the cost of carry model may not result in profits, but losses. The

strategy resulted in only a 52% correct profit trading decision, which is just as good

as flipping a coin. Alternative models were estimated using R-studio based on

econometric techniques. These models appear to not be very useful, however, a

weak relationship with the S&P daily returns was observed.

Basis risks exist for either long or short hedge thus hedging is not always perfect

(Pelletier 2006) where the risk is equal to the spot price of the commodity deducted

by the future price of the commodity.

58


5. Recommendation

Based on the conclusion it is recommended that

Investors and producers should make use of different financial instruments to

protect themselves from risk. An investor must also consider holding the underlying

asset during volatility times when derivatives are selling at a premium.

The fundamentals such as macroeconomic factors, substitutes, supply and demand

growth rates, refining capacity and politics between players must be closely

followed to estimate prices. Regression models on the level of dependence on

individual factors and investor attitude towards these changes should be developed

to profit from price changes.

Long term investment in oil prices is suitable as the prices have been found to

follow an upward trend.

A risk-averse investor must refrain undertaking large scale investments during

volatility times as prices seem to follow a random walk and is majorly controlled by

market speculation

Synthetics with high maturity dates should be considered by an investor to reduce

Value at Risk (VaR) and increase profit probability due to large scale fluctuations.

Long straddle and strangle strategies should also be considered due to high

variations.

Long calls in substitute assets during bullish crude oil times can be considered by

investors as substitutes price increases are causally related with crude oil price

increases with a lag. The lag period can be calculated by analysing historical lags.

59


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7. Appendices

Detailed Calculations Appendix

DateWTI Spot

Price

WTI Futures

Price

FedFunds 13

Week T-Bill

Rate

I/R expressed

monthlyStorage Costs / 12 t

Futures Value

(Cost of Carry

Model)

Difference

(Market-

Theoretical)

Sep 03,

2013 108.67 108.54 0.02 0.0000167 0.001666667 0.733333333 108.8 -0.26

Sep 04,

2013 107.29 107.23 0.02 0.0000167 0.001666667 0.533333333 107.39 -0.16

Sep 05,

2013 108.5 108.37 0.02 0.0000167 0.001666667 0.5 108.59 -0.22

Sep 06,

2013 110.62 110.53 0.02 0.0000167 0.001666667 0.466666667 110.71 -0.18

Sep 09,

2013 109.62 109.52 0.02 0.0000167 0.001666667 0.366666667 109.69 -0.17


Sep 10,

2013 107.48 107.39 0.02 0.0000167 0.001666667 0.333333333 107.54 -0.15

Sep 11,

2013 107.65 107.56 0.02 0.0000167 0.001666667 0.3 107.7 -0.14

Sep 12,

2013 108.72 108.6 0.01 0.0000083 0.001666667 0.266666667 108.77 -0.17

Sep 13,

2013 108.31 108.21 0.01 0.0000083 0.001666667 0.233333333 108.35 -0.14

Sep 16,

2013 106.54 106.59 0.02 0.0000167 0.001666667 0.133333333 106.56 0.03

Sep 17,

2013 105.36 105.42 0.01 0.0000083 0.001666667 0.1 105.38 0.04

Sep 18,

2013 108.23 108.07 0.01 0.0000083 0.001666667 0.066666667 108.24 -0.17

Sep 19,

2013 106.26 106.39 0.01 0.0000083 0.001666667 0.033333333 106.27 0.12

Sep 20,

2013 104.7 104.67 0.01 0.0000083 0.001666667 0 104.7 -0.03

1


Sep 23,

2013 103.62 103.59 0.02 0.0000167 0.001666667 0.966666667 103.79 -0.2

Sep 24,

2013 103.22 103.13 0.02 0.0000167 0.001666667 0.933333333 103.38 -0.25

Sep 25,

2013 102.68 102.66 0.02 0.0000167 0.001666667 0.9 102.84 -0.18

Sep 26,

2013 103.1 103.03 0 0.0000000 0.001666667 0.866666667 103.25 -0.22

Sep 27,

2013 102.86 102.87 0.02 0.0000167 0.001666667 0.833333333 103 -0.13

Sep 30,

2013 102.36 102.33 0.02 0.0000167 0.001666667 0.733333333 102.49 -0.16

Oct 01,

2013 102.09 102.04 0.02 0.0000167 0.001666667 0.7 102.21 -0.17

Oct 02,

2013 104.15 104.1 0.02 0.0000167 0.001666667 0.666666667 104.27 -0.17

Oct 03,

2013 103.29 103.31 0.03 0.0000250 0.001666667 0.633333333 103.4 -0.09

2


Oct 04,

2013 103.83 103.84 0.03 0.0000250 0.001666667 0.6 103.94 -0.1

Oct 07,

2013 103.07 103.03 0.03 0.0000250 0.001666667 0.5 103.16 -0.13

Oct 08,

2013 103.54 103.49 0.05 0.0000417 0.001666667 0.466666667 103.62 -0.13

Oct 09,

2013 101.63 101.61 0.05 0.0000417 0.001666667 0.433333333 101.71 -0.1

Oct 10,

2013 103.08 103.01 0.05 0.0000417 0.001666667 0.4 103.15 -0.14

Oct 11,

2013 102.17 102.02 0.08 0.0000667 0.001666667 0.366666667 102.23 -0.21

Oct 15,

2013 101.15 101.21 0.14 0.0001167 0.001666667 0.233333333 101.19 0.02

Oct 16,

2013 102.34 102.29 0.1 0.0000833 0.001666667 0.2 102.38 -0.09

Oct 17,

2013 100.72 100.67 0.05 0.0000417 0.001666667 0.166666667 100.75 -0.08

3


Oct 18,

2013 100.87 100.81 0.04 0.0000333 0.001666667 0.133333333 100.89 -0.08

Oct 21,

2013 99.28 99.22 0.04 0.0000333 0.001666667 0.033333333 99.29 -0.07

Oct 22,

2013 97.63 97.8 0.04 0.0000333 0.001666667 0 97.63 0.17

Oct 23,

2013 96.9 96.86 0.04 0.0000333 0.001666667 0.933333333 97.05 -0.19

Oct 24,

2013 96.65 97.11 0.03 0.0000250 0.001666667 0.9 96.8 0.31

Oct 25,

2013 97.4 97.85 0.04 0.0000333 0.001666667 0.866666667 97.54 0.31

Oct 28,

2013 98.74 98.68 0.04 0.0000333 0.001666667 0.766666667 98.87 -0.19

Oct 29,

2013 98.29 98.2 0.04 0.0000333 0.001666667 0.733333333 98.41 -0.21

Oct 30,

2013 96.81 96.77 0.04 0.0000333 0.001666667 0.7 96.93 -0.16

4


Oct 31,

2013 96.29 96.38 0.04 0.0000333 0.001666667 0.666666667 96.4 -0.02

Nov 01,

2013 94.56 94.61 0.04 0.0000333 0.001666667 0.633333333 94.66 -0.05

Nov 04,

2013 94.58 94.62 0.05 0.0000417 0.001666667 0.533333333 94.67 -0.05

Nov 05,

2013 93.4 93.37 0.05 0.0000417 0.001666667 0.5 93.48 -0.11

Nov 06,

2013 94.74 94.8 0.05 0.0000417 0.001666667 0.466666667 94.82 -0.02

Nov 07,

2013 94.25 94.2 0.05 0.0000417 0.001666667 0.433333333 94.32 -0.12

Nov 08,

2013 94.56 94.6 0.06 0.0000500 0.001666667 0.4 94.62 -0.02

Nov 12,

2013 93.12 93.04 0.08 0.0000667 0.001666667 0.266666667 93.16 -0.12

Nov 13,

2013 93.91 93.88 0.08 0.0000667 0.001666667 0.233333333 93.95 -0.07

5


Nov 14,

2013 93.76 93.76 0.08 0.0000667 0.001666667 0.2 93.79 -0.03

Nov 15,

2013 93.8 93.84 0.08 0.0000667 0.001666667 0.166666667 93.83 0.01

Nov 18,

2013 93.03 93.03 0.09 0.0000750 0.001666667 0.066666667 93.04 -0.01

Nov 19,

2013 93.35 93.34 0.08 0.0000667 0.001666667 0.033333333 93.36 -0.02

Nov 20,

2013 93.34 93.33 0.08 0.0000667 0.001666667 0 93.34 -0.01

Nov 21,

2013 95.35 95.44 0.07 0.0000583 0.001666667 0.933333333 95.5 -0.06

Nov 22,

2013 94.53 94.84 0.07 0.0000583 0.001666667 0.9 94.68 0.16

Nov 25,

2013 93.86 94.09 0.08 0.0000667 0.001666667 0.8 93.99 0.1

Nov 26,

2013 93.41 93.68 0.07 0.0000583 0.001666667 0.766666667 93.53 0.15

6


Nov 27,

2013 92.05 92.3 0.07 0.0000583 0.001666667 0.733333333 92.17 0.13

Nov 29,

2013 92.55 92.72 0.06 0.0000500 0.001666667 0.666666667 92.66 0.06

Dec 02,

2013 93.61 93.82 0.05 0.0000417 0.001666667 0.566666667 93.7 0.12

Dec 03,

2013 95.83 96.04 0.06 0.0000500 0.001666667 0.533333333 95.92 0.12

Dec 04,

2013 96.97 97.2 0.06 0.0000500 0.001666667 0.5 97.05 0.15

Dec 05,

2013 97.14 97.38 0.06 0.0000500 0.001666667 0.466666667 97.22 0.16

Dec 06,

2013 97.48 97.65 0.06 0.0000500 0.001666667 0.433333333 97.55 0.1

Dec 09,

2013 97.1 97.34 0.07 0.0000583 0.001666667 0.333333333 97.16 0.18

Dec 10,

2013 98.32 98.51 0.07 0.0000583 0.001666667 0.3 98.37 0.14

7


Dec 11,

2013 97.25 97.44 0.07 0.0000583 0.001666667 0.266666667 97.29 0.15

Dec 12,

2013 97.21 97.5 0.07 0.0000583 0.001666667 0.233333333 97.25 0.25

Dec 13,

2013 96.27 96.6 0.07 0.0000583 0.001666667 0.2 96.3 0.3

Dec 16,

2013 97.18 97.48 0.07 0.0000583 0.001666667 0.1 97.2 0.28

Dec 17,

2013 96.99 97.22 0.07 0.0000583 0.001666667 0.066666667 97 0.22

Dec 18,

2013 97.59 97.8 0.07 0.0000583 0.001666667 0.033333333 97.6 0.2

Dec 19,

2013 98.4 98.77 0.06 0.0000500 0.001666667 0 98.4 0.37

Dec 20,

2013 99.11 99.32 0.07 0.0000583 0.001666667 1.066666667 99.29 0.03

Dec 23,

2013 98.62 98.91 0.07 0.0000583 0.001666667 0.966666667 98.78 0.13

8


Dec 24,

2013 98.87 99.22 0.07 0.0000583 0.001666667 0.933333333 99.03 0.19

Dec 26,

2013 99.18 99.55 0.07 0.0000583 0.001666667 0.866666667 99.33 0.22

Dec 27,

2013 99.94 100.32 0.07 0.0000583 0.001666667 0.833333333 100.08 0.24

Dec 30,

2013 98.9 99.29 0.07 0.0000583 0.001666667 0.733333333 99.03 0.26

Dec 31,

2013 98.17 98.42 0.07 0.0000583 0.001666667 0.7 98.29 0.13

Jan 02,

2014 95.14 95.44 0.07 0.0000583 0.001666667 0.633333333 95.24 0.2

Jan 03,

2014 93.66 93.96 0.07 0.0000583 0.001666667 0.6 93.76 0.2

Jan 06,

2014 93.12 93.43 0.05 0.0000417 0.001666667 0.5 93.2 0.23

Jan 07,

2014 93.31 93.67 0.04 0.0000333 0.001666667 0.466666667 93.38 0.29

9


Jan 08,

2014 91.9 92.33 0.05 0.0000417 0.001666667 0.433333333 91.97 0.36

Jan 09,

2014 91.36 91.66 0.04 0.0000333 0.001666667 0.4 91.42 0.24

Jan 10,

2014 92.39 92.72 0.05 0.0000417 0.001666667 0.366666667 92.45 0.27

Jan 13,

2014 91.45 91.8 0.03 0.0000250 0.001666667 0.266666667 91.49 0.31

Jan 14,

2014 92.15 92.59 0.04 0.0000333 0.001666667 0.233333333 92.19 0.4

Jan 15,

2014 93.78 94.17 0.04 0.0000333 0.001666667 0.2 93.81 0.36

Jan 16,

2014 93.54 93.96 0.04 0.0000333 0.001666667 0.166666667 93.57 0.39

Jan 17,

2014 93.96 94.37 0.05 0.0000417 0.001666667 0.133333333 93.98 0.39

Jan 21,

2014 94.51 94.99 0.04 0.0000333 0.001666667 0 94.51 0.48

10


Jan 22,

2014 96.35 96.73 0.04 0.0000333 0.001666667 0.966666667 96.51 0.22

Jan 23,

2014 97.23 97.32 0.04 0.0000333 0.001666667 0.933333333 97.38 -0.06

Jan 24,

2014 96.66 96.64 0.04 0.0000333 0.001666667 0.9 96.81 -0.17

Jan 27,

2014 95.82 95.72 0.05 0.0000417 0.001666667 0.8 95.95 -0.23

Jan 28,

2014 97.49 97.41 0.05 0.0000417 0.001666667 0.766666667 97.62 -0.21

Jan 29,

2014 97.34 97.36 0.04 0.0000333 0.001666667 0.733333333 97.46 -0.1

Jan 30,

2014 98.25 98.23 0.02 0.0000167 0.001666667 0.7 98.37 -0.14

Jan 31,

2014 97.55 97.49 0.02 0.0000167 0.001666667 0.666666667 97.66 -0.17

Feb 03,

2014 96.44 96.43 0.05 0.0000417 0.001666667 0.566666667 96.53 -0.1

11


Feb 04,

2014 97.24 97.19 0.06 0.0000500 0.001666667 0.533333333 97.33 -0.14

Feb 05,

2014 97.4 97.38 0.07 0.0000583 0.001666667 0.5 97.48 -0.1

Feb 06,

2014 97.84 97.84 0.07 0.0000583 0.001666667 0.466666667 97.92 -0.08

Feb 07,

2014 99.98 99.88 0.08 0.0000667 0.001666667 0.433333333 100.06 -0.18

Feb 10,

2014 100.12 100.06 0.07 0.0000583 0.001666667 0.333333333 100.18 -0.12

Feb 11,

2014 99.96 99.94 0.05 0.0000417 0.001666667 0.3 100.01 -0.07

Feb 12,

2014 100.38 100.37 0.05 0.0000417 0.001666667 0.266666667 100.43 -0.06

Feb 13,

2014 100.27 100.35 0.03 0.0000250 0.001666667 0.233333333 100.31 0.04

Feb 14,

2014 100.31 100.3 0.02 0.0000167 0.001666667 0.2 100.34 -0.04

12


Feb 18,

2014 102.54 102.43 0.05 0.0000417 0.001666667 0.066666667 102.55 -0.12

Feb 19,

2014 103.46 103.31 0.06 0.0000500 0.001666667 0.033333333 103.47 -0.16

Feb 20,

2014 103.2 102.92 0.05 0.0000417 0.001666667 0 103.2 -0.28

Feb 21,

2014 102.53 102.2 0.05 0.0000417 0.001666667 0.933333333 102.69 -0.49

Feb 24,

2014 103.17 102.82 0.05 0.0000417 0.001666667 0.833333333 103.32 -0.5

Feb 25,

2014 102.2 101.83 0.05 0.0000417 0.001666667 0.8 102.34 -0.51

Feb 26,

2014 102.93 102.59 0.05 0.0000417 0.001666667 0.766666667 103.06 -0.47

Feb 27,

2014 102.68 102.4 0.04 0.0000333 0.001666667 0.733333333 102.81 -0.41

Feb 28,

2014 102.88 102.59 0.05 0.0000417 0.001666667 0.7 103 -0.41

13


Mar 03,

2014 105.34 104.92 0.05 0.0000417 0.001666667 0.6 105.45 -0.53

14


15

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crude oil price risk management report final