ING Financial Markets

IBC: 2012 Commodities Seminar

Jens VrolijkAntwerpen, October 2012

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Agenda• Why commodity hedging?

• So how can a company hedge? supplier contracts, futures, and OTC

• OTC hedging instruments

• How is the hedging price determined?

• Moving to the products• From the barrel to the pump: Crude oil , refined products and coal

• Store of value or raw material: Base and precious metals

• The global food stock: Agricultural and soft commodities

• Procedures, risk and documentation• ISDA documentation or “contrat cadre”

• CDD, MIFID

• Concluding remarks

Why commodity hedging?

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Commodity prices are dictating headlines…

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Producers Traders, distributors Refiners, smelters, roasters, processors

Traders, inventory, warehousing

Utilities, breweries, transport etc

Financial

and

Risk management

If your company is a part of the commodity supply chain…

Lending

Bonds

FX, interest

M&A

PCM, Leasing

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…NOT hedging your commodity exposure is taking a conscious risk

Producers Traders, distributors Refiners, smelters, roasters, processors

Traders, inventory, warehousing

Utilities, breweries, transport etc

Fin/Risk mgmt

Which revenues next year?

How much CapEx for the coming years?

And if prices fall below production costs?

What if my trade margins get squeezed?

What happens my inventory if prices suddenly drop?

What if my raw material costs more than sales prices?

What if energy costs go up so my profits disappear?

What if next year more refineries appear?

What happens to the value of my inventory if prices suddenly drop?

What if my trade margins get squeezed?

What if I have to buy at suddenly huge prices?

What if I don’t know yet how much volume I need to buy next year?

So how can a company hedge?

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Commodity Physical Market

Commodity Financial Market

• Appeared hundreds years ago and available for all the commodities

• Over-the-Counter transactions

• With physical delivery settlement

• Appeared in the 80’s for some specific commodities

• The objective is not a physical delivery but only cash settlement

OTCStandardized Market

• Stocks market (Nymex, ICE, LME) • Over-the-Counter transactions

+ • Tailor-Made transactions

-

• Controlled by the supplier

• No price transparency

• Important counterparty risk

• Difficult to find a counterparty

+ • Clearinghouse (no counterparty risk)

-• Standardized contract (volume , underlying, maturity)

• Margin Call (cost of capital)

• Limited access for company (costs)

+• Tailor-made transactions • Diversification against the supplier control

-

• No Margin Call but Credit Risk (exposure to the banks)

• ING limited trading mandate: The availability of a specific commodity depends on the liquidity on the standardized markets

Using supplier, futures or OTC price fixations

OTC hedging instruments

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Hedging instrumentsSwaps

• For a determined period, ING takes over the market price of the commodity product, while the buyer of the swap pays an agreed fixed price

• Net settlement is calculated over a pre-agreed index (independent source), typically market Marketscan

• A swap contract requires no upfront premium payment

Options

• Caps and Floors

• Vanilla – Asian/European

• Protection against price increases or decreases above or below pre-agreed index levels

• An upfront premium must be paid to reflect the level of protection derived

By combining swaps and buying/selling call/put options, different hedging structures can be created to more specifically target the individual companies’exposure profile, market view, budget levels, etc.

All products can be expressed in different currencies (USD, EUR, GBP)

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Fixed-for-floating Swap• The Fixed-for-floating Swap provides maximum predictability

of commodity cost or revenue, as it locks the price rate for the required tenor and notional quantity volume

• Client pays or receives floating commodity price assessment

• Client receives or pays a fixed rate

• The diagram below illustrates the cash flows under physical purchase or sale and the swap accordingly

Swap pay-off

EffectiveRate

Underlyingmarket priceassessment

xxx.xx US$ per MT

Underlying market price assessment

Swap Level

xxx.xx US$ per

MT

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Fixed-for-floating SwapClient fixes the price of the physical product purchase

At the end of each settlement period during the life of the swap, the daily price quotations, as published during this period, are used to calculate the average floating price of the settlement period. The floating price is compared to the fixed price of the swap:

• If the average of the product prices is above the agreed fixed price,Client pays the difference (times the volume) to ING• If the average of the product prices is below the agreed fixed price,Client receives the difference (times the volume) from ING•The monthly average is most often based on daily physical price indices

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Client ReceivesClient PaysMonth AverageDaily PriceFixed Price

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Cap option• The Cap provides protection against a rise in the price

above the Cap Rate

• And allows client to fully participate in decreasing rates

• The Cap comes at a premium

• The Cap Rate can be set at client’s discretion

• The diagram below illustrates the effective payment under physical purchase combined with a Cap

Cap pay-off

Effectiverate

xxx.xx US$ per MT

Swap rate

xxx.xx US$ per MT

xxx.xx US$ per

MT

Cap rate

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Zero - cost collar• The Collar provides protection against a rise in market price

assessment below the Floor Rate

• And allows Client to benefit from decreasing rates up to the Cap Rate

• The Collar is a zero-cost solution

• Either the Cap or Floor can be set at Client’s discretion

Collar pay-off

Effectiverate

xxx.xx US$ per MT

Underlying market price assessment

Swap rate

xxx.xx US$ per

MT

xxx.xx US$ per MT

xxx.xx US$ per MT

xxx.xx US$ per

MT

Underlyingmarket priceassessment

Floor rate

Cap rate

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Zero - cost collarClient 1. Purchases a Cap protection

2. Sells a Floor protection to finance the Cap

• If the average of the product prices is above > the agreed Cap Price, ING pays the difference (times the volume) to Client• If the average of the product prices is below < the agreed Floor Price, ING receives the difference (times the volume) from Client• No premium is exchanged•The monthly average is most often based on daily physical price indices

Client ReceivesClient PaysMonth AverageDaily PriceFixed PriceCap PriceFloor Price80

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Products comparedAll products are effective hedges against adverse commodity price rate movements

Product Pro Con

Commodity Swap

Rate fixed, hence no uncertainty at all

Zero cost solution

No benefit from rate movements your favor

Commodity Collar

Benefit from rate movements down to the Floor Rate

Protection against rate movements above the Cap Rate

Zero cost solution

Protection at a higher level vis-à-vis standard Swap

Commodity Cap or Floor

Full participation in rate movements in your favor

Full protection against rate movements above the Cap Rate or below Floor Rate

Protection comes at premium payable

How is the hedging price determined?

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• The forward/futures yield curve can be positive (contango) or negative ( backwardation)• The forward/futures level depends on the offer and demand for each future contract• The shape of the curve reflects the characteristics of underlying on the physical market Seasonality ( harvest for soft, winter for energy), economy growth expectations, geopolitical tension (oil conflict)

• The shape of the curve can be an opportunity in term of timing to enter in a hedge position

Contago• Increasing Forward price level

• No arbitrage pricing theory (cost of capital and cost of storage)

• Positive premium between forward and spot price

• Premium for fixed payer , good timing for fixed receiver

• No booming market, costly stocking underlying (metals)

Backwardation• Decreasing Forward price level

• High inelasticity of fundamentals explains a convenience premium

• Negative Premium between forward and spot price

• Good timing for fixed buyer, premium for fixed receiver

• Booming market, risk of shortage (“normal backwardation” with oil)

So how is the hedging price determined?

Moving to the products

Crude Oil & Refined Products

From the barrel to the pump

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Oil product interdependency in financial marketsThe prices of refined oil products in financial markets reflect cost and market

conditions:• The price of its raw material: Crude oil (Brent or WTI as benchmarks, approved in trading mandate)• Transportation costs• Cost of processing crude oil into refined products (refining cost and margin)• Storage costs• Market conditions at each stage along this way and in the local market (Location, FOB, CIF, Lot size)

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Oil product interdependency in financial marketsIn the financial market, three strongly related but slightly differing groups of refined

products are traded:• Residual fuels• Middle distillates• Light ends

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Oil product interdependency in financial marketsVolatilities and price trends have a strong relation because:• The price of its raw material: CRUDE OIL (BRENT OR WTI as benchmarks, approved in trading mandate) is the same

for all refined products• Transportation costs are similar• Refining market conditions are similar

Differences in absolute level between price indexes occur because:• Market conditions at each stage along this way and in the local market (Location, FOB, CIF, Lot size):

- Location hubs are ARA (Adam/Rdam/Antwerp), NWE (North-west Europe), MED (Mediterranean), SING (Singapore), US Gulf etc.

- Inco terms: FOB (Free on Board), CIF (Cost Insurance & Freight)- Lot size: Cargoes (tanker size), Barges (river boat, truck)

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Oil product interdependency in financial marketsProducts are traded as spreads in a refining margin basket:

Base & Precious Metals

Store of value or raw material

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Base metals underlying references• Copper (Grade A)

• Zinc (Special High Grade)

• Primary Aluminium

• Standard Lead

• Tin

• Primary Nickel

• World market for fungible grades and specifications

• Exchange trading with physical delivery is setting benchmark prices

• Strong correlation between geographically dispersed markets

Agricultural & Soft Commodities

From the fields to the silos

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US CBOT, EU LIFFE, and more…• CBOT

• NYSE-LIFFE Euronext

• Grains / wheat

• Oilseeds

• Corn

• Softs

• Livestock

• World market for fungible grades and specifications

• Exchange trading with physical delivery is setting benchmark prices

• Strong correlation between geographically dispersed markets

Which underlying products can be hedged?

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Refined products (cont’d)• Naphtha

• Naphtha CIF Cargoes NWE• Naphtha FOB Barges Rotterdam

• Gasoil• ICE Gasoil: QSA Comdty (5 yrs)• 0.1 CIF Cargoes NWE (3 yrs)• 0.1 FOB Cargoes MED (3 yrs)• 0.1 CIF MED (3 yrs)• 0.2 FOB Barges Rotterdam (2 yrs)• 0.2 FOB Cargoes MED (2 yrs)• 0.5 FOB Cargoes Singapore (3 yrs)• Gasoil 50ppm FOB Barges Rotterdam (3 yrs)• Gasoline Premium Unleaded FOB Barges Rotterdam (3 yrs)• Nymex RBOB Gasoline (5 yrs)

• Jet Fuel• Jet Aviation FOB Cargoes Med (3 yrs)• Jet Kerosene CIF Cargoes NWE (5 yrs)• Jet Kerosene FOB Barges Rotterdam (3 yrs)• Singapore Jet Fuel (3 yrs)

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Energy products (i)Crude Oil• Brent

• ICE: COA Comdty, 5 yrs

• Dated Brent• Platts fixing, 5 yrs

• WTI• NYMEX: CLA Comdty, 5 years

Gas• Henry Hub

• NYMEX: NRA Comdty, 5 years

• European gas:• A.o. NBP, ZBT, TTF

Refined products• Fueloil

• Fueloil 1% CIF Cargoes Med• Fueloil 1% CIF Cargoes NWE• Fueloil 1% FOB Barges Rotterdam• Fueloil 1% FOB Cargoes Med• Fueloil 1% FOB Cargoes NWE• Fueloil 1.5% FOB Barges Rotterdam• Fueloil 3% US Gulf Cost Water• Fueloil 3.5% CIF Cargoes Med• Fueloil 3.5% FOB Barges Rotterdam• Fueloil 3.5% FOB Cargoes Med• Fueloil 180cst FOB Cargoes Singapore• Fueloil 380cst FOB Cargoes Singapore

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Refined products (cont’d)• Diesel• Diesel ULSD 10ppm CIF Cargoes NWE (5 yrs)• Diesel ULSD 10ppm CIF Cargoes NWE UK (3 yrs)• Diesel ULSD 10ppm FOB Barges Rotterdam (5 yrs)• Diesel ULSD 10ppm CIF Med (3 yrs)• Diesel ULSD 10ppm FOB Med (3 yrs)• Diesel ULSD 50ppm CIF Cargoes Med• Diesel ULSD 50ppm FOB Cargoes Med

Coal• API #2

• FOB ARA

• API #4• FOB Richard’s Bay, South Africa

• API #6• Newcastle, Australia

Products:• Swaps

• Caps / Floors / Collars

• Other structured solutions

Energy products (II)

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(Product, Bloomberg Generic Ticker, Max Tenor)

Agriculture / Grains

• Wheat • US: W A Comdty, 5 yrs / EMEA: CAA

Comdty, 2 yrs

• Corn / Maize • US: C A Comdty, 5 yrs / EMEA: EPA

Comdty, 1 yr

• Rapeseed• LIFFE Rapeseed, IJK Comdty, 3 yr /

Canadian Canola, RSA Comdty, 1 yr

• Rice• RRA Comdty, 1 yr

• Soybean, soybean oil, soybean meal• S A Comdty, 5 yrs / BOA Comdty, 5 yrs /

SMA Comdty

• Oat• O A Comdty, 3 yr

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Softs

• Sugar• US: Nr. 11 raw SBA Comdty, 5 yrs, EMEA:

LIFFE white sugar QWA Comdty, 3 yrs

• Cotton• CTA Comdty, 3 yrs

• Coffee• NYBOT Arabica KCA Comdty, 3 yrs /

LIFFE Robusta DFA Comdty, 1 yrs

• Cocoa• ICE Cocoa CCA Comdty, 2 yrs, LIFFE

Cocoa QCA Comdty, 2 yrs

• Orange juice• ICE Frozen Orange Juice Conc, JO1

Coomdty

• Lumber• LBA Comdty, 1 yr

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Livestock

• Live Cattle• LCA Comdty, 2 yrs

• Feed Cattle• FCA Comdty, 2 yrs

• Lean Hogs• LHA Comdty, 2 yrs

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Commodities traded: agricultural and soft commodities

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Commodities traded: base & precious metalsBase metals

• Aluminum• LME: LMAHDY Cmdty, 5 yrs

• Copper• LME: LMCAD Comdty, 5 years

• COMEX: HGA Comdty, 5 years

• Zinc• LME: LMZSDY Cmdty, 5 yrs

• Lead• LME: LMPBDY Cmdty, 5 yrs

• Nickel• LME: LMNIDY Cmdty, 5 yrs

• Tin• LME: LMSNDY Cmdty, 5 yrs

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Precious metals

• Gold• GOLDS Cmdty (5 yrs)

• Silver• SILV Comdty (5 yrs)

• Platinum• PLAT Comdty (3 yrs)

• Palladium• PALL Comdty (3 yrs)

Products:• Swaps• Caps / Floors / Collars• Other structured solutions

Procedures, Risk and Documentation

How to get from origination to hedging

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• ISDA documentation or contrat cadre / raamcontract• MIFID

Documentation

Thank you for your time!

Any remaining questions?

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Disclaimer

This presentation was prepared to serve as a platform for discussion and does not carry any right of publication or disclosure. Neither this presentation nor any of its contents may be used for any other purpose without the consent of ING. The information in this presentation reflects prevailing conditions and ING’s judgement as of this date, all of which are accordingly subject to change. Specifically, the recommendations contained in this report represent ING’s judgement only. In preparing this presentation, ING has relied upon and assumed, without independent verification, the accuracy and completeness of all information. Available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. Please note that the terms and conditions contained herein are for discussion purposes only and that the issuing of this presentation is no commitment to enter into any transaction or to negotiate the terms of conditions thereof.