Derivatives and Commodity Hedging
OECD-MENA Senior Budget Officials Network
Randy Ewell, World Bank, Banking and Debt Management Department
The World Bank
Treasury
1818 H Street, N.W.
Washington, DC, 20433, USA
treasury.worldbank.org
The world has changed …
Commodity prices have fallen sharply, beginning in July 2008 with
the sharpest falls over the past month
Falls have been most severe in oil and metals
Agricultural commodity prices have also fallen, but by less
Price falls have been both large and fast
Many intermediaries in the commodity chain, who are naturally long,
will have lost considerable money unless they were hedged and will
may experience financing difficulties in the coming months
Un-hedged northern hemisphere farmers may experience large losses
since the price falls have come just as crops are brought to market
Decreasing prices create an opportunity for importers (of food/oil) to
lock in lower prices
2
The aggregate picture
275
Commodity prices rose
steadily from 2003 until
the summer of 2008
This is the longest and
most general commodity
boom since the 1920s
Foods
Beverages
Agricultural raw materials
Metals
Energy
250
225
200
175
150
Not all prices shared in
the boom, and some
started to fall in 2007
125
100
75
2000
2001
2002
2003
2004
2005
2006
2007
2008
IMF commodity price indices, normalized at 2000 = 100 deflated by US PPI. The
2008 figure is the January-July average
3
Crude Oil
90
Most least developed
countries are oil importers
but a significant minority
are major exporters
70
($/bl, 2000 prices)
Crude oil prices rose
more or less steadily from
2001 to early July 2008
reaching over $140/bl
80
60
50
40
30
20
10
00
Ju
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Ju
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Ja 5
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Ja 7
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8
0
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They have now halved to
$70/bl
Average, Brent and WTI first positions, deflated by US PPI.
Source: IMF
4
Non-Ferrous Metals
900
Along with oil, metals
prices have fallen furthest
and fastest – particularly
over the past month
Al
Cu
Ni
Pb
Sn
Zn
600
500
400
300
200
100
20-Oct-08
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M 7
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7
Ju
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N 7
ov
-0
Ja 7
n0
M 8
ar
-0
M 8
ay
-0
8
Ju
l -0
Se 8
p08
Cu, Pb & Sn are around
the same level as Jan
2006
700
(Jan 2003 = 100)
Al, Ni & Zn are lower
now than at the start of
2006
800
Source: LME
5
Maize
350
Johannesburg
Chicago
300
250
200
150
100
50
8
Ju
l-0
7
08
Ja
n-
Ju
l-0
07
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n-
6
Ju
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06
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n-
5
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05
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4
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04
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3
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03
0
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n-
South African (SAFEX)
white maize prices also
rose but this reflected local
factors. Although they have
now fallen sharply in dollar
terms, this is almost all due
to the downward fall of the
Rand
400
$/ton (2006 values)
Chicago (CBOT) corn
prices jumped sharply in
2006 to peak in June 2008
at $7/bl. They have now
fallen to $4/bl.
CBOT first position and SAFEX spot prices (converted into dollars),
deflated by US PPI. Sources: CBOT, SAFEX and IMF
6
Rice
380
370
360
350
340
330
ul
-0
7
14
-A
ug
-0
7
28
-A
ug
-0
7
11
-S
ep
-0
7
25
-S
ep
-0
7
9O
ct
-0
7
23
-O
ct
-0
7
6N
ov
-0
7
20
-N
ov
-0
7
4D
ec
-0
7
18
-D
ec
-0
7
31
-J
ul
-0
7
320
17
-J
$/ton
Rice is the principal food of
many poor people. An increase
in the rice price has a negative
impact on poverty levels
worldwide
India prohibits rice
exports
Bangkok rice export price.
Source: World Bank
7
Cotton
This price fall will have
caused serious problems for
any unhedged ginner
1400
60
1200
50
1000
40
800
30
600
20
400
10
200
0
(F.CFA/kg, 2000 prices)
(c/lb, 2000 prices)
70
c/lb
F.CFA/kg
0
Ja
n0
Ju 0
lJa 00
n0
Ju 1
lJa 01
n0
Ju 2
lJa 02
n0
Ju 3
lJa 03
n0
Ju 4
lJa 04
n0
Ju 5
lJa 05
n0
Ju 6
lJa 06
n0
Ju 7
lJa 07
n0
Ju 8
l-0
8
They have dropped sharply
over the past month to 60c/lb,
lower in real terms than in
2004
1600
80
Cotton prices have been
very stable since 2005, albeit
at a low level
Cotlook A Index deflated by US PPI, and converted into F.CFA/kg
and deflated by Burkina Faso CPI. Source: ICAC and IMF.
8
Policy Responses
The food price crisis led many countries to revert to the food
policies of the 1970s
Export bans
Costly strategic grain reserves
Reversal of diversification policies
Price stabilization/subsidy programs
These policies carry risks
Can be destructive to market / trade
Total financing needed for these interventions are unknown /
unpredictable
9
Dealing with Risk
10
Increased Interest in
Risk Management
Governments need to..
Plan for & budget responses
Raise financing for responses & ensure rapid implementation
Ensure that they are protected against future shocks
Donors & International community should..
Maximize value & impact of assistance
Ensure resources are not diverted from longer term programs
Both have led to renewed interest in ex ante solutions
Since ex post reactions are costly, inefficient, and difficult to
finance & implement when countries are already in crisis
11
Significant Factors for a Nation
No Shareholders – only Voters
Not necessarily driven by returns on Capital or Equity
Risk appetite virtually zero
Unfortunately, short term Horizons
Affected by Politics
Not necessarily Commercial decisions, therefore the
solution is not necessarily a commercially driven one
Cannot ignore the ‘Power of One’ – the VETO
All solutions have to pass the ‘Monday Morning
Quarterback’ test
12
Why Would a Nation Hedge ?
Reduce Volatility of the Budget in favor of stability
Strengthen the probability of meeting the Budget
‘Targeted’ Hedging of Key Elements in Budget
Education
Health
Infrastructure
Inflation
Imports where there is inelastic demand and no substitution
To address security of supply & security of energy and food
Investment of Government Funds
Commodity Indices, Bonds, Notes where inversely Correlated to
Budget
Event’ Hedging
13
Hedging Products
A commercial contract which limits the impact of adverse price
movements which might take place between buying (or incurring
production costs) and selling
Why?
Traditional (unhedged) price stabilization programs can’t survive without high
levels of subsidy / bailout
Market intermediaries (co-ops, exporters) can’t survive repeated years of
trading losses
Banks
A) Can’t survive repeated years of default when borrowers mismanage
price exposures and have financial losses as a result
B) Will have to charge high interest rates to maintain lending in high risk
agricultural sectors -the high cost of finance erodes margins for all
14
Oil Price Volatility Hedging
Introduction
Why Hedge?
Oil prices are volatile and hard to predict
Exposure to oil price may harm fiscal policy
Uncertain fiscal revenues linked to oil exports may lead to
shelving of planned projects or wasteful use of ‘windfall’
revenues
Hedging stabilizes cash flows
Allows to lock in prices in advance or specify their range
Substantially reduces volatility of revenues
Reduces the risk of sudden financial loss due to adverse
market movements
No Hedge
15
Selling on a spot basis exposes
producer to rising and falling
commodity prices
Current Price
USD/BBL
5
-10
-15
Market Oil Price (USD/BBL)
.8
75
.5
73
.4
71
.3
69
.3
67
.3
65
.4
63
.6
61
.8
59
.0
58
.3
56
.6
54
.4
.9
52
-5
51
.8
0
49
Profit/Loss
10
Oil Price Volatility Hedging
Introduction
There are two ways to pursue stabilization
Self Insurance:
Oil revenues in excess of a predefined average
level are saved. Savings are used to
complement oil revenues when they fall below
average.
Hedging with
markets
Oil revenues can be fixed or floored for future
dates using market instruments.
The second method is usually more efficient
Oil Price Volatility Hedging
Hedging with Markets
There are generic instruments
Futures/Forwards
Swaps
Put options
No cost. Lock in future price. Do
not permit upside gains
Upfront cost (to buy puts).
Place a floor on future price.
Permit upside gains.
Derivatives Introduction
Growth in
Derivatives Use
Hedging
Derivatives are used for either
Hedging, or
Speculation
Hedgers use derivatives to manage risk and protect
themselves against the possibility that the market might go
“against them”
Speculation
Speculators use derivatives to produce a return
They “take a view”, i.e. bet on where the market is going
and try to make a profit
Scope of the
Presentation
• For our purposes, the use of derivatives is a risk management tool
19
Who Hedges and Why?
End users: “SHORT” energy – concerned about rising prices
Eg. Airline, Industrial, Shipper, Road Transport, Railway: all active
hedgers
Producers: “LONG” energy – concerned about falling prices
Eg. Energy Majors and Independents, State Oil Companies
Refiners and Power-Generators: MARGIN exposed – concerned about
relative prices
Oil Refiner: Crude oil versus oil products (called “cracks”)
Power-generator: Coal / Oil / Gas versus Electricity (“Dark / Spark
spreads”)
Traders and Distributors: TIMING and / or BASIS RISK
Mismatch between purchase price and sale price window
Mismatch between purchase price INDEX sale price INDEX
Eg. buy LNG on Brent Index, Selling on UK Gas NBP
20
Forward Contract
Forward
Contract
Forward
Contract vs
Futures
OTC Contract
An over-the-counter (OTC) contract determining the price of the
underlying to be paid or received on an obligation beginning at a future
start date
Essentially forwards contracts lock-in the price of the underlying
Instrument is similar to that of a future
The payment under the contract is equivalent to a margin payment
but…
…Payment at maturity only: Higher credit risk
Forward contracts are not standardized
Maturity dates agreed by the parties
Nominal amount can be adjusted
Nominal amounts in any currency
Day count convention applicable in the reference rate and currency chosen
21
Futures
Futures
The role of
clearing
houses
Futures: obligation to buy or sell an underlying instrument at a certain price and date
A futures is a method to lock in a price
Physical delivery of the underlying asset
Cash settlement: difference between the spot and the futures price
Exchange traded and standardized contract: specified quantity and quality of the
instrument, price per unit, date and method of delivery (if any)
Futures counterparties interact with the exchange’s clearinghouse (CH). Clients do
not know whom they have traded with
A futures trade is really two trades
Party A
Credit Risk
Mitigation
Clearing house
Party B
The agreement will be honored by the CH
To protect itself the CH demands that
An initial collateral amount is deposited to cover future losses
A futures account is marked to market daily. Daily margin increase to cover
unrealized losses from daily market movements
No party will incur a big loss at maturity
22
Swaps
What is a
Swap?
Characteristics
of Swaps
A contract between two counterparties to exchange streams of
cash flows
Defined period of time and can be customized
Contracts are traded over-the-counter (OTC)
Cash flows are calculated over a notional principal amount
Interest Rate
Swaps
Exchange of fixed payments against floating interest payments
Maturities vary by market; in major currencies, 3 months to 30 years
Used to alter interest rate exposure and align asset and liabilities
Currency
Swaps
Exchange payments in one currency for another
Maturities vary by market; in major currencies, 3 months to 30 years
Used to alter the currency exposure of an asset or liability
Commodity
Swaps
Exchange payments linked to the price of a commodity
Used to reduce volatility in income/expenditures due to fluctuations
23
Forward and Futures: A Summary
Similarities
Both futures and forwards represent agreements to buy or sell some underlying asset
in the future
Both allow for physical or cash settlement depending on the underlying instruments
(interest rates, commodities, etc)
Both entail market risk and can be used for hedging purposes
Futures
Forwards
Exchange
Exchange traded
Over the counter
Counterparty
Clearinghouse
Counterparty in the forward
agreement
Transaction
Timing
Marked-to-market every day
Transact when purchased and on
the settlement date
Customization
Standardized: Amount, currency,
dates are fixed
Non-standardized: Amount,
currency, maturity dates can be
adjusted
Credit Risk
Minimal: essentially eliminated
through margining process
Counterparty credit risk
Regulation
Highly regulated
Private, unregulated transactions
Liquidity
Highly liquid
Illiquid
Bid-Ask Spread
Low
High
Differences
24
Endogenous Term-Structure of Futures
Prices
For low oil prices the market is in contango, i.e. the
term structure is upward-sloping.
For medium oil prices the term structure of futures
prices can be slightly humped
For high oil prices the market is in backwardation.
Backwardation occurs when the oil price expected for the
expiration date declines with the maturity of the futures contracts.
Oil futures prices exhibit “mean-reversion,” i.e., prices in
contracts for delivery many months in the future converge
to the long-term expected price.
Hedging with Futures or Forward Contracts
Firm commitment that provide for the futures sale/delivery of
crude oil at a specified price
Gains or losses realized daily (Futures)
P/L from the agreed upon price vs. the actual market price
on the delivery date is usually settled on the delivery date
Profit to seller
= initial futures price - ultimate market price
Profit to buyer
= ultimate market price - initial futures price
Using Futures for Hedging
$30.00
$20.00
$10.00
Profit / Loss
Oil Futures
A country with a long position in commodities (i.e. an oil producer) loses out if the price of
the commodity drops and gains if the commodity price rises.
To hedge that position, it can sell exchange-traded futures to lock in the price.
Therefore, no matter if the price moves up or down, the producer is not exposed to the
volatility because the gain/loss on the futures contract will offset the gain/loss on the
commodity.
$0.00
-$10.00
Long Inventory
-$20.00
Short Futures
Final Payout
-$30.00
$90
$95
$100
$105
$110
$115
$120
$125
$130
$135
$140
Price / Barrel
27
Hedging through OTC Options - Price Floor
(Insurance)
$140
$135
Market Price
$130
Floor - Realized Price
$125
$120
$/Barrel
Price Floors
Alternatively, if the producer wants to participate in the upside gains, it may
choose to enter into a series of put options to create a price floor, which
means that the producer is guaranteed a minimum price for its commodities.
However, an upfront premium must be paid to purchase this series of put
options
$115
$110
$105
$100
$95
$90
1
2
3
4
5
6
7
8
9
10
11
12
Month
28
Consumer: Buying a Call Option – Cap
Key considerations
Illustrative example
Objective
To cap forward price.
Description
It is the right, but not the obligation, to buy specific
volumes of diesel at a specified price (the strike price)
during a specified period of time.
Price
USD/mt
The client receives the difference between
the floating and fixed price
1500
In purchasing a call option, the party is effectively buying
insurance against higher products prices.
Swap
No exchange
The buyer pays an upfront premium for protection from
prices above the specified cap strike price.
The average monthly settlement price is compared to the
strike
•
If settlement price is lower than the strike price, the
client does not receive anything
•
If settlement price is higher than the strike, the client
receives the difference between the strike and the
settlement price
Advantages
Locks in a cap over a time period and is protected from
any price appreciation above the strike
Price rises in the physical market are compensated by
hedging gains
Time
Strike
Market Price
Potential gains
Potential costs
Indicative Levels - Jet Cargos CIF NWE
Aug 2008- Jul 2009
Strike
Premium
USD 1500 / mt
USD 85 /mt
Benefit from potential upside, should diesel prices drop.
Disadvantages
The buyer has to pay an upfront premium to buy a call
option.
29
Hedging Instruments - Summary
The below table illustrates the tools available to hedge against a fall in commodity prices
Hedging
Description
Benefits
Instruments
Fixed for
Floating
Swap
Enables the party to eliminate their price exposure,
protecting themselves from a fall in oil prices.
Potential Costs
No upfront premium
Forgone benefit from
By receiving a fixed market rising oil prices
To do this the party sells a swap to bank and receive
price there is greater control
a fixed rate in return for paying the floating market
over their revenue base.
rate.
In purchasing a put option, The buyer is effectively
buying insurance against lower prices.
Floor
The party pays an upfront premium for protection
from prices below the specified floor strike price
Collars involve buying a put and offsetting the
premium by selling a call option struck above the
market.
Zero Cost
Collar
The party receives the same protection as a put
option provides, however, the group has sold away
some of its upside in order to finance the purchase of
the put.
Able to retain 100% of the
Must pay an upfront
upside if market prices rise
premium for upside
(minus the premium paid for
protection.
floor).
No upfront premium is paid.
Floored on the downside,
but is allowed to ride the
market up to the call strike
that it sells.
Party loses the
benefit of rising prices
above the cap option
strike price.
30
Case Study – Outright Exposure - Airline
An airline is exposed increase in jet fuel prices and can choose a variety of tool to hedge
depending on their risk philosophy.
The most vanilla product that an airline could utilise is a swap. Here the airline would
enter a swap and pay a fixed price in return for the floating price.
Hedging
Tools
Fixed for
Floating
Swap
Description
Benefits
Potential Costs
Enables the airline to eliminate their price
No upfront premium
exposure, protecting themselves from a rise in
fuel prices.
By receiving the floating
market price the client
To do this the airline would enter a swap and
now has greater control
receive the floating market rate in return for
over their cost base
paying a fixed price.
Forgone benefit
from falling prices
Airline pays supplier floating
price for jet fuel
Airline
Supplier
Airline receives jet fuel from supplier
Airline receives the
floating price from
Bank
Airline pays a fixed
price to Bank
Bank
31
Case Study – Outright Exposure - Airline
An airline can also hedge their exposure using options.
The below table outlines the different hedging options available:
Hedging
Tools
Description
Benefits
In purchasing a call option, The airline is
effectively buying insurance against higher The client is able to
retain 100% of the
prices.
Cap
downside if market
The airline pays an upfront premium for
prices decline (minus
premium paid for cap)
protection from prices above the specified
cap strike price.
Collars involve buying a call and offsetting No upfront premium is
the premium by selling a put option struck
paid.
below the market.
Zero Cost
The client is capped on
Collar The airline receives the same protection as The upside, but is
a cap option provides, however, the group allowed to ride the
has sold away some of its downside in order market down to the put
to finance the purchase of the call.
strike that it sells.
No upfront premium is
paid
Similar ides to a Zero Cost Coupon, yet the
Airline would sell an additional call with a
Three way
Market levels are
strike above the existing collar to fund a
capped at a lower level
lower collar
than a Zero Cost
Coupon
Potential Costs
The client must
pay an upfront
premium for
upside protection.
The client loses
the benefit of
falling prices
below the floor
option strike price.
The client is
exposed to prices
above the upper
call level and
loses the benefit
of price below the
floor
32
Hedging through OTC Swaps
(Fixed Price Swap)
$140
$135
Market Price
$130
Sw ap - Realized Price
$125
$120
$/Barrel
Fixed Price
Swaps
Swaps are basically a series of futures or forward contracts. Swaps can be
used when a commodity producer wants to hedge at a several points in time.
In this case, the producer enters into a fixed price swap, which guarantees
a set selling price no matter how much the commodity price moves in the
future.
$115
$110
$105
$100
$95
$90
1
2
3
4
5
6
7
8
9
10
11
12
Month
33
Hedging through OTC Swaps
(Fixed Price Swap)
Producer receives
floating price from
off taker supplier
Producer
Off taker
Producer delivers
oil to off taker
Producer pays
the floating
price
throughout
period
Producer receives
a fixed price
throughout the
period
Bank
34
Consumer: Buying a Fixed Price Swap
Key considerations
Illustrative example
Objective
To lock in forward price.
Description
Price
USD/mt
The client receives the difference between
the floating and fixed price
The buyer locks in the price for a fixed volume of diesel
over a predetermined period by buying a fixed price
swap
The average monthly settlement price is compared to the
swap price
•
If settlement price is lower than the swap price, the
buyer pays the difference between the settlement
price and the swap price
•
If settlement price is higher than the swap price,
the buyer receives the difference between the
swap price and the settlement price
Advantages
Locks in a fixed price over a time period and is protected
from any price appreciation above the swap price
Price rises in the physical market are compensated by
hedging gains
No upfront premium required
Disadvantages
1325
The client pays the difference between the fixed and
floating price
Hedged
Market Price
Potential gains
Potential costs
Time
Indicative Levels – Jet Cargos CIF NWE
Aug 2008- Jul 2009
Fixed Level
USD 1325.00 / mt12
Loose all the potential gain from downside price moves
below the swap price
Price decreases in the physical market are offset by
hedging losses
35
Using Put Options for Hedging
$30
Long Inventory
Long Put
$20
Final Payout
$10
Profit / Loss
Oil Put
Options
Alternatively, the commodity producer may want to participate on the upside movement of the commodity
price, which is not possible if futures contracts are used.
Buying put options allows the producer to gain when the price of the commodity drops, which offsets the loss
in the commodity position. On the other hand, when the price of the commodity rises, the producer will gain
from the commodity position, and at the same time do not face a marked-to-market loss in the hedging
instrument as in the case of the future.
The cost is the price of the option, which can be very high in volatile markets
$0
-$10
-$20
-$30
$90
$95
$100
$105
$110
$115
$120
$125
$130
$135
$140
Price / Barrel
36
Hedging through OTC Options - Zero Cost
Collars (Price Bands)
$140
$135
Market Price
$130
Collar - Realized Price
$125
$120
$/Barrel
Price Bands
Since buying options can be expensive, the producer may choose to forgo some upside
by selling call options at a higher strike price and at the same time, lower its price
protection by buying a put option at a lower striker price, which is basically a collar
strategy.
Collars can be structured so that it costs the producer nothing, but a trade-off must be
made with a lower floor when compare with a normal floor strategy.
$115
$110
$105
$100
$95
$90
1
2
3
4
5
6
7
8
9
10
11
12
Month
37
Consumer: Zero Cost Collar
Key considerations
Illustrative example
Objective
To hedge at zero cost whilst benefiting from the part of the
downside
Price
USD/mt
Description
The party buys a call option and finances it by selling a put for
the same time period and quantities at zero upfront cost.
1500
There are multiple possible combinations of call and put
strikes so that the collar is zero-cost
A non-zero-cost collar can also obviously be envisaged (i.e.
the client paying a reduced premium compared to the
standalone call)
The monthly average settlement price is compared to the
strike levels of the monthly put and call
•
If the settlement price is lower than put strike, the client
pays the difference between the average and the put
strike
•
If the settlement price is higher than call strike, the
client receives the difference between the call strike and
the average
•
If the monthly average is between the two strikes,
nothing happens.
Advantages
Hedging method against upward price moves while
maintaining some downside participation
Zero-cost structure
Disadvantages
The client receives the difference between
the call strike and fixed price
No exchange
Swap
1200
The client pays the difference between the put strike
and floating price
Strike - Put
Strike - Call
Market Price
Potential gains
Potential costs
Time
Indicative Levels - Jet Cargos CIF NWE
Aug 2008- Jul 2009
The client buy Call Strike
USD 1500 / mt
The client sell Put Strike
USD 1200 / mt
If the market price drops below the put strike , the client will be
buying at the put strike.
The client has upward price exposure comparing the current
swap level vs. the put strike
38
Rules for Sovereign Hedging
Understand all aspects of ones current exposures and the contemplated
Hedge
Strong procedures with checks and balances
Remember……..
……..This is NOT speculation!
Create a regulatory environment for Industry to hedge in order to……
Encourage Investment
Reduce Volatility of Earnings
Encourage Consumers to take ownership of Hedging
Regulatory & Tax Environment
Reward ‘Right Way Exposure’
Do NOT remove totally the fundamental price movement
This is needed in order that supply and demand can balance out
39
Questions to Consider
In light of the recent financial crisis, to what extent are governments still
concerned about commodity price volatility?
The recent fall in food/energy prices has created some relief for
governments who are importing these commodity classes. Are they able
to take advantage of the price decreases and lock in supplies/prices at
these lower levels? If not, why not?
Should governments be involved in commodity risk management?
If so, how?
If not, why not?
Are there other examples of countries using macro level commodity
risk management strategies?
What should the World Bank Group be doing to support governments
in this area?
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