Energy Price Risk: Trading and Price Risk Management 1403903409, 9781403903402, 9781403946041

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Energy Price Risk

Tom James

ENERGY PRICE RISK

Energy Price Risk TOM JAMES

© Tom James 2003 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. The information presented in this book has been derived from sources believed to be accurate and reliable, but it has not been independently verified in all cases. Accordingly, neither the author nor the publisher gives any representation or warranty of the accuracy, completeness or currentness of such information. The methods and examples in this book are only intended to demonstrate the relevant concepts in general terms. They may have to be adjusted or modified to be applied to real transactions. Moreover the information in this book is not intended as financial advice or as a recommendation for any financial transaction. Neither the author nor the publisher is liable for any actions prompted or caused by the information presented in this book. Any views expressed herein represent those of the author and do not necessarily represent the views of Carr Futures or its affiliated entities. First published 2003 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–0340–9 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 07 06 05 04 03 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Contents

Foreword Preface 1

Risk Management The Risk Matrix Financial Risks Basis Risk Legal, Operational and Tax Risks Summary

2

Energy Derivatives Markets: On-Exchange and Off-Exchange On-Exchange and Over-the-Counter Futures Swaps and Options Summary Generally Accepted Oil Conversion Factors Used in the Derivatives Industry Generally Accepted Gas Conversions Volume API Gravity and Density/Volume per Tonne Power and Gas Conversion Factors

3

Energy Futures Contracts Introduction Key Facts About Futures Contracts Futures Options Contracts Hedging in Futures Markets Exchange of Futures for Physicals (EFP) and Deliveries via Futures Markets IPE (London) Brent Crude Futures Contract – Specification Ipe (London) Brent Crude Options Contract – Specification

xi xiii 1 1 2 3 6 7 8 9 10 15 24 30 31 31 32 32 33 33 33 35 36 37 44 44 v

vi

CONTENTS

IPE (London) Gasoil Future Contract – Specification IPE (London) Gasoil Options Contract – Specification IPE Natural Gas Futures Contract – Specification NYMEX WTI Light, Sweet Crude Oil Futures WTI Light, Sweet Crude Oil Calendar Spread Options NYMEX Heating Oil Futures NYMEX New York Harbor Unleaded Gasoline Futures and Options NYMEX Henry Hub Natural Gas Futures and Options TOCOM Tokyo Commodity Exchange Middle East Crude Oil Futures Contract TOCOM Futures Contract Specifications – Kerosene TOCOM Futures Contract Specifications – Gasoline Coal Futures Central Appalachian Coal Futures 4

OTC Energy and Related Derivative Markets OTC Energy Derivative Markets The OTC Oil Derivatives Market The Key Oil and Gas Related OTC Swaps European Power and Gas Markets Global Power Markets – With Developed or Developing Derivatives Markets European Gas Markets European Coal Swaps (Cash Settled not Physical Settlement) Weather Derivatives Developments – Freight Rate Swaps (Cash Settled) Derivatives Forward Curve Assessments

46 47 48 49 52 53 56 58 60 63 66 68 69 72 72 73 78 81 81 85 88 91 96 97

5

Options – Trading and Hedging Application Strategies Volatility Types of Options Option Strategies for Hedging Energy Price Exposure The Greeks Option Strategies OTC Options and Popular Structures Options Trading – Volatility Trading

107 108 110 110 111 113 115 119

6

Energy Option Pricing – Which Models Are Used? Types of Options in the Energy Markets General Rules for Option Values Types of Options Models Utilised in the Energy Industry Option Pricing Bibliography

125 125 125 127 128

CONTENTS

vii

7

Value At Risk and Stress Testing A Risk Management Scenario VAR and Other Risk Measurement Methods What Does VAR Do? Variance/Covariance VAR Historical Simulation VAR Method Monte Carlo VAR Simulation (Stochastic Process) VAR Recap VAR to Illustrate Hedge Effectiveness Stress Testing and Value-At-Risk Summary

130 130 131 133 134 135 136 137 137 138 140

8

Questions to Ask When Establishing a Risk Management or Trading Program

141

9

Management Controls The Collapse of Barings The Lessons of History Creating a Risk Management or Trading Policy Corporate Derivatives Risk Management Policy and Procedures Document Back Office Systems Role of External or Internal Audit and Compliance A Risk Management Review The Collapse of Enron, 2001

145 145 147 149

An Eavesdropper’s Guide to Hedging Nine Great Sayings on Hedging Heard in the Market – With Comments Conclusion

164

11

Operational Risk Key Components of Operational Risk Assessing and Controlling Operational Risk Gathering Information on Operational Risk Operational Risk Reduction, Control and Containment Summary

167 167 169 172 173 175

12

Derivatives Contracts Application Listing and Some Hedging Scenario Examples What is Hedging? General Recap on Energy Derivatives Energy Derivatives Selection Grid Hedging Application Examples

176 176 177 177 178

10

152 153 158 159 160

164 166

viii

CONTENTS

13

Risk Management Process and Policy Creation Guidelines The Risk Management Process Trading Controls – Position Limits Some Key Guidelines for a Risk Management Policy

201 201 203 205

14

Applied Technical Analysis in the Energy Markets What is Technical Analysis? The Principles of Technical Analysis The Technical Analysis Bar Chart Other Types of Chart Price Gaps as Price Targets Fibonacci Retracement Levels Mathematical Indicators Moving Averages Chart Patterns Summary

211 212 213 213 219 222 224 225 228 228 240

15

After Enron – A Practical Guide to Credit Control and Risk Mitigation Methods The Collapse of Enron Methods for Managing Credit Risk Exposure Ways to Reduce Credit Risk via the ISDA Schedule Collateralisation Guidelines for Taking Collateral From Counterparts Credit Insurance The New Tool of the Trade – Credit Default Swaps (CDS) The Development of the CDS Market Total Return Swaps Credit Risk Mitigation via Clearing Houses Management Guidelines on Establishing a Credit Control Framework

241 241 244 246 249 250 252 253 260 262 263 266

16

Finance in Energy Credit Status in the Energy Sector Financing Using Derivative Structures

268 268 276

17

OTC Derivatives Legal Risk Control and Documentation The ISDA Agreement The ISDA Master Agreement ISDA Publications Pre-Confirmations and Long-Form Confirmations ISDA Documentation Processing Trading Before an ISDA is Signed ISDA Master Agreement Schedule

286 287 287 288 289 290 293 293

CONTENTS

Step by Step Explanation of a Typical ISDA Master Agreement Schedule Between a Trader and a Bank Additional Notes Proposed ISDA Changes The Advent of Independent Sources of Data that can be Applied to Replacement Value Calculations Arbitration 18

19

ix

294 311 311 315 315

International Accounting Standards for Derivatives Introduction Consolidation and Clarification of Accounting Standards Since 2001 FAS 133 – Effective From 1 January 2001 in the USA International Accounting Standards Board (IAS) FRS 13 – UK Accounting Standards Board Closing Note Totem Risk

317 317

Glossary of Terms

337

319 320 323 327 328 331

Appendices 1 Example of a Risk Management Review of a Company Using Derivatives to Hedge Oil Requirement 2 The Main Energy Sector and Transportation Names/Credits Traded in the CDS Market (September 2002) 3 The ISDA Master Agreement 4 Example Derivatives Trade Confirmation Under ISDA

457 461 486

Index

000

442

Foreword Roy Leighton

When Lord Keynes travelled to Bretton Woods in 1944 in his briefcase were four files to be decided upon by distinguished world financial leaders as the basis for stable economic growth and recovery after the Second World War. Three of these files came to fruition in institutions which we know today as the World Bank, WTO and IMF. The fourth file never saw the light of day – the World Commodity Fund (WTF) – this was considered too big a challenge for struggling post-War economies. Since then, the best brains of governments and business have tried to solve the economic problems of commodity-dependent countries and businesses. They have experimented with buffer stocks, price support mechanisms and other ideas, but most of these schemes have failed and been an expensive waste of scarce donor aid. In the UN and at the World Bank there is much talk of the Debt Problem of the Third World, but in many cases debt is only the symptom – the reality is a Commodity Problem. Fortunately, today the modern financial services industry has developed risk management instruments to manage volatile commodity markets, and these tools are now being recognised by multilateral institutions as the viable alternative to wasteful traditional projects designed to aid poor countries. Risk management in energy is a top priority for heavily indebted poor countries. For the first 70 years of the twentieth century the price of energy was fairly stable, despite world conflicts, and the business of energy was largely conducted between governments and multinational blue chip corporations. Suddenly it all changed in 1973, when the Middle East realised the true value of their ‘black gold’ and oil prices shot up as OPEC asserted powers over supply. Since then the volume of activity on open and transparent trading markets has soared; initially in oil, then in gas and nowadays electricity and weather. Hedging activities have flourished, initially for high energy consumers – airlines, aluminium smelters, electricity generators and the like. Today xi

xii

FOREWORD

no equity investment analyst presentation for these types of companies is complete without a clear explanation of the hedging strategy and position. Energy producers are now following the hedging approach of consumers due to the economic chaos brought about by unhedged exposure to crude oil which quite recently saw prices of US$10 per barrel and US$28 per barrel within an 18 month period. Too often in derivatives the potential user of these price risk instruments is blinded by a blend of trading jargon and mathematical formulae. You don’t need to know how to price derivatives mathematically to be able to shop around and use them effectively. This book demystifies today’s world of risk management and effectively explains to the reader the mitigation tools and strategies available in the market. Failure to utilise such risk management tools is truly to speculate. Roy Leighton Chairman: European Advisory Board Crédit Lyonnais SA Futures & Options Association

Preface

The relationship between risk and reward is at the heart of business. In any endeavour, the risk of heavy losses is seen as a justification for handsome returns, while lower risk enterprises command more modest margins. Perhaps for this reason, the most risky and rewarding businesses are sometimes portrayed as a species of high-stakes casino. But such a comparison is misleading. All successful businesses must learn to assess and manage risk in ways that allow them to exploit opportunities while limiting their exposure to unpredictable factors in their operating environment. The more volatile the market, the more important this process of risk management becomes. The energy industry and its associated markets certainly experience more than their fair share of volatility. Indeed, historians use the more turbulent incidents in the industry’s recent past (the oil price shock of 1973, the Gulf War of 1991) as key mileposts in general economic history. So it’s no surprise that, over the years, the energy industry has honed risk management into a fine art, although still perhaps not an exact science. One of the key concepts in this ‘fine art’ is the use of derivatives: financial instruments that derive their value from an underlying asset. Derivatives contracts allow some players in a market to hedge their risks while others take advantage of the opportunities that such hedging provides. As in other financial markets, the three main tools are futures, options and swaps. A futures contract is a way of agreeing to buy and sell an asset for delivery at a future date, while an option is a contract which confers the right, but not the obligation, to do so. A swap is an agreement to fix a price in an otherwise floating market. The idea of using derivatives in the energy market has been around for many years. The first Heating Oil (Gasoil) Futures contracts were traded on the New York Mercantile Exchange in 1979 and the first oil swap was reported in 1986 (between a bank, an oil trader and an Asian airline). But it was the Gulf War of 1991 that really brought the market to life. The perceived threat to the world’s oil supplies posed by Saddam Hussein’s invasion of Kuwait in August 1990 caused the price of crude oil xiii

xiv

PREFACE

to jump by over 50% in a single month and the markets have never forgotten that brutal lesson. Since then, the continuing tensions in the Middle East, changes in legislation and the ongoing deregulation of economies and markets around the world have introduced more and more businesses to the risks and rewards of the volatile oil, power and gas markets. The result is that the demand for energy derivatives has increased exponentially over recent years. This book aims to provide a practical introduction to the trading of energy derivatives and their use as tools of price risk management. These are normally considered to be highly specialised activities, but this does not mean that they should be treated in isolation. Energy derivatives cannot be properly understood or effectively used unless they are considered as part of a bigger picture. When a company chooses to control price risk through the use of derivatives it may find that it increases the risks in other areas of its business; for example, it may increase its operational, legal or tax risks. For this reason, this book covers many of the issues and topics surrounding energy price risk management to ensure that the use of derivatives does not cause any unwanted or unplanned difficulties. Tom James [email protected]

CHAPTER 1

Risk Management

In most financial markets there are a fairly small number of fundamental price drivers which can be easily translated into pricing and risk management models. In currency markets, for example, the commodity that has to be delivered is cash, a piece of paper which is easily stored, transferred and not sensitive to weather conditions. But energy markets are concerned with bulky, dangerous commodities that have to be transported over vast distances through some of the most politically unstable regions of the world. This means that there are a large number of factors that can affect energy prices. A fairly short list might include: the weather, the balance of supply and demand, political tensions, comments from country leaders, decisions taken by OPEC, analysts’ reports, shipping problems, and changes to tax and legal systems. All these contribute to the high levels of volatility in energy markets which often experience sudden price movements from one day to the next, or even from one minute to the next.

THE RISK MATRIX One way of understanding how these factors combine to influence energy prices is to use the risk matrix pictured in Figure 1.1. It illustrates how all the risks shown interrelate and affect one another and makes it clear that relationships between them are never two-dimensional. It also makes the point that it is impossible to manage price risk effectively without reviewing all the other risks that an individual or a firm may face. As the matrix shows, the key risks to be managed in an organisation when using derivatives for trading or price risk management purposes are: credit risk, liquidity risk, cash flow risk, basis risk, legal risk, tax risk and operational risk. All these risks will have a direct bearing on which derivatives are employed and the choice of trading partner. They will also affect decisions on where trading takes place (which is dependent on 1

2

ENERGY PRICE RISK

Le

C

T

L

• Price risk • Credit risk • Liquidity risk • Cashflow risk • Basis risk • Legal risk • Tax risk • Operational risk

– – – – – – – –

P C L Ca B Le T Or

P Ca

Or

b

FIGURE 1.1 The risk matrix

jurisdiction and tax risk), and how much is traded (which will depend on operational risks).

FINANCIAL RISKS Price risk This is the risk of losing money as a result of price movements in the energy markets and is sometimes referred to as ‘market risk’. Typically, producers will lose money when prices fall, while users will find themselves out of pocket when prices increase. Credit risk Credit risk is the risk of financial losses due to the counterpart to a contract defaulting. It is often said that a hedge contract is only as reliable as the credit standing of the counterpart and credit risk management has moved to the top of the priority list for the energy industry. The credit crunch felt in the USA energy sector in the aftermath of the Enron disaster has prompted energy traders to review credit policies and also review effective methods to control and reduce credit risk wherever possible. Liquidity risk In the context of this book, this is the risk of losses caused by a derivatives market becoming illiquid. This happened during the Gulf War when there was so much volatility in the markets that many banks and oil traders would not give a bid or offer price. Companies who were exposed to those

BASIS RISK

3

markets at the time were sometimes unable to close out their positions or could only do so at great cost to themselves. Cash flow risk This is the risk that an organisation will not be able to produce the cash to meet its derivatives obligations. In the late 1990s, Korean Airlines found itself in this kind of situation and suffered heavy losses as a result. The company had been hedging against movements in the jet fuel price by using derivatives which were denominated in dollars. When the Korean won suddenly fell in value against the dollar, the company found that the cost of the dollars needed to service its derivatives contracts had soared. The company lost out because it had not hedged against the risk of a negative movement in the currency differential between the won and the US dollar.

BASIS RISK What is basis risk? Basis risk is the risk of loss due to an adverse move or the breakdown of expected differentials between two prices (usually different products). In the context of price risk management, basis risk describes the risk that the value of a hedge (using a derivative contract or structure) may not move up or down in sync with the value of the price exposure that is being managed. In the energy market, these market movements may be triggered by factors such as poor weather conditions, political developments, physical events or changes in regulation. These can lead to basis risk occurring in circumstances such as the following: 1 Physical material in one location cannot be delivered to relieve a shortage in another location. 2 A different quality of product cannot be substituted for an energy product in severe shortage. This often happens in the pipeline gas and power markets if there are any problems with transmission networks. 3 There is not enough time to transport or produce an energy product to alleviate a shortage in the market. When conducting price risk management, the ideal derivatives contract is one that has a zero risk or the lowest basis risk with the energy price that protection is needed from. The larger the basis risk, the less useful the derivative is for risk management purposes. The attraction of over-the-counter (OTC) swaps and options is that basis risk can at times be zero, as OTC contracts can often price against the same price reference as the physical oil. However futures contracts (sometimes referred to as ’On-exchange’ derivatives) traded on exchanges like the

4

ENERGY PRICE RISK

THE PERILS OF LIQUIDITY AND CASH FLOW RISK: METALLGESELLSCHAFT AG In 1993 the German conglomerate Metallgesellschaft AG announced that its Refining and Marketing Group (MGRM) had been responsible for huge losses of around $1.5 billion, which it had incurred by writing oil futures contracts on the New York Mercantile Exchange (NYMEX). The great irony of the situation was that its position had been perfectly sound from an economic point of view. The company’s difficulties stemmed from the fact that it had ignored the perils of liquidity and cash flow risk. In the early 1990s MGRM agreed to sell 160 million barrels of oil at a fixed price at regular intervals over a ten-year period. At the time this kind of forward contract looked like a lucrative strategy; as long as the spot price for oil remained lower than the price that MGRM had fixed, the company was sure to make a profit. However, it was vulnerable to a rising oil price, so it hedged this risk using futures contracts. Now, if the oil price rose it would lose on its fixed price forward contracts, but gain on its futures. If the price fell, it gained on the forward contracts, but lost on the futures. This appeared to adequately hedge MGRM’s price risk, but unfortunately failed to take account of its liquidity and cash flow risk. One of MGRM’s problems was the sheer size of the position it had taken. The 160 million barrels of oil that it had committed to sell were equivalent to Kuwait’s entire production over an 83 day period. It has been estimated that the number of futures contracts needed to hedge the position would have been around 55,000. NYMEX was known to be a large and liquid market, but its trade in contracts relevant to MGRM’s position averaged somewhere between 15,000 to 30,000 per day. There was thus a clear theoretical risk that MGRM could have problems liquidating its futures position. This risk created an imbalance in the market as many other players realised the size of MGRM’s position, which became in itself a factor in market pricing. Prices inevitably began to move against the company. This liquidity risk was compounded by the cash flow risk which resulted from the way that MGRM’s hedge had been structured. As was noted earlier, when oil prices went down, the value of the company’s fixed rate forward contracts rose and the value of the futures fell. The problem arose because although the forward contracts increased in value, they did not generate the cash flow which was needed to fund the regular margin calls that were due on the futures contracts. The structure of the hedge had succeeded in dealing with price risk over the life of the hedge, but had failed to deal with cash flow risk in the short term. This was probably the major factor in the staggering losses that the company suffered.

International Petroleum Exchange, the New York Mercantile Exchange and the Tokyo Commodity Exchange all have their pricing references and terms fixed in the exchange’s regulations. This means that if their pricing reference does not match the underlying physical exposure, the basis risk must either be accepted or an OTC alternative needs to be sought. (There

BASIS RISK

5

will be more on the differences, advantages and disadvantages of onexchange versus OTC in later chapters.) Components of basis risk See Figures 1.2 and 1.3. • Locational basis – You utilise a derivatives contract which prices against exactly the same specification of energy you are hedging price risk against. However, the derivatives contract is pricing against the same energy contract but in a different geographic region. – You have locational basis risk. Localised supply/demand factors, political tension, grid problems or, in the case of hydrocarbons/gas, pipeline problems, in either the location used for pricing the derivatives contract or the location where your physical supply is located, could make your derivatives contract a liability rather than a risk-reducing benefit, e.g.

Singapore Gasoil

European Gasoil

FIGURE 1.2 Locational basis risk • Time basis This is a common exposure in many markets – In energy markets a time basis exposure can be very dangerous, particularly when there is a sudden shift in demand or transportation problems occur. • For example, let us take a Merchant Power generator in the USA who is expecting stronger natural gas prices in the summer time (due to additional use of air conditioning etc.). It hedges its position by buying the August contract in NYMEX Natural Gas Henry Hub futures If a severe heat wave was to arrive early in summer, say in late June, then the price of July natural gas may become much stronger than the August price. • Therefore August natural gas futures may not give adequate price risk cover against the July natural gas requirement.

FIGURE 1.3 Time basis risk

Mixed basis risk Mixed basis risk occurs when an underlying position is hedged with more than one type of mismatch between the energy that is the subject of the price risk management and the pricing index reference of the derivatives instrument that is being used. For example, if a January Gasoil (heating oil) Cargo is hedged with a March Jet Kerosene swap, it would leave both time and product basis exposures.

6

ENERGY PRICE RISK

BRENT CRUDE FUTURES AND THE CUSHING CUSHION The success of the Brent Crude Oil Futures contract is an interesting example of the importance of basis risk in the energy markets. This contract was first traded on London’s International Petroleum Exchange (IPE) in 1983, two years after the West Texas Intermediate (WTI) crude futures contract had been launched on the NYMEX in New York. On the surface, both contracts do similar jobs, for hedging purposes, at least. So, over the years, why have international companies chosen to hedge with the IPE Brent futures contract rather than its better established and more liquid American rival? The answer is a particular kind of basis risk, known in the industry as the ‘Cushing Cushion’ (after the Cushing refinery in Oklahoma, the destination of several of the south-east USA’s major oil pipelines). The ‘Cushing Cushion’ means that WTI ‘s crude price in the USA can act totally independently from international market prices. This can be because pipeline bottlenecks at the Gulf coast are preventing additional foreign crude from reaching the mid-continent refineries or it can be because bad weather has closed the Louisiana Offshore Offloading Point (LOOP), halting the offloading of foreign crude from carriers into the pipeline system. In situations like these, the first reaction of speculators and refineries which depend on oil in the pipeline system is to buy WTI NYMEX Futures. Sometimes WTI Premiums of US$3.00 a barrel over the IPE Brent price have been seen due to LOOP problems, pipeline problems or both. So for anyone hedging international crudes such as West African, Brent, Middle East crude oils, Dubai or Tapis, the WTI NYMEX contract carries a significant basis risk. The IPE Brent future, on the other hand, is exempt from this basis risk, which is almost certainly one of the keys to its success.

LEGAL, OPERATIONAL AND TAX RISKS Legal risk This is the risk that derivatives contracts may be not be enforceable in certain circumstances. The most common concerns in this area surround clauses on netting of settlements, netting of trade, bankruptcy and the concern that the liquidation of contracts may be unenforceable. Opinions on many jurisdictions around the world can be obtained from the International Swaps Dealers Association (ISDA). (Legal contract issues and negotiation pointers are covered in Chapter 17.) Operational risk The risk that may occur through errors or omissions in the processing and settlement of derivatives is known as operational risk. Internal controls alongside an appropriate back office system (whether manual or computerised) should be employed to reduce this risk.

SUMMARY

7

Tax risk Tax risk can occur when there are changes to taxation regulations that affect either the derivatives market directly or the physical underlying energy market in some way. This can create additional costs to the trade. For derivatives contracts the issue of imposed withholding taxes on any settlement payments is normally an issue covered by ISDA contracts (see Chapter 17).

SUMMARY When designing an energy price risk management or trading program, it is essential to be aware of all the risks that are involved in the energy market and the ways in which they interrelate. These can be summarised as: credit risk, liquidity risk, cash flow risk, basis risk, legal risk, tax risk and operational risk. But it is important to remember that any hedging strategy which focuses narrowly on any one of these and ignores the others may be worse than having no hedging strategy at all.

CHAPTER 2

Energy Derivatives Markets: On-Exchange and OffExchange

Derivatives normally make the headlines for all the wrong reasons. In the public mind, they are often associated with the activities of greedy speculators or with highly publicised corporate financial disasters. This is ironic because derivatives are essentially instruments to manage and reduce risk. They were created to provide opportunities to minimise price risk and to lock in profits, while reducing balance sheet volatility and the potential for losses. It is true that there have been cases in which the use of derivatives has led to spectacular losses, but this has normally been the result of their mistaken misuse or outright abuse by incompetent or ruthless individuals. Certainly, in the normal course of business life, derivatives are a prudent and, indeed, indispensable tool of price risk management. Derivatives are financial contracts that derive their price or value from an underlying price or asset reference. They can be divided into three main types: futures contracts, swaps contracts and options. ■

■

■

Energy futures contracts are legally binding standardised agreements on a regulated futures exchange to make or take delivery of a specified energy product (oil, gas, coal, power), at a fixed date in the future, and at a price agreed when the deal is executed. Energy swaps represent an obligation between two parties to exchange – or swap – cash flows, one of which is a fixed price normally agreed at execution, while the other is based on the average of a floating price index during the contract period. No physical delivery of the underlying energy takes place; there is only money settlement. Options are agreements between two parties that give the buyer of the option the right, but not the obligation, to buy or sell at a specified price

8

ON-EXCHANGE AND OVER-THE-COUNTER

9

on or before a specific future date. They can apply to a specific futures contract (a futures option) or a specific cash flow (if an OTC Option) or they can be used to buy or sell a specific swap contract (if an OTC Swaption). When the option is exercised, the seller of the option (also know as the writer of the option) must deliver, or take delivery of the underlying asset or contract at the specified price (unlike a swap in which there is no obligation). The specified price is known as the ‘strike price’, which is the price level at which the option becomes profitable independent of whether you are a seller or a buyer. Derivatives are often referred to as ‘off-balance sheet’ items. This term is used because, in the past, there was no need for derivatives to appear on a company’s balance sheet (now this is only the case when hedging using derivatives). Derivatives were not required to appear on the balance sheet because a derivatives contract requires no transfer of the principal value of the contract; in other words, there is no commitment to lend money or take money. For example, when a one million dollar swap is traded, the principal value of one million dollars is not exchanged. Instead, an exchange is made of the cash flow of the difference between the agreed fixed price on the derivative instrument and the forward floating price reference that the derivative prices out against.

ON-EXCHANGE AND OVER-THE-COUNTER In the energy industry, derivatives can be bought and sold in two main ways: on-exchange and over-the-counter (OTC). On-exchange refers to the futures markets which are found on regulated financial exchanges such the New York Mercantile Exchange (NYMEX) and London’s International Petroleum Exchange (IPE). The OTC market is specific to the nonstandard swaps and OTC options. These are usually traded directly between two companies (principals, players) in the energy markets. Although the futures markets are important to the energy industry, it relies much more heavily on OTC derivatives. This is because OTC derivatives are customised transactions, whereas their on-exchange counterpart, the ‘futures’ contract, is a standard contract. In theory, each deal on the OTC market is unique, so it is important to be alert to contract terms, pricing mechanisms and price reference when using OTC derivatives. Some companies find that the measurement and control of risks can be more difficult with an OTC contract because of the lack of price and liquidity transparency in the OTC market (unlike regulated futures exchanges, which publish public real-time price data) and this can create the possibility of an unexpected loss. There are also sometimes additional legal, credit and operational risks with OTC derivatives compared to on-

10

ENERGY PRICE RISK

exchange futures contracts. However, the OTC market remains a popular option for price risk management purposes. Many companies find that there are benefits in the flexibility of an OTC derivative because it can be valued against the same price reference as the energy which is being produced or consumed. As the pie chart in Figure 2.1 shows, energy OTC derivatives markets are far less liquid than most other financial derivatives markets (see also Table 2.1), accounting for less than half of one per cent of the value outstanding on derivatives markets worldwide. This means that those who take part in energy markets whether as market makers, traders or end-users (usually companies with underlying price risk in the energy being hedged either as a producer or consumer), need to have clear policies for derivatives usage, including strong management controls and organisational reporting structures effective before derivatives are employed. They should also provide shareholders with information that will put to rest any unjustified fears associated with their company’s use of derivatives. Indeed, as a result of the concerns of regulators and public shareholders around the world, more and more information is now required by international accounting standards (for more on this point, see Chapter 18). Evolution since 1998

120

Product breakdown at end-2001

90

Commodities Equity 0.6% Foreign exchange 1.9% 17.3%

60

30

Interest rate 80.1%

0 98 H1

99 H1

00H1

01 H1

FIGURE 2.1 OTC derivatives contracts: global amounts outstanding (US$ trillions). Source: BIS (Bank for International Settlement; http://www.bis.org/)

Table 2.2 shows more historical data.

FUTURES A brief history of the futures markets Oil futures contracts have been traded on financial exchanges since the 1970s, although ad hoc negotiated physical supply contracts have been

FUTURES

11

TABLE 2.1 The global OTC derivatives market1: amounts outstanding (US$ billions). Source: BIS Report published 15 May 2002: OTC Market Size (http:// www.bis.org/) Notional amounts

Gross market values

End June End Dec End June End Dec End June End Dec End June End Dec 2000 2000 2001 2001 2000 2000 2001 2001 Grand total

94,008

95,199

99,755 111,115

Foreign exchange contracts

15,494

15,666

16,910

Outright forwards and forex swaps

10,504

10,134

2,605

3,194

Currency swaps Options Interest rate contracts 2 FRAs

2,572

3,180

3,045

3,788

16,748

578

849

773

779

10,582

10,336

283

469

395

374

3,832

3,942

239

313

314

335

2,385

2,338

2,496

2,470

55

67

63

70

64,125

64,668

67,465

77,513

1,230

1,426

1,573

2,210

6,771

6,423

6,537

7,737

13

12

15

19

47,993

48,768

51,407

58,897

1,072

1,260

1,404

1,969

Options

9,361

9,476

9,521

10,879

145

154

154

222

Equity-linked contracts

1,645

1,891

1,884

1,881

293

289

199

205

Forwards and swaps

340

335

329

320

62

61

49

58

1,306

1,555

1,556

1,561

231

229

150

147

584

662

590

598

80

133

83

75

Swaps

Options Commodity contracts 3 Gold

261

218

203

231

19

17

21

20

Other

323

445

387

367

61

116

62

55

Forwards and swaps

168

248

229

217

...

...

...

...

Options Other 4

155

196

158

150

...

...

...

...

12,159

12,313

12,906

14,375

392

483

417

519

937

1,080

1,019

1,171

Gross credit exposure 5 Memorandum item: exchange-traded contracts 6

13,918

14,215

19,464

23,540

1 All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the gross negative market value of contracts with non-reporting counterparties. 2 Singlecurrency contracts only. 3 Adjustments for double-counting estimated. 4 Estimated

around since oil was drilled in the USA in the 1850s. The first formalised regulated futures exchange for oil was the New York Mercantile Exchange (NYMEX) which started contracts on heating oil in 1977 (relaunched as the

12

ENERGY PRICE RISK

TABLE 2.2 Billions of OTC derivatives notional outstanding. Source: BIS (http://www.bis.org/) Jun 1998

Dec 1998

Jun 1999

Dec 1999

Jun 2000

Dec 2000

Jun 2001

Dec 2001

451

415

444

548

584

662

590

598

Gold

193

182

192

243

261

218

203

231

Forwards and swaps

103

76

87

119

120

101

88

101

Options Other precious metals

82 25

99 50

102 62

124 54

141 57

116 55

116 25

130 30

Forwards and swaps

15

22

24

14

9

11

10

16

Options

11

28

38

40

49

44

15

14

Other commodities

233

183

190

251

266

389

361

337

Forwards and swaps

138

114

103

148

159

238

218

201

95

69

87

103

106

152

143

135

Total commodity contracts

Options

current contract in 1979) which was followed by West Texas Intermediate contract (WTI crude). On the other side of the Atlantic, the International Petroleum Exchange (IPE) of London was launched in 1981 and now boasts, in the Brent Crude Oil Futures contract, the leading international benchmark for the pricing of physical crude markets around the world; approximately 70% of the world’s crude oil markets price in some way against Brent Crude Oil. Both NYMEX and IPE also operate futures markets for Natural Gas and Electricity/Power. In recent times, there has been concern that the liquidity in the physical Brent crude oil market has been getting smaller, and as a result some oil majors have taken the initiative to participate in the development of Brent–Forties–Osenberg (BFO)-related trading rather than just Brentrelated trading. Pricing information services such as Platts have already modified the crudes they include in their Brent price reporting and even the International Petroleum Exchange is examining (September 2002) the use of BFO prices in its price index for settling the Brent Futures contract. In the Far East, SIMEX (now merged into SGX in Singapore) ran a popular Fuel Oil Futures contacts in Singapore until the early 1990s, when it was overtaken in popularity by the OTC (off-exchange over-the-counter derivatives market) and Asia is now totally dependent on OTC derivatives for risk management purposes in energy markets. However, a Tokyo Commodity Exchange (TOCOM) contract for Middle East crude oil has been attracting both interest and trading volume, and this could become a useful on-exchange futures contract tool for Middle East crude hedging,

FUTURES

13

particularly since Asia is heavily dependent on Middle East crude imports for oil refinery operation. Futures versus OTC At one time it was easy to distinguish the futures market from the OTC market and also to establish the pros and cons of using one or the other. As Figure 2.2 shows, when risk managers or traders used futures contracts they knew that the contract would be traded on an exchange, that they would have an account with their futures broker and that they were operating in a highly regulated market. They could also see the price of the contract on a screen and they could be sure that the security of the contract and its performance would be guaranteed by the clearing house of the exchange. This in turn was guaranteed by ‘margins’ (good faith payments by everyone with a futures position on that particular exchange), plus the funding the exchange raised itself and the funds contributed by its clearing broker members. Client A

Client B

Wants to buy 1 futures

Wants to sell 1 futures

Broker

Broker trades on the Futures Exchange

Broker

Clearing house

Broker Client A Broker informs Client that the new Futures position has been created

Clearing house creates 1 new futures contract: a Buy + a Sell. It guarantees the performance on these trades

Broker Client B Broker informs Client that the new Futures position has been created

FIGURE 2.2 Basic futures trade transaction flow

Margins on a futures exchange can be split into two types: ‘initial margins’ and ‘variation margins’. Initial margins are the good faith deposit that is placed with the clearing house or that a broker finances (at a cost) when a trade is opened. A variation margin is the daily revaluation of a portfolio with the clearing house. If the valuation is negative, you or your broker (if you have a credit line) will have to place a margin to cover that negative variation margin. If the next day the portfolio has a positive

14

ENERGY PRICE RISK

variation margin (i.e. it is showing an unrealised profit), because the position has not been traded or closed out yet, some of that margin will be returned. However when OTC contracts are used there is always the credit risk of the other company in the transaction, as well as a liquidity risk and a lack of price transparency because there is no screen to display a real-time price. The convergence of OTC and futures The clear distinction between the OTC energy market and the futures markets is now disappearing as the two markets converge. Clearing houses around the world have started to accept OTC trades into their guarantee umbrella. This means that after executing bilateral OTC trades with one another, both counterparts can agree to ‘give-in’ their OTC deal to a clearing house. This process basically makes the clearing house the counterpart to the OTC deal, so that the two OTC counterparts can benefit from the higher credit quality of the clearing house as well as getting other benefits such as more netting opportunities on settlement and offsetting of positions. The usual market approach is for two OTC counterparts to trade an OTC derivative contract with one another directly and to take on one another’s credit risk: OTC counterpart

OTC counterpart

In the new convergence environment we now sometimes have a situation like this: Two companies negotiate an OTC deal with one another but on the basis of the clearing house becoming what is termed the ‘central’ counterpart.

OTC counterpart

Clearing house

OTC counterpart

Although market share penetration has been slow in the oil sector, we have seen the newer power and gas markets embracing electronic trading platforms in a big way. This has brought about greater price transparency as users can view and trade prices onscreen like futures markets. As a result, power and gas markets have been the quickest to embrace OTC clearing. Futures contracts settlement on expiry Energy futures contracts all entail physical and cash delivery on expiry (apart from IPE Brent Crude Futures in London). So if a seller (someone

SWAPS AND OPTIONS

15

who is short in the market) holds the futures contract to expiry he will have to deliver the underlying physical energy (oil, gas, power) and if a buyer (someone who is long in the market) holds the contract to expiry, he will have to take delivery of the underlying physical energy. However, actual delivery via futures markets like the NYMEX or IPE is very small, normally less than 2% of the total open interest (the total amount of outstanding contracts in the market). The majority of trades on these markets are for hedging and or speculative purposes, with consumers or producers of energy preferring to make delivery via the normal physical markets rather than through the futures markets.

SWAPS AND OPTIONS Swaps contracts settlement on expiry Swaps are contracts which, unlike futures, never go to physical delivery. They are by their very legal structure purely financially based contracts, which allow companies to benefit from the price/value movement of the underlying asset that the swaps price is derived from. It is called a swap because the two counterparts to the deal, the buyer and the seller (the long and the short) exchange an agreed fixed price today for the unknown floating price In the future. When traders are negotiating an OTC deal they focus on: ■ ■ ■ ■ ■ ■

The fixed price The floating price reference (see Chapter 3 for a listing) Pricing period (e.g. one month, quarterly, calendar year) Start date or effective date End date or termination date Payment due date. For example, for a swap priced against an American or European floating price reference, payment due date is normally the fifth business day after the last pricing day of each pricing period. In energy and generally commodity markets, OTC derivatives will price out monthly, so even if a quarterly contract is traded, after each month during the pricing period, one third of the volume will price out and a settlement will become due by or a payment received by the organisation. For contracts pricing against an Asian-based floating price reference, payment for settlement is generally due 10 business days (sometimes up to 14 business days) after each pricing period.

Option contracts on expiry What happens to an option contract on expiry and when or whether it is exercised (transfers into its underlying) depends very much on the type of

16

ENERGY PRICE RISK

option it is and also whether it is a futures option (traded on a futures exchange, referred to as traded options) or whether it is an OTC option. When a traded options position is held on a futures exchange, if the option is ‘in the money’ on expiry, the clearing house will prompt clearing brokers to notify their customers that their option is in the money and request whether they wish to exercise the option as it is profitable to do so. An option is in the money when it has intrinsic value; i.e. exercising the option into its underlying futures contract (in respect of traded options) and then trading out (closing out) that futures contract would bring a profit. In some instances, if the traded option is heavily in the money, the clearing house of the futures exchange may even exercise it automatically, which acts as a safety net for users of the market. However, there are no safety nets in the OTC world of derivatives. If you have a profitable swaption that could exercise into a profitable swaps position for you and you forget to tell your counterpart that you wish to exercise it by the cut-off time (written in the original option contract), you will be left to negotiate with that other counterpart. It will be up to your counterpart whether they will still let you exercise the swaption and if they do, it will most probably come at a price. Types of swaps in energy markets Plain vanilla – terms used to describe a simple averaging swap A plain vanilla swap (Figure 2.3) is a monthly averaging swap with the following features. ■ ■ ■

Fixed prices versus floating prices in the future are exchanged; i.e. they are is swapped. They are used extensively in Oil, LPG and LNG related hedging and trading. When executing the deal counterparts discuss the fixed price agreed today and which floating price reference they will use to calculate the settlement.

The following is a cash flow example of a plain vanilla deal: ■ ■ ■

Counterpart A buys fixed price 15.00 (buys fixed, sells floating) Counterpart B sells fixed price 15.00 (sells fixed, buys floating Floating price reference is chosen, e.g. Platts average during the price period (say) March 2003 = 16.00 Floating A

B Fixed

FIGURE 2.3 A plain vanilla swap

SWAPS AND OPTIONS

■

17

Net result: ● Counterpart A = +$1.00 (difference between fixed/floating) ● Counterpart B = –$1.00 ● Counterpart B pays Counterpart A US$1.00. Only the difference is exchanged, not the principal notional amount.

Differential swap A differential swap is like a plain vanilla swap except that instead of one fixed price versus a floating price, it is based on the difference between a fixed price in two products. In the oil sector, the most popular differential swap is the Jet Kero versus Gasoil (Figure 2.4), commonly termed the ‘regrade’ swap.

Gasoil

Jet Kero

FIGURE 2.4 A differential swap

The following is a cash flow example of a differential swap: ■ ■ ■

■

Counterpart A buys fixed price Kero and sells fixed price Gasoil at a difference of US$0.50 per barrel Kero premium. Counterpart B sells fixed price Kero and buys fixed price Gasoil at a difference of US$0.50 per barrel Kero Premium. Floating price reference is chosen, e.g. Platts Kero and Gasoil average difference during the price period (say) March 2003 = 0.60 Kero premium. Net result: ● Counterpart A = +$.10 (difference between fixed differential and the floating differential) ● Counterpart B = –$0.10 cents per barrel ● Counterpart B pays Counterpart A US$0.10. Only the difference is exchanged, not the principal notional amount.

Differential swaps are used across the whole energy spectrum. In the power and gas markets we see ‘spark spreads’ (Table 2.3), where hedgers and traders use derivatives pricing against the difference (referred to as the ‘dif’) between power and gas markets. This is based on the amount to be made by burning gas and selling power in a perfect world using a standard percentage efficiency of the conversion of energy. The normal efficiency used is 49.13% and the spark spread is quoted in megawatt hours (MWh). In coal versus power there is the so-called ‘dark spread’, which works on the same principle as the spark spread with two fixed prices and two

18

ENERGY PRICE RISK

TABLE 2.3 Spark spread Gas price Pence per therm

£/MWh

Power price

Spark spread

£/MWh

£/MWh

September

12.15

4.15

12.7

4.26

October–December July–September

20.55 16.5

7.01 5.63

16.35 14.55

2.08 3.09

floating prices documented in swaps confirmation. However, the net exposure is only on the differential between the two products/instruments. In the UK, dark spreads use an energy conversion efficiency of 5,000 MT of coal producing 55 MW of electricity at an efficiency of 38%. (There will be more detail on this in Chapter 3.) Participation swaps Participation swaps are similar to regular plain vanilla fixed for floating swaps as the fixed price buyer can be 100% protected when prices rise above the agreed fixed price or the fixed price seller can be 100% protected when prices move down below the agreed fixed price. However, unlike an ordinary swap, the client ‘participates’ in the downside by only an agreed percentage. The percentage of participation affects the starting fixed price of the swap. A fixed price buyer who only wants to participate in a percentage of any price move lower may find that the fixed price quoted for a participation swap would be higher than a normal swap. On the other hand, if you were a seller of fixed price who wanted to participate in only a percentage of any move higher that would incur a loss on the short swap position, you might find that the fixed price quoted for a Participation Swap would be lower than a normal swap. Double up swaps By using the double up swap, swap users can achieve a swap price which is better that the actual market price, but the swap provider will retain the option to double the swap volume before the pricing period starts. If a company has price exposure to energy prices going higher, but the current plain vanilla swap is not being quoted around its budgeted level, it may find that a double up swap will let it hedge some of its required volume closer to its hedging budget level. The risk is that the market price could move against the derivatives position and the swap could price out against twice the original executed volume. Double up swaps are not commonly used in the market for price risk management purposes (hedgers tend to use options more if the current swap price is not interesting for them). However, double up swaps could offer an interesting

SWAPS AND OPTIONS

19

opportunity for speculators who have a strong price direction view on their particular energy focus and want to get a head start by buying at a better price level than the current plain vanilla swap, or selling at a higher level than the plain vanilla swap quotes. Margin swaps This is where an organisation can take its overall price risks from several energy inputs and outputs of the business process and get a complete swap structure that guarantees its profit margin. Organisations could construct complex hedges themselves to protect their energy inputs/ outputs. This has a cost in terms of managing many individual positions with perhaps several counterparts. It can therefore be more cost efficient and easier to enter into a margin swap with one counterpart who is willing to provide a contract that covers all the price risks (Figure 2.5). Energy inputs

Energy outputs Naphtha Jet Kero

Crude oil feedstock

Gasoil Oil refiner

Fuel oil Gasoline

Floating price risk absorbed by margin swap counterparty Fixed price on feedstock Refiner

One contract

Margin swap counterparty

Fixed price on product

FIGURE 2.5 Example of a margin swap for an oil refiner

However, it should be remembered that price risk management is never free and there are always costs attached to any control function in a company internally or externally. Administration and human resources available in an organisation will have to be reviewed and adjusted if necessary depending on the level of activity the organisation expects to have in derivatives.

20

ENERGY PRICE RISK

Knock-ins and knock-outs – integration with swaps and options Knock-in and knock-out options are two types of barrier option which are activated if the underlying moves through a trigger price level, in the case of a knock-in, and is cancelled or deactivated in the case of a knock-out. A market maker or trader will normally offer a more attractive price on this kind of option because the buyer is giving the seller of the option the opportunity to cancel it before its original expiry/termination date. This adds another dimension of opportunity or potentially reduced risk to the seller of the option; hence the lower price than an option of same strike price, tenure and underlying price reference without such a barrier option structure. Knock-in and knock-out triggers can be integrated with both swaps and options. Figure 2.6 shows how the barrier option either comes to life (is knocked in) or is extinguished (knocked out) under certain conditions. In practice, the event which activates or kills the options is defined in terms of a price level (the barrier).

Price

Type of option Out In Up

Up-and-out

Up-and-in

Down

Down-and-out

Down-and-in

FIGURE 2.6 Barrier options – caps/floors

A common example is the up-and-out floor (put) which is typically purchased by an energy producer to hedge their natural long position in the energy markets. Up-and-out floor (put) may be an attractive alternative to the normal floor or put option, as it is less expensive and provides the same price protection if prices move down from current levels. However, if prices move upwards, the increase in the underlying commodity’s price reduces the need for downside risk protection at the original strike price. If the price moves up sufficiently to cross the selected ‘barrier’ price, then the option is cancelled/extinguished. The owner may consider re-entering a hedge by buying another floor at a higher strike price, which gives more valuable protection than the floor with the lower strike price which was cancelled. The barrier option may also be combined with a rebate. For a knock-out option, the rebate is paid when the option is cancelled prior to its normal expiry as a compensation to the holder. The up-and-out barrier is less expensive than a standard Asian, European or American option because the underlying price may fall below the

SWAPS AND OPTIONS

21

strike price after initially rising, hitting the barrier and cancelling the option. However, there may be liquidity issues with this strategy, as there are a limited number of traders in the market who may be able to quote you this more complicated option strategy.

The common and more liquid option markets in energy – calls and puts, caps and floors On futures exchanges, traded options are referred to as calls and puts, while in the OTC market the same sort of contracts are referred to as caps and floors. If an organisation buys a call or cap, it gives the buyer of the option price protection against the market moving above the agreed price, the ‘strike price’, in return for the payment of a premium or fee. The strike price is the level at which the players can participate in the market via the option contract. If an organisation buys a put or floor, it gives the buyer of the option protection against the market moving below the strike price, again in return for the payment of a premium or fee. Figure 2.7 illustrates the various possibilities.

Call/cap Market higher Value increases Put/floor Market lower Value increases

Original option cost

Value of commodity

FIGURE 2.7 Calls and puts, caps and floors

Options strategies can be very flexible and can help companies achieve exactly the risk reduction or risk exposure profile they want to have. When a buyer purchases an option, the cost of the contract is the premium paid, and the buyer will not be required to pay any more than whatever the market price demands. If an option is sold on its own, it is called a naked option. This means that the seller does not own the underlying physical commodity or does not have another futures or swaps position against the option that has been sold. In this case, there is unlimited risk if the market price moves in an adverse way (Figure 2.8).

22

ENERGY PRICE RISK If the option is sold as a naked option: Cap/call

Potential unlimited loss exposure on the option if the underlying market price moves above the strike price of the option

Floor/put

Potential unlimited loss exposure on the option if the underlying market price moves below the strike price of the option

FIGURE 2.8 The risks of naked options

Main option styles ■ American style – An American style option is one that may be exercised into its underlying instrument (i.e. a futures contract) on any business day until expiry. All the IPE and NYMEX traded options on energy futures contracts are American style. These options are more expensive than European options because they give so much flexibility to the buyer as to when the option can be exercised. ■ European style – These are not very common in the energy markets, as they only permit the buyer to exercise the option on expiry. European options are cheaper than American options, but generally more expensive than Asian-style. ■ OTC Asian style – This is the most common option style in the OTC market and they are sometimes called ‘restrospective’ or ‘path-dependent’ options. The reason for this is that they are average price options, with their profit being dependent on the price history of the underlying energy market that is being used as the price reference, either overall or sometimes at a specific stage in the life of the option. The cost of an option – its premium There are many types of option models available and each one has its own particular use depending on the type of option that is being used. It is not necessary to have an in-depth understanding of the mathematics of these models. However, users should understand what needs to be put into the model in order to obtain the right answers and they should be able to interpret the output results. It is fair to say, though, that the core factors that play an important role in determining the value of any option are generally those shown in Figure 2.9. Margin options These are options that can price against a complex structure of differentials instead of pricing against a single floating price reference. Earlier in

SWAPS AND OPTIONS

23

Reference rate (benchmark e.g. futures or swaps) Strike Expiry

Option pricing model

Premium/ cost of option

Volatility estimate Interest rate (risk-free e.g. base rate)

FIGURE 2.9 Option premium calculation principles – premium.

the chapter, we looked at the illustration of a margin swap for an oil refiner. That oil refiner could have bought an option on its refining margin instead of using the swap strategy. The option strategy might at first appear less attractive, as it contains an up-front premium cost, whereas the swap strategy would not require any such cost. However, the flexibility offered by the option strategy becomes apparent if the margin gets better. If the refiner had used the swap strategy its profitability would be fixed, although if the margin improved, any loss on the swap would be offset by better prices on the resale of its physical assets: the petroleum products. In this case, it would just have the opportunity cost. But if it paid a premium for an option strategy (e.g. a margin option) then if the margin improved more than the cost of its option strategy, it would still be able to benefit from that margin improvement. This is most useful when dealing with a present day or even forward negative margin – a situation which has been experienced by oil refiners in some of the fuel oil markets for a long time. In this case, the refiners might have good margins which they wish to lock in by using swaps on the middle distillates (e.g. Naphtha, Gasoil, Jet) but they are still faced with the need to halt any further exposure in the Fuel Oil margin becoming more negative (and at the same time, they do not want to lock in a negative margin). In this instance, the refiner could look at a Crack Option (Crude (feedstock) versus Fuel Oil) and still have the potential to benefit and profit from any improvement in the margin on this product in the future. Option premium cash flow When a traded option is purchased on a futures exchange, it is normal to put up ‘margin’, in the form of a good faith deposit (approximately 10% of the notional value, subject to market volatility at the time of the trade). After that, the position will be marked to market on a daily basis and there

24

ENERGY PRICE RISK

will be an obligation to finance any negative ‘variation margin’. In the case of an OTC option, the buyer normally pays the premium up-front to the seller. This generation of cash premium is where OTC options can offer interesting opportunities for linkage to commodity- or energy-linked projects that require financing. It is possible to create structures that offer a price risk hedge at the same time as generating prompt cash flow which can be reinvested in the project or in other business activities of the organisation (these activities are usually associated with the structured finance departments of banks). For traders who are trying to make money by speculating in the very risk of the energy price moving or not (as the case may be), options offer the ability to do the following: ■ ■ ■

Create trading strategies that profit from price direction moves Create trading strategies that profit from the price moving in a particular price band Create trading strategies that profit from the price staying the same by using volatility trades; money can be made not from the market price moving up or down, but on volatility increasing or decreasing.

SUMMARY The energy derivatives markets provide risk managers and traders with an enormous choice of instruments both for price risk management and for speculation. Traditionally, the energy industry has favoured over-the counter (OTC) derivatives which can be customised to meet the needs of both counterparts to the deal. However, some companies have found drawbacks to the OTC market such as a lack of liquidity or price transparency. But these problems should be ironed out as the OTC market converges with the on-exchange market to provide a more effective and efficient service to all parties concerned.

SUMMARY

25

KEY OPTIONS TERMINOLOGY American option An option which can be exercised on any business day up to and including the expiry date. Asian option A path-dependent option, also known as an average rate options. This is an option where the settlement is based on the difference between the strike and the average price of the underlying floating reference price over a determined period of time. At-the-money An option term used to describe the fact that the optionunderlying is equal to the option’s strike price. This can be applied to a futures contract, a swaps contract or some average price of an underlying energy market. Delta Delta gives you a mathematical measurement of how sensitive an option is to price changes in the underlying energy market. Delta operates on a scale of 0 to 1. For example a Delta of 0.5 implies that if the underlying moved by US$1 dollar the option could move by US$0.50, or half of the underlying energy market’s price move. European option An option which can be exercised on the expiry date only. Fair value The combination of intrinsic value and time value, as calculated by the option pricing model. Implied volatility The volatility value placed on option quotes. In-the-money It means the option is profitable, if you exercise the option or trade out of it you can gain a profit. Intrinsic value The difference between the strike price and the current market rate. Out-of-the-money The option is not in-the-money, and it would not profitable to exercise the option or trade out of it. Premium Price or cost of an option. Strike price The entry price into the underlying; participation level. Time value The difference between the option premium and the intrinsic value, including time until expiry, volatility and cost of carry (interest percentage). Value date The date when the underlying is settled or delivered. Volatility The normalised annualised standard deviation of the underlying futures/swap contract.

26

ENERGY PRICE RISK

KEY DERIVATIVES TERMINOLOGY Abandon Where an option holder chooses not to exercise his or her option. Arbitrage The purchase or sale of an instrument and the simultaneous taking of an equal and opposite position in a related market when the pricing is out of line. For example, in the oil markets, major arbitrages are traded between Heating Oil in New York and Gasoil in Europe, and Gasoil in Europe versus Gasoil in Singapore. Assignment (futures) Notice sent by a clearing house of a futures exchange to an option writer (option seller) that the option has been exercised. Assignment (swap) Where the original counterpart to a swap deal transfers the position to a third party organisation who then takes over as the counterpart to the deal. We were able to see instances of this happening during the Enron collapse in 2001. In order to reduce overall losses on its books it assigned profitable OTC derivative deals that it held in one commodity with one counterpart with losing trades held with other counterparts. All parties involved had to accept these assignments. Average price contract A contract which is conditional on an average of market prices rather than a single market price on one single day. Very common average price contracts are the monthly average price swaps in the OTC oil markets. Back office A term for the department handling the operation functions of processing trades done by the trading operation. Backwardation The decrease in the forward prices of the market as their expiration time increases (i.e. the energy market is cheaper the further in the future you check out the prices). Benchmark A pricing reference from which other energy markets are compared to or priced off using some pricing formula. (e.g. 70% of the world’s crude oil markets are priced off the Benchmark Brent Crude Oil in the UK North Sea. A lot of the world’s natural gas is priced of crude oil ‘benchmarks’) Book Another term for a derivatives portfolio (e.g. ‘the company’s book is long (they have bought) German Power for 4th Quarter’). Call/cap A call option is the futures market equivalent of an OTC cap option. These options give the purchaser of the option the right, but not the obligation, to buy the option’s underlying asset at some future point in time at the option’s strike price. (The strike price is the price you agree you would buy at if you had bought the call/cap or sell if you had sold the call/cap whatever the option is based on, e.g. a futures contract or a swaps contract.) Carry cost The cost of storing energy, oil, gas etc. from one pricing or delivery month to another. For example, to store Gasoil in the Amsterdam–Rottderdam–Antwerp storage region in North West Europe you may find a typical storage cost of US$1.25 per MT per month. If the IPE

SUMMARY

27

Gasoil futures contract today was US$250 per MT and next month US$252 dollars, then in a perfect world, you could buy storage, fill it up with Gasoil at a cost of US$250 per MT, and use the futures market or OTC swaps market to lock in the value of US$252 dollars per MT and make a profit of US$0.75 per MT (US$252 minus storage cost US$1.25 minus Gasoil cost of US$250 = US$0.75 per MT). Cash-settled contract A derivative contract in which counterparties exchange money at settlement rather than delivering actual oil, gas or power, in exchange for cash. The money exchanged is based on the value of the underlying energy. Whether a derivative contract goes to physical delivery instead of the cash-settled route can affect accounting rules that can be applied even if an organisation is hedging and not speculating (see Chapter 18). Contango The situation in which forward prices increase the further forward you look (also known as a ‘normal’ market in the USA). Counterparty risk The risk of one side of a party to a contract not fulfilling an obligation of a contract. Credit derivative Also known as a Credit Default Swap or CDS for short. It enables the trading and also the risk mitigation/reduction of credit risk on a particular entity or group of entities. More widely used now in the energy sector. A CDS is usually more expensive than traditional trade credit insurance, where available, but there are generally more specific payout trigger events than those seen in credit insurance contracts, which brings more comfort to users. Deal capture This describes the operational process of recording a signed derivatives contract in the organisation’s trading ‘book’. Day trade A position opened and closed within the same trading day. Delivery The process of final settlement of a futures contract, swaps contract or option via cash settlement or physical delivery (in the case of futures). Delta Delta represents the change in overall value of an option given one unit change in the price of the underlying of the option (i.e. the option price movement in relation to the futures contract it is based on or the swaps contract it is based on). Derivative contract A financial contract that derives its price (value) from an underlying energy price or asset. Early exercise Indicates exercising the option prior to its expiration date. Limited to American style options. Embedded option An optionality within a contract that is not specifically referred to as an option. End user Generally refers to buyers of derivatives contracts or risk management services who use the oil, gas or power for their own purposes. EFET European Federation of Electricity Traders. This is the organisation that created the EFET master trading agreement which the forward power and natural gas markets of continental Europe tend to trade under.

28

ENERGY PRICE RISK

Events In derivatives contract terms, an event is something that happens in the real world and in turn triggers an ‘event’ in a swap agreement. For example, when Enron had its credit rating downgraded this triggered a ‘credit event’ in some of its derivatives trades and it was forced to place collateral with some of its counterparts, creating a huge cash flow crunch and in turn triggering its downfall. It can also mean, in terms of the market place, an extreme event that triggers rapid price movement in the energy markets. Exchange This is usually a regulated trading centre that offers standard contracts and requires the use of their clearing house and margining of trades. Exercise The process of taking up the options rights on an option contract. Exotic contract A derivatives contract with a complex structure. The opposite of a plain vanilla contract, which is simple. Exotic options New OTC options including barriers. Expiration The date on which a forward, futures, swap or option contract expires/terminates. In an OTC trade it is usually described as the end date. Extrinsic value The amount by which the premium on an option exceeds the intrinsic value, often caused by time value in the option. Front office A term to describe the trading operation of marketing, trading and managing the trading books. Usually the department that provides the means of executing a company’s hedging or trading strategy. Future A standardised contract offered by an exchange allowing a company or individual to trade or protect against future price movements. On expiry in energy markets, it usually goes to physical delivery. GTMA Grid Trading Master Agreement, created by Allen & Overy lawyers in London, UK. UK Electricity forward markets trade under this agreement, unlike other energy swaps which trade under ISDA Master Agreements. Hedge A derivative transaction that reduces or mitigates the price risk an organisation may have in its day-to-day business operation. For example, an airline hedges its exposure to Jet Fuel prices by using Jet Fuel/Kero-related derivatives contracts. Historical volatility An indication of past volatility in the energy market. Initial margin The good faith collateral placed with the clearing house for futures exchange or OTC contracts. Initial margin is paid on the opening of a new derivative position. The clearing house sets the level of initial margin required on each derivatives contract based on current market circumstance, including price volatility. The initial margin is returned once the derivative position has been closed out either through expiry or by the user trading out of the contract by trading an opposite position. Implied volatility The volatility implied from the market price of an option. You can use an option model to reverse engineer what the level of implied volatility is from an option premium being quoted in the market. ISDA International Swaps & Derivatives Association (http://www.isda. org/), the group that created the ISDA Master Agreement 1992, the backbone

SUMMARY

29

for the majority of energy-related derivatives trades (with the exception of UK and European Power and Nat Gas OTC, which trade under GTMA, NBP and EFET agreements). IPE International Petroleum Exchange of London (http://www.ipe.uk. com/). Liquidity This is based on the amount of trading going on in a particular derivatives contract. The greater the liquidity, the greater a user’s confidence may be in the efficiency of that market and in turn the value of the prices generated by that market. Liquidity can play a big part in selecting derivatives contracts for hedging or speculation purposes. Long A trading term that describes someone who has already bought a futures contract, a call option or swap, and who is holding a derivative that benefits them if energy prices move higher. Marked-to-market The daily revaluation of a derivatives portfolio, sometimes referred to as ‘marking-to-market’. The norm in the energy trading world is to mark-to-market derivatives every day for risk management and general management reporting and control purposes. Traders may refer to their MTM value, which is the latest marked-to-market value of their derivatives portfolio or even their derivatives plus physical energy position. Maturity The time at which a contract expires. Notional The dollar value of the underlying asset upon which a derivative contact is based. For example, a user sells 500,000 barrels of crude oil swaps at a fixed price of US$28. Besides being a pretty good level to sell crude oil on a historical basis, the notional value of the deal is 500,000 × US$28 = US$14 million. NYMEX The New York Mercantile Exchange (http://www.nymex.com). Open position The number of contracts that have not been offset by close of business. Paper contract A derivatives contract that allows the counterparties to the deal to cash-settle with money and not through physical delivery. All swaps contracts are cash-settled, but most futures contracts go to physical delivery. Settlement price The price at which all futures are margined; a representative price for the close of the day’s trading. Swaption An option on a swap transaction. These options can be buyers or sellers of the underlying swap and also American or European style. Tick The standard minimum price movement, usually referring to the minimum price movement of an on-exchange futures contract. However, the OTC energy markets have created their own kind of standardisation as well. Price discovery The process of determining the market value of a particular energy derivatives contract. Risk management The process of evaluating, measuring and managing the various risks within a company’s portfolio of financial and energy exposures as well as any assets.

30

ENERGY PRICE RISK

Short Someone who has sold futures or swaps or has bought a put/floor option. They benefit from the market going lower. It can also mean someone who is naturally short in the physical market. For example, consumers of energy are naturally short, always exposed to the prices going higher, unless they hedge. VAR Value At Risk is a type of derivatives position analysis that provides users with a possible profit/loss within a set probability parameter: usually 95% or 99% confidence level over 24 hours. There are different approaches to VAR analysis, and these are discussed in later chapters. Variation Daily movements of debits and credits to and from exchange clearing members, as a result of futures and options positions being markedto-market. With some OTC contracts now also being cleared via futures clearing houses, this is starting to be applied to OTC contracts as well.

GENERALLY ACCEPTED OIL CONVERSION FACTORS USED IN THE DERIVATIVES INDUSTRY Barrels per tonne Crude Oil

7.9–6.5

Brent Crude

7.57

Naphtha

9.0

Motor Gasoline

8.9–8.0

Gasoil and Kero/Jet Fuel Oil

7.45 6.9–6.3

US gallons price to US$ per tonne Heating Oil (NYMEX)

Heating oil price × 3.1323 e.g. 74.00 (cents per US gallon) × 3.1323 = 231.79 per MT

This is utilised for calculating the arbitrage between International Petroleum Exchange of London Gasoil Futures contracts and the NYMEX New York Harbor Heating Oil, both similar grades of petroleum product. (Arbitrage is the difference in price for two similar grades of oil in different locations; if the arbitrage is ‘on’ it means you can move oil from one location to another and cover the cost of shipping).

GENERALLY ACCEPTED GAS CONVERSIONS

31

US gallons price to US$ per barrel Heating Oil (NYMEX: http://www. nymex.com/)

Heating oil price × 42 e.g. 0.74 dollars per gallon × 42 = US$31.08

GENERALLY ACCEPTED GAS CONVERSIONS Litres/tonne Ethane

2730

Propane

1962

Butane Naphtha (distillate feedstock)

1735 1463

Aviation Turbine Fuel

1248

Aviation Turbine Fuel, Wide Cut

1260

Middle Distillate Feedstock

944

Derv Fuel

1182

Gasoil 1 tonne of liquid methane

1172 16 barrels = 50,000 cubic feet = 360 million therms per annum

100 million cubic feet of natural gas per day 1 therm

= 100,000 Btu = 105.5 MJ = 29.3 kWh

1 Btu (British thermal unit)

= 1.055 kJ

1 Btu/lb

= 2.326 kJ/kg

1 kilowatt hour (kWh)

= 3.6 MJ

VOLUME 1 gallon (US) 1 barrel

= 3.78541 litres = 42 gallons (US) = 158.987 litres

32

ENERGY PRICE RISK

API GRAVITY AND DENSITY/VOLUME PER TONNE Degrees API @ 60 EF

Density @ 15 EC

Barrels per tonne

25.0

903.7

6.97

26.0

897.9

7.02

27.0

892.3

7.06

28.0

886.7

7.10

29.0

881.1

7.15

30.0

875.7

7.20

31.0

870.3

7.24

32.0

865.0

7.28

33.0 34.0

859.7 854.5

7.33 7.37

35.0

849.4

7.42

36.0

844.3

7.46

37.0

839.3

7.51

38.0

834.4

7.55

39.0

829.5

7.60

40.0 41.0

824.7 819.9

7.64 7.69

42.0

815.2

7.73

POWER AND GAS CONVERSION FACTORS kWh 1 kWh 1GJ 1 therm

GJ –

therm

ft 3

mn Btu

0.0036

0.0342

0.00342

m3

277.8

–

9.478

0.95

950

26.25

0.018

0.022

0.1055

–

0.1

96.59

2.766

0.0019

0.0024

–

965.9

27.66

0.019

0.024

293.1

1.055

10

0.2997

0.0011

0.0102

0.001

–

1 m3

10.58

0.0381

0.362

0.0362

35.3023

1

t oe

29.3071

ft 3

1 mn Btu

t LNG

3.3367 0.094515 0.000066 0.0000855

0.0283 0.000019 0.000024 –

0.00072

0.00083

1 t LNG

15,000

52

520

52

48,690

1,379

–

1.2

1 t oe

11,700

42.2

400

40

39,220

1,110

0.77

–

kWh GJ therm mn Btu ft3 m3 1 t LNG 1 t oe

kilowatt hour gigajoule therm million British thermal units cubic feet cubic metres 1 tonne Liquid Natural Gas 1 tonne oil equivalent

CHAPTER 3

Energy Futures Contracts

INTRODUCTION Futures markets have been used by traders in commodities for hundreds of years. Trading in rice futures was being conducted in Osaka, Japan as early as the 18th century. The New York Mercantile Exchange (NYMEX), the world’s largest regulated energy futures exchange, started life in 1872 as the Butter and Cheese Exchange of New York, before being renamed ten years later. Exchange-traded futures and options provide several important economic benefits, including the ability to shift or otherwise manage the price risk of cash and physical market positions. As open markets where large numbers of potential buyers and sellers compete for the best prices, futures markets like the TOCOM in Tokyo, SGX in Singapore, IPE in London, EEX in Germany, Nord Pool in Scandinavia, NYMEX in New York, and Intercontinental Exchange out of the USA, allow energy companies to discover and establish competitive prices. Partly because these markets provide the opportunity for leveraged investments, they attract large pools of risk capital. As a result, futures markets are among the most liquid of all global financial markets, providing low transaction costs and ease of entry and exit. This, in turn, fosters their use by a wide range of businesses and investors who want to manage price risks. Today’s futures industry functions with a number of time-tested institutional arrangements, including clearing house guarantees and exchange self-regulation.

KEY FACTS ABOUT FUTURES CONTRACTS A futures contract is a standardised agreement between two parties that: ■

Commits one party to sell and the other party to buy a stipulated quantity and grade of oil, gas, power, coal, or other specified item at a set price on or before a given date in the future. 33

34

ENERGY PRICE RISK

MAIN GLOBAL OIL, GAS, COAL AND POWER FUTURES EXCHANGES ■ ■ ■ ■ ■ ■ ■

■ ■

IPE London: http://www.ipe.uk.com/ EEX: http://www.eex.de/ UKPX: http://www.ukpx.com/ NYMEX New York: http://www.nymex.com/ TOCOM Tokyo/SGX: http://www.tocom.or.jp/ SGX Singapore: http://www.sgx.com/ Nord Pool: http://www.nordpool.com/

Requires the daily settlement of all gains and losses as long as the contract remains open. For futures contracts remaining open until trading terminates, the expiry of the contract provides either for delivery of the underlying physical energy product or a final cash payment (cash settlement).

Futures contracts have several key features: ■ ■ ■

■

■

The buyer of a futures contract, the ‘long’, agrees to receive delivery. The seller of a futures contract, the ‘short’, agrees to make delivery. The contracts are traded on regulated exchanges either by open outcry in specified trading areas (called pits or rings) or electronically via a computerised network. Futures contracts are marked-to-market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing futures accounts held by brokers for their customers. Futures contracts can be terminated by an offsetting transaction (i.e. an equal and opposite transaction to the one that opened the position) executed at any time prior to the contract’s expiration. The vast majority of futures contracts are terminated by offset or a final cash payment rather than by delivery. For example, on the IPE and NYMEX less than 2% of the open interest (total contracts open) in their energy futures contracts go to physical delivery each month.

A standardised energy futures contract always has the following specific items : ■ ■ ■ ■

Underlying instrument: the energy commodity or price index upon which the contract is based. Size: the amount of the underlying item covered by each contract. Delivery cycle: the specified months for which contracts can be traded. Expiration date: the date on which a particular futures trading month will cease to exist and therefore all obligations under it will terminate.

FUTURES OPTIONS CONTRACTS

■

■

35

Grade or quality specification and delivery location: a detailed description of the energy commodity, or other item that is being traded and, as permitted by the contract, a specification of items of higher or lower quality or of alternate delivery locations available at a premium or discount (e.g. NYMEX WTI Crude futures contract allows traders to deliver alternative crudes and they have a table of premium and discounts that are fixed for those alternative crude oils). Settlement mechanism: the terms of the physical delivery of the underlying item or of a terminal cash payment. In fact, the only non-standard item of a futures contract is the price of an underlying unit, which is determined in the trading arena.

The mechanics of futures trading are straightforward: both buyers and sellers deposit funds called initial margin (a sort of good faith deposit) with a brokerage firm who would be a clearing member of the exchange the futures contract it on. This initial margin amount is typically a small percentage – around 10% of the total notional contract value. If you buy (go long) a futures contract and the price goes up, you profit by the amount of the price increase multiplied by the contract size. On the other hand, if you buy and the price goes down, you lose an amount equal to the price decrease multiplied by the contract size. If you sell a futures contract (go short) and the price goes down, you profit by the amount of the price decrease multiplied by the contract size. If you sell and the price goes up, you lose an amount equal to the price increase multiplied by the contract size. These profits and losses are paid daily via the variation futures margin which a clearing broker must deposit with the clearing house every day on behalf of its customers. The broker either finances this for its customer or calls its customer for collateral against unrealised losses. Some futures exchanges have position limits dependent on whether you are a speculator, trader or hedger. Sometimes daily maximum price movements are also enforced. These usually only apply to USA-based exchanges contracts. For example, price limit and position limits do not apply to IPE oil futures contracts. During the Gulf War some participants found that NYMEX was forced to suspend trading, while the IPE carried on trading. These are points to consider when choosing futures contracts.

FUTURES OPTIONS CONTRACTS An option is the right, but not the obligation, to buy or sell a specified number of underlying futures contracts or a specified amount of an energy commodity or index at an agreed price (based on the strike price of the option) on or before a given future date.

36

ENERGY PRICE RISK

Options on futures are traded on the same exchanges that trade the underlying futures contracts and are standardised with respect to the quantity of the underlying futures contracts, expiration date, and strike price (the price at which the underlying futures contract can be bought or sold). There are two types of options – call options and put options. A call option on a futures contract gives the buyer the right, but not the obligation, to purchase the underlying contract at a specified price (the strike or exercise price) during the life of the option. A futures put option gives the buyer the right, but not the obligation, to sell the underlying contract at the strike or exercise price before the option expires. The cost of obtaining this right to buy or sell is known as the option’s ‘premium’. This is the price that is bid and offered in the exchange pit or via the exchange’s computerised trading system. As with futures, exchange-traded options positions can be closed out by offset – execution of a trade of equal size on the other side of the market from the transaction that originated the position. The major difference between futures and options arises from the different obligations of an option’s buyer and seller. A futures contract obliges both buyer and seller to perform the contract, either by an offsetting transaction or by delivery, and both parties to a futures contract derive a profit or loss equal to the difference between the price when the contract was initiated and when it was terminated. In contrast, an option buyer is not obliged to fulfil the option contract. The option buyer’s loss is limited to the premium paid, but in order for the buyer to make a profit, the price must increase above (call option) or decrease below (put option) the option’s strike price by the amount of the premium paid. In turn, the option seller (writer or grantor), in exchange for the premium received, must fulfil the option contract if the buyer so chooses. This situation – the option’s exercise – takes place if the option has value (is ‘in the money’) before it expires. The price risk for the seller of an option can be unlimited (unless the risk is hedged with other options or futures positions) and this is why some companies to this day prohibit their traders from selling options. These companies may consider they do not have good enough controls or systems in place to monitor short sale option price risk exposure.

HEDGING IN FUTURES MARKETS The purpose of a hedge is to avoid the risk of adverse market moves resulting in major losses. Because the physical cash markets and futures markets do not always have a perfect price correlation relationship, there is no such thing as a perfect hedge, so there is almost always some profit or loss (basis risk).

EXCHANGE OF FUTURES FOR PHYSICALS (EFP)

37

In futures markets, hedging involves taking a futures position opposite to that of a cash market position. That is, a corn farming cooperative would sell corn futures against its crop, an importer of Japanese cars would buy yen futures against its yen liability, a precious metals merchant would purchase gold futures against a fixed-price gold sales contract and an energy producer or consumer might look at buying or selling energy futures against their price risk exposure in anticipation of a market price increase/decrease. Examples of the types of risk management activities that rely on the use of futures include: ■ ■ ■ ■ ■ ■

■

Stabilising cash flows Setting purchase or sale prices of commodities and securities More closely matching balance sheet assets and liabilities Reducing transaction costs Decreasing costs of storage Locking in ‘cost of carry’ forward profits, i.e. profitable situations where the market price structure is such that if you hold energy in storage from one month to another if you sell forward in the futures markets, you can lock in a profit by holding that inventory. Minimise the capital needed to carry inventories and the size of security of supply inventories required, by locking in guaranteed physical delivery in the future. The clearing house guarantees performance of the contract.

Figure 3.1 shows how the futures trading process works. Figures 3.2–3.4 show the structure of the oil, gas and power futures markets. With the prospect of a Pan-Asean natural gas pipeline interconnector grid, there should be some interesting opportunities over the next decade or so to see natural gas trading and indeed perhaps natural gas futures markets develop in Thailand, Malaysia, Singapore, Indonesia etc. Other physical forward contracts and OTC power markets around the world are noted in Chapter 4 on OTC derivatives markets available.

EXCHANGE OF FUTURES FOR PHYSICALS (EFP) AND DELIVERIES VIA FUTURES MARKETS Two energy futures markets offer EFPs in the context of the following examples: the NYMEX market in New York and the IPE in London. Generally no more than 2% to 5% of all energy futures contracts ever go to physical delivery via the exchange. (IPE Brent is the only large energy futures contract that does not go to physical delivery on expiry; instead it goes to cash settlement.)

Broker executes sale of 1 futures contract (1 lot) on the futures exchange

Client B

FIGURE 3.1 The futures trading process illustrated. Source: Energy College London – http://www.energycollege.org/

Client B Is left with 1 short (selling) futures position which is held in its futures account at its clearing broker (FCM). The FCM holds the position at the clearing house.

Creates a buy and sell (long and short) Contract for the futures brokers who are clearing members

Client A Is left with 1 long (buying) futures position which is held in its futures account at its clearing broker (FCM). The FCM holds the position at the clearing house.

Client A

Central clearing house e.g. London Clearing House

Client B Wants to sell 1 futures contract

Order given to broker

Futures broker and clearing member report trace to Client B

FUTURES MARKET International Petroleum Exchange Tokyo Commodity Exchange Singapore Exchange New York Mercantile Exchange

Futures broker and clearing member report trace to Client A

Broker executes buy of 1 futures contract (1 lot) on the futures exchange

Order given to broker

Client A Wants to buy 1 futures contract

38 ENERGY PRICE RISK

EXCHANGE OF FUTURES FOR PHYSICALS (EFP)

39

S UK Russia East coast EEC

J

NOR MED

U S A

U S A

AG

AFR

West coast SGP

A AFR AG EEC J MED SGP

Australia Africa Arab Gulf Europe Japan Mediterranean Singapore

UK S USA NOR

United Kingdom Scandinavia/Nordic markets United States of America North Asia (inc. China, Korea)

A

Oil futures contracts

FIGURE 3.2 Oil futures are traded on TOCOM Tokyo/SGX (http://www.tocom. or.jp/), IPE London (http://www.ipe.uk.com/), SGX Singapore (http://www. sgx.com/) and NYMEX (http://www.nymex.com/). The futures traded are IPE Brent Crude futures, IPE Gasoil futures, NYMEX WTI Crude Oil futures, NYMEX Heating Oil (like Gasoil) futures and NYMEX Gasoline futures

Companies who do choose to deliver, however, have several options. They can choose standard delivery (as per the specification of the futures contracts laid down in the rule book of the futures exchange) or they can attempt to arrange an Alternative Delivery Procedure (ADP). This would normally happen if someone wishes to deliver some energy which is not in keeping with the specifications of the futures contract (so it cannot be delivered via the exchange/clearing house procedure) or two parties are stuck with a position and they just wish to negotiate directly with one another on some cash settlement. In ADP transactions, market participants release both the Exchange and their clearing broker member from all liabilities related to the delivery negotiated between parties. Traders and hedgers can also execute an Exchange of Futures for Physicals (EFP). EFPs Companies using energy futures contracts for hedging purposes are often not interested in making or taking delivery at the specified locations. In many cases, they are not interested in being matched to a trading partner

40

ENERGY PRICE RISK

S UK Russia East coast EEC

NOR J MED

U S A

U S A

AG

SGP AFR

A AFR AG EEC J MED SGP

Australia Africa Arab Gulf Europe Japan Mediterranean Singapore

UK S USA NOR

United Kingdom Scandinavia/Nordic markets United States of America North Asia (inc. China, Korea)

West coast

A

Natural gas futures exchanges

FIGURE 3.3 Gas futures are traded on NYMEX (http://www.nymex.com/) and IPE London (http://www.ipe.uk.com/). The futures traded are IPE National Balancing Point (price reference) United Kingdom Gas futures and NYMEX Henry Hub Natural Gas futures

by the futures exchange. More often than not, a hedger using futures finds it more economical to make or take delivery of physical energy elsewhere, under terms that differ from those of the futures contract. An EFP provides the mechanism for such transactions and is usually the preferred method of delivery because it provides greater flexibility. EFPs allow companies to choose their trading partners, delivery site, the grade of product to be delivered, and the timing of delivery. The EFP mechanism allows buyers and sellers to execute their physical energy market transaction on the basis of negotiated price. However, the quantity of the cash commodity involved in an EFP must be approximately equal to the quantity specified by the number of futures contracts involved in the EFP. This is the main concern of futures exchanges, who will investigate from time to time to ensure that parties to EFPs are executing the equivalent volume of physical versus futures. After both parties to an EFP agree to such a transaction, the price at which the EFP is to be cleared is submitted to their futures broker who in turn submits it to the futures exchange which then registers the trade. The price of the futures position created by the EFP can be outside the daily

EXCHANGE OF FUTURES FOR PHYSICALS (EFP)

41

S UK Russia East coast NOR J EEC MED

U S A

U S A

AG

SGP AFR

A AFR AG EEC J MED SGP

Australia Africa Arab Gulf Europe Japan Mediterranean Singapore

UK S USA NOR

United Kingdom Scandinavia/Nordic markets United States of America North Asia (inc. China, Korea)

West coast

A

Power futures exchanges with liquidity

FIGURE 3.4 Power futures are traded on Nord Pool (http://www.nordpool.com/) and EEX European Energy Exchange (http://www.eex.de/). Nord Pool trades futures and options in power for Norway, Sweden, Denmark, Finland; EEX trades futures for the German power market

trading range of that futures market. This is the nominal price of the EFP. The EFP parties can then effect the actual physical exchange at a price they negotiate between themselves. The practical mechanics of an EFP transaction EFPs can be effected between two futures market participants – a long and a short hedger – provided there is a physical market transaction between the parties. For example, a futures market long (a buyer) would take delivery of crude oil from a futures market short (the seller) with whom the EFP is conducted. In this transaction, the buyer’s hedge is liquidated, as is the seller’s, and the actual transfer of crude oil occurs between the parties not via the exchange. An EFP market is normally quoted amongst futures brokers, so this is the first point of call for any organisation looking to find some counterpart to an EFP transaction. Example: Using an EFP to initiate a position On 15 December, an oil refiner who wishes to protect a portion of his oil products inventory wishes to sell futures to protect against falling prices.

42

ENERGY PRICE RISK

At the same time, a Gasoil oil distributor is concerned about rising prices and looks to buy to protect his forward purchases. They agree to a price of Gasoil, net the basis, and register the EFP with the futures (IPE or NYMEX) exchange. Once registered, both parties will receive a futures positions at a price which reflects the exact basis between the futures contract chosen and the specific physical Gasoil price. On 14 January, the diesel refiner arranges with the distributor for the physical delivery of the fuel. At that time, the refiner and the distributor independently offset their futures positions on the exchange via their broker. In this case, the long (buyer) sells back its futures position into the exchange and the short (seller) hedgers buy back their short hedge from the exchange. They have ‘swapped’ futures obligations, thus terminating their contract obligations on the exchange and open interest in the relevant futures contract would therefore reduce. In other words, they have closed out their futures contracts before expiry – before they matured – in consideration of their exchange of physical market positions. The transaction occurs at the price, location, and time negotiated by the parties. Example: using an EFP transaction to liquidate (close out) a position On 15 December, a crude oil trading company wants to cover forward purchases of West African crude oil, so it buys 500 contracts of February IPE Brent futures (500,000 barrels) on the Exchange at a price of US$24 per barrel. At about the same time, a crude oil producer in Africa is seeking to protect the value of its forward floating price crude oil physical sale contracts. So it sells 500 contracts of the February IPE Brent Futures (500,000 barrels) at a price of US$24.15 (on a different day). On 12 January, the two companies agree to a cash deal for 500,000 barrels of Bonny Light crude oil, the equivalent of 500 IPE Brent Futures contracts. Since both companies have hedge positions already in their futures broker accounts, they agree to close out those hedge positions by use of an EFP. Since they can register the EFP with the Exchange at any price that they agree to, they agree to use a price that is equal to the exact basis of their delivery point and the price quoted on the Exchange. By using the EFP, the hedge was taken off using the exact basis. This avoided the possible market risk of covering the hedge in the open market at the Exchange where there is no guarantee as to the price at which the hedge would be liquidated. It also enabled the removal of timing risk as the hedge can be closed out/netted out simultaneously with the physical

EXCHANGE OF FUTURES FOR PHYSICALS (EFP)

43

transaction being executed. Quite often, traders in crude oil markets are trading VLCC (Very Large Crude Carriers) which carry 2 million barrels or 2000 lots of either NYMEX WTI Futures or IPE Brent Futures. Trying to close this position out without adversely affecting the market price due to futures market liquidity issues would take many hours to conclude if it were not for the EFP mechanism. On average, the largest clips size the IPE Brent or NYMEX WTI Futures usually trade in is 100 lots or 100,000 barrels. EFPs can involve deliveries to points other than those specified in the underlying futures contracts, and/or different energy commodities, and/ or different delivery periods, while transaction prices can be negotiated between parties to the EFPs. These negotiated prices can reflect differentials based on quality, location and timing, including transportation and quality differentials between the two products and delivery points. The Exchange clearinghouse treats EFPs as trades for margining purposes. Once the EFP is effected, margin funds can be released on the business day following the posting of the EFP. In EFPs involving a futures market hedger and a physical product market participant that initially is not holding a futures position, the hedger’s margin funds are released on the business day following the EFP posting. The physical market participant then becomes responsible for maintaining the account established for margin funds until the hedge is liquidated or delivery of the contracts is made. The NYMEX Exchange requires written documentation on EFPs and provides standardised forms for this purpose. The IPE market in London does not require written documentation, but it still reserves the right to make enquiries at any time. Information to be supplied can include: ■ ■ ■ ■ ■ ■

The fact that an EFP transaction is being effected. A statement that the EFP has resulted in a change in ownership of a particular energy commodity. The date the transaction occurred. The type and quantity of the energy futures involved in the EFP transaction. The price at which the futures transaction is to be cleared. The names of the clearing broker members involved in the EFP.

The buyer’s and seller’s clearing members must satisfy the Exchange that the transaction is a legitimate EFP. Evidence of a change in ownership of the cash commodity involved in the EFP (or a commitment for such a change), as well as payment received by the firm selling the product, must be made available to the Exchange and secured by the clearing broker members representing the parties to the EFP upon specific request from the Exchange.

44

ENERGY PRICE RISK

IPE (LONDON) BRENT CRUDE FUTURES CONTRACT – SPECIFICATION Date of launch 23 June 1988. Money settlement, no physical delivery. Trading hours Open 08:00; Close 09:45 (local time, electronic) Open 10:02; Close 19:30 (local time, open outcry) Unit of trading One or more lots of 1,000 net barrels (42,000 US gallons) of Brent crude oil. Specification Current pipeline export quality Brent blend as supplied at Sullom Voe. Quotation The contract price is in US dollars and cents per barrel. Minimum price fluctuation One cent per barrel, equivalent to a tick value of $10. Maximum daily price fluctuation There are no limits. Daily margin All open contracts are marked-to-market daily. Trading period Twelve consecutive months then quarterly out to a maximum 24 monthly and then half yearly out to a maximum 36 months. Position limits There are no limits to the size of position.

IPE (LONDON) BRENT CRUDE OPTIONS CONTRACT – SPECIFICATION Date of launch 11 May 1989. Trading hours Open 10:02; Close 19:30 (local time) Unit of trading One IPE Brent Crude futures contract. Quotation The contract price is in US dollars and cents per barrel.

IPE (LONDON) BRENT CRUDE OPTIONS CONTRACT

45

Strike price increments Multiples of 50 cents per barrel. A minimum of five strike prices are listed for each contract month; one nearest to the previous business day’s official settlement price for that month, two (or more) above and two (or more) below that price. During any trading day the Exchange may add one or more strike prices nearest to the last price listed. Minimum price fluctuation One US cent per barrel. Maximum daily price fluctuation There are no limits. Daily margin All open contracts are marked-to-market daily. Option premium Due to futures style margining option premiums are not paid/received at the time of the transaction. Rather margins are paid/received every day according to the changing value of the option and the total value to be paid/received is only known when the position is closed (by an opposing sale/purchase, exercise or expiry). It is a fundamental principle of option trading that the buyer never pays more than the premium. Trading period The first six quoted months of the underlying IPE Brent Crude futures contract, with a new position being introduced immediately on expiry of the first option month, such that six months will always be quoted. Position limits There are no limits to the size of position. Cessation of trading Trading shall cease at the close of business on the third business day prior to cessation of trading in the underlying IPE Brent Crude futures contract. Exercise and automatic exercise IPE Brent Crude options can be exercised into Brent Crude futures contracts. IPE options contracts are of American-style exercise, allowing the buyer to exercise call and/or put options up to 1700 hours on any business day (except on expiry day) during the life of the contracts, by giving an exercise notice to LCH in respect of such options. On expiry day the buyer has up to one hour after the cessation of trading to exercise his options. At that time LCH will automatically

46

ENERGY PRICE RISK

exercise all options that are in the money on behalf of the Member unless instructed otherwise by the Member.

IPE (LONDON) GASOIL FUTURE CONTRACT – SPECIFICATION Date of launch 6 April 1981. Physical delivery on expiry settlement Trading hours Open 08:00; Close 09:00 (local time, electronic) Open 09:15; Close 17:27 (local time, open outcry). Scope Contracts are for the future delivery of Gasoil into barge or coaster or by in-tank or inter-tank transfer from Customs and Excise bonded storage installations or refineries in the Amsterdam, Rotterdam, Antwerp (ARA) area (including Vlissingen and Ghent) between the 16th and the last calendar day of the delivery month. Unit of trading One or more lots of 100 metric tonnes of Gasoil, with delivery by volume, namely 118.35 cubic metres per lot being the equivalent of 100 tonnes of Gasoil at a density of 0.845 kg/litre in vacuum at 15 °C. Specification Gasoil shall be delivered in bulk and free of all liens and claims, be of merchantable quality conforming to the quality specification. Origin Any origin, EU qualified. Quotation The contract price is in US dollars and cents per tonne (on an EU import duty paid basis). Minimum price fluctuation 25 cents per tonne, equivalent to a tick value of $25. Maximum daily price fluctuation There are no limits. Daily margin All open contracts are marked-to-market daily. Trading period Up to 12 consecutive months forward, then quarterly out to 24 months, then half-yearly out to 36 months.

IPE (LONDON) GASOIL OPTIONS CONTRACT – SPECIFICATION

47

Position limits There are no limits to the size of position.

IPE (LONDON) GASOIL OPTIONS CONTRACT – SPECIFICATION Date of launch 20 July 1987. Trading hours Open 09:15; Close 17:27 (local time) Unit of trading One IPE Gasoil futures contract Quotation The contract price is in US dollars and cents per tonne. Strike price increments Multiples of US$2.50 per tonne. A minimum of five strike prices are listed for each contract month; one nearest to the previous business day’s official settlement price for that month, two (or more) above and two (or more) below that price. During any trading day the Exchange may add one or more strike prices nearest to the last price listed. Minimum price fluctuation Five US cents per tonne. Maximum daily price fluctuation There are no limits. Daily margin All open contracts are marked-to-market daily. Option premium Due to futures style margining option premiums are not paid/received at the time of the transaction. Rather, margins are paid/received every day according to the changing value of the option and the total value to be paid/received is only known when the position is closed (by an opposing sale/purchase, exercise or expiry). It is a fundamental principle of option trading that the buyer never pays more than the premium. Trading period The first 11 quoted months of the underlying Gasoil futures contract, with a new position being introduced immediately on expiry of the first option month, such that 11 months will always be quoted.

48

ENERGY PRICE RISK

Position limits There are no limits to the size of position. Cessation of trading Trading shall cease at close of business on the fifth business day prior to cessation of trading in the underlying IPE Gasoil futures contract. Exercise and automatic exercise IPE Gasoil options can be exercised into Gasoil futures contracts. IPE options contracts for American-style exercise, allowing the buyer to exercise call and/or put options up to 17:00 hours on any business day (except on expiry day) during the life of the contracts, by giving an exercise notice to LCH in respect of such options. On expiry day the buyer has up to one hour after the cessation of trading to exercise his options. At that time LCH will automatically exercise all options that are in the money on behalf of the Member unless instructed otherwise by the Member.

IPE NATURAL GAS FUTURES CONTRACT – SPECIFICATION Date of launch 31 January 1997 Trading hours 09:30 to 17:00 UK time, except Daily contracts (09:30 to 16:00, UK time) Trading mechanism Electronic, Energy Trading System (ETSII). Also by Exchange of Futures for Physicals (EFPs). Unit of trading 1 lot equals 1,000 therms of natural gas per day of contract duration (1 therm = 29.3071 kilowatt hours). Contract size Minimum of 5 lots of 1,000 therms per lot (example: 5 lots September = 5 × 1000 therms × 30 days = 150,000 therms). Quotation Sterling, pence per therm. Minimum price movement (‘tick size’) 0.01 pence per therm. Maximum daily price fluctuation No limit.

NYMEX WTI LIGHT, SWEET CRUDE OIL FUTURES

49

Contract description Season contracts are strips of six individual and consecutive contract months. Season contracts are always an (April–September) strip or (October–March strip). Quarter contracts are strips of three individual and consecutive contract months. Quarter contracts always comprise a strip of (Jan–Feb–Mar) or (Apr–May–Jun) or (Jul–Aug–Sep) or (Oct–Nov–Dec). Month contracts are strips made up of individual and consecutive calendar days. A monthly contract is 28, 29, 30 or 31 individual day contracts, determined by the precise number of calendar days in the month. Month contracts are listed 9, 10 or 11 consecutive months into the future. Balance of the Month (BOM) contract is a strip of individual day contracts. The precise number of day contracts is determined by the number of days outstanding in the current calendar month. The BOM contract reduces in size on a daily basis, generating a daily delivery obligation. Day contracts are listed from day ahead (D – 1) to seven days ahead (D – 7). A contract held through to expiry obligates the seller to make physical delivery. Delivery must be made equally throughout the delivery period and equivalent to the number of lots open at the time of expiry. Initial margin Initial margin is calculated on all open contracts and called by LCH from clearing members in order to cover the costs that may be incurred by LCH in closing the position of a member that goes into default. Initial margin is returned upon closure or at expiry of a position. Variation margin All open contracts are ‘marked-to-market’ at the end of each trading day. Variation margin is calculated on the number of lots open for each contract. This process uses the day to day change in settlement price for each contract.

NYMEX WTI LIGHT, SWEET CRUDE OIL FUTURES Trading unit Futures: 1,000 US barrels (42,000 gallons). Options: One NYMEX WTI light, sweet crude oil futures contract.

50

ENERGY PRICE RISK

Trading hours Futures and options: Open outcry trading is conducted from 10:00 a.m. until 2:30 p.m. After hours futures trading is conducted via the NYMEX ACCESS® Internet-based trading platform beginning at 3:15 p.m. on Mondays through Thursdays and concluding at 9:00 a.m. the following day. On Sundays, the session begins at 7:00 p.m. All times are New York time. Trading months Futures: 30 consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Additionally, trading can be executed at an average differential to the previous day’s settlement prices for periods of two to 30 consecutive months in a single transaction. These calendar strips are executed during open outcry trading hours. Options: Twelve consecutive months, plus three long-dated options at 18, 24, and 36 months out on a June/December cycle. Price quotation Futures and options: Dollars and cents per barrel. Minimum price fluctuation Futures and options: $0.01 (1¢) per barrel ($10.00 per contract). Maximum daily price fluctuation Futures: Initial limits of $3.00 per barrel are in place in all but the first two months and rise to $6.00 per barrel if the previous day’s settlement price in any back month is at the $3.00 limit. In the event of a $7.50 per barrel move in either of the first two contract months, limits on all months become $7.50 per barrel from the limit in place in the direction of the move following a one-hour trading halt. Options: No price limits. Last trading day Futures: Trading terminates at the close of business on the third business day prior to the 25th calendar day of the month preceding the delivery month. If the 25th calendar day of the month is a non-business day, trading shall cease on the third business day prior to the last business day preceding the 25th calendar day. Options: Trading ends three business days before the underlying futures contract.

NYMEX WTI LIGHT, SWEET CRUDE OIL FUTURES

51

Exercise of options By a clearing member to the Exchange clearinghouse not later than 5:30 p.m., or 45 minutes after the underlying futures settlement price is posted, whichever is later, on any day up to and including the option’s expiration. Options strike prices Twenty strike prices in increments of $0.50 (50¢) per barrel above and below the at-the-money strike price, and the next ten strike prices in increments of $2.50 above the highest and below the lowest existing strike prices for a total of at least 61 strike prices. The at-the-money strike price is nearest to the previous day’s close of the underlying futures contract. Strike price boundaries are adjusted according to the futures price movements. Delivery F.O.B. seller’s facility, Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or interfacility transfer (pumpover). Delivery period All deliveries are rateable over the course of the month and must be initiated on or after the first calendar day and completed by the last calendar day of the delivery month. Alternate Delivery Procedure (ADP) An alternate delivery procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange. Exchange of Futures for, or in connection with, Physicals (EFP) The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position. Deliverable grades Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37° API gravity nor more than 42° API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, South Texas Sweet.

52

ENERGY PRICE RISK

Specific foreign crudes of not less than 34° API nor more than 42° API. The following foreign streams are deliverable: UK Brent and Forties, and Norwegian Oseberg Blend, for which the seller shall receive a 30¢per-barrel discount below the final settlement price; Nigerian Bonny Light and Colombian Cusiana are delivered at 15-cent premiums; and Nigerian Qua Iboe is delivered at a 5-cent premium. Inspection Inspection shall be conducted in accordance with pipeline practices. A buyer or seller may appoint an inspector to inspect the quality of oil delivered. However, the buyer or seller who requests the inspection will bear its costs and will notify the other party of the transaction that the inspection will occur. Position limits 20,000 contracts for all months combined, but not to exceed 1,000 in the last three days of trading in the spot month or 10,000 in any one month. Margin requirements Margins are required for open futures or short options positions. The margin requirement for an options purchaser will never exceed the premium.

WTI LIGHT, SWEET CRUDE OIL CALENDAR SPREAD OPTIONS In an effort to help market participants mitigate the considerable price risk that is often present between contract months of a futures contract, the New York Mercantile Exchange introduces calendar spread options on its light, sweet crude oil futures contract. The contract is simply an options contract on the price differential between two delivery dates for the same commodity. The price spread between contract months can be extremely volatile because the energy markets are more sensitive to weather and news than any other market. A widening of the month-to-month price relationships can expose market participants to severe price risk which could adversely affect the effectiveness of a hedge or the value of inventory. The calendar spread options can allow market participants who hedge their risk to also take advantage of favourable market moves. To put market relationships in perspective, one must keep in mind two terms which describe the price curve. When the price for a contract month nearer to the present time is higher than the price for a contract further into the future, the market is said to be in backwardation. Typically, this means that prices are high because supplies are tight; in this case, the

NYMEX HEATING OIL FUTURES

53

strike price for a calendar spread options contract will be a positive number. Conversely, when the nearby price is less expensive than the farther-dated prices, the market is in contango. When the price curve is in contango, strike prices of calendar spread options contracts will be negative. A negative price is not unusual in spread relationships. A commodity’s price curve is likely to change over time. Calendar spread options can be used to manage the exposure a business has to these changes. The risk manager for a crude oil producer will use futures contracts to hedge production. In contango markets, the producer, who is a seller of oil, would seek downside protection by buying puts; an oil buyer would purchase calls. A crude oil producer with excess storage capacity can make money when the price curve is in contango by purchasing the cheaper prompt month and selling the more expensive deferred contract month. When the markets are in backwardation, however, spare storage capacity is an asset that generates no cash flow. Selling put options on calendar spreads generates cash flow, and having the asset as a backstop enables the oil company to sell the put. Additionally, in a steeply backwardated market, it can be costly to buy back a hedge after it has appreciated in value on its way to becoming the prompt month. Buying calls on the calendar spread can reduce such costs, and can complement the short hedge by allowing for participation in the rising market. The calendar spread options contracts are similar in concept to the crack spread options contracts introduced in 1994. Light, sweet crude oil calendar spread options contracts will be available for any combination of the first four months, any pair of consecutive months during the 13 listed months; and the closest June/December, December/June, and December/ December spreads. At exercise, the buyer of a put options contract will receive a short position in the futures market for the closer month and a long position in the futures market for the farther-dated month. The buyer of a call options contract will receive a long position in the futures market for the closer month and a short position in the futures market for the farther-dated month.

NYMEX HEATING OIL FUTURES Trading unit Futures: 42,000 US gallons (1,000 barrels). Options: One NYMEX Division heating oil futures contract.

54

ENERGY PRICE RISK

Trading hours Futures and options: Open outcry trading is conducted from 10:05 a.m. until 2:30 p.m. After hours futures trading is conducted via the NYMEX ACCESS® Internet-based trading platform beginning at 3:15 p.m. on Mondays through Thursdays and concluding at 9:00 a.m. the following day. On Sundays, the session begins at 7:00 p.m. All times are New York time. Trading months Futures: Trading is conducted in 18 consecutive months commencing with the next calendar month (for example, on January 2, 2002, trading occurs in all months from February 2002 through July 2003). Options: 18 consecutive months. Price quotation Futures and options: In dollars and cents per gallon: for example, $0. 7527 (75.27¢) per gallon. Minimum price fluctuation Futures and options: $0.0001 (0.01¢) per gallon ($4.20 per contract). Maximum daily price fluctuation Futures: Initial limits of $0.06 (6¢) per gallon are in place in all but the first two months and rise to $0.09 (9¢) per gallon if the previous day’s settlement price in any back month is at the $0.06 per gallon limit. In the event of a $0.20 (20¢) per gallon move in either of the first two contract months, limits on all months become $0.20 per gallon from the limit in place in the direction of the move following a one-hour trading halt. Options: No price limits. Last trading day Futures: Trading terminates at the close of business on the last business day of the month preceding the delivery month. Options: Trading ends three business days before the underlying futures contract. Exercise of options By a clearing member to the Exchange clearinghouse not later than 5:30 p.m., or 45 minutes after the underlying futures settlement price is posted, whichever is later, on any day up to and including the option’s expiration. Options strike prices Twenty strike prices in one-cent-per-gallon increments above and below the at-the-money strike price, and the next ten strike prices in

NYMEX HEATING OIL FUTURES

55

five-cent increments above the highest and below the lowest existing strike prices for a total of at 61 strike prices. The at-the-money strike price is the nearest to the previous day’s close of the underlying futures contract. Strike price boundaries are adjusted according to the futures price movements. Delivery F.O.B. seller’s facility in New York Harbor, ex-shore. All duties, entitlements, taxes, fees, and other charges paid. Requirements for seller’s shore facility: capability to deliver into barges. Buyer may request delivery by truck, if available at the seller’s facility, and pays a surcharge for truck delivery. Delivery may also be completed by pipeline, tanker, book transfer, or inter- or intra-facility transfer. Delivery must be made in accordance with applicable federal, state, and local licensing and tax laws. Delivery period Deliveries may only be initiated the day after the fifth business day and must be completed before the last business day of the delivery month. Alternate Delivery Procedure (ADP) An alternate delivery procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange. Exchange of Futures for, or in connection with, Physicals (EFP) The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position. Grade and quality specifications Generally conforms to industry standards for fungible No. 2 heating oil. Inspection The buyer may request an inspection for grade and quality or quantity for all deliveries, but shall require a quantity inspection for a barge, tanker, or inter-facility transfer. If the buyer does not request a quantity inspection, the seller may request such inspection. The cost of the quantity inspection is shared equally by the buyer and seller. If the product meets grade and quality specifications, the cost of the quality inspection is shared jointly by the buyer and seller. If the product fails inspection, the cost is borne by the seller.

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ENERGY PRICE RISK

Position limits 7,000 contracts for all months combined, but not to exceed 1,000 in the last three days of trading in the spot month or 5,000 in any one month. Margin requirements Margins are required for open futures or short options positions. The margin requirement for an options purchaser will never exceed the premium.

NYMEX NEW YORK HARBOR UNLEADED GASOLINE FUTURES AND OPTIONS Trading unit Futures: 42,000 US gallons (1,000 barrels). Options: One NYMEX Division New York Harbor unleaded gasoline futures contract. Trading hours Futures and options: Open outcry trading is conducted from 10:05 a.m. until 2:30 p.m. After hours futures trading is conducted via the NYMEX ACCESS® Internet-based trading platform beginning at 3:15 p.m. on Mondays through Thursdays and concluding at 9:00 a.m. the following day. On Sundays, the session begins at 7:00 p.m. All times are New York time. Trading months Futures: Twelve consecutive months. Options: Twelve consecutive months. Price quotation Futures and options: In dollars and cents per gallon, for example, $0. 8522 (85.22¢) per gallon. Minimum price fluctuation Futures and options: $0.0001 (0.01¢) per gallon ($4.20 per contract). Maximum daily price fluctuation Futures: Initial limits of $0.06 (6¢) per gallon are in place in all but the first two months and rise to $0.09 (9¢) per gallon if the previous day’s settlement price in any back month is at the $0.06 per gallon limit. In the event of a $0.20 (20¢) per gallon move in either of the first two contract months, limits on all months become $0.20 per gallon from the limit in place in the direction of the move following a one-hour trading halt. Options: No price limits.

NYMEX NEW YORK HARBOR UNLEADED GASOLINE

57

Last trading day Futures: Trading terminates at the close of business on the last business day of the month preceding the delivery month. Options: Expiration occurs three business days before the underlying futures contract. Exercise of options By a clearing member to the Exchange clearinghouse not later than 5:30 p.m., or 45 minutes after the underlying futures settlement price is posted, whichever is later, on any day up to and including the option’s expiration. Options strike prices Twenty strike prices in one-cent-per-gallon increments above and below the at-the-money strike price, and ten strike prices in five-cent increments above the highest and below the lowest existing strike prices for a total of at least 61 strike prices. The at-the-money strike price is the nearest to the previous day’s close of the underlying futures contract. Strike price boundaries are adjusted according to the futures price movements. Delivery F.O.B. seller’s facility in New York Harbor ex-shore. All duties, entitlements, taxes, fees, and other charges paid. Requirements for seller’s shore facility: capability to deliver into barges. Delivery may also be completed by pipeline, tanker, book transfer, or inter- or intra-facility transfer. Delivery must be made in accordance with applicable federal, state, and local licensing and tax laws. Delivery period Deliveries may only be initiated the day after the fifth business day and must be completed before the last business day of the delivery month. Alternate Delivery Procedure (ADP) An alternate delivery procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange. Exchange of Futures for, or in connection with, Physicals (EFP) The commercial buyer or seller may exchange a futures position for a physical position of equal quantity by submitting a notice to the Exchange. EFPs may be used to either initiate or liquidate a futures position.

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ENERGY PRICE RISK

Position limits Any one month/all months: 7,000 net futures, but not to exceed 1,000 in the last three days of trading in the spot month. Grade and quality specifications Generally conforms to industry standards for Phase II Complex Model Reformulated Gasoline. TABLE 3.1 New York Harbor unleaded gasoline specifications: Phase II Complex Model 2000 Oxygen Benzene

1.7% min by weight 1.3% max by volume

Month

RVP

VOC reduction

January

15 max

n/a

February

15 max

n/a

March

13.5 max

n/a

April May

n/a n/a

23.4 min 23.4 min

June

n/a

23.4 min

July

n/a

23.4 min

August

n/a

23.4 min

1–15 September

n/a

23.4 min

16–30 September October

13.5 max 13.5 max

n/a n/a

November

15 max

n/a

December

15 max

n/a

NYMEX HENRY HUB NATURAL GAS FUTURES AND OPTIONS Trading unit Futures: 10,000 million British thermal units (mmBtu). Options: One NYMEX Division natural gas futures contract. Trading hours Futures and options: Open outcry trading is conducted from 10:00 a.m. until 2:30 p.m. (natural gas futures and options will close at 2:45 p.m. on any futures termination day that falls on a Wednesday). After hours futures trading is conducted via the NYMEX ACCESS® internet-based trading platform beginning at 3:15 p.m. on Mondays

NYMEX HENRY HUB NATURAL GAS FUTURES AND OPTIONS

59

through Thursdays and concluding at 9:00 a.m. the following day. On Sundays, the session begins at 7:00 p.m. All times are New York time. Trading months Futures: 72 consecutive months commencing with the next calendar month (for example, on 2 January 2002 trading occurs in all months from February 2002 through January 2008). Options: 12 consecutive months, plus contracts initially listed 15, 18, 21, 24, 27, 30, 33, 36, 39, 42, 45, 48, 51, 54, 57, 60, 63, 66, 69, and 72 months out on a March, June, September, December cycle. Price quotation Futures and options: Dollars and cents per mmBtu, for example, $2.850 per mmBtu. Minimum price fluctuation Futures and options: $0.001 (0.1 ¢) per mmBtu ($10.00 per contract). Maximum daily price fluctuation Futures: $1.00 per mmBtu ($10,000 per contract) for all months. If any contract is traded, bid, or offered at the limit for five minutes, trading is halted for 15 minutes. When trading resumes, expanded limits are in place that allow the price to fluctuate by $2.00 in either direction of the previous day’s settlement price. There are no price limits on any month during the last three days of trading in the spot month. Options: No price limits. Last trading day Futures: Trading terminates three business days prior to the first calendar day of the delivery month. Options: Trading terminates at the close of business on the business day immediately preceding the expiration of the underlying futures contract. Exercise of options By a clearing member to the Exchange clearinghouse not later than 5:30 p.m. or 45 minutes after the underlying futures settlement price is posted, whichever is later, on any day up to and including the options expiration. Option strike prices Twenty strike prices in increments of $0.05 (5¢) per mmBtu above and below the at-the-money strike price in all months, plus an additional 20 strike prices in increments of $0.05 per mmBtu above the at-the-money price will be offered in the first three nearby months, and the next 10 strike prices in increments of $0.25 (25¢) per mmBtu above the highest

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ENERGY PRICE RISK

and below the lowest existing strike prices in all months for a total of at least 81 strike prices in the first three nearby months and a total of at least 61 strike prices for four months and beyond. The at-the-money strike price is nearest to the previous day’s close of the underlying futures contract. Strike price boundaries are adjusted according to futures price movements. Delivery location Sabine Pipe Line Co.’s Henry Hub in Louisiana. Seller is responsible for the movement of the gas through the Hub; the buyer, from the Hub. The Hub fee will be paid by seller. Delivery period Delivery shall take place no earlier than the first calendar day of the delivery month and shall be completed no later than the last calendar day of the delivery month. All deliveries shall be made at as uniform as possible an hourly and daily rate of flow over the course of the delivery month. Alternate Delivery Procedure (ADP) An alternate delivery procedure is available to buyers and sellers who have been matched by the Exchange subsequent to the termination of trading in the spot month contract. If buyer and seller agree to consummate delivery under terms different from those prescribed in the contract specifications, they may proceed on that basis after submitting a notice of their intention to the Exchange. Exchange of Futures for, or in connection with, Physicals (EFP) or Swaps (EFS) The commercial buyer or seller may exchange a futures position for a physical position or a swaps position of equal quantity by submitting a notice to the Exchange. EFPs and EFSs may be used to either initiate or liquidate a futures position. Quality specifications Pipeline specifications in effect at time of delivery. Position limits 7,000 contracts for all months combined, but not to exceed 1,000 in the last three days of trading in the spot month or 5,000 in any one month.

TOCOM TOKYO COMMODITY EXCHANGE MIDDLE EAST CRUDE OIL FUTURES CONTRACT TOCOM fixes the commission rates. Date of listing: 10 September 2001

TOCOM MIDDLE EAST CRUDE OIL

61

Type of crude oil Middle East crude oil (the average value of Dubai and Oman which acts as the benchmark price of Middle East crude oil.) Contract unit 100 kl Trading method Computerised continuous trading. Price quotation Japanese yen per kiloliter. Minimum price fluctuation ¥10 per 1 kiloliter Daily price fluctuation Limit standard price (*Note 1) Price limit Less than ¥6,000 ¥6,000 to less than ¥12,000 ¥12,000 to less than ¥18,000 ¥18,000 and over

¥300 ¥500 ¥700 ¥900

per per per per

kl kl kl kl

The Exchange may change the amount of the price limit at its discretion, according to the market situation. Customer Position Limit (long position and short position each) Current contract month: 40 contracts: on and after the 10th of each month (or the first business day thereafter if the 10th falls on a weekend/ holiday) 80 contracts: from the first business day to the 9th of each month 2nd contract month: 160 contracts, 3rd contract month: 400 contracts Other contract months: 800 contracts each month; total: 2,400 contracts Initial customer margin Standard price (*Note 2) Less than ¥6,000 ¥6,000 to less than ¥12,000 ¥12,000 to less than ¥18,000 ¥18,000 and over

Margin ¥45,000 per contract ¥75,000 per contract ¥105,000 per contract ¥135,000 per contract

The above margins are minimum amounts determined by the Minister of Economy, Trade and Industry. The Exchange is entitled to set greater amounts.

62

ENERGY PRICE RISK

Customer Trading Commission to Futures Clearing Merchants (*Note 3) ¥3,800 Trading hours 9:00 a.m. to 11:00 a.m., 12:30 p.m. to 3:30 p.m. Contract months Six consecutive months from the current contract month Last trading day Jan–Nov: the third business day prior to the last business day Dec: the third business day prior to either the 24th or the business day immediately preceding the 24th if it falls on weekend/holiday On the last trading day, those who hold positions in the current contract month must liquidate all of their positions by placing market orders at the opening of the market. No new position is allowed to be established on the last trading day. Delivery Cash settlement (no delivery) Final settlement price Yen-based average value of Dubai and Oman calculated by the Exchange based on the prices reported by Reuters, Bloomberg, Petroleum Argus, ICIS-LOR, Rim Intelligence and Telerate. Notes: 1. An average of the closing prices on the preceding business day for all contract months except the current contract month. 2. A monthly average of closing prices for all contract months except the last three business days in the previous month. 3-1 The above commission rate is charged per side per contract, except in the case of a day trade, where the above rate is charged as roundturn fee. 3-2 Commissions are negotiable (1) between originating and clearing FCMs of an omnibus account; (2) between an FCM and a customer where orders are transmitted electronically and the registration for the exemption from fixed-commission rate is made to the Exchange by the FCM; or (3) for customers who market, produce or process physical commodities (i.e. commercials). 3-3 Volume discount When the volume of customer’s executed contracts exceeds 1,000 contracts per trade or delivery, commission to FCMs on the exceeded

TOCOM FUTURES CONTRACT SPECIFICATIONS – KEROSENE

63

amount is discounted by 30%. Day trade, omnibus positions, fund positions and positions established by commercials are not applicable. TOCOM also lists a futures contract for Kerosene and Gasoline which can be utilised to hedge the domestic Japanese market. It should be noted that at the time of publishing of this book, the general understanding is that the majority of the volume traded in these contracts, including the Crude Oil contract, is speculative volume from retail investors. This may effect the correlation of the futures contracts with the underlying physical markets. More physical traders/hedgers are expected to enter the crude oil market as a result of the SGX Singapore Exchange listing, towards the end of 2002, the TOCOM Crude contract, but in US$ and in barrels. OTC swaps participants and traders may find interesting arbitrage opportunities between the TOCOM contract in Tokyo in yen/kilolitre, the SGX contract in US$ and Barrels and also the OTC Swaps markets in Dubai and Oman crudes.

TOCOM FUTURES CONTRACT SPECIFICATIONS – KEROSENE Date of listing: 5 July 1999 Standard Kerosene of JIS K2203 Grade 1 Contract unit 100 kl Delivery unit 100 kl Trading method Computerised continuous trading Price quotation Japanese yen per kiloliter Minimum price fluctuation ¥10 per 1 kiloliter Daily price fluctuation limit Standard price (*Note 1) Less than ¥17,000 ¥17,000 to less than ¥24,000 ¥24,000 to less than ¥31,000 ¥31,000 and over

Price limit ¥400 per kl ¥500 per kl ¥600 per kl ¥700 per kl

64

ENERGY PRICE RISK

The Exchange may change the amount of the price limit at its discretion, according to the market situation. Customer position limit (long position and short position each) Current contract month: 70 contracts 2nd contract month: 200 contracts 3rd contract month: 600 contracts Other contract months: 1,200 contracts each month Total: 4,000 contracts Initial customer margin Standard price (*Note 2) Less than ¥17,000 ¥17,000 to less than ¥24,000 ¥24,000 to less than ¥31,000 ¥31,000 and over

Margin ¥60,000 per contract ¥75,000 per contract ¥90,000 per contract ¥105,000 per contract

The above margins are minimum amounts determined by the Minister of Economy, Trade and Industry. Commission to FCMs (*Note 3) (per contract) ¥3,800. Delivery commission to FCMs (*Note 3) The same as above. Trading hours 9:00 a.m. to 11:00 a.m., 12:30 p.m. to 3:30 p.m. Contract months Six consecutive months from the current contract month. Last trading day The 20th of the month preceding the delivery month (if the day is a holiday, last trading day is advanced.) Delivery period Throughout the delivery month. Delivery points Refineries and oil tanks located in Tokyo, Kanagawa and Chiba, provided with both barge and lorry delivery facilities, and appointed by the Board. (In case of delivery into lorry, buyers are obliged to pay the surcharge decided by the Board.) Delivery Physical delivery (not cash settlement).

TOCOM FUTURES CONTRACT SPECIFICATIONS – KEROSENE

65

Deliverable commodities Kerosene of JIS K2203 Grade 1, which is refined within Japan or cleared through the customs. Contract price and tax The contract price shall be inclusive of the cost of delivery into barge in refineries or oil tanks located in Tokyo Bay area but exclusive of consumption tax. Delivery method 1. Option of delivery points: Seller 2. Delivery method: Delivery into barge or lorry 3. Option of delivery method: Buyer 4. Option of delivery day: Buyer in principle 5. Matching of Buyer and Seller: Determined by drawing lots, except when parties to deliver find their counterparts by themselves during the period from Last Trading Day to Lottery Day. 6. Divided delivery: Delivery can be divided Quantity tolerance on delivery ±2% of the volume per delivery Notes 1. An average of the closing prices on the preceding business day for all contract months except the current contract month. 2. A monthly average of closing prices for all contract months except the last three business days in the previous month. 3-1 The above commission rate is charged per side per contract, except in the case of a day trade, where the above rate is charged as roundturn fee. 3-2 Commissions are negotiable (1) between originating and clearing FCMs of an omnibus account; (2) between an FCM and a customer where orders are transmitted electronically and the registration for the exemption from fixed-commission rate is made to the Exchange by the FCM; or (3) for customers who market, produce or process physical commodities (i.e. commercials). 3-3 Volume discount When the volume of customer’s executed contracts exceeds 1,000 contracts per trade or delivery, commission to Futures Clearing Merchants on the exceeded amount is discounted by 30%. Day trade, omnibus positions, fund positions and positions established by commercials are not applicable.

66

ENERGY PRICE RISK

TOCOM FUTURES CONTRACT SPECIFICATIONS – GASOLINE Date of listing: 5 July 1999 Standard Regular gasoline of JIS K2202 Grade 2 Contract unit 100 kl Delivery unit 100 kl Trading method Computerised continuous trading Price quotation Japanese yen per kiloliter Minimum price fluctuation ¥10 per 1 kiloliter Daily price fluctuation limit Standard price (*Note 1) Less than ¥17,000 ¥17,000 to less than ¥22,000 ¥22,000 to less than ¥27,000 ¥27,000 and over

Price limit ¥400 per kl ¥500 per kl ¥600 per kl ¥700 per kl

The Exchange may change the amount of the price limit at its discretion, according to the market situation. Customer position limit (long position and short position each) Current contract month: 100 contracts 2nd contract month: 200 contracts 3rd contract month: 600 contracts Other contract months: 1,200 contracts each month Total: 4,000 contracts Initial customer margin Standard price (*Note 2) Less than ¥17,000 ¥17,000 to less than ¥22,000 ¥22,000 to less than ¥27,000 ¥27,000 and over

Margin ¥60,000 per contract ¥75,000 per contract ¥90,000 per contract ¥105,000 per contract

TOCOM FUTURES CONTRACT SPECIFICATIONS – GASOLINE

67

The above margins are minimum amounts determined by the Minister of Economy, Trade and Industry. The Exchange is entitled to set greater amounts. Customer trading commission to FCMs (*Note 3) (per contract) ¥3,800. Customer delivery commission to FCMs (*Note 3) The same as above. Trading hours 9:00 a.m. to 11:00 a.m., 12:30 p.m. to 3:30 p.m. Contract months Six consecutive months from the current contract month. Last trading day The 20th of the month preceding the delivery month (if the day is a holiday, last trading day is advanced). Delivery period Throughout the delivery month. Delivery points. Refineries and oil tanks located in Tokyo, Kanagawa and Chiba, provided with both barge and lorry delivery facilities, and appointed by the Board. (In case of delivery into lorry, buyers are obliged to pay the surcharge decided by the Board.) Delivery Physical delivery (not cash settlement). Deliverable commodities 1. Deliverable commodities: Regular gasoline of JIS K2202 Grade 2, which is refined within Japan or cleared through the customs. 2. Gasoline tax: Contract price does not include gasoline tax; buyers must pay the sellers the amount equivalent to the gasoline tax when taking delivery. Contract price and tax The contract price shall be inclusive of the cost of delivery into barge in refineries or oil tanks located in Tokyo Bay area but exclusive of gasoline tax and consumption tax. Delivery method 1. Option of delivery points: Seller 2. Delivery method: Delivery into barge or lorry 3. Option of delivery method: Buyer 4. Option of delivery day: Buyer in principle

68

ENERGY PRICE RISK

5. Matching of Buyer and Seller: Determined by drawing lots, except when parties to deliver find their counterparts by themselves during the period from Last Trading Day to Lottery Day. 6. Divided delivery: Delivery can be divided Quantity tolerance on delivery ±2% of the volume per delivery. Notes 1. An average of the closing prices on the preceding business day for all contract months except the nearest contract month. 2. A monthly average of closing prices for all contract months except the last three business days in the previous month. 3-1 The above commission rate is charged per side per contract, except in the case of a day trade, where the above rate is charged as roundturn fee. 3-2 Commissions are negotiable (1) between originating and clearing FCMs of an omnibus account; (2) between an FCM and a customer where orders are transmitted electronically and the registration for the exemption from fixed-commission rate is made to the Exchange by the FCM; or (3) for customers who market, produce or process physical commodities (i.e. commercials). 3-3 Volume discount When the volume of customer’s executed contracts exceeds 1,000 contracts per trade or delivery, commission to FCMs on the exceeded amount is discounted by 30%. Day trade, omnibus positions, fund positions and positions established by commercials are not applicable.

COAL FUTURES The USA has more high-quality coal than any other country, with nearly 30% of the world’s bituminous and anthracite coal reserves. Only China produces more bituminous coal than the USA, but almost all of its production is consumed domestically. US coal exports, chiefly central Appalachian bituminous, make up 16% of the world export market and are an important factor in world coal prices. At current rates of recovery and use, it is estimated that US coal reserves will last more than 250 years. The importance of coal can be seen from the fact that coal-fired power stations still account for approximately 55% of total electricity output in the USA. Because coal is a bulk commodity, transportation is an important aspect of its price and availability. Railroads carry more than half of the coal mined in the USA, often hauling the coal in unit trains. Unit trains with several locomotives pulling anywhere from 60 to 120 cars loaded solely with coal are a common sight in both Appalachia and the western USA.

CENTRAL APPALACHIAN COAL FUTURES

69

The inland waterway system is the other major mode for coal transportation, especially along the Ohio and Mississippi Rivers. The impact on the environment of coal use is a serious issue. Any effort to curtail atmospheric emissions can be expected to involve reduced coal use, even though the amount of air pollution produced by coal burning has been greatly diminished during he past 30 years. For example, the volume of coal used by electric utilities leapt from 320 million tons in 1970 to nearly a billion tons in the late 1990s, an increase of more than 200%, yet sulphur dioxide emissions from coal-fired plants declined 27%. Coal prices are still mainly traded in the OTC market. However, for both the US coal mining and electric power industries, NYMEX Coal Futures provide a range of ways to mitigate risk. For the international coal trading or consuming market, it can also offer another tool for price monitoring and price risk mitigation perhaps on an arbitrage basis with European or other regional OTC hedging markets. (e.g. United Kingdom-based OTC swaps on coal grade API2). Coal producers can sell futures contracts to lock in a specific sales price for a specific volume of the coal they intend to produce in coming months. Electric utilities can buy coal futures to hedge against rising prices for their baseload fuel. Power marketers, who have exposure on both the generating and delivery sides of the electricity market, can hedge with coal futures to mitigate their generation price risk, and hedge with electricity futures to control their delivery price risk. Non-utility industrial coal users, such as steel mills, can use futures to lock in their own coal supply costs. International coal trading companies can use futures to hedge their export or import prices. Power generating companies that use both coal and natural gas to produce electricity can use coal futures in conjunction with the NYMEX Henry Hub natural gas futures to offset seasonal cost variations and to take advantage of the ‘spark spread’ – the differential between the cost of the two fuels and the relative value of the electricity generated by each of the two fuels. Useful physical coal market price information and analysis can be obtained from Argus (http://www.argusonline.com/).

CENTRAL APPALACHIAN COAL FUTURES Trading unit 1,550 tons of coal. Trading hours Open outcry trading is conducted from 10:30 a.m. until 2:00 p.m. All times are New York time.

70

ENERGY PRICE RISK

Trading months 24 to 26 consecutive months based on a quarterly schedule. As contracts expire, the 26th month will roll forward until it becomes the 23rd month. At that point, new 24th, 25th, and 26th month contracts will be added. Price quotations US dollars and cents per ton. Minimum price fluctuation $0.01 per ton ($15.50 per contract). Maximum price fluctuation $12.00 per ton ($18,600 per contract) for all months. If any contract is traded, bid, or offered at the limit for five minutes, trading is halted for 10 minutes. When trading resumes, expanded limits are in place that allow the price to fluctuate by $24.00 in either direction of the previous day’s settlement price. There are no price limits on any month during the last three days of trading in the spot month. Last trading day Trading terminates on the fourth to last business day of the month prior to the delivery month. Contract delivery unit The seller shall deliver 1,550 tons of coal per contract. A loading tolerance of 60 tons or 2%, whichever is greater, over the total number of contracts delivered is permitted. Delivery location Delivery shall be made F.O.B. buyer’s barge at seller’s delivery facility on the Ohio River between Mileposts 306 and 317, or on the Big Sandy River, with all duties, entitlements, taxes, fees and other charges imposed prior to delivery paid by the seller. There will be a discount of $0.10 per ton below the final settlement price for any delivery to a terminal on the Big Sandy River. Heat content Minimum of 12,000 Btus per pound, gross calorific value, with an analysis tolerance of 250 Btus per pound below. Ash content Maximum of 13.50% by weight with no analysis tolerance. Sulfur content Maximum of 1.00%, with analysis tolerance of 0.050% above. Moisture content Maximum of 10.00%, with no analysis tolerance.

CENTRAL APPALACHIAN COAL FUTURES

71

Volatile matter Minimum of 30.00%, with no analysis tolerance. Hardness/grindability Minimum 41 Hardgrove Index with three point analysis tolerance below. Hardness measures how difficult it is to pulverize coal for injection into the boiler flame. Size Three inches topsize, nominal, with a maximum of 55% passing onequarter-inch-square wire cloth sieve or smaller, to be determined on the basis of the primary cutter of the mechanical sampling system. Exchange of Futures for, or in connection with, Physicals (EFP) The buyer or seller may exchange a futures position for a physical position of equal quantity/quality by submitting a notice to the Exchange. EFPs may be used either to initiate or liquidate a futures position. The EFP deadline is 10:00 a.m. (New York time) on the first business day following termination of trading. Position accountability level Any one month/all months: 5,000 net futures, but not to exceed 200 in the last three days of trading in the spot month. Trading symbol QL

CHAPTER 4

OTC Energy and Related Derivative Markets

OTC ENERGY DERIVATIVE MARKETS Nearly all the key terms of an OTC derivatives deal are negotiable, which means that the pricing reference, the payment terms and the volume can all be adjusted to suit the counterparts to the deal. This is a benefit if an organisation has a very specialised or unique price risk which requires a one-off hedging tool. Basically, anything is possible in the OTC energy markets, although, of course, the price of the derivative instrument quoted to suit a customer’s precise and perhaps esoteric needs, may not always be attractive. Fortunately, for risk management purposes, the core energy markets, like the larger oil, gas and electricity (power) markets have some active and fairly standardised OTC contracts. They are standard both in their floating price reference, and in the sort of minimum contract volume that would normally be traded. Indeed, the increasing standardisation in the plain vanilla OTC markets has led to the development of a number of electronic trading platforms. People often ask why regulated futures exchanges seem to be unable to launch new petroleum futures contracts. The answer is that the needs of the market are already being met by the now well-established and liquid OTC derivatives market. Another supporting factor of this observation is that futures exchanges have been successful in launching futures contracts in both the natural gas and power markets. The reason for this is that the regulated futures markets were launched soon after deregulation prior to or at the same time as an OTC market was establishing itself. The effectiveness of the OTC market can also be seen in Asia, which overtook Europe as the second largest oil consuming region in the world several years ago. Today, Asia includes the world’s second, third, seventh, eighth and ninth largest importers of oil: Japan, Korea, India, China and Taiwan. However, Asia still does not have a liquid and internationally 72

THE OTC OIL DERIVATIVES MARKET

73

recognised futures exchange for energy market. This is because its needs for energy-related derivatives contracts seem to be well served by the established OTC market, for which Singapore is the key trading hub. There is only one bastion of support for the energy futures industry in Asia, which is the Tokyo Commodity Exchange or TOCOM. It is making great progress with its Middle East crude futures contract and product futures, but the range of market participants and liquidity is still a long way away from that seen on the IPE and the NYMEX. Singapore Exchange launched the TOCOM Middle East crude contract in Singapore but in US dollars and barrels instead of yen and kilolitres in Q4 2002, and it is still not clear whether this will be successful. Rather than trying to create a brand new contract, an interesting approach by SGX has been to create a forex hybrid of the TOCOM Middle East crude contract. Since traders should be able to offset margin calls between the SGX contract (in US$ per barrel) and the TOCOM contract (yen/kilolitres) either at the exchange/clearing house level or at their clearing broker level, there are interesting opportunities to trade the forex arbitrage between the two contracts, and also to trade the arbitrage between TOCOM and SGX contract with the OTC Dubai/Oman, WTI Crude Futures on NYMEX and/or Brent Futures on the IPE. Apparently, there is already some speculative trading between the TOCOM Middle East crude contract and the Dubai/Oman OTC swaps arbitrage and also against the WTI NYMEX Futures.

THE OTC OIL DERIVATIVES MARKET The vast majority of physical transactions and OTC swaps are priced using an industry-recognised publication – Platts, which is a division of McGraw-Hill. Platts publishes a daily assessment of the price of any given crude oil or oil product in any given location, according to Platts’ own specifications, and also publishes an assessment of the forward curve. These daily value assessments are based on the aggregated bids and offers from many brokers and dealers around the world during a specified time window for each geographic region (usually towards the end of each business day in each major time zone: Asia (Singapore), Europe (London), USA (New York, and then the West Coast). Swaps are usually priced off the monthly average of these Platts assessments and lead to a monthly financial payment equivalent to the difference between the traded fixed price and the calculated average floating price multiplied by the contractual monthly quantity. Only the difference is paid and there is no exchange of physical energy, hence no delivery risk. The main oil OTC trading/pricing hubs Figure 4.1 shows the main oil OTC trading/pricing hubs:

74

ENERGY PRICE RISK

S UK Russia East coast NOR J EEC MED

U S A

U S A

AG

AFR

West coast SGP

A AFR AG EEC J MED SGP

Australia Africa Arab Gulf Europe Japan Mediterranean Singapore

UK S USA NOR

United Kingdom Scandinavia/Nordic markets United States of America North Asia (inc. China, Korea)

A

Key OTC oil pricing hubs

FIGURE 4.1 The main oil OTC trading/pricing hubs

■ ■

■

ASIA: Singapore is the main pricing hub EUROPE: Mediterranean prices, Arab Gulf Prices, North West Europe (N.W.E.) and Amsterdam–Rotterdam–Antwerp (A.R.A.) as the main pricing hubs. USA: New York Harbor, US Gulf Coast, US West Coast (L.A. Pipeline) are some international reference points for oil markets.

The one world energy derivatives market At the time of writing (September 2002), oil-related OTC derivatives (sometimes referred to as paper trading) were in a bull trend in terms of volume, number of participants and types of contracts traded. Many new entrants came into the market after the collapse of Enron, and producers and consumers have continued to feel the financial impact and advantages of greater price oil volatility since late 1998. With the daily physical consumption of crude oil already over 80 million barrels and annual trade valued at almost $1 trillion, the growth in paper energy trading seems assured, with new financial products evolving to meet the needs of producers, refiners, marketers and consumers. Such a large number of participants, spread so widely around the world has created a close to real-time ‘One world energy derivatives market’. Because of the close to real-time impact on the physical energy markets

THE OTC OIL DERIVATIVES MARKET

75

around the world, all energy companies now have to monitor the derivatives market prices, even if they are not using derivatives themselves. If they do not, they may well face situations where they will not have an explanation for their management or shareholders when big unexpected adverse price movements affect their organisation. OTC oil trading is not conducted on regulated, established financial exchanges such as NYMEX, IPE, TOCOM or SGX, and it is a market that is monitored but not regulated by government agencies. However, with the increasing level of convergence between OTC and futures, as seen in the clearing house initiatives to permit OTC derivatives to be cleared via existing futures clearing houses such as NYMEX (http://www.nymex.com/) or the London Clearing House (http://www.lch.com/), the core OTC energy derivatives are becoming more and more indistinguishable from futures trades. Monthly trading volume data for the OTC oil markets (2002) Singapore (Asia Oil Pricing Hub) The Singapore market is oriented to cargo size shipments, so individual transactions, sometimes referred to as ‘clips’, are quite large compared to an IPE Brent Futures contract which is a minimum trade of 1,000 barrels. Almost everything in the Singapore market is sold in 50,000 barrel clips and the typical cargo size is 150,000 barrels; High Sulfur Fuel Oil used for ships bunkering is the only exception. Both 180 CST (the main OTC Fuel Oil swap market) and 380 CST fuel oil is traded in 5,000 MT but it can also be traded in clips as small as 1,000 MT units. Although a user should expect to see a difference in price between the same fuel oil swap, the same tenure is quoted for 5,000 MT Clip volume and 1,000 MT Clip volume. This is because the market maker and the traders take a liquidity risk by quoting a swap for 1,000 MT because most people only trade in 5,000 MT. Traders may not be able to trade out of that risk or hedge that risk easily with other OTC market participants (unless they are able to build up 5,000 MT in his portfolio and then trade a 5,000 MT clip out in to the market). Singapore OTC swaps volumes (excluding options volumes) In Singapore, OTC swaps transactions were approximately 300,000,000 barrels per month on average for the months up to October 2002 according to a survey conducted by the Energy College, London (http://www. energycollege.org/). To put this into perspective in terms of growth, in 1998, the Singapore swaps market was estimated to be around 150,000,000 barrels per month. Key OTC swaps Singapore Figure 4.2 is an example of a typical quote sheet from an OTC broker in Singapore illustrating the key markets being traded in OTC oil derivatives. Figure 4.3 shows the breakdown of the markets.

1.71

Dubai Swap

29.75 0.85

Kerosene

Regrade

4.37

Kerosene –1.34

5.07

3.70

0.40

Oct

–1.50

5.60

3.90

0.53

Nov

######

1.37

30.22

28.85

25.55

Oct

1.31

Nov

1.60

0.42

0.04

Nov

1.18

1.56

Nov

26.66

25.15

26.35

26.73

Oct

–1.54

6.21

4.11

0.66

Dec

2.50

–0.33

–0.30

0.03

0.10

Oct/Nov

1.28

Dec

1.65

0.50

0.11

Dec

1.15

1.54

Dec

0.14

0.23

0.26

0.25

Oct/Nov

–1.46

5.63

3.90

0.53

Q4, 02

######

1.70

30.52

28.82

25.45

Nov

1.30

Q4, 02

1.58

0.41

Q4, 02

1.17

Q4, 02

26.52

24.92

26.10

26.48

Nov

–1.94

6.13

4.01

0.94

Q1, 03

1.75

-0.40

-0.38

0.02

0.10

Nov/Dec

1.24

Q1, 03

1.78

0.67

Q1, 03

1.11

Q1, 03

0.18

0.23

0.26

0.25

Nov/Dec

#####

1.72

30.55

28.82

25.45

Q4, 02

–2.85

2.67

1.82

–1.39

Sep

–2.85

3.57

2.20

–1.11

Oct

–3.09

4.01

2.31

–1.07

Nov

-0.40

0.21

0.60

0.30

Q4/Q1

0.51

0.71

0.77

Q4/Q1

WTI/Brent

26.50

24.92

26.09

Q4, 02

vs Tapis Swap

#####

2.10

30.90

28.80

25.35

Dec

1.12

Q2, 03

1.96

0.88

Q2, 03

1.08

Q2, 03

26.34

24.69

25.84

26.23

Dec

–3.18

4.57

2.47

–0.98

Dec

2.12

30.34

28.22

25.15

Q1, 03

Nov

Oct

25.99

24.21

25.32

Q1, 03

–3.04

4.05

2.32

–1.05

Q4, 02

1.07

1.52

0.45

0.25

Q1/Q2

1.28

1.55

0.46

0.64

0.67

Q1/Q2

–3.72

4.35

2.23

-0.84

Q1, 03

1.05

28.82

27.77

24.90

Q2, 03

25.53

23.57

24.65

Q2, 03

FIGURE 4.2 Typical quote sheet from an OTC broker in Singapore. Source: Ginga Petroleum (OTC Brokers) Singapore (http://www.ginga.com.sg/; Tel: +65 6292 8484)

–1.15

3.52

Gas Oil

Fuel

0.32

Sep

Naphtha

/Bbl

2.75

–0.52

–0.47

0.05

0.15

Sep/Oct

1.33

Oct

1.51

0.30

–0.07

Oct

1.20

1.58

Oct

0.43

0.23

0.14

0.00

Sep/Oct

Crack Spreads vs Dubai Swap

######

28.90

Gas Oil

Fuel(ton)

25.70

Naphtha

1.36 Sep

Products

vs Dub swap

Sep

0.60

Brent Swap

Dated Brt

0.36

Sep

EFS Brent

Appi Tapis vs

1.35 1.11

Brent/Dub

IPE Swap/Swap

27.09 Sep

Tapis Swap

EFS/Swap

26.49 25.38

Dubai Swap

26.73

EFP Brent

IPE Brt Swap

Sep

Crude

Market Report(Crude, Products, Crack) Access Oct 28.28-0.11 16/08/2002 12:10 Singapore time

76 ENERGY PRICE RISK

THE OTC OIL DERIVATIVES MARKET 6%

2% 30%

23%

F

E

77

A

D B C 16% 23%

A: Gasoil

B: Kero Diff C: Fuel oil D: Dubai/Tapis E: Naphtha F: Open-Spec

FIGURE 4.3 Estimated percentage breakdown for Singapore OTC swaps volume. Source: Energy College Ltd – London (http://www.energycollege.org/)

The pro-active OTC swaps broking community in Singapore (there are around 10 active OTC broking companies in Singapore) adds market liquidity by assisting price discovery in the market and by developing two-way markets for buyers and sellers of oil. Typically most Asian oil products and related crude oils can be traded up to 18 months forward, with most of the liquidity in 1 to 12 months forward markets. Beyond two years forward, the number of participants quoting prices become more limited (mainly to large bank traders and major international oil companies). European Oil OTC Market Volumes Figure 4.4 shows the volume of monthly swaps in metric tonnes estimated for the European market. The barrel equivalent is 600,000,000 (approx.) barrels of oil swaps traded per month in 2002 up to October 2002. A: IPE Brent Swaps B: Brent Diff Swaps C: 3.5% Barge Rotterdam J 23%

2% 3% K

4% A

5% B

C

I

D: N.W.E. Fob Cargoes 5% D 4% E

H

G

18% 3%

E: Gasoil Arb SGP/IPE 8% F: Gasoil V Brent G: Gasoline V Brent

F

25%

H: Med/N.W.E. Gasoil Cargoes V IPE Gso I: Jet Diffs J: Naphtha K: Naphtha Crack

FIGURE 4.4 Percentage breakdown of European swaps. Source: Energy College Ltd – London (http://www.energycollege.org/)

78

ENERGY PRICE RISK

THE KEY OIL AND GAS RELATED OTC SWAPS Asia Unless otherwise specified by traders or brokers, a quote on a Singaporebased swap will price against the mean average of Platts’ high/low assessment of the relevant Singapore physical market. Fixed for floating swaps, caps and collar options will normally be available certain markets. Generally speaking, the tenures versus liquidity available in these derivatives is something like: ■ ■ ■

Strong liquidity in 1 to 6 months forward Good liquidity from 6 month to 12 month Fair liquidity thereafter up to 24 months forward.

Key products ■ Singapore Gasoil 0.5% ■ Singapore Jet Fuel-Kero ■ Regrade – the spread between Singapore Gasoil and Singapore Jet Fuel ■ 180 CST Fuel Oil ■ 380 CST Fuel Oil ■ Naphtha ■ Tapis Crude Oil – Malaysian exported crude oil ■ Dubai/Oman Crude Oil – Middle east marker crude, meaning many Asian refiners are buying crude oil as feedstocks for their refineries on a Dubai/Oman pricing basis Europe Unless otherwise specified by traders or brokers, a quote on a Europeanbased swap will normally price against the mean average of Platts’ high/ low assessment of the relevant European physical market. Fixed for floating swaps and caps and collar options will normally be available in the following markets: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

Premium Unleaded Barge FOB ARA Premium Unleaded Crack Swap N.W.E. Naphtha Crack N.W.E. Gasoil Crack Swap N.W.E. Gasoil 0.2% cargo CIF N.W.E. Gasoil 0.2% Cargo FOB MED LPG Propane CIF ARA Large Brent/Dubai Swaps WTI Crude Oil versus Brent Crude Swaps Rotterdam Gasoil 0.2% sulphur barges Jet Fuel, North West Europe (N.W.E.) Cargoes CIF basis Jet Fuel, Rotterdam Barges FOB

THE KEY OIL AND GAS RELATED OTC SWAPS

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Gasoil IPE futures look-alike swap ● Prices against the 1st line IPE Gasoil futures contract (except the last trading day when it rolls over to the next futures contract) Fuel Oil 1% North West Europe (N.W.E.) Cargoes CIF basis Fuel Oil 1% North West Europe (N.W.E.) Cargoes FOB basis Fuel Oil 3.5% Rotterdam Barges FOB Basis Fuel Oil Mediterranean 3.5% Cargoes FOB basis Dated Brent related Swap (Dated Brent is spot North Sea Oil) ● Platts’ dated Brent spot market assessment now takes in to account Brent, Osenberg, and Forties crude oil trades, mainly due to industry concerns about the diminishing Brent crude oil production traded in the North Sea Physical oil market. Brent IPE futures look-alike swap ● Prices against the 1st line IPE Gasoil futures contract (except the last trading day when it rolls over to the next futures contract) Brent Bullet Swap ● Prices against the 1st line IPE Brent futures contract Dubai Crude Oil Swap trade out of London (as well as Singapore) EN590 grade Gasoil North West Europe (N.W.E.) Cargoes CIF basis EN590 grade Gasoil Mediterranean (M.E.D.) Cargoes Gasoline – Rotterdam Eurograde barges Naphtha North West Europe (N.W.E.) CIF Cargo swap European Natural Gas Firm Physical, Fixed Price European Natural Gas Firm Physical, Fixed Price, Spread Zeebrugge versus NBP UK National Balancing Point indexed OTC Swaps basis NBP97 contract LPG Mid East/North Africa/Asia – Saudi CP Pricing used as Index for OTC Swaps LPG other, which have a crude related pricing formula can be proxy hedged using crude oil swaps related to the LPG pricing. LNG with Crude related pricing formula – proxy hedging in Crude futures/related OTC derivatives markets

More exotic one-off derivative structures are normally available, given the higher number of participants in the European oil swaps market and the higher liquidity in the plain vanilla market. Generally speaking the tenures versus liquidity available in these derivatives is something like: ■ ■ ■ ■ ■

Strong liquidity in 1 to 6 months forward Strong liquidity from 6 month to 12 month Good liquidity thereafter up to 24 months forward Fair liquidity thereafter up to 36 months forward Quotes available up to 5 years forward

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Quotes available from a limited number of financial institutions/oil majors for tenures up to 10 years (Longer for Crude Oil)

For up to date volume data and contract information consult: http://www.platts.com/ http://www.carrfutures.com/ http://www.prebon.com/ http://www.theice.com/ http://www.tfsenergy.com/ http://www.tullett.com/ USA Unless otherwise specified by traders or brokers, a quote on a USA-based swap will normally price against the mean average of Platts’ high/low assessment of the relevant American physical market. Fixed for floating swaps and caps and collar options will normally be available in the following markets: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

Nymex WTI related 1st line futures look-a-like swap Nymex WTI related Bullet Swap Nymex Heating Oil futures related Bullet Swap Nymex Heating Oil futures related 1st line futures look-a-like swap Nymex Gasoline futures related 1st line futures look-a-like swap Nymex Gasoline related Bullet Swap New York Harbor #2 Heating Oil Barges 1% Fuel Oil New York Harbor C.I.F. Cargo basis 3% US Gulf Coast Cargo US Gulf Coast Gasoline 87 New York Harbor Reformulated RFG Gasoline 87 Barges New York Harbor Gasoline 87 Barges Canadian Natural Gas Firm Physical, Fixed Price Canadian Natural Gas Firm Physical, Canadian Gas Price Reporter Natural Gas, Fixed for Float (Inside FERC) Natural Gas, Fixed for Float (NGI)

As in Europe, more exotic one-off derivative structures are normally available, given the higher number of participants in this oil swaps market and the high liquidity in the market. In the USA, the tenures versus liquidity available in these derivatives is something like: ■ ■ ■ ■ ■

Strong liquidity in 1 to 6 months forward Strong liquidity from 6 month to 12 month Very Good liquidity thereafter up to 24 months forward Fair liquidity thereafter up to 36 months forward Quotes available up to 5 years forward

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Quotes available from a limited number of financial institutions/oil majors for tenures up to 10 years (Longer for Crude Oil like WTI crude)

For up to date volume data and contract information, consult: http://www.platts.com/ http://www.carrfutures.com/ http://www.prebon.com/ http://www.theice.com/ http://www.natsource.com/ http://www.tullett.com/ http://www.nymex.com/

EUROPEAN POWER AND GAS MARKETS Figure 4.5 shows the five European energy hubs.

S UK

EEC

U S A

NOR

J

U S A

MED AG

AFR

SGP

A

England and Wales Scotland, Ireland

A

Northern Germany, Poland, ScandinaviaNordpool

B

France, Germany, Benelux, Switzerland Northern Italy, Austria

D

C

Spain & Portugal

Southern Italy and Greece

A: B: C: D:

Zeebruge Bacton Emden Milan Baumgarten

Power markets Gas trading hubs

FIGURE 4.5 The European energy hubs

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GLOBAL POWER MARKETS – WITH DEVELOPED OR DEVELOPING DERIVATIVES MARKETS Amsterdam (http://www.apx.nl/) ■ Day ahead power trading. ■ German power market ideas have failed.

Leipzig/EEX (http://www.eex.de/) ■ Mixture of spot physical market and power futures contracts. ■ Deregulation began early compared to other European countries (in 1998). ■ Power trading in Germany is around six times actual German consumption. (A general rule is that a derivatives market needs to gain a critical mass of around six times underlying physical trading to be stable, so it looks like German OTC power trading is here to stay!) ■ Liquidity for the OTC market generally up to one year forward.

Hanover Bank Clearing (http://www.clearing-bank.de/) ■ Physical and OTC clearing facility for German power.

Powernext Paris (http://www.powernext.fr/) ■ Day ahead power trading. ■ French power supply market was opened to partial competition in February 2000. So far about 30% of the supply market is open to competition. ■ In February 2003 the threshold for consumers opened for competition will become 9 GWh, opening up a total of 34% of the market. ■ Powernext to launch on-exchange trading on 26 November 2002. ■ Plans to develop OTC derivatives in 2003. ■ French power trading is a growing business.

Austrian Power Exchange (http://www.exaa.at/) ■ A new exchange, so not much activity yet. ■ Just spot market for power at the moment.

Warsaw Power Exchange (http://www.polpx.pl/) ■ Not much activity in 2002. ■ Day ahead physical power trading.

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Limited futures market under development.

Madrid – Spanish Power Market (http://www.spectrongroup.com/) ■ Physical system in Spain deregulated. ■ Spanish OTC power trading appears to have taken off from the first quarter of 2001. Industry estimates total volumes hit 7.9 TWh, compared with 4.3 TWh over the full year of 2000. Switzerland Power (http://www.spectrongroup.com/) ■ Swiss parliament approved the Swiss Electricity Market Law, the key to deregulation in December 2000. ■ Opening up of the market is expected to happen in 2003. ■ No power exchange in Switzerland yet. ■ OTC trading of power was estimated by industry sources at around 35 TWh in 2001. This works out at around 0.5 times total Swiss power consumption. Italy Power ■ The Italian power market was partially opened to competition in March 1999 by Decree 79/99, better known as the Bersani decree. ■ Around 2,000 large customers, accounting for 30% of Italian consumption, were freed to choose their suppliers from April 1999. On 1 January 2000, opening was extended to 35%. ■ A further opening on 1 January 2002 exposed 40% of the market to competition. A new law passed in March 2001 will open around 60% of the market 90 days after Enel has divested generation capacity totalling 15,000 MW. These divestments are required by the Bersani decree and must be completed by 1 January 2003. ■ In 2000 own use in the open market was 25.8 TWh, or 36% of the total open market. In fact, Enel has reported that its sales to eligible customers account for only 19% of its sales volumes at the current opening level. This exposure will rise to a still modest 25% in 2002. ■ There is no liquid forward OTC market yet. Nord Pool (http://www.nordpool.com/) ■ The most liquid trading market. ■ Covering Scandinavia. ■ OTC, Bi-Lateral, Cleared OTC, Physical forward UKPX (http://www.ukpx.com/) ■ The UK Power Exchange provides a market for trading in both spot and futures contracts in electricity. It also acts as a clearing house for OTC transactions.

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The England and Wales electricity market was a pioneer of power deregulation in 1990. In June 1999 OM announced its intention to create Britain’s first independent power exchange. The UK Power Exchange (UKPX) utilises OM’s power market systems within its existing UK-based Recognised Investment Exchange, the OM London Exchange Ltd. The UK Power Exchange opened on 26 May 2000. Liquid market. The OTC and Exchange traded power volumes for 2001 were reported to be around three times greater than UK national consumption, with 2002 volumes growing at a high rate.

US power markets (http://www.theice.com/) ■ USA market is very deregulated. ■ Power trading really took off with the advent of the Enron online system, now superseded by The Intercontinental Exchange (http:// www.theice.com/) ■ If you wish to trade OTC derivatives for trading or hedging purposes there is a vast and ever-changing array of products available. ■ The biggest issue in America has been problems surrounding the effective physical distribution of power, with not enough power where it is most needed. On several occasions over the past five years or so this has created big price spikes which have damaged the energy trading community. ■ Liquidity in power trading is good. Singapore power market ■ Still early days in the development of the Singapore power market. ■ No derivatives market yet, but there is the prospect of a Pan-Asean derivatives market over the next eight years. ■ Most interesting prospect is for development of Asean interconnectors which might spur on the eventual development of a power trading grid from Thailand down through Malaysia, Singapore and Indonesia. ■ The Public Utilities Board (PUB) was formed in 1963, and is responsible for the supply of electricity, piped gas and water to the entire population of Singapore. The PUB was reorganised in October 1995 to continue supplying water, and to take on the new role of regulating the electricity and piped gas industries. ■ The vertically integrated electricity industry was restructured in 1995 to introduce competition in electricity generation and supply. Two generation companies (PowerSenoko Ltd and PowerSeraya Ltd), a transmission and distribution company (PowerGrid Ltd) and a supply company (Power Supply Ltd) were formed under Singapore Power Ltd.

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The third generation company, Tuas Power, took over the development and operation of the Tuas Power Station. On 1 April 1998, the Singapore Electricity Pool (SEP), a wholesale electricity market, commenced operation to facilitate trading of wholesale electricity in a competitive environment. Generation companies will have to compete to sell electricity through the Pool. Electricity suppliers will purchase electricity at competitive prices from the Pool for resale at the retail level. As competition in electricity generation and supply develops, there will be less reliance on regulation. In 1999, the Singapore government reviewed the electricity industry structure with a view to further enhance efficiency through competition in electricity generation and retail, while ensuring reliability and security of supply. Acting on the findings of the review, the government launched the following initiatives in March 2000 to deregulate further the electricity industry: ● Competition in generation. ● Generation companies will be kept separate from PowerGrid Ltd, the grid operator, to ensure a level playing field. ● Competition in retail. Full retail competition for large industrial and commercial consumers was introduced from 1 April 2001; retail competition for smaller consumers not yet introduced. ● Formation of an Independent System Operator – An independent market and system operator (ISO) will be established by separating the system and market operator functions currently within PowerGrid. This is to make system and market operations more transparent to industry players. The ISO will be formed as part of PUB. ● PowerGrid is the only grid owner. Goh Geok Ling, Chairman, Tuas Power Ltd, Singapore: ● ‘As the first independent electricity player in the wholesale electricity Pool, Tuas Power sees the ongoing restructuring of the electricity industry as a positive development for both industry players and consumers. The divestment of Power Senoko and Power Seraya out of Singapore Power in April 2001, redesign of the wholesale Pool rules and liberalisation of the retail market will bring about a more level playing field for industry participants.’

EUROPEAN GAS MARKETS Europe Biggest European markets ■ United Kingdom: NBP (National Balancing Point)

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http://www.heren.com/ http://www.ipe.uk.com/ http://www.theice.com/ http://www.spectrongroup.com/ Futures are available at the IPE futures market in London: http://www. ipe.uk.com/. OTC markets trade around six times the volume of the IPE futures markets and now OTC derivatives on UK Nat Gas executed on the Intercontinental Exchange (http://www.theice.com/) can be cleared via the London Clearing House. Although the OTC and futures contracts are not fungible and cannot be offset for settlement purposes, the London Clearing House does offer margin offsets, so a trader with an equal but opposite position in OTC versus the IPE Futures contract can obtain up to 75% margin offset, reducing the overall margin funding required for its open positions (launched September 2002). OTC markets trade futures prices as well as Heren report prices. More detail on the widely utilised Heren daily report can be found at http:// www.heren.com/. Figure 4.6 shows the level of activity in UK natural gas swaps. '000 Th 2121827 2138012 1999754 2008278 2070710 1942100 1369323 2521593 2252378 2636348

Series1

3000000 2500000

'000 Therms

Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02

2000000 1500000 1000000 500000 0 Jun- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar01 01 01 01 01 01 01 02 02 02 Month

FIGURE 4.6 UK natural gas swaps derivatives activity (note the drop in trading volume around the Enron collapse; Enron was a very large participant) ■

■

Belgium: Zeebrugge This market is also very active, with OTC deals traded on a daily basis against this price reference. Biggest issue surrounding this is the gas interconnector. During 2002 it continued to have problems, which created volatility in the market. Other hubs for gas trading in Europe: Holland: Bunde-Oude Germany: Aachen Austria: Baumgarten France: Blaregnies

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The following derivatives contracts are available to users in these gas markets: ■ ■ ■ ■

Index Financial swaps European, Asian, and Daily financial and physical options All physical forwards

The following are available at all UK and Continental European points: ■ ■ ■ ■ ■ ■

NBP Zeebrugge (Hub/Flange) Bunde Ouden Zelzate Eynatten St. Fergus Capacity

Spark spreads – power versus natural gas UK spark spread example – available on the UK OTC market A few years ago, a standard began to develop around 60 MW of power versus 100,000 therms of gas. The standard product defaulted to gas calendar days for power and gas. However, it is never a perfect match, as gas days remain at 06:00–6:00 hrs and power at 23:00–23:00 hrs. For example, a winter spark spread would run 23:00 30 September–23:00 31 March for power and 06:00 1 October–06:00 1 April for gas. When a spark spread order is traded in the market, it is normally quoted as a spread price in £/MWh (UK pounds per megawatt hour) and also a preferred fixed power price will be offered along with the differential spread, the required spark spread. When trading, having set the fixed power price leg of the deal using a conversion rate of 49.1349% (representing 100,000 therms/60 MW), the gas price is calculated as follows in pence/therm correct to three decimal places: Gas price in p/therm = =

(Power price - Spread) ´ 24 ´ 100 ´ Volume of power Volume of gas (Power price - Spread) ´ 24 ´ 100 ´ 60 100 , 000

Contracts are based on Standard GTMA (Grid Trading Master Agreement), produced by Allen & Overy lawyers in London (http://www. allenovery.com/) and NBP 1997. A recent update on this received from Spectron Brokers in London (http://www.spectrongroup.com/) a leading broker in the European Power OTC market, says that this approach still remains active, but the standard has changed a bit.

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These days companies prefer not to match gas and power dates but rather to keep them as their generic dates, so dates could mismatch by up to about 6 days. However, if traded, it obviously makes no difference as the dates are progressively unwound. Volumes no longer have to be 60 MW and 100,000 therms, although the same efficiency has been kept. Consequently 15 MW and 30 MW with respect to 25,000 therms and 50,000 therms are common. About six market makers regularly give support to this spark spread activity. Spectron has also noted that short-term trading is regularly legged off the spark spreads and may account for as much as 50% of the total volume transacted in power/gas markets.

EUROPEAN COAL SWAPS (CASH SETTLED NOT PHYSICAL SETTLEMENT) These are normally ISDA-based contracts. No coal futures have developed in Europe. The coal market The financial traded coal aims to represent the international sea-borne steam coal market, which is the kind used by power plants. The majority of coal is dug from dedicated mines and transported by rail no more than 50 miles to a power plant. In the last 20 years, there has been a 25-fold rise in traded international coal moved long distance by sea from the main exporting countries (South Africa, Australia, Columbia etc.) to the consuming countries (Europe, Japan etc.). This is partly as a result of the closure of the state-subsidised mines in the UK and uneconomic domestic producers in Japan. Size In the year 2000, sea-borne steam coal was an estimated 348 million MT – about 12% of world production. The financial swaps on coal price are mainly traded as a swap index against estimated coal prices. In terms of traded volume data is sketchy, but for the year 2000 brokers estimate it was around 85 million MT. The industry-wide view is that, following the trend of European deregulation, competitive pressure and increase in hedge activity and also the continued growth of the sea-borne markets, this OTC derivatives market will grow substantially. For Europe, generally accepted estimates are that trade is increasing at around 5% annually for the next decade. This is greater than the growth in demand for electricity.

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OTC coal swaps There are four large producers and many consumers in the OTC coal swaps market. The main producers are BHP Billiton, RTZ, Anglo American and Glencore, who dominate the sea-borne trade. Of lesser importance, but likely to increase, are Total Elf, the Americans (e.g. Consol), Russia, China and Poland. On the consuming side, all of the integrated power generators (e.g. TXU, RWE and AEP) are involved and there are some ‘pure’ traders (e.g. Cargill and Coeclerici). At present the trading banks are not generally involved. The exception is Morgan Stanley, which has a successful joint venture with the Spanish energy house Endessa, covering coal trading as well as power trading. The key to the producers is Billiton, as it is the largest producer by equity ownership, the most active in the swap market and also has a dominant position in South Africa in the main port, Richard’s Bay (RBCT). South African tonnage for the recent years has been the base tonnage in the demand/supply balance, as it can be shipped east or west, while the new producers and China have the ‘swing’ tonnage. China’s position and recent structural changes in their production profile (lots of small mine closures etc.) is the key to the global supply and demand. There are no dominant consumers/traders but in no particular order AEP, Duke, TXU, Nuon, Essent, Cargill, EdF, Morgan Stanley are among the most important in Europe. Key brokers in the OTC market include: ■ ■ ■ ■

TFS, whose price indices for coal are the basis for the majority of trade at presnt (http://www.tfsenergy.com/) GFI – (http://www.gfinet.com/) Spectron (http://www.spectrongroup.com/) Natsource Tulletts (http://www.natsource.com/)

For the coal derivatives market to develop, it is important that there is a solid critical base of consumers, producers and financial traders. The good news for the industry is that during 2002 some new large entrants, on the consumer/trade side, including Bewag, Aquilla and Nordic PowerHouse joined the market. Also, more financial traders like Goldman have been looking to join the market. The key trade pattern copied by the indices used for pricing the coal derivatives in Europe, is the traditional tonnage delivered into Antwerp–Rotterdam–Amsterdam, (the ARA region). Whilst the majority of the coal delivered into ARA is shipped ex-South Africa, it also includes tonnage (depending on market conditions) from the USA and Colombia. The pricing references for coal swaps There are a number of indices discussed in the market:

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Global Coal’s RB index (http://www.globalcoal.com). This is nascent but must be watched, as Global Coal is a hub owned by 26 major producers/consumers. It may become dominant, but it has a long way to go. Its success will depend on physical contracts being written against this index. The TFS indices (http://www.tfsenergy.com/), called the APis, are the main ones used at present for OTC trading. The key difference between Global Coal’s index and the APis is that Global’s is calculated from physical trade data based on concluded deals rather than collated from estimates as with the APis. Coal swaps related to APi grade 2 (APi2) are liquid and also some trade in APi grade 4. It is brokered not only by TFS but by Spectron, Natsource, GFI etc.

Internal estimates by leading coal brokers suggest that the OTC coal swaps market may have increased to as much as 120–150 million MT on an annualised basis by year end 2002, from a reputed figure of around 80 million MT in 2000. This figure takes into consideration the slight setback seen in this market due to the Enron collapse, so the market is doing pretty well, considering Enron was a very active participant and a major market shareholder in the coal derivatives market prior to its demise. The main pricing reference for coal swaps at present: APi indices There are four APi indices: ■ ■ ■ ■

APi1 – an American contract which is dormant as nothing is really trading against this index. APi2 – delivered cost, insurance freight Amsterdam–Rotterdam– Antwerp – CIF ARA. This is generally the most active contract. APi3 – free on board Port Waratah, Newcastle, Australia – FOB PWCS Australia Api4 – free on board South Africa – FOB RBCT SA, actively brokered by European swap brokers. It is utilised to hedge coal imports in to the ARA region from South Africa.

These are swaps so they only need an ISDA in place to trade and at present there are no cleared contracts via any European derivatives clearing house. Users have to accept counterparty credit risk. Market volume breakdown About two thirds of the coal swaps business is APi2. APi3 is rarely traded. The balance is APi4 grade which tends to be illiquid, with wide spreads, not least because of the control exercised by the producers at their equityowned RBCT terminal. The indices are announced weekly (Monday morning), and averaged for the month and year.

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Trading patterns spotted in the coal swaps markets The typical trade is quarters and calendars, although months do trade more on the APi2. The minimum size is 5,000 MT/month, while the normal size is 10,000 MT a month; more than 25,000 MT/month is considered large. There have been trades up to 3 years forward reported in 2002, and index-based physical contracts up to 4 years forward. The majority of participants actively trade up to 2 years forward in the cash settled coal swaps (based on ISDA agreements). Brokers report that on a busy day (as of 2002) typical daily tonnage is in the range 1–2 million MT, representing about 20–35 swaps trades. There are even reports of some cap and floor (call and put) option activity in the OTC financial coal markets. Other trading and hedging opportunities using these derivatives ■ ‘Soot’ spreads, sometimes referred to as the ‘dark spread’ (coal vs. power). ■ Relative values of gas/coal etc. ■ Arbitrage APi2/Api4 – use freight futures route equivalent to Baltic Exchange Route 4. Speculators can try to strip out the various components of freight and coal specification to lock in some margin. This is a bit like the development in Freight Rate Swaps in Singapore discussed later in this chapter. Freight Rate Swaps in Singapore are a function of the Opec-Spec Naptha exports of physical Naphtha from Singapore to Japan versus the Naphtha financial swaps in Singapore priced against Platts’ pricing. These are being brokered by Ginga Petroleum (http:// www.ginga.com.sg/).

WEATHER DERIVATIVES You can’t change the weather (although in the UK we live in hope!), but, thanks to a relatively new commodity product called a weather derivative, you can protect yourself from losing money when the weather turns bad for your business. Trends in growth of weather derivatives From just a few transactions in the mid-1990s, the formalised exchange of weather risk has evolved into a big business. Weather derivative trading jumped 72% in the year ended 31 March 2002 and is now a $4.3 billion industry, according to a recent survey conducted by PricewaterhouseCoopers for the Weather Risk Management Association. ‘Weather risk’ embraces a wide variety of natural phenomena, but if the focus is limited to temperature risk, the market place starts to look almost as standardised as any commodity futures market. In fact, the 2002 survey

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conducted for the Weather Risk Management Association (WRMA – http://www.wrma.org/) showed results that weather derivatives against temperature references accounted for over 80% of the total volume (e.g. heating degree/cooling degree days). Temperature-related weather derivatives help people hedge or trade the temperature at certain agreed geographic points around the world. It is reported in the markets that in Europe alone there over 300 regularly quoted geographic points you can trade temperature derivatives against! Demand for weather risk derivatives indexed against temperature references is most probably driven by energy producers/users given the link between energy demand and fluctuations in temperature. Weather risk management developed earlier and faster in North America than elsewhere. Japan and Europe’s markets have evolved to be more diversified in terms of sectors covered, but the standard products in over-the-counter (OTC) markets are still degree day swaps and options. Although Europe’s sectoral mix has always featured a greater proportion of non-energy end users than in the USA, 2002 has seen a strong pickup in energy-driven weather hedging. With the last few years’ merger and acquisition activity and the reorganisation of wholesale market practice now digested (for example, the UK’s New Electricity Trading Arrangements), energy firms are increasingly turning to address their weather exposure, and many new trading desks have been, or shortly will be, established. Nowhere has this growth been greater than in Germany, which has now eclipsed the Nord Pool region in terms of weather trading activity. Although London’s Heathrow Airport is still by far the most heavily traded reference station, the market is seeing a large increase in interest for prices on products referenced to previously obscure stations in locations such as Essen. Part of the recent development had been aided by the success of trades with non-energy sector end-users who have substantial risk in the opposite direction from the energy firms. This has expanded total capacity for risk. The entry of significant new desks at banks, reinsurers and energy firms over the last year has also had a dramatic effect. While summer 2001 in Europe featured only a handful of OTC trades, summer 2002 proceeded at a much faster pace, with 100–200 inter-dealer trades closing per month. Dealers are reporting customer requests running at rates exceeding 10 a day – and closing half of these deals. Interestingly, although dealers report increasing interest from a very wide variety of non-energy sectors, the impetus for weather element diversity (both in cross-commodity/dual-trigger products and in structures based on variables other than simply temperature) has also been driven by strong demand from the energy sector. As renewable sources of energy are increasingly promoted, the interest in wind speed and precipitation hedges is growing. Likewise, products that allow energy firms to

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tailor energy risk management solutions to their customers’ precise needs (for example, managing peaking risk by ensuring adequate supply of physical energy) can be more accurately priced, and better hedged, by using weather derivative technology. Another interesting development in the market is the growth of ‘shortend’ trading. The market for monthly temperature risk products has ballooned, and now ten of these trade for every seasonal deal (the more traditional product). Very short end products (essentially the forecast risk for the next few business days) are bringing an element of familiarity to the product; energy firms’ ‘prompt’ desks (those trading day-ahead and balance-of-week risk) are now able to trade the weather dimension of their risk, separate from any physical dimensions. As a body of experience in trading this risk builds up, we are seeing increased interest in trading weather as a forecast product, rather than the actuarially valued measure it started as. Examples of energy industry use of weather hedging The most prevalent use of weather derivatives has been to hedge uncertainty in volumetric demand for energy, due to temperature fluctuations. For this purpose, deals are often referenced to the number of heating (or cooling) degree days in a period. This measures the daily deviation from a reference temperature (e.g. 18 °C), and sums the negative (for HDDs) or positive (CDDs) deviations over the period. It thus gives a proxy for the amount of energy that homes will consume heating or cooling their property to bring it back to ‘room temperature’. However, it is not obligatory to use the degree day construct – deals can simply reference the average temperature over the period. For example, consider the summer exposure of a gas supplier and an electricity generator in a temperate country that exhibits strong ‘stickiness’ of temperature over a season – i.e. summers tend to be either ‘hot’ or ‘mild’, but rarely ‘average’. Unfortunately for both companies, households use gas but not electricity for heating, and the proportion of gas as a fuel in the power generation mix is very low. The gas company, therefore, will experience sharply stronger demand in a mild summer, and the power company will experience the opposite demand sensitivity: Figure 4.7. The companies can smooth their variability of income by exchanging payments under an average temperature swap. The actual average temperature for the summer is established at the end of the season, and for every 0.1 °C this exceeds 17.0 °C, the power company pays $20,000 to the gas company. If average temperature is below 17.0 °C, $20,000 per 0.1 °C is paid by the gas company to the power company. With a contractual maximum payment of $400,000, the deal allows both firms to smooth the variability of expected revenues within the high-probability range of possible temperature outcomes (from 15 to 19 °C): Figure 4.8.

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Demand (USD)

2,500,000 2,000,000 1,500,000 1,000,000 500,000 –

8

13 18 23 28 Average summer temperature (degrees C)

Power company summer demand sensitivity

Demand (USD)

2,500,000 2,000,000 1,500,000 1,000,000 500,000 –

12 14 16 18 20 22 24 26 Average summer temperature (degrees C)

FIGURE 4.7 Demand sensitivity for gas and power companies

Both companies have achieved a smoothing of their anticipated earnings for the upcoming summer, allowing greater certainty in budgetary planning. One company’s ‘bad’ year in effect offsets the other company’s ‘good’ year. Not all risks can be transferred quite as easily – often risk protection is best provided by a market-maker or risk-absorber, who effectively manages a diverse portfolio of weather risks. The portfolio effect means that the hedger can receive an attractive price, even though the counterparty does not have an exactly opposing risk. Often such products come as options rather than swaps; here, the hedger’s risk is covered, against an initial payment to the hedge provider. This is analogous to the purchase of an insurance product. For example, a hydropower generator will be concerned about low rainfall – but this risk might be described as only significant when reservoir capacity falls below a certain trigger level. The generator could purchase, for example, a precipitation put that is triggered only when annual rainfall is less than 30% of the average. Another product might pay out only if two successive years are below 50% of the average.

WEATHER DERIVATIVES

95

Demand (USD)

Gas company sensitivity: hedged and unhedged 2,500,000 2,000,000

Hedged with swap

1,500,000 1,000,000 500,000 –

8

13 18 23 28 Average summer temperature (degrees C)

Demand (USD)

Power company sensitivity: hedged and unhedged 2,500,000 2,000,000 1,500,000 1,000,000 500,000 –

Hedged with swap

12 14 16 18 20 22 24 26 Average summer temperature (degrees C)

FIGURE 4.8 Hedging demand sensitivity

An important point to note in valuing options is that the value to the hedger is not simply the probabilistic value of the outcome being hedged (i.e. protection against a one-in-five year event should be worth more than 20%.) The reason is that the hedger must also value the cost of doing nothing, i.e. self-hedging. The firm should include the internal cost of the capital that should be provisioned against the probability of this event happening. Additionally, other costs should be taken into consideration, such as the impact on a company’s reputation of unexpectedly depleted earnings (e.g. adverse equity analyst coverage), and impaired ability to carry out intended capital expenditure. A ‘bad weather hit’ could impair a firm’s ratings and worsen its cost of capital. Overall, weather derivatives provide a flexible and powerful risk management tool for energy firms. The products have largely evolved from the energy sector, and therefore address energy firms’ risks most directly. The use of financial weather risk management techniques has become so commonplace since 1997 that firms now have to justify why they are not using the products.

96

ENERGY PRICE RISK

Widening use The big increase in weather risk management came as more businesses became aware of weather derivatives, which were created only five years ago as a way to help utilities hedge their risk of losing money to a warmerthan-normal winter or a cooler-than-normal summer. There are also new derivative products being developed that are tailored to meet the needs of specific businesses. ‘It’s one of the ways that public utilities can smooth out the bumps in their earnings’, said Mark Palazzo, a spokesman for Entergy-Koch Trading, which last year was involved in 35% of all the weather transactions in the world markets. ‘You don’t have to look at rate increases to cover losses from weather conditions’.

DEVELOPMENTS – FREIGHT RATE SWAPS (CASH SETTLED) Freight is an integral part of the global energy business, directly or indirectly oil or gas shipped around the world affects power prices in some way. The biggest and in the past the least hedgeable risk in an international oil transaction, for example, has been the freight rate movements. In recent years, there have been some interesting developments in the freight swaps markets. In the past, the forward freight rate market was focused on dry freight which is helpful if you are trying to trade freight risk against coal, coffee or cocoa, but not much use to anyone trading a cargo of oil! In terms of liquidity and the number and type of participants from the energy industry, perhaps the most interesting development is the Freight Rate Swap out of Singapore. Ginga Petroleum (S) Pte Ltd (http://www. ginga.com.sg/) started developing ‘tanker freight swaps’ for clean petroleum product tankers in Asia in May 2000. The main routes are Singapore to Japan 30,000 MT shipments, and Arab Gulf to Japan 55,000 MT shipments and Arab Gulf to Japan 75,000 MT. These are swaps (cash settled) which settle against the mean average of daily prices published by McGraw-Hill Platts’ clean tanker rate assessment (http://www.platts.com/). Tanker freight swaps are a beneficial risk management tool for the energy industry because, in the past companies sometimes had un-hedgeable freight exposure on both physical and paper positions. The main participants in this market are petroleum products traders and shipping charterers, as well as tanker owners and banks. Trading volume can be tailor-made for needs of users and most commonly traded lot is 10,000 metric ton per contract month. Most frequently talked tenures for these swaps are 2 to 3 months in the future, while bid/offer quotation is usually available for up to 6 months in the future. Figure 4.9 shows an example of tanker freight swaps.

DERIVATIVES FORWARD CURVE ASSESSMENTS Tanker Freight Swaps

97

29-Jul-02

Platt’s Clean Tanker Rate Assessment (WS)

MR(SIN/JP)

LR1(AG/JP)

LR2(AG/JP)

MR/LR1 spread

MR/LR2 spread

LR1/LR2 spread

As of July 26 As of July 25 Average for July

188 188 190.95

160 155 153.4

135 135 133.3

Average for June Average for May

185.111 164.954

132.5 134.863

126.666 122.954

28 33 37.55 42.61 30.09

53 53 57.65 58.44 42

25 20 20.1 15.83

SWAPS Requirement 30KMT (SG/JP)

Period Aug Sep Oct Q4 Q1 Aug Sep Oct Q4 Aug Sep Oct Q4

Buy WS190(I) WS190(I)

Sell

WS197.5(I) WS190(I) WS155(I)

WS205(I) WS202.5(I) WS160(I)

WS132.5(I) WS130(I) WS130(I) WS130(I)

WS140(I) WS140(I) WS140(I) WS140(I)

55KMT (AG/JP)

75KMT(AG/JP)

11.91

Last Fixtures Sing/Jpn 30kmt AG/JP 55kmt

Santan/Jpn 190 heard on sub AG/JP LR1 160 on sub

AG/JP 75kmt

AG/JP LR2 135-137.5

SK/JP 30kmt

KR/JP USD205K

Trend AG/JP LR2 rate was maintained at WS135 in platts. There were no fresh fixture for AG/JP LR2 last weekend. A vessel was heard on sub for Rsea/Jpn around WS135 lvl, however, this seems considered one-off fixture. There is very limited LR2 availability for August, however, chartering activity as well seems quiet down. Shipbrokers pegged LR2 rate stable around WS135. AG/JP LR1 rate climbed up 5 pts to WS160. A couple of LR1 were reported on sub at WS160 for AG/JP 2H Augst. It looks like abt 10 vessels remaining for 2H August. Shipbrokers assessed LR1 rate around WS160-WS155. Sing/Jpn MR rate was unchanged at WS188 in the platts assessment. A vessel was heard on sub for Santan/JPn around WS190. Modern/larger MRs are said tight for 1H Aug. Shipbrokers assessed Sing/Jpn MR rate WS190 more or less. According to a report, average refinery run in Singapore as of July 26th was 55.9%. Best regards, Chisa Wada Ginga Petroleum 65-6292-8484

FIGURE 4.9 Tanker freight swap report. Source: Ginga Petroleum (S) Pte Ltd (http://www.ginga.com.sg/); Contact: Ms Chisa Wada Tel: +65 6 292 8484

Rates quoted in the report are based on World Scale Levels and as previously mentioned the swaps settle out against Platts’ clean tanker assessment price level reports.

DERIVATIVES FORWARD CURVE ASSESSMENTS A very recent development has been the introduction by a few specialist firms of independent assessments of the forward curves for an increasing number of global energy derivatives markets. This is a wonderful new tool

98

ENERGY PRICE RISK

for risk managers all over the world. It enables both bankers and end users to have a trusted third party forward curve for day-to-day valuation and accounting purposes. The Enron scandal in 2001 rocked many shareholders’ confidence in companies’ use of energy derivatives as well as their pricing and accounting, so the opportunity to utilise third party market assessments of forward curves is a very positive step towards assuring that a reasonable value is attached to derivatives. Indeed, under the new accounting regimes of FAS 133 and international accounting standards (see Chapter 18) derivatives need to be revalued on a regular basis, even if they are employed by an end user such as a power producer or airline. At the time of publication, there were two companies offering this forward curve pricing service in the energy space: ■ ■

McGraw-Hill Platts: http://www.platts.com/ Totem Risk: http://www.totemvaluations.com/

Platts Forward Curve service (PFC) Platts Forward Curve was the first independent service to provide assessments and historical data based on actual transactions, bids and offers, for the global oil derivatives market. Platts Forward Curve provides: ■ ■

Independent assessments of swaps in European, Asian or US petroleum markets based on real market activity rather than modes. Independent swaps market commentary.

Their full service covers both exchange traded futures and options and over-the-counter swaps, allowing subscribers to: ■ ■ ■

Mark-to-market their derivatives portfolio. Benchmark risk management models. Perform complete profit and loss analysis.

European series Platts Forward Curve provides swap assessments, going forward as much as three years, for over 150 data points covering crude oil and crude oil products. Crude swaps assessments: ■ ■ ■ ■ ■ ■

Brent CFD Dated to frontline Brent WTI-Brent Brent-Dubai EFS Dubai inter-month swaps Products: Crack spread swaps relating the value of gasoline, naphtha and gasoil to Brent

DERIVATIVES FORWARD CURVE ASSESSMENTS

■

99

A selection of European benchmark swaps including gasoline, naphtha, jet fuel, diesel and gasoil, and fuel oil.

Asia series In addition to Asian assessments for swaps on Tapis and Dubai, the two regional marker crudes, Platts Forward Curve provides crack spread swap values against these two markers, and Singapore products and product timing spread swaps. American Series The American series reports on swaps traded in the USA: on the Atlantic Coast, Gulf Coast and West Coast. Crude swaps covered include Brent and WTI-Brent and products include gasoline, jet fuel, no. 2 and residual fuel oil swaps. Further information on this can be obtained from: Platts, Wimbledon Bridge House, 1 Hartfield Road, London SW19 3RU, UK. Tel: +44 (0) 20 8543 1234 Fax: +44 (0) 20 8545 6635; http://www.platts.com/. Totem Risk valuations The other firm that has recently entered the energy space to deliver forward curve data on a daily basis to the energy trading community is Totem (http://www.totemvaluations.com/). They are now quoting a large array of markets around the world. More information on Totem Risk and also how their service assists companies now faced with the new stricter accounting regime under FAS 133 and IASC accounting standards for derivatives can read more about this in Chapter 18 on international accounting standards for derivatives. Table 4.1 shows a table of forward curves published by Totem Risk.

Light, Sweet Crude Oil (first nearby contract)

Brent Crude (first nearby contract)

BRENT (DTD)

Brent Crude (first nearby contract)

Brent

Dated/Brent

Brent/Dubai

IPE

NYMEX

Reference Publication(s)

Dubai (front month)

IPE/PLATTS

Brent Crude (first nearby PLATTS/IPE contract)

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

WTI

Crude Oil Index Group

Oil Indices

Index Short Name

US$/Bbl

US$/Bbl

US$/Bbl

US$/Bbl

Price Units

Spread

Spread

Outright

Outright

Conversion Factor

S

S

S A O Average rate

S A O Average rate

Option Type

O: Out-of-the-money Options

A: At-the-money Options

S: Swaps/Forwards

Instruments valued

Regular Market Valuations are offered in the following contracts and indices. Additional contracts or instruments will be included on request Maturities valued follow market conventions for each underlying but gernerally include months, quarters, seasons and calendar years as appropriate Contact Tom Charlesworth for further details Email [email protected] Tel + 44 20 7212 2693 Fax + 44 20 7804 1735 www.totemvaluations.com

Energy Market Valuations

TABLE 4.1 Table of forward curves published by Totem Risk

100 ENERGY PRICE RISK

Cargoes CIF new Gasoil.2 Gasoil (first nearby contract)

Gasoil .2 CIF NWE/IPE Gasoil

PLATTS/IPE

US$/MT

PLATTS/IPE

Gasoil (first nearby contract)

Barges FOB Rotterdam Gasoil.2

Gasoil .2 Barges FOB Rotterdam/IPE Gasoil

US$/MT

PLATTS/IPE

Cargoes FOB Med Gasoil.2 Gasoil (first nearby contract)

US$/MT

US$/MT

US$/Gal

US$/MT

Gasoil .2 FOB MED/IPE Gasoil

PLATTS/IPE

PLATTS/IPE

Gasoil (first nearby contract)

US$/Bbl

Gasoil (first nearby contract)

Singapore Gasoil Reg 0. 5%

East/West Gasoil

Brent Crude (first nearby IPE contract)

US$/MT

US$/Bbl

Cargoes CIF new EN590

Gasoil (first nearby contract)

IPE Gasoil Crack

IPE

NYMEX

EN590 CIF NWE/IPE Gasoil

Gasoil (first nearby contract)

IPE Gasoil

Light, Sweet Crude Oil (first nearby contract)

US$/Gal

Heating Oil (first nearby PLATTS/NYMEX contract)

Heating Oil (first nearby contract)

Nymex number 2 Heat Crack

NYMEX

US$/Bbl

Price Units

USGC No.2/Nymex No.2 USGC No.2 Heating Oil

Heating Oil (first nearby contract)

Nymex number 2 Heat

Heating Oil Index Group

Tapis

Tapis/Brent

Reference Publication(s)

Brent Crude (first nearby APPI/IPE contract)

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Index Short Name

Spread

Spread

Spread

Spread

Spread

Spread

Spread

Outright

Spread

Outright

Spread

7.45 Bbls/MT

Conversion Factor

S

S

S

S

S

S

S

S

S

A O Average rate

A O Average rate

Option Type

DERIVATIVES FORWARD CURVE ASSESSMENTS 101

Cargoes CIF new Jet

Jet CIF NWE/IPE Gasoil

PLATTS/IPE

Barges FOB Rotterdam Prem Unl

Eurograde Crack

Fuel Oil Index Group

Barges FOB Rotterdam Prem Unl

Eurograde

PLATTS/IPE

PLATTS/NYMEX

Brent Crude (first nearby PLATTS/IPE contract)

Light, Sweet Crude Oil (first nearby contract)

US GULF COAST PIPELINE Light, Sweet Crude Oil Unl-87 (first nearby contract)

NYMEX

USGC Unleaded Crack

NYMEX

Unleaded

NYMEX Unleaded Crack Unleaded

NYMEX Unleaded Light, Sweet Crude Oil (first nearby contract)

Singapore Gasoil Reg 0. PLATTS 5%

Singapore Regrade

Gasoline Index Group

PLATTS

Jet CIF NWE

Jet FOB Cargoes MED/Jet Cargoes FOB Med Jet CIF NWE

Singapore Kero

PLATTS/IPE

Heating Oil (first nearby PLATTS/NYMEX contract)

Gasoil (first nearby contract)

PLATTS

Reference Publication(s)

Jet FOB Barges/IPE Gasoil Barges FOB Rotterdam Jet Gasoil (first nearby contract)

USGC 54 Jet/Nymex No. Gulf Coast JET54 2 Heating Oil

Cargoes CIF new Jet

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Jet CIF NWE

Jet Index Group

Index Short Name

US$/Bbl

US$/Bbl

US$/Bbl

US$/Bbl

US$/Gal

US$/Bbl

US$/MT

US$/MT

US$/Bbl

US$/MT

US$/MT

Price Units

Spread

Spread

Spread

Spread

Outright

Spread

Spread

Spread

Spread

Spread

Outright

8.33 Bbls/MT

8.33 Bbls/MT

Conversion Factor

S

S

S

S

S

S

S

S

A

A

Average rate

Average rate

A O Average rate

Option Type

102 ENERGY PRICE RISK

NEW YORK CARGO NO6 1 Light, Sweet Crude Oil (first nearby contract)

GULF COAST WATERBORNE NO6 3

Cargoes FOB new 1 PCT

1% CIF NYH Fuel crack

3% USGC Fuel Crack

1% new Fuel Crack

ANR Pipeline Co., Louisisana

Midwest, Chicago Citygate

ANR ,La

Chicago City Gate

Permian

PLATTS/NYMEX

PLATTS/NYMEX

Henry Hub Natural Gas

Henry Hub Natural Gas

Henry Hub Natural Gas

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/NGI

NYMEX/Inside FERC

NYMEX

Brent Crude (first nearby PLATTS/IPE contract)

Transwestern Pipelines Co. Henry Hub Natural Gas , Permian Basin

Columbia Gulf, Louisiana Columbia Gulf Transmission Co., Louisiana

Henry Hub Natural Gas

Henry Hub

North American Natural Gas Index Group

Natural Gas Indices

Singapore HSFO 180 CST Barges FOB Rotterdam 3. PLATTS 5 PCT

East/West Fuel

Light, Sweet Crude Oil (first nearby contract)

Barges FOB Rotterdam 3.5 Brent Crude (first nearby PLATTS/IPE PCT contract)

3.5% Barges Fuel Crack

PLATTS

Barges FOB Rotterdam 3.5 PCT

3.5% Barges Fuel

Reference Publication(s)

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Index Short Name

Spread

Spread

Spread

Spread

Spread

Outright

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Outright

US$/Bbl

US$/Bbl

US$/Bbl

US$/MT

US$/Bbl

US$/MT

Price Units

6.35 Bbls/MT

6.35 Bbls/MT

6.35 Bbls/MT

Conversion Factor Average rate

S

S

S

S

S A O European

S

S

S

S

S

A

Option Type

DERIVATIVES FORWARD CURVE ASSESSMENTS 103

El Paso Natural Gas Co, San Juan Basin

South Louisiana, Henry Hub

East Texas, Houston Ship Canal, Large Packages

Citygates, Mich.-Michcon Henry Hub Natural Gas

California, Malin

Socal Topock, Southern Henry Hub Natural Gas California Border Average

Natural Gas Pipeline Henry Hub Natural Gas company of America, Louisiana zone

San Juan

Henry Hub

Houston Ship Canal

MICHICON

MALIN

Southern California Border

NGPL, Louisiana zone

Henry Hub Natural Gas

Panhandle Eastern Pipelines Co., TX OK (Mainline)

PG&E city-gate

Northwest Pipeline Corp., Henry Hub Natural Gas Rocky Mountains

Tennessee, Texas (zone 0) Henry Hub Natural Gas

Panhandle

PGE city-gate

Northwest, Rocky Mountains

Tennessee, Texas (zone 0)

Henry Hub Natural Gas

Henry Hub Natural Gas

NGPL, South Texas zone Natural Gas Pipeline company of America, South Texas zone

Henry Hub Natural Gas

Henry Hub Natural Gas

Henry Hub Natural Gas

Henry Hub Natural Gas

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Index Short Name

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/NGI

NYMEX/NGI

NYMEX/GD

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

Reference Publication(s)

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

Price Units

Conversion Factor

S

S

S

S

S

S

S

S

S

S

S

S

Option Type

104 ENERGY PRICE RISK

Transco zone 1 (pooling point)

Northeast, Transco Zone 6 Henry Hub Natural Gas

CNG Transmission Corp., Henry Hub Natural Gas Appalachia

Columbia Gas Transmission Corp., Appalachia

West Texas, Waha

Texas Eastern Transmission Henry Hub Natural Gas Corp., East Louisiana zone

Market Center Spot-Gas Prices, Northeast, Texas Eastern zone M-3

Transcontinental Gas Pipe- Henry Hub Natural Gas lines Corp., zone 3

Transco Zone 1

Transco Zone 6

CNG Southpoint

TECO

WAHA

TETCO-ELA

TETCO-M3

Transco Zone 3

Belgian Gas

Zeebrugge Hub

European Natural Gas Contract Group

NYMEX/Inside FERC

Tennessee Gas Pipelines Co., La. & Offshore (zone1)

TENN-LA

NBP

Henry Hub Natural Gas

Henry Hub Natural Gas

Henry Hub Natural Gas

Henry Hub Natural Gas

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

US$/mmBtu Spread

Price Units

Physical Delivery pence/therm Spread

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

NYMEX/Inside FERC

TETCO South Texas zone Texas Eastern Transmission Henry Hub Natural Gas Corp., South Texas zone Henry Hub Natural Gas

Reference Publication(s)

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Index Short Name Conversion Factor

S

S

S

S

S

S

S

S

S

S

S

S

Option Type

DERIVATIVES FORWARD CURVE ASSESSMENTS 105

NBP

UK Gas

Price Units

Outright

Physical Delivery Euro/MWh

German high voltage grid

German high voltage grid

Nordpool system price

Spanish grid price

German high voltage grid German high voltage grid

As defined by GTMA

As defined by GTMA

German Power baseload

German Power peakload

Nordic Power

Spanish Power

Swiss Power

UK Power - baseload

UK Power - peakload

Euro/MWh

Physical Delivery £/MWh

Physical Delivery £/MWh

Physical Delivery Euro/MWh + Financial

Spanish Grid Price

Nordpool System Euro/MWh Price

Physical Delivery Euro/MWh

Physical Delivery Euro/MWh

French Power - peakload French high voltage grid

Physical Delivery Euro/MWh Physical Delivery Euro/MWh

French Power - baselaod French high voltage grid

Dutch high voltage grid

Dutch Power - baseload

Dutch Power - peakload Dutch high voltage grid

Physical Delivery Euro/MWh

Austrian (St. Peter) High Voltage Grid

Physical Delivery Euro/MWh + Financial

Outright

Outright

Spread

Outright

Outright

Outright

Outright

Outright

Outright

Outright

Outright

Spread

Physical Delivery pence/therm Outright

Physical Delivery Euro/MWh

Reference Publication(s)

Austrian Power

European Power Contract Group German high voltage grid

Bunde Hub

German Gas

Electricity Indices

Underlying Name (index For spread valuations 1) Underlying Name (index 2)

Index Short Name Conversion Factor

S

S A O European

S

S

S A O European

S

S A O European

S

S

S

S

S

S A O European

S

Option Type

106 ENERGY PRICE RISK

CHAPTER 5

Options – Trading and Hedging Application Strategies

Energy ‘options’ go one step further than a simple on-exchange futures contract or even an OTC fixed or floating swap contract. They can be compared to insurance policies, because there is a premium to pay but if the market moves against you there is no requirement to pay any more money. When a family takes out a policy on the contents of their home, they are purchasing the right (or the option) to claim replacement goods if the house gets burgled. In the same way, the purchaser of an energy option is buying the right to claim price protection (or benefit as a trader) from the seller of the option if the price of the chosen energy market rises above the price specified in the contract (called the ‘strike price’). An option is exactly what the name implies: when traders buy oil options, they buy the right, but not the obligation, to purchase a certain amount of an energy market (oil, gas, power, coal) at a certain price at a certain future date. That means that the user can set a maximum price it would like to pay for the energy in December, for example, and then buy an option at that price. If somebody sells the buyer that option, they have promised to supply a particular amount of energy, in December, at that particular price. The majority of derivative options are never linked to physical delivery of energy, but merely give the user the benefit from the exposure to the cash flow of an equivalent position in the underlying energy. As discussed in Chapter 3, only a very small percentage of exchange-traded futures contract go to actual physical delivery: somewhere around 2% of total open interest. The advantages of derivative option structures over and above a straightforward futures and or swap structure are as follows: ■

Initial outlay of cash in many cases is restricted to the premium paid, which in the case of zero cost collars (buy cap, sell floor or sell cap, buy floor, depending on the underlying energy price exposure, but the two 107

108

■

■

ENERGY PRICE RISK

options premium cost/revenue offset one another to create zero cost). This structure is very common among end users with a short energy price risk (they are exposed to energy prices moving higher) so they need to buy caps (calls) and sell floors (puts) in order to create zero cost protection against prices moving higher. There is less opportunity cost than a swap or futures strategy, because option strategies can enable the user to protect against adverse price risk movements, but at the same time still benefit from beneficial price movements in the underlying physical energy market. Another advantage of option strategies (which we discuss in this chapter) is that traders who are unsure about the outright price direction of an underlying assets can take a position on volatility rather than market price.

VOLATILITY Volatility plays an important part in the pricing of an option strategy, and is also an important part of evaluating whether or not an option should be considered too expensive to purchase or not. There are two types of volatility: ■

■

Historical volatility Normalised annualised standard deviation of the underlying energy futures/swap contract. Implied volatility (IV) The volatility value placed on an option premium quotation from a trader or market maker. When an option quote is received, the premium value can be put into an appropriate option model to calculate some idea of the implied volatility that the other trader or market maker considers appropriate for this trade. In most cases, the higher the IV, the higher the premium of the option (Figures 5.1 and 5.2). By comparing Reference rate (benchmark, e.g. futures or swaps) Strike Expiry

Option pricing model

Premium/ cost of option

Volatility estimate Interest-rate (risk-free, e.g. base rate)

FIGURE 5.1 Option premium calculation principles – premium

VOLATILITY

109

KEY TERMINOLOGY USED IN THE ON-EXCHANGE AND OTC OPTIONS MARKETS American option An option which can be exercised on any business day up to and including the expiry date. More expensive than European options. Asian option The main options found in the over-the-counter energy markets are Asian-style options. They are called path-dependent, because their final value is dependent on the path of the underlying energy market (e.g. in a December option, the option will eventually price out against the average price of the energy market the option is based on over the whole month of December, just like a whole month averaging swap). Basically, the profit from an Asian option depends on the price history of the underlying commodity that is being used as the price reference, over all or part of the life of the option. The advantage of the option is that if you bought the option, if the market has moved against the option position (in terms of price movement) the only cost or loss of opportunity was the cost (or premium) of the option. However, with a swap position you would be locked in and have potentially unlimited ‘opportunity cost’ if the market moved against the derivative position. These are normally cheaper than American-style or European-style options. At-the-money (ATM) Option whose exercise price is the same as the market price of the underlying energy. European option An option which can be exercised on the expiry date only. Cheaper than American options. Fair value The combination of intrinsic value and time value, as calculated by an option pricing model. In-the-money (ITM) A call is said to be ‘in-the-money’ when the value of the underlying energy futures or swap price is higher than the option’s strike price. A put is ‘in-the-money’ when its strike price is higher than the value of the underlying energy futures or swap price. Intrinsic value The difference between the strike price and the current market rate. Out-of-the-money (OTM) A call is ‘out-of-the-money’ when the value of the underlying energy futures or swap price is less than the option strike price. A put is ‘out-of-the-money’ when its strike price is less than the value of the underlying energy futures or swap price. Premium The price or cost of the option. Strike price The entry price into the underlying participation level. Time value The difference between the option premium and the intrinsic value, including time until expiry, volatility and cost of carry (interest %). Value date Date when the underlying is settled or delivered.

110

ENERGY PRICE RISK Reference rate (benchmark, e.g. futures or swaps) Strike Expiry

Option pricing model

Premium/ cost of option

Implied volatility, i.e. implied by premium Interest-rate (risk-free, e.g. base rate)

FIGURE 5.2 Option premium calculation principles – implied volatility

data from volatility and implied volatility, judgement calls can be made on whether IV is looking expensive. A simple scenario is if you buy an option when IV is very high, and then afterwards the market does not move but IV drops, you will most probably find the value of the option that you purchased will have reduced (all other factors remaining equal).

TYPES OF OPTIONS ■

■

In futures markets: ● Calls – the right but not the obligation to buy the underlying futures contract at the strike price. ● Puts – the right but not the obligation to sell the underlying futures contract at the strike price. In swaps markets ● Caps – Over-The-Counter (OTC) name for what structurally gives users the same protection and or exposure to market price movement as calls in the futures market. ● Floors – Over-The-Counter (OTC) name for what structurally gives users the same protection and or exposure to market price movement as puts in the futures market.

OPTION STRATEGIES FOR HEDGING ENERGY PRICE EXPOSURE Simple option strategies for hedging against market price movements can be summarised as follows:

THE GREEKS

To hedge a ‘short’ energy exposure with options Buy call or cap Sell put or cap Buy call spread Sell put spread

111

To hedge a ‘long’ energy exposure with options Sell call or cap Buy put or cap Sell call spread Buy put spread

Financial exposure and/or protection received when using options compared to swaps/futures contracts can be summarised as in Table 5.1. TABLE 5.1 Summary of exposures: options vs. swaps/futures Position

Risk

Reward

Long call

Limited to premium

Unlimited

Long put

Limited to premium

Almost unlimited*

Short (written) cap/floor Unlimited (if option posi- Cash premium received tion is not hedged) (call/put) Long (purchased) under- Almost unlimited* lying swap/future Unlimited Short (sold) underlying swap/future

Unlimited Almost unlimited*

*Since asset value or derivative contract value cannot fall below zero

The flexibility of options really starts to become clear when we look at combinations of the above strategies of buying some calls/caps or selling some puts/floors at different tenures and different strike prices, and for differing volumes. The variety of combination structures that can be created using options is endless; the possibilities are only limited by our own creativity and the complexity of the exposure that needs to be protected against (or in the case of an investor/trader, the exposure that they wish to become exposed to). However, there are some quite regularly applied structures in the energy derivatives markets which can be discussed here as a base for traders/hedgers to work from.

THE GREEKS In the rest of this chapter, we will look at strategies that can give investors or traders exposure to or protect hedgers from: ■ ■

Changes in market price risk Changes in market volatility

But before we can look further into option trading and hedging strategies we need to look more closely at what could be described as the atomic

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ENERGY PRICE RISK

structure of options: the components or forces in action in an option’s price and also how it reacts to changes in the underlying energy market it Is valued/priced off. These components or forces in action in an option’s price are commonly known as the ‘Greeks’: ■ ■ ■ ■

Delta Gamma Theta Vega

Delta Delta shows how much the option’s price changes when there is a change in the underlying asset price. It is closely related to but not equal to the probability that the option will be exercised. From a risk management perspective, the delta of an option is important for creating a risk-neutral portfolio, i.e. you are trying to hedge the underlying cash commodity or futures or swap using options. Gamma ■ Gamma measures the rate at which delta changes. Some options have very high gamma which means that a small change in the underlying asset’s price can lead to a significant change in delta. ■ Gamma can be a major headache for risk managers, because they must delta hedge their portfolio on a regular basis, i.e. they must constantly watch the delta change due to a high gamma situation to make sure they are not under-hedged via options. ■ Gamma is at its highest when the option is ‘at-the-money’ and reduces as the energy price goes up or down, pushing the option either in-themoney or out-of-the money. ■ Risk managers should be aware that the writer (seller) of an option is always negative gamma, whether the option is a call or a put. ■ The holder or buyer of an option is therefore positive gamma. ■ For traders who are negative gamma, the only way to reduce this gamma exposure is to go long on other options. ■ Negative gamma is dangerous because an adverse movement in the underlying can lead to a substantial loss while a favourable (profitable) move leads to only a minor profit. Theta ■ This measures the time decay in an option. A person who is long on an option (bought, buyer), whether a call (cap) or put (floor), suffers from time decay, because as the option approaches maturity its value gets closer to its intrinsic value.

OPTION STRATEGIES

■

■

■ ■ ■ ■

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There is a relationship between theta and gamma: when gamma is high, theta is also high, which means that the option loses value more quickly as it approaches maturity, its expiration date. From a risk perspective, an option with high theta could be good news for a counterpart who is short (already has sold) and bad news for the trader who is long (already bought). However, along with high theta is high gamma, and the counterpart who has sold the high theta option is effectively holding a ‘risky’ option. The general understanding is that if you sell an option time is in your favour, as you profit from time decay. ‘Theta pays for gamma’: this means you benefit from theta but are suffering from high gamma. You can’t have it both ways; you cannot benefit from theta and gamma on the same option!

Vega ■ This measures the sensitivity of an option to a change in volatility of the underlying asset. ■ Delta, however, tells you the sensitivity of the option’s price to a change in the underlying asset/swap etc. ■ For example, traders who are very certain that volatility in the market is going to increase would try to build their portfolio so that it had very high vega. ■ As with theta, the option is most sensitive when it is at-the-money. ■ Vega is positive when you are long calls and also puts. ■ An increase in the volume makes the option more valuable. ■ Vega calculations are important for volatility trading (strategies discussed later in this chapter – butterflies, straddles, strangles). ■ You would calculate the ‘implied volatility’; if you feel it is too high you could sell both a call and a put and then buy them back at a cheaper price as volatility calms down – as it reduces.

OPTION STRATEGIES Figure 5.3 illustrates how the value of caps in the OTC market (and calls in futures market) and floors in the OTC market (puts in the futures market) move compared to the overall value of the energy commodity they are valued against. To recap: ■

Buying caps/calls A buyer of a cap (call) is protected for a fixed premium on the market price becoming stronger

114

ENERGY PRICE RISK Value of option

Cap value increase Floor value increase

Original cost

Value of commodity

FIGURE 5.3 Caps/floors (calls/puts). Source: Energy College Ltd, London (http:// www.energycollege.org/) Price Value of option

Cap value increases Seller of option may start to lose money

Floor value increases Seller of option may start to lose money as market drops

Original cost

Value of commodity

FIGURE 5.4 Seller of caps/floors

■

Buying floors/puts A buyer of a floor (put) is protected for a fixed premium on the market price becoming weaker

Figure 5.4 illustrates the selling of caps/floors. To recap: ■

■

Selling caps/calls ● A seller of a cap (call) receives a fixed premium for selling the option. ● Cash is received for selling the option (premium), this is what becomes useful in finance deals with derivatives. ● There is exposure if the average market price during the life of the option goes above the fixed cap price/strike price. Selling floors/puts ● A seller of a floor (put) receives a fixed premium for selling the option. ● Cash is received for selling the option (premium); this is what becomes useful in finance deals with derivatives.

OTC OPTIONS AND POPULAR STRUCTURES

●

115

There is exposure if the average market price during the life of the option goes below the fixed floor price/strike price.

Tables 5.2 and 5.3 show how to hedge using options.

OTC OPTIONS AND POPULAR STRUCTURES The option products that are most frequently used in the oil market are caps, floors and collars, and the most commonly traded OTC options are Asian options. These do not exercise into any other contract, they just TABLE 5.2 Hedging short energy positions with options Anticipations

Characteristics

Short call

Implied volatility down

Limited profit; unlimited loss; limited protection; cash credit; risk profile at expiration equivalent to a short put

Long put

Implied volatility up

Unlimited profit; limited loss; unlimited protection; important cost; risk profile at expiration equivalent to a long call

Short call spread or bull spread

Implied volatility direction depends on the strikes:

Unlimited profit; unlimited loss; limited protection; low cost; risk profile at expiration equivalent to a long semi-futures

●

●

●

Long put spread or bear spread

Sell call and buy call with higher strike If a rise in implied volatility is expected: buy ATM call/sell ITM call equal volume If a fall in implied volatility is expected: buy OTM call/sell ATM call with equal volume

Implied volatility direction depends on the strikes: ●

●

●

Sell put and buy put with higher strike If a rise in implied volatility is expected: buy ATM put/sell OTM put equal volumes on both options If a fall in implied volatility is expected: buy ITM put/sell ATM put equal volume again

Unlimited profit; unlimited loss; limited protection; low cost; risk profile at expiration equivalent to a long semi-futures

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ENERGY PRICE RISK

TABLE 5.3 Hedging long underlying positions with options Anticipations

Characteristics

Short call

Implied volatility down

Limited profit; unlimited loss; limited protection; cash credit; risk profile at expiration equivalent to a short put

Long put

Implied volatility up

Unlimited profit; limited loss; unlimited protection; important cost; risk profile at expiration equivalent to a long call

Short semifutures

Implied volatility direction depends on the strikes:

Limited profit; limited loss; unlimited protection; low cost; risk profile at expiration equivalent to a long fence or a bull spread

●

●

●

Short call spread or bull spread

Implied volatility direction depends on the strikes: ●

●

●

Long put spread or bear spread

Buy put and sell call with a higher strike If a rise in implied volatility is expected: sell OTM call/buy ATM put, equal volumes If a fall in implied volatility is expected: sell ATM call/buy OTM put, equal volumes

Sell call and buy call with higher strike If a rise in implied volatility is expected: buy ATM call/sell ITM call equal volumes If a fall in implied volatility is expected: buy OTM call/sell ATM call, equal volumes

Implied volatility direction depends on the strikes: ●

●

●

Sell put and buy put with higher strike If a rise in implied volatility is expected: buy ATM put/sell OTM put, equal volumes If a fall in implied volatility is expected: buy ITM put/sell ATM put, equal volumes

Unlimited profit; unlimited loss; limited protection; low cost; risk profile at expiration equivalent to a long semifutures

Unlimited profit; unlimited loss; limited protection; low cost; risk profile at expiration equivalent to a long semifutures

OTC OPTIONS AND POPULAR STRUCTURES

117

cash-settle against the underlying price reference (unlike futures options which end up expiring into a futures contract which must be traded out of). The next most popular kind of option is a swaption, which can be American- or European-style. This exercises into a swaps contract buy or sell at the strike price selected.

Asian options ■ The profit from an Asian option depends on the price history of the underlying commodity that is being used as the price reference, over all or part of the life of the option. ■ It is sometimes referred to in the financial markets as a ‘path-dependent option’. ■ Cheaper than European options. ■ Cannot use the Black–Scholes formula for pricing options; because this is an average price option, the average prices are not lognormally distributed. ■ The alternative option pricing method is the Monte Carlo approach (see Chapter 6 for more details on this option model).

The zero cost collar The collars structure is very popular with hedgers in the energy market. In particular, end-user consumers of energy often use the ‘zero cost collar’, as it offers cheap insurance with no up-front cost. It is made by simultaneously buying a cap and selling a floor (Figure 5.5). The option strategy pays the buyer of the collar (i.e. the buyer of the cap, the seller of the floor) if the market rises. However, if the market falls below the floor the exposure is open. An oil consumer who buys a collar gets protection from an adverse upward move but pays nothing for it. However, the oil consumer does not necessarily give away all of the benefit of lower prices. Cap Floor

FIGURE 5.5 A zero cost collar

Barrier options Barrier options were invented to reduce the initial cost of hedging with buying of options. The barrier option either comes to life (is knocked-in) or is extinguished (knocked out) under certain conditions. In practice, the event that activates or kills the option is defined in terms of a price level (barrier).

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ENERGY PRICE RISK

The barrier option may be combined with a rebate: for knock-out options, the rebate is paid when the option is cancelled as a compensation to the holder. A typical example of a barrier option is the ‘up-and-out floor’ (put). Barrier options – caps/floors, knock-in/knock-out All the combinations illustrated in Figure 5.6 linked to a cap or floor are available in the OTC market.

Price

Type of option Out In Up

Up-and-out

Up-and-in

Down

Down-and-out

Down-and-in

FIGURE 5.6 Barrier options – caps/floors

Up-and-out floor (put) This is typically purchased by energy producers who want to hedge their natural long position in the markets. An up-and-out floor (put) may be an attractive alternative to the normal floor/put option, as it is less expensive and provides the same price protection if prices move down from current futures/swap quoted levels. However, if prices move upwards the increase in the underlying commodity’s price reduces the need for downside risk protection at the original strike price. If the price moves up sufficiently to cross the selected ‘barrier’ price, the ‘knock-out’, then the option is cancelled or extinguished: it is ‘knocked-out’. The hedger may then consider re-entering the market with a new hedge by buying another floor but at a higher strike price. The up-and-out barrier is less expensive that a standard Asian, European or American option because the underlying price may fall below the strike price after initially rising, hitting the barrier and cancelling the option. Crack and spread options Some banks and traders or market makers will even quote options on differentials such as the refinery margin – crude versus products. This is particularly useful when having to deal with negative system margins. When running a refinery an organisation cannot choose to stop producing some petroleum product. Refinery engineers may be able to reduce the production of a loss-making product, but in the end you will still have to protect against the negative margin becoming worse. A crack option offers protection against the margin becoming worse, but at the same time allows an organisation to benefit from an improvement in the margin.

OPTIONS TRADING – VOLATILITY TRADING

119

Compared to using swaps or futures to lock in the negative margin, you will not be able to appreciate from an improvement In the margin. This applies to petrochemical margins and power production margins such as spark spread options. It is even possible to create a zero cost collar spark spread option, or refinery option, where you can sell the margin option at one level and buy protection against the margin at another, giving protection from the margin going below the floor price margin option and locking in the margin at the strike price sold on the cap margin option. Other spread or arbitrage options seen in the market from time to time include: crude versus crude, the complete refinery margin options, and individual cracks between crudes and petroleum products such as gasoil, jet fuel and fuel oil. There are also spark spread options, i.e. natural gas versus power prices, or gasoil or fuel oil versus power prices. Delayed start date options As well as the knock-in and knock-out option into the caps and floors used for trading or price risk management, it is now also possible to obtain a delayed start date from traders and market makers. One example of the application for this can be found in the chapter on hedging examples/ scenarios. If an organisation were trying to hedge the production of a new refinery, oil field, petrochemical plant or utility power station, it is quite possible that it would have an approximate start date for production or completion, but between now and that date some delay might occur. The nightmare scenario for hedgers or risk managers is to be stuck with a hedge but the asset/energy to be hedged not turning up or being ready. Immediately that hedge becomes a speculative position for accounting purposes and is an unwanted, unprotected risk in its own right. This could certainly undermine a company’s cash flow forecasts. So, to reduce this risk it is possible (at a price) to obtain delayed start dates built into option structures and sometimes the optionality of this start date delay can be embedded into a swaps hedge structure as well. It usually means that at a certain date, perhaps three months before the derivatives hedge start date kicks in, the user of the hedge can nominate on a particular day, or any day up to a certain cut-off point, to delay the start of the hedge to another date. The delayed start date would normally be fixed; alternatively, it would be possible to delay the hedge to another specified date or delay it by X number of days.

OPTIONS TRADING – VOLATILITY TRADING Options can be used to trade the market price; in other words, they can be used to benefit from movements in the underlying swaps or futures

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ENERGY PRICE RISK

market. However, for investment trading purposes, options can also be used to benefit from the market going nowhere! At the beginning of this chapter we talked about two types of volatility, one of which was implied volatility. This is an important component in the cost or value of an option. By using special combinations of calls and puts or caps and floors for OTC markets, it is possible to make a trade based on whether as a trader you think volatility will increase or decrease. This is done by what is known as volatility trading and involves setting up a delta neutral portfolio (delta neutral = market price neutral). Volatility strategies A trader who wants to take advantage of the underlying volatility of the market increasing or decreasing can use the following option strategies: ■

■

Straddles Sell call (cap) and sell put (floor) at the same strike price in the same market. It is important to appreciate that although a short straddle is delta neutral (± balanced), it is not gamma neutral. Strangles These are essentially the same as straddles except that a trader will use out-of-the money options. They also use different strike prices.

A trader who thinks that volume is going down would normally sort (sell) these options, while if he or she thinks that volume is going up, the trader would go long (buy) them. Butterfly strategy The only issue with using straddles and strangles is the potentially unlimited loss on the strategy. This can be managed, but it must be actively

■

Your view = Volatility is going to increase ● Buy (long) a straddle or strangle Long straddle involves buying purchasing the put (floor) and the call (cap) at the same strike price. ● Short (sell) butterfly strategy

■

Your view = Volatility is going to decrease ● Short (sell) straddle or strangle Short straddle involves selling (writing) the put (floor) and the call (cap) at the same strike price. ● Long (buy) butterfly strategy

OPTIONS TRADING – VOLATILITY TRADING

121

hedged and monitored. However, because of this risk concern there are other trading strategies that have less up-front risk. The butterfly (Figure 5.7) is an option strategy that has both limited risk and restricted profit potential. It is created by using four strike prices. The strategy may be set up using caps or floor options. + The cost of the option

Profit

Profit

–

+ Price of underlying

Fixed profit upside between these two points

–

FIGURE 5.7 Butterfly strategy

A short or long butterfly: ■ ■

Allows the trading of volatility. Has an advantage over a straddle and even less risk than a strangle because the structure creates a fixed cap on maximum loss. This is already built into the strategy, so active position management requirements are reduced.

A long (buy) butterfly: ■ ■ ■

Requires option premiums to be paid Offers limited risk Is used when the view is that volatility is going to decrease

Strike

Buy 1 × call

Sell 2 × call

Buy 1 × call

US$20

US$22

US$24

A short (sell) butterfly: ■ ■ ■

Receives more premium then premia paid out Has limited risk Is used when the view is that volatility is going to increase

122

Strike

ENERGY PRICE RISK

Sell 1 × call

Buy 2 × call

Sell 1 × call

US$20

US$22

US$24

Ratio backspreads It is also possible to trade both the market price and volatility at the same time by using special options structures called ratio backspreads. A backspread is a delta neutral spread which is achieved by buying options with smaller deltas and selling options with large deltas. It will also consist of more long (bought) options than short (sold) options with all options expiring at the same time. ■

■

Ratio call backspread Consists of buying calls at a higher strike price than the strike price of call options sold. Ratio put backspread Consists of buying puts (floors) at a lower strike price than the strike price of the puts (floors) sold.

Typically a trader will execute a backspread for some positive cash flow (i.e. some credit premium in their favour), since the amount of option premium received for the sold options is greater that the premium paid for the options bought in the strategy. In a call (cap) backspread strategy (which is a directionally bullish strategy), if the energy market price collapses, then all the options in the strategy will most probably expire with zero value. In a put (floor) backspread strategy (which is a directionally bearish strategy), if the energy market price rises by an extreme measure, then all the options in the strategy will most probably expire with zero value. A trader would choose the type of backspread, either a cap or floor, which directionally reflected his or her price direction expectations. Call backspread option strategy In a call backspread (Figure 5.8), the profit potential is unlimited if the market price of the underlying energy market moves higher. The key to a backspread is that some price movement will happen during the lifetime of the option strategy. If the market price does not really move much, any backspread strategy is more than likely to end up being a losing strategy. Example: Strike prices in a crude oil call backspread option strategy could look something like this: Long Short

600 December 200 December

US$25 strike US$20 strike

Calls @ 24 cents Calls @ 78 cents

Long Short

400 March 200 March

US$27 strike US$22.50 strike

Calls @ 23 cents Calls @ 51 cents

OPTIONS TRADING – VOLATILITY TRADING

123

Buy a higher exercise price

+

Sell the lower exercise price

Profit

–

+ Price of underlying

–

FIGURE 5.8 Call backspread option strategy

Put backspread option strategy In a put backspread strategy (Figure 5.9) the profit potential is unlimited if the market price falls. Again it should be noted that if the market price does not really move much any backspread strategy is more than likely to lose. Buy the lower strike (exercise) price

+

Sell the higher exercise (strike) price

Profit

–

+ Price of underlying

Profit potential unlimited if the market price moves lower below the put/floor purchased –

FIGURE 5.9 Put/floor backspread option strategy

Example: Strike prices in a crude oil put backspread option strategy could look something like this.

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ENERGY PRICE RISK

Long 600 December US$20 strike Short 200 December US$25 strike

Puts @ 20 cents Puts @ 120 cents

Long 400 March US$22.50 strike Puts @ 150 cents Short 200 December US$25 strike Puts @ 249 cents Recap on option trades against market implied volatility TABLE 5.4 Comparison of option trades against implied volatility Increase in Result of a large market price swing in implied the underlying swaps volatility or futures contract

Decrease in Time value effect implied volatility

Ratio call backspread

Beneficial

Beneficial

Not beneficial

Not beneficial

Ratio put backspread

Beneficial

Beneficial

Not beneficial

Not beneficial

Long straddle

Beneficial

Beneficial

Not beneficial

Not beneficial

Short straddle

Not beneficial

Not beneficial

Beneficial

Beneficial

Long strangle

Beneficial

Beneficial

Not beneficial

Not beneficial

Short strangle

Not beneficial

Not beneficial

Beneficial

Beneficial

Long butterfly

Not beneficial

Not beneficial

Beneficial

Beneficial

Short butterfly

Beneficial

Beneficial

Not beneficial

Not beneficial

CHAPTER 6

Energy Option Pricing – Which Models Are Used?

Modern option pricing techniques are considered to be among the most mathematically complex of all applied areas of finance, although these modern techniques have their origins in work that dates back to 1877. At that time Mr Charles Castelli wrote a book The Theory of Options in Stocks and Shares. Mr Castelli’s book introduced the general public to the hedging and speculation aspects of options, but lacked any usable theoretical base. The financial markets really had to wait until the work of Fischer Black and Myron Scholes was published in 1973 for anything that was very practical for options valuations. That was when they introduced their landmark option pricing model: Black–Scholes, perhaps the most famous of all option models.

TYPES OF OPTIONS IN THE ENERGY MARKETS The most popular options in the energy futures markets such as IPE/ NYMEX are all American-style options. However, in the over-the-counter (OTC) markets, Asian options (path-dependent options) are the most popular. The distinction between American, European and Asian-style options is an important one, because of the models that are needed to value them. For the purposes of this book, the Black–Scholes model cannot be applied to bottom line Asian options because they are whole month average options, and distributions of arithmetic averages of a set of lognormal distributions do not have analytically tractable properties.

GENERAL RULES FOR OPTION VALUES American-style options ■ The minimum value for a call (cap) is zero and the maximum is the difference between the underlying energy futures or swap market price 125

126

■

■

■

■

ENERGY PRICE RISK

and the strike price (exercise price) of the option, whichever is the greater. The option value cannot be a negative value. The minimum value for a put (floor) is zero and the maximum is the difference between the underlying energy futures or swap market price and the strike price (exercise price) of the option, whichever is the greater. The option value cannot be a negative value. The maximum value for a put (floor) is its strike price. The underlying futures/swap cannot become negative in value, so the biggest profit on a put (floor) is the difference between its strike price (exercise price) and zero. Time to expiry – the value of a call (cap) option with a longer time value/ validity time until expiration must be at least the same as that of a corresponding shorter-dated American-style call. For example, if you take quotes for at-the-money call (cap) for the month of December and the at-the-money call (cap) for the month of January, the January at-themoney call (cap) should be worth more than December because of an extra month’s of time value in the option. American-style call (cap) options should sell for at least the same price as a European-style call option, and normally they will cost more than European style options. This is because American style options give the buyer the right to trigger/exercise the option into its underlying futures/ swaps contract at any time during the lifetime of the option. However, European style options give much less flexibility, by only allowing the option to be exercised at a single point in time, usually the expiry date of the option.

European-style options ■ The minimum value for a call (cap) is zero and the maximum is the difference between the underlying energy futures or swap market price and the strike price (exercise price) of the option, whichever is the greater. The option value cannot be a negative value. ■ The minimum value for a put (floor) is zero and the maximum is the difference between the underlying energy futures or swap market price and the strike price (exercise price) of the option, whichever is the greater. The option value cannot be a negative value. ■ The maximum value for a put (floor) is its strike price. The underlying futures/swap cannot become negative in value so the biggest profit on a put (floor) is the difference between its strike price (exercise price) and zero. Asian options The majority of over-the-counter (OTC) energy option transactions are made up of Asian-style caps, floors and zero cost collars. Asian options are a type of path-dependent option, sometimes referred to as a look-back

TYPES OF OPTIONS MODELS UTILISED IN THE ENERGY INDUSTRY

127

option where the buyer has the right to exercise the option at the average price of the underlying energy market over the period of the option. Asian options are cheaper than ordinary European style options because the volatility of an average is lower that the volatility surrounding just one point in time, as is the case for a European style option. In the energy markets we usually deal with quite long averages, and like swaps, Asian options in energy markets tend to cover whole month averages (20 pricing days approximately). For more on the mathematics and developments in financial modelling, visit the University of Oxford Mathematical Institute at http://www. maths.ox.ac.uk/. There is also some interesting new development work in various risk management modelling including energy sector work by Professor Robert Jarrow at http://www.kamakuraco.com/. There is an online option calculator at the following Web site: http:// www.optionvue.com/FairMarketValueCalculator.htm. Effect of market changes on an option’s value Table 6.1 shows the effect of market changes on the value of options. Figure 6.1 shows the relative cost of different types of option. TABLE 6.1 Effect of market changes on an option’s value Cap value (call) Floor value (put) The price of the energy futures/swap rises Increases

Decreases

The price of the energy futures/swap falls

Decreases

Increases

Volatility increases

Increases

Increases

Volatility decreases

Decreases

Decreases

Time decay effect

Decreases

Decreases

American style options

Most expensive

European style options Cheapest

Asian style options

FIGURE 6.1 Cost of options.

TYPES OF OPTIONS MODELS UTILISED IN THE ENERGY INDUSTRY All traded options on the energy markets of the New York Mercantile Exchange and the International Petroleum Exchange are American style options. The models that can be applied to these are a combination of:

128

■ ■

ENERGY PRICE RISK

the Barone-Adesi and Whaley model; and the famous Black–Scholes model

Black–Scholes is perhaps the most famous option model because it is a simple solution to what can be a complicated problem. The model requires a limited number of data inputs and requires relatively simple mathematical calculations. Although the Black–Scholes model was originally developed just with European options in mind (an analytical option pricing formula which is used to price European options on non-dividend asset), it can be extended to price American options as well. Option calculators will often use the Barone-Adesi and Whaley method. This method prices an American option by valuing the corresponding European option using the Black–Scholes method and then adds on an early exercise premium (since unlike European style options, an American style option can be exercised on any day and at any time up to and including its expiry date if the underlying price exceeds some market price level calculated by the model). However, this model cannot be applied to Asian options Asian option pricing Monte Carlo simulation is the tool to use for Asian options, since when an Asian option is defined in terms of arithmetic averages of the underlying energy price over a one month period (which is 99% the case in energy markets), no Black–Scholes or analytical pricing formula is going to be of any use. Monte Carlo simulation is a simulation of many possible paths that the underlying energy price may take. The estimate of value of the option in this case is the average of the expected gain/profit, discounted from the end of the life of the option to the beginning, using the risk free interest rate. A more detailed definition of Monte Carlo simulation is that it is a mathematical technique for calculating derivative values which can be only predicted statistically. The name is derived from the analogy of generating a sequence of random numbers as if from the roulette wheel at the casino in Monte Carlo, where the result arrives by chance.

OPTION PRICING BIBLIOGRAPHY This is a recommended bibliography for mathematical discussions on pricing models for American, European, and Asian style options. J. Barraquand and T. Pudet (1996) Pricing of American path-dependent contingent claims. Mathematical Finance, 6(1):17–51. This is a comprehensive theoretical analysis of pricing path-dependent derivatives. It introduces the Forward Shooting Grid numerical technique.

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H. Ben Ameur, M. Breton and P. L’Ecuyer (1999) A numerical procedure for pricing American-style Asian options. Technical Report G-99-39, GERAD. A formulation of the problem of pricing Asian options as a dynamic programming problem. M. Broadie and P. Glasserman (1996) Estimating security price derivatives using simulation. Management Science, 42(2):269–285. D. P. Leisen (1998) Pricing the American put option: a detailed convergence analysis for binomial models. Journal of Economic Dynamics and Control, 22:1419–1444. Theoretical and numerical investigation of the convergence of different binomial models for American put option pricing. Introduction of a new method for decreasing initial errors. F. Longstaff and E. Schwartz (2001) Valuing American options by simulation: a simple least-squares approach. The Review of Financial Studies, 14(1):113–147. Least squares Monte Carlo approach for pricing options with American-style exercise opportunities. Examples of application to a wide variety of options. R. Zvan, P. Forsyth and K. Vetzal (1998) Robust numerical methods for PDE models of Asian options. Journal of Computational Finance, 1:39–78. D. Pilipovic (1997) Valuing and Managing Energy Derivatives. McGraw-Hill. F. Black and M. Scholes (1973) The pricing of options and corporate liabilities. Journal of Political Economy, 81(3):637–654. R. M. Bookstaber (1981) Option Pricing and Strategies in Investing. AddisonWesley. E. Corcoran (1990) Fischer Black calculated risks enable mathematician to turn a profit. Scientific American, March, 78–79. J. Hull (1989) Options, Futures, and other Derivative Securities. Simon & Schuster. J. Hull (1991) Introduction to Futures and Options Markets. Simon & Schuster. M. Kripalani (1991) Formula for success. Forbes, 28 October, pp. 203–204. J. M. Laderman (1984) Fischer Black is practicing what he teaches. Business Week, 6 August, p. 75. J. F. Marshall and V. K. Bansal (1993) Financial Engineering. Kolb Publishing Company. Mathsoft Inc. (1994) Mathcad for Windows User’s Guide. A. C. Shapiro (1992) Multinational Financial Management. Allyn and Bacon. R. A. Strong (1994) Speculative Markets. HarperCollins College Publishers. A. L. Tucker (1991) Financial Futures, Options & Swaps. West Publishing Company. R. Whaley (1986) Valuation of American futures options: theory and empirical tests. Journal of Finance, 41(1), March, pp. 127–150. D. S. Wilford, C. W. Smith and C. W. Smithson (1995) Managing Financial Risk. Irwin Inc., pp. 312–400.

CHAPTER 7

Value At Risk and Stress Testing

‘It is not the size of the position, but the capital at risk that really matters.’ When an organisation embarks on trading or hedging in the energy markets, it is important that a methodology for market risk measurement is adopted. One of the key concepts of risk measurement in the energy sector is now the probability-based risk measurement method known as value-at-risk or VAR for short. The results produced by a VAR model (and there are different types of VAR) is simple for all levels of staff from all areas of an organisation to understand and appreciate. That is why VAR has been adopted so rapidly across many industries.

A RISK MANAGEMENT SCENARIO Let’s create a scenario. A risk manager at ABC Trader Ltd is responsible for managing the company’s natural gas positions. The Board of Directors call this person in for a meeting, after hearing about derivatives losses suffered by other companies in the natural gas market. The Board want to know if the same thing could happen to their company. That is, they want to know just how much market risk the company is taking. How should the risk manager reply? The risk manager could start by listing out and describing the company’s natural gas derivatives positions, but this isn’t likely to be helpful and does not answer the Board’s real question: ‘How much market risk is the company taking?’. The risk manager is in a tricky position. Listing the positions of the company only helps if the Board of Directors actually understand all of the positions and all the derivative instruments and the risks inherent in each and every one. Of course, all guidelines point out that the Board of Directors should be involved in approving risk management policies and they should have a broad general understanding of derivatives, but the reality is that they are not involved in the day-to-day risk management and 130

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trading functions and so will probably not be able to appreciate these details, however well the risk manager explains them. The risk manager could perhaps talk about the portfolio’s sensitivities. He or she could explain how much the value of the portfolio changes when various underlying market rates or prices change, and perhaps option deltas and gammas. But even if the risk manager is confident in his or her ability to explain these in plain language, this does not clearly quantify what risk the company taking in the natural gas market! The risk manager could make the bold statement (if true) that the organisation, in line with Risk Management Policy, never speculates but rather uses derivatives only to hedge. This would mean that there could be a loss of opportunity but there would be no massive risk of uncovered losses as a result of speculation gone wrong. But the Board of Directors by this stage might ask again, ‘How much is the company at risk in the natural gas market? Are our hedges effective?’. Maybe the risk manager’s best answer would start with: ‘The value at risk of our natural gas positions is X million dollars’. This is the kind of answer that the VAR method is designed to supply. Value-at-risk is a mathematical approach to modelling financial risk in a derivatives portfolio that, put simply, poses the question: How much money could an organisation lose over a given period of time on its trading portfolio?

VAR AND OTHER RISK MEASUREMENT METHODS Value-at-risk (VAR), was conceived in 1993 partly in response to various financial disasters. Work started on its development in 1988 after central banks wanted a methodology to set minimum capital requirements in banks to protect against credit risk in trading. Banks began adopting it around 1993–1995 and, in recent years, non-bank energy traders and endusers have begun to use VAR. Now the majority of major oil companies and traders are using the VAR method for risk measurement. As a practitioner, when using VAR in the energy markets, it should be remembered that any valuation model is simply a representation of a possible reality or a possible outcome, based on certain probability and confidence percentage parameters. It is all too easy to experience a false sense of security when using VAR and to believe that its valuations represent the limit of what an organisation could lose in a 24 hour period. For this reason, some stress testing of derivative portfolios should be used alongside VAR. For example, a company could periodically take its trading position and test the result of a three standard deviation move in energy market prices, as well as changes in market prices and volatility (if

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Complementary risk measurement methods

Value At Risk

Stress tests

Maximum expected loss within a certain time frame and % probability

The What if? scenarios testing

Sensitivity analysis

What if? All energy prices change by 5%, 10%, 25%, 50%?

Variance/covariance

Historical VAR What if history repeats? Monte Carlo VAR Looks at large number of possible outcomes all sharing certain defined statistics

FIGURE 7.1 Risk measurement methods

the company has option positions). Value-at-risk, like any risk measurement tool, is not sufficient on its own, and so an organisation should have a number of risk measurement tools as part of its risk management policy. Figure 7.1 shows some of the main measurement techniques available to complement VAR. The use of stress tests and sensitivity analysis alongside VAR will be examined later in this chapter. Before VAR was developed, trading companies only had risk measurement tools such as ‘add-on’ approaches, in which companies would set an in-house margin rate (capital charge) for derivative trades. The percentage was based on a percentage of notional value and would vary depending on the tenure of the derivatives deal. For example, the add-on rule could be that when a deal is in the tenure range of one to six months forward, a value of 10% is taken of the notional value as the add-on risk. So, for a deal involving 50,000 barrels of Jet Fuel at US$25 per barrel the notional value would be US$1.25 million, which would mean that 10% of that figure (US$125,000) would be booked to be used by the company’s trader on this derivative position. Then, in addition to this, every day any unrealised loss would be added to the position and the add-on value would be revalued based on the most current fair value of the derivative.

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The problem with this approach is that, as Bank of International Settlement research has indicated, ‘add-on’ methodologies can create situations in which too much capital is being used on a risk, and sometimes not enough capital is being allocated to reflect the risk being taken as a trader. For this reason, companies still using an ‘add-on’ methodology should seriously review their position.

WHAT DOES VAR DO? There are different types of VAR model which will be examined in this chapter from a practical application standpoint, but, basically, VAR measures the worst expected loss over a given time horizon with a certain confidence – or probability – level. VAR allows management to see the probable risk their company is taking, or, in the case of companies hedging, it can also illustrate reduction in possible financial exposure. It has great appeal, since VAR can summarise all the market risks of the entire portfolio of a firm (e.g. oil, gas, power, coal, forex) across physical and derivatives positions and represent that as one number in US dollars. The key use of VAR is for assessing market risk (exposure to losses in the market place through physical and derivative positions) although VAR is being used more frequently to assess credit risk (credit VAR modelling). However, VAR does not give a consistent method for measuring risk, as different VAR models will come up with different VAR results. It should also be noted that VAR only measures quantifiable risks; it cannot measure risks such as liquidity risk, political risk, or regulatory risk. In times of great volatility, such as war, it may also not be reliable. For this reason, VAR models should always be used alongside stress testing, as mentioned earlier in the chapter. To calculate VAR, a VAR mathematical model needs to be chosen and, in some cases, historical price data on the relevant markets should be obtained. Then a time horizon should be selected (for example, overnight) and a probability – or confidence – factor should be chosen. Most VAR models use a time horizon of one day (sometimes referred to as the ‘holding period’) and, in the energy industry, the most common confidence level is around 95% (although more conservative companies often prefer a higher figure). A 95% confidence level means that the company is expecting this value at risk loss to be exceeded, on average, one day in every twenty. The confidence level should, of course, be reviewed and approved at the Board of Directors level in the organisation at the time of approving the organisation’s Risk Management Policy. There are several different types of VAR and in terms of practical applications some are better than others. The three most important types are:

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NICK LEESON AND THE COLLAPSE OF BARINGS In February 1995 the world was shocked by the news that the UK’s oldest bank, Barings, had collapsed. Investigations revealed that its downfall was largely due to the activities of one of its young investment officers, Nick Leeson. Mr Leeson worked in the bank’s Singapore office and traded on the Singapore Monetary Exchange (SIMEX). His risky and unauthorised derivatives investments in the Japanese futures market resulted in losses of around 1.3 billion dollars. This huge loss wiped out the firm’s entire equity capital and led inevitably to the bank’s the collapse. Putting aside the lack of properly enforced risk management policies for a moment (these will be discussed in Chapter 9: Management Controls), it is interesting to note that under normal market conditions the potential loss of Mr Leeson’s trading positions would have exceeded US$835 million 5% of the time. If these VAR calculations had been in place, the parent company Barings Bank in London may have been able to provide some protection against the disaster that was awaiting them.

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Variance/covariance VAR This is generally the most popular method among energy market participants. The historical method In essence, this method ask ‘What if history repeats itself?’ Monte Carlo VAR simulation This method looks at a large number of possible outcomes all sharing certain defined statistics and is also known as stochastic simulation.

VARIANCE/COVARIANCE VAR The variance/covariance approach was pioneered by JP Morgan with its product RiskMetrics (which can still be found on the Internet at http:// www.riskmetrics.com/). It involves using information on the volatility and the correlation between the various markets in which an organisation is holding derivative and physical positions. VAR takes into account the price correlation relationships between the various parts of an organisation’s energy derivatives/physical portfolio. One would expect that a buy and a sell even in two different energy markets which were highly correlated with one another would produce a low VAR. However, if an organisation held a long (buy) position in coffee beans and a short (sell) in North Sea Brent Crude oil, one would expect that these would not have much of a price correlation relationship and the VAR would be much higher, as there would be no offsetting between the long and the short positions within the organisation’s portfolio.

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Variance/covariance models are fairly easy and quick to compute and calculate, as they can be produced on a spreadsheet, and they are useful for the intra-day management of simple futures/swaps portfolios. However, they are not suitable for complex portfolios of derivatives. An analysis of options contracts, for example, will often produce erroneous results under this model. Monte Carlo VAR is the only methodology that can produce precise VAR results for more complex derivatives portfolios that include options. Summarising variance/covariance methodology: ■

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Strength ● Easily calculated in markets which have readily available market data. Weakness ● Historic correlations and volatility relationship may break down under extreme market conditions. Requires ● VAR calculator.

HISTORICAL SIMULATION VAR METHOD The historical VAR method is simple to understand and uses real historical data from the markets that an organisation is active in. If the data is available, it is possible to use this method to run a historical VAR on a trading portfolio as if it were going through the Gulf War of the early 1990s, for example. The method works by running the position of the current organisation’s portfolio against historical market movements to create a P+L scenario. For example, if an organisation’s current portfolio consists of 30% Natural Gas, 50% Singapore Fuel Oil and 20% UK APi2 Coal, it should obtain the historical market data for the three components of its portfolio for the last 720 data items (720 market/business days = approximately 3 years). Then for each day over that 720 day historical period the value of the current portfolio can be calculated. The drawback of this approach is that it is very time-consuming and can be very demanding on computer resources if the portfolio is complex or if it is run over many years of historical data. Summarising the historical VAR model: ■

Strengths ● As well as being simple, the historical VAR approach is more realistic than the variance/covariance approach, since the volatilities and correlations in this approach are not actual figures, but just estimates based on averages over a specified time.

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It does not require mapping, unlike variance/covariance. Mapping is the sometimes painful process of trying to fit a derivatives position into the volatility statistics which are available. Weaknesses ● Time-consuming, computer resource hungry. ● Reliant on history repeating itself. ●

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MONTE CARLO VAR SIMULATION (STOCHASTIC PROCESS) The Monte Carlo simulation method can be used to handle complex derivative portfolios including OTC/exotic options and it has a number of similarities to the historical simulation model. The key difference is that the historical simulation model carries out the simulation using the real observed changes in the market place over the last X periods (using historical market price data) to generate Y hypothetical portfolio profits or losses, whereas in the Monte Carlo simulation a random number generator is used to produce tens of thousands of hypothetical changes in the market. Many energy market participants will use a minimum of 30,000 calculations in this process. These are then used to construct thousands of hypothetical profits and losses on the current portfolio, and the subsequent distribution of possible portfolio profit or loss. Finally, the VAR is determined from this distribution according to the parameters set (e.g. 95% confidence level). The more hypothetical simulations that are used the better the result will be, but this will depend on how long you can wait and how fast your computer is! The large number of calculations required by this method means that the computation of this VAR on a large complex portfolio can take hours. However, with computing power getting rapidly cheaper this is no longer such an issue as it once was. The Internet is also enabling software firms to allow companies to use their computers to do the calculations, removing the need to invest in lots of in-house computing power. This type of outsourcing approach is becoming more popular even in the investment banking community. Two firms pioneering this in the energy trading industry are Innova (http://www.ifs.dk/) and http://www.sknt. com/. Although the Monte Carlo simulation process is rather complex, in terms of precision it is certainly considered by users as the most effective of the three VAR methods discussed in this chapter. Summarising Monte Carlo simulation: ■

Strengths ● The most precise/effective VAR model.

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Can handle complex derivative portfolios, including options. Generally more realistic results. Weaknesses ● The most complex to calculate. ● The slowest to calculate. ● As an organisation’s trading activity/position increases over time additional computer processing power requiring hardware upgrades may be required. ● ●

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VAR RECAP The great thing about VAR in terms of practical implementation and application across an organisation is that the output of VAR calculations is easy for everyone to understand. This has been the key factor in promoting its widespread adoption across non-financial traders, energy companies and end-users. The output from VAR calculations is a currency value, which in the energy industry is usually given in US dollars. It shows clearly how much an organisation is risking over the chosen time horizon within a certain confidence level. If the VAR result for Trader A’s portfolio is US$2 million but for Trader B’s portfolio is US$3 million, it is easy to see who is putting the company at more risk. So, by using the above scenario of Traders A and B, a risk manager might report to her management that within a 95% confidence level, the company is risking a potential loss of no more than US$5 million over the next 24 hours. As a result, the energy sector can decide how to allocate economic capital as a trader or speculator and how to trade off risk and return.

VAR TO ILLUSTRATE HEDGE EFFECTIVENESS Both producers and consumers can use VAR to assess and quantify the effectiveness of hedges in an easy-to-understand format, but it should be remembered that an effective hedge is not necessarily a profitable one. It is possible to have an effective hedge that loses money on the derivatives side of the hedge but still allows the company to profit from cheaper physical energy as a consumer, or higher physical prices as a producer. Companies which are hedging may suffer an ‘opportunity cost’ in economic terms, but as long as they do not have too much basis risk, the derivatives hedge + physical purchase/sell should net out. Until VAR began to be adopted more widely by the energy industry (from around 1998 onwards), staff who were responsible for hedging programs in companies were often faced with difficult questions about

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why hedges lost money on the derivatives side of the deal. For them, it was difficult to show how effective a hedge was. Most of the time, companies would gauge the effectiveness of a hedge by whether they made money on their derivatives hedge. But with VAR it can be shown that swaps, futures and/or options positions actually reduce a company’s potential risk to exposure by a US dollar value. After all, the fundamental aim of hedging is to protect against disaster scenarios, to reduce balance sheet volatility or profit/loss volatility and to protect operating profit margins from being eroded. With VAR, it is easy to take a simple, practical approach to demonstrating the effectiveness of a hedge position. A physical energy position can be put into the VAR model and then run to show how much money is being risked in the chosen time horizon and confidence level by not hedging. If an opposing hedge derivatives position is added to the model, the reduction of potential risk exposure can be presented as a clear figure in US dollars. This makes it easy for management from all divisions and business areas to appreciate the amount of risk reduction. So, VAR can illustrate the effectiveness of a hedge strategy, or highlight that a supposed hedge is actually increasing risk due to bad correlation between your physical energy and the chosen derivatives contract. This is particularly the case when using a ‘proxy’ hedge. This is a derivatives contract (swaps, futures, or option) that is not pricing against exactly the same pricing index as the underlying physical energy buy/sell and so in rare cases the amount of potential risk reduction is not worth the cost of hedging. (See ‘Basis Risk’ and ‘Hedge or trade’, Chapter 1, for more details)

STRESS TESTING AND VALUE-AT-RISK So, VAR can be used to provide a probability-based boundary on likely losses for a specified holding period and confidence level (for example, the maximum loss that is likely to be experienced over one day with a 95% level of confidence). It can also be used to assess the risk-adjusted performance of individual business units. However, we have to recognise that there are limitations to the ability of statistical models such as VAR to accurately capture what happens in exceptional circumstances. VAR may be able to tell us that within a 95% confidence level certain things will happen, but it does not tell us what might happen in that 5% gap! By definition, exceptional circumstances occur rarely, and statistical inference is imprecise without a sufficient number of observations. Although Monte Carlo VAR simulation can get a user close to perfection through tens of thousands of calculations, stress testing is still advisable alongside this approach.

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Stress testing analysis methodologies In stress testing, two standard ways of developing scenarios are commonly employed: ■ ■

Historical scenarios (using historical price data). Hypothetical scenarios.

Energy sector traders tend to use a mixture of both approaches. Historical scenarios employ shocks that occurred in specific historical episodes. A simple way to do this is to identify days in the past that were ‘stressful’ and use the observed changes in market risk factors on those days. For example, a portfolio of market risk exposures could be stress tested by seeing how its value would change given the changes recorded for market risk factors for a day, or over a longer period. The selection of the day, or period, is typically based on ‘headline’ disturbances, such as the Gulf War in the oil markets, Iraq invading Kuwait, big OPEC decisions, or the power crisis in California. One advantage of this technique is that the structure of market factor changes is historical rather than arbitrary. The fact that the market moves used are historical fact enhances the credibility of the exercise from the point of view of risk management, due diligence and, as a result, senior management. Another advantage of historical scenarios is their transparency. A statement like ‘if the Gulf War happened tomorrow, the firm would lose X million dollars’ is easy to understand and put in to perspective. One disadvantage of historical scenarios is that firms may (consciously or unconsciously) structure their risk-taking to avoid losing money on shocks that have occurred in the past, rather than anticipating future risks that do not have a precise historical parallel. This could represent a conscious choice on the part of traders, if firms give traders an incentive to minimise exposure to stress tests through limits or capital charges. It could also represent an unconscious choice, if traders overestimate in their own minds the likelihood of shocks that they have first-hand experience of. Another obvious but key disadvantage of historical scenarios is that they may be difficult to apply to derivatives products which did not exist at the time of the historical event in question. This is one of the reasons why hypothetical scenarios are also important. The hypothetical or sensitivity stress test approach One reason why an organisation may choose to conduct hypothetical stress testing as well as historical stress testing on its derivatives portfolio is that hypothetical stress tests allow them to assess the extent to which the conventional wisdom (based on the history of recent market moves) may be driving position-taking (or lack thereof as the case may be!) Hypothetical scenarios use a structure of shocks thought to be plausible in some foreseeable circumstances for which there is no exact parallel in

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recent history. This begs the question how far back in history do you go. Generally many energy traders do not look back beyond more than five years of historical data. This is because the further one looks back in history, the bigger the chances are that the fundamental supply/demand factors of the energy market will have changed. This, in turn, affects the benefit of applying that historical price movement to a current live derivatives portfolio. Perhaps the most prudent approach to stress testing is to use a mixture of the last five years’ data plus a few snapshots of data related to particular disaster scenarios like the Gulf War. Limitations of stress tests In practice, stress tests are often neither transparent nor straightforward. They are based on a large number of risk management choices as to what risk factors to stress, what range of values to consider, and what time frame to analyse. Even after such choices are made, risk managers are faced with the considerable tasks of analysing the results and trying to identify what implications, if any, the stress test results may have for their organisation. A well-understood limitation of stress testing is that there are no probabilities attached to the outcomes. Stress tests simply help to answer the question ‘How much could be lost?’.

SUMMARY Over recent years, the development of VAR models of risk measurement has greatly improved the risk manager’s ability to assess market and credit risks and to help others in the organisation understand what those risks mean. However, even the most rigorous VAR analysis cannot capture the potential effects of all exceptional circumstances, and for this reason VAR should be used alongside periodic stress testing of an organisation’s trading, derivatives portfolio and exposures, in order to obtain a balanced risk measurement policy.

CHAPTER 8

Questions to Ask When Establishing a Risk Management or Trading Program

These are some of the key questions to ask when collecting information that will help to create a policy for the usage of derivatives either as a trader, speculator or hedger. 1. What is your organisation? A consumer, a producer or a trader? 2. What products does the organisation have price risk in? ● Products ● Fixed or floating price risks 3. Is your organisation’s aim hedging or trading? Which of these are you trying to do? ● Mitigate a disaster risk scenario ● Protect budgeted levels ● Control overall price risk ● Trade risk as speculator 4. Will you let traders speculate or only hedge? 5. What is your total volume of energy to hedge or how much do you wish to trade? 6. As a hedger, how much do you want or need to hedge? ● When hedging look at up to 50% of exposure for general day-to-day hedging requirements. ● Any hedging over 50% of consumption or production volume is speculative and should only be considered as rare case pre-emptive measures ahead of a ‘disaster scenario’. This could be during protracted periods of extreme high prices (as a consumer) or extreme low prices as a producer of energy. Or it could be as opportunistic 141

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hedging opportunities when historically high profitability can be ensured in by locking in low prices as a consumer or high returns as a producer. – One exception to this guideline is when as a consumer you have 100% of sales/income fixed (e.g. a charter airline which has pre-sold all seats on flights and is exposed to floating price jet fuel). – Another example is if you are a trader buying a feedstock for your own refinery system, or you are buying power or gas for your company and you need to fix this cost so that other departments in the organisation can cost delivery of finished goods or products for customers. – Usually end-users will hedge around 20% to 30% of volumes around budget levels up to 18 months forward, leaving an additional 20% to 30% (up to 50% total) for opportunistic hedging if levels come below budget levels. – End-users should also generally look to have another policy for hedging in times of extreme price moves, allowing the energy procurement department or the dedicated risk management departments to act quickly to protect the firm against extreme price moves that might be seen in times of war etc. For example, if you were an electricity consumer in the USA when power costs spiked to US$10,000 per MWh, you would have wanted to protect yourself before that happened, perhaps by up to 100%. Or, as an airline, as tension increased, you would have wanted to protect yourself ahead of the Gulf tension in the Iraq/Kuwait confrontation. Answering all these previous questions will help an organisation to then look at the next step of putting together a risk management policy. 1. What types of derivatives should be used? ● Futures ● Options – OTC? On-exchange? – Can traders only buy options or will they be allowed to sell options as well? (This can incur open exposures for companies if not as part of a larger structure. Also in some derivative disasters, the sale of options has been used to generate cash flow to cover up losses elsewhere in a portfolio.) ● Swaps 2. What tenures/how far forward the organisation can utilise these derivatives? ● Normally, an organisation should state in its risk management policy (as a hedger) or derivatives usage document (as a speculator) which derivative types can be used, in which markets they can be used and also how far forward each type of derivative contract (futures,

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options, swaps) in each market (e.g. Singapore Gasoil, Dubai Crude, Brent, Fuel Oil Rotterdam). 3. Which derivatives markets to utilise? ● For hedgers – this decision will be based on how well the available energy derivative markets correlate in terms of price (and also causation relationship) with the underlying energy markets that are to be hedged and in which the organisation has price risk exposure. Then, once a list of possible energy derivatives that match requirements are selected, an organisation must then review this list with the contract liquidity in mind. (Checking with brokers on the average daily volume, normal bid/offer spread gap, number of active counterparts). If liquidity is bad then an organisation may have to consider a proxy hedge. ● A proxy hedge example – IPE Brent Futures to hedge Middle East crude exposure. IPE Brent is not a Middle East crude contract, but it has high liquidity and has some price correlation relationship with Middle East crudes. This might be instead of using the OTC Dubai or Oman swaps which are much more closely linked with Middle East crude, but price transparency and overall liquidity may not be good enough for some organisations. ● For traders/speculators – this decision will be based upon liquidity of the energy derivatives markets (volume and number of counterparts trading the market) and also the level of price transparency that exists. For a trader/speculator the lack of price transparency can be an attraction, whereas for a hedger, price transparency is more important than liquidity. Liquidity is more important for traders, since they will normally wish to trade out/close out a position ahead of its expiry/settlement. An organisation hedging will normally let derivatives contracts run their full term through to expiry as it is hedging an underlying energy price risk. So, for a hedger, the ability to trade out/ close out a derivatives position may be less of a concern. The price linkage between the derivative and the energy price risk being hedged may be more important to the hedger than the liquidity of the market. 4. How will the operations department manage these derivative positions? ● Will the organisation require new IT infrastructure to process and manage these derivative positions? ● Does the organisation have the relevant skill sets or will training be required prior to the start of this activity? ● How will these derivative positions be valued? – Valued against third party forward curve assessment, e.g. Platts Forward Curve or broker quotes/dealer quotes? ● How often will these derivative positions be valued?

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– Daily, weekly, monthly, quarterly For a trader/speculator, how will the position limits be set? – Volumetric limits? – Notional value limits? – Will the limits be set by tenure and product? – Which traders can trade what products and which types of derivatives can they trade? Who will be responsible for monitoring these positions and reporting any break in the organisation’s policy for derivatives usage? What reports will be produced to assist risk monitoring/performance function? – Open position reports – Market value reports – Profit and loss reports – Hedge effectiveness reports (correlation analysis between the derivatives used for hedging and the underlying energy risk being hedged) How often will these reports be produced? Who has to see these reports and sign them off as read? Prior to any activity starting, the organisation must assess the operational risk of this new business, as well as credit risk, market risks, legal risks, tax risks etc. Who will be responsible for ensuring that there are ongoing regular reviews of these risks?

This is certainly not an exhaustive list, but all of these questions can assist an organisation’s management to start looking at policy decisions and to put together a short paper on what they propose to let their risk managers and traders do. Accounts departments can also get a good idea of what type of accounting for derivatives will have to be handled, either as hedges or speculative trades (see Chapter 18). All the information from this short paper, and feedback on it from the relevant line managers in the organisation, should then be put together for presentation to the Board of Directors/Board of Management, who should create a general policy and reporting structure for the organisation. Line managers should then take this general policy and, with reference to the Board’s decision, fine-tune a more detailed risk management derivative usage guidebook for traders, operations and managers. This operational document should be submitted again for approval by the Board of Directors.

CHAPTER 9

Management Controls

THE COLLAPSE OF BARINGS On 18 July 1995, the world’s financial institutions received a shocking wake-up call. That was the day when the UK’s oldest bank, Barings, officially collapsed, posting a loss of US$1.3 billion. The firm’s entire capital had been wiped out as a result of unauthorised and extremely risky derivatives investments in the Japanese futures markets made by one of its young investment officers, Nick Leeson. Many in the media blamed the disaster on the nature of derivatives themselves, but the real reason for the bank’s collapse was the complete lack of enforced management controls throughout the organisation. On the face of it, Barings collapsed because it could not meet the enormous trading obligations that Leeson had established in its name. When it went into receivership on 27 February 1995, Barings had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. Leeson had also sold 70,892 Nikkei put and call options with a nominal value of $6.68 billion, which had allowed him to generate up-front premium (positive cash flow) to offset any losses on the futures. The size of the Barings positions was obviously huge, particularly when compared with the bank’s reported capital of about $615 million! The alarming size of the positions should have been clear to Barings’ management at the time. In January and February 1995, Barings Tokyo and London transferred US$835 million to the Singapore office to enable Leeson to meet his margin obligations on the Singapore International Monetary Exchange (SIMEX). The transfers were so large that Barings’ management was asked several times by the British Treasury why so much cash was being sent to Singapore. If the managers responsible had taken notice of these warnings and undertaken a proper investigation of the activities of the Singapore office at that time, the collapse of the bank might well have been averted. 145

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The cash, or at least around US$500 million of it, was put down as loans futures to customers of Barings Futures Singapore. The credit risk implication of the client advances represented by these ‘top-up’ balances would have been significant if the total funds remitted to Singapore were to meet genuine client margin calls. Yet the credit risk department did not question why Barings was lending over US$500 million to its clients to trade on SIMEX and collecting only 10% in return. It did not seem to have any idea of who these clients were, yet Barings’ financial losses would have been significant if some of these clients defaulted. After all, the bank’s capital was only US$615 million! No credit limit per client or on the total ‘top-up’ funds was set. Indeed, clients who were advanced money this way appear not to have undergone any credit approval process. The credit committee never formally considered the credit aspects of the ‘top-up’ balance, although they could see the growth of these advances as recorded on the balance sheets. Plainly put, the credit risk controls of Barings did not exist. The fact that such important indicators as cash flow and credit risk were ignored is bad enough, but the management of Barings also broke one of the other key rules of any trading operation. They allowed Leeson to settle his own derivatives trades by putting him in charge of both the dealing desk (the front office) and the back office (the administration of derivatives trades). This is a clear breach of the principle of segregation of duties. To put it simply, the front office executes derivatives trades, while the back office records all the trade confirmations, settles the trades, checks them and assesses the accuracy of prices used for its internal valuations and marked-to-market reports (MTM). It also accepts and releases payments for derivatives trades. Since Leeson was in charge of the back office, he had the final say on payments, ingoing and outgoing confirmations and contracts, reconciliation statements, accounting entries and position reports. In other words, he was perfectly placed to relay false information back to London. Abusing his position as head of the back office, Leeson hid information in the now infamous ‘88888’ account. Barings London did not know of its existence because Leeson had asked a systems consultant to remove error account ‘88888’ from the daily reports which Barings Futures Singapore sent electronically to London. The lack of segregation of duties at Barings Singapore office was perhaps the most serious failing of management controls. But what was even worse in this case is that some managers were fully aware of this position. Tony Hawes, the Group Treasurer, reported the unsatisfactory nature of the situation as early as February 1994, but nothing was done. He subsequently made his views known to James Baker, who undertook an audit of Barings in Singapore in July/August 1994. The internal audit report made specific recommendations on the segregation of job roles, but

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again there was a major control failure and none of the recommendations was implemented. Since Leeson controlled the back office and because Barings had no independent unit checking the accuracy of his reports, the market risk reports generated by Barings’ risk management unit were totally inaccurate. Leeson’s futures positions showed zero market risk because trades were supposedly offset by opposite transactions on another exchange (arbitrage between SIMEX and TOKYO). The unfortunate result was that Barings’ shareholders learnt the painful truth behind the saying ‘garbage in, garbage out’ because a system is only as good as the data put into it! Barings’ problems could also have been avoided if appropriate management had reviewed transactions and management information reports and held discussions with appropriate personnel about the nature of business transacted. Such approaches provide line management with an objective look at how decisions are being made and ensure that key personnel are operating within the parameters set by the organisation and within the ‘Internal Control Framework’ (ICF – the guidelines and policies for usage and reporting of derivatives in the organisation). But what really shocked the financial world and made a lot of companies rethink their internal reporting and control structures was the simple fact that the Nikkei 225 and JGB futures contract that Nick Leeson traded were plain vanilla derivative instruments. As listed contracts, they were extremely transparent (unlike OTC) and Barings was required to pay (or receive) daily Initial and Variation margins and so needed funds from London. In January and February 1995 alone, Leeson asked for US$835 million. He could not hide his build-up of positions on the OSE because the exchange publishes weekly numbers. Other banks could see Barings’ enormous positions, and many assumed that the positions were hedged as arbitrage positions because such large positions were far too big compared to the bank’s capital base (US$615 million). Barings’ collapse is an extreme example of internal control and information system failures, all adding up to a massive unexpected loss. Derivatives can be very beneficial for organisations looking to control price risk or for companies looking to trade in the energy derivatives markets in a controlled environment. However, senior management of companies using derivatives must never disregard the guidelines and recommendations which have been drawn up by practitioners, regulators and risk management advisors.

THE LESSONS OF HISTORY Dealers and end-users should use derivatives in a manner consistent with the overall risk management and capital policies approved by

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their Boards of Directors. These policies should be reviewed as business and market circumstances changes. Policies governing derivatives use should be clearly defined, including the purpose for which these transactions are to be undertaken. Senior management should approve procedures and controls to implement these policies and management at all levels should enforce them.’ This short paragraph was written by the G30 group in the early 1990s and it serves as a good starting point to explain controls for derivatives users. Particularly important is the recommendation that organisations should have a policy that defines the purpose of using derivatives; in other words, it should be clear whether they are being used for speculation or hedging. This is even more relevant in today’s market than it was at the time it was written, since even non-bank users of derivatives are now required to make accounting disclosures for derivatives. The accounting approach depends on whether the derivatives contracts are for hedging or speculation. This is an example of how controls and requirements are interlinked and how policies need to be reviewed regularly. Accounting and reporting regulations can modify controls and reporting requirements to the outside world. Many control failures that resulted in significant losses for derivatives users could have been substantially reduced or even avoided if the Board and senior management of the organisations had established strong risk management controls. It is worth pointing out that the occurrence of deliberate fraud in organisations is very low; in the majority of cases the main problem is simple human error. By examining what could be termed derivative ‘disasters’, like the collapse of Barings, it can be seen that the typical control breakdowns have been in five broad categories: 1. Management control Senior management can weaken controls by promoting and rewarding managers who are generating profits but who fail to implement internal control policies or address issues identified by risk management reviews and internal audits. Such approaches send a message that internal controls are considered secondary to other goals in the organisation, and this in turn can reduce the commitment to and quality of its controls. 2. Risk assessment Companies which have sustained large losses in the past have often neglected to assess the risks of new derivatives instruments or trading activities. It is essential to review procedures and risk management systems when an organisation decides to move from using simple derivatives (futures, plain vanilla swaps) to more complex derivatives such as traded options, or OTC option structures.

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3. Segregation of duties One of the main causes of derivatives disasters has been the lack of segregation of duties. This has sometimes occurred when senior management have assigned a highly regarded individual responsibility for supervising two or more areas with conflicting interests. For example, if one individual is supervising both the front office (execution of derivatives trades) and the back office (the department where trades are reconciled and exception reports are generated for management information), then this person’s duties are clearly not properly segregated. 4. Reporting (communication) To have any chance of being effective, policies and procedures must be communicated to all staff involved in the use of derivatives. Senior management should ensure that the organisational structure and management accountability are clearly defined. Sometimes losses in companies have occurred because key staff have not been fully aware of the derivatives usage policies of their own organisation. As a result, activities that were outside the scope of the authorised usage of derivatives were never reported to higher management. Until it was too late! 5. Reviews/audits There have been cases in which auditors or internal reviews have exposed weaknesses in a company’s controls or reporting structures but these have been ignored by senior management.

CREATING A RISK MANAGEMENT OR TRADING POLICY The risk management and trading policy parameters for the usage of derivatives will vary from organisation to organisation, but here are some key guidelines and key stages that can help. Component 1 – Board level approval The Board of Directors should establish and approve an effective policy on the use of derivatives which is consistent with the strategy, commercial objectives and risk appetite of the underlying business and should approve the instruments to be used and how they are to be used. The Board of Directors should: 1. Review the proposed purpose and use of derivatives. 2. Ensure that this is consistent with management capabilities, financial position and commercial objectives, including any legal restraints. 3. Approve a list of derivatives and agree the reason for using them. 4. Ensure that the appropriate policies and control procedures are in place.

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5. Implement an independent review of risks and rewards. 6. Nominate two or more Board members to be responsible for derivatives. 7. Regularly review actual derivative usage. 8. Ensure that management reports are fit for purpose. 9. Ensure on-going training of key personnel. Component 2 – policies and procedures Senior managers should establish clear written procedures for implementing the derivatives policy set by the Board. These should cover: 1. 2. 3. 4. 5. 6.

Trading authority – who can trade and what they can trade. Management reporting lines. Position limits in derivatives markets. Counterparty approvals. Documentation approvals. Valuation procedures. Checklist: 1. Appoint a senior manager to be responsible for policies and procedures. 2. Design and document limits for market and credit risk. 3. Design and document procedures for when limits are passed. 4. Design and document procedures for approving brokers or counterparties to be used. 5. Ensure that accounting policies have been established. 6. Ensure that all taxation implications have been considered. Component 3 – control and supervision Senior Management should ensure that derivative activities are properly supervised and are subject to a clear framework of internal controls and audits to ensure that derivative usage is in compliance with corporate policy (and external regulation in the case of a financially regulated institution). Checklist: 1. Regularly review the level of expertise in the organisation. 2. Perform an independent review of the internal controls. 3. Ensure that management reports are fit for purpose. 4. Examine computer systems and check they are robust and cannot be amended by unauthorised personnel. 5. Ensure regular internal audit checks. Component 4 – organisation, roles and responsibility Senior management should establish a sound risk management function providing an independent framework for reporting, monitoring and controlling all aspects of the risk matrix (see Chapter 1).

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Checklist: 1. Allocate very clear responsibilities to individuals using organisation charts and clear job descriptions. 2. Use appropriate market risk and valuation techniques. 3. Ensure that all significant limit excesses are reported to the Board of Directors (in exception reports). 4. Perform price movement stress testing to assess the effect of abnormal market movements on positions. Component 5 – credit procedures All credit risks to which the organisation will be exposed should be measured and analysed, and these risks should be minimised through the use of effective credit management (e.g. collateralisation of positions with credit weak counterparts, credit defaults derivatives, credit insurance). Checklist: 1. Analyse the risks inherent in both exchange-traded and OTC derivatives. 2. Minimise credit risk through netting agreements and other techniques. 3. Establish credit risk limits in derivatives markets (overall limits) and counterpart by counterpart limits. 4. Establish procedures for authorising credit limit excesses. Decide on the person responsible for giving approvals and the person who will deputise in his or her absence. 5. Establish policies and procedures in the event of a counterparty or broker becoming insolvent. If positions are held in futures markets with a broker, the organisation’s funds should be segregated from the operating capital of the broker. This is the regulatory norm these days, but it is worth checking the agreements with the broker, as it means that the funds are protected if the broker goes bankrupt. Component 6 – legal and documentary Procedures should be in place for monitoring legal risk, covering legal capacity, authority, compliance and the need for the appropriate documentation. Checklist: 1. Establish that the organisation has the power (internally and externally) to use derivatives in the manner envisaged. 2. Ensure that the authority to deal in derivatives is delegated to the appropriate staff. 3. Complete a list of authorised existing and potential brokers and counterparties. Note any restrictions. 4. Obtain warranties from each broker or counterparty as to its power to deal in derivatives.

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5. Review documentation. 6. Use master trading agreements for OTC derivatives. The use of standard ISDA agreements for cash-settled OTC deals will mean that an organisation will have access to lots of legal and other expertise on matters relating to their derivatives deals. This can help keep up-front legal costs down as well as creating greater legal assurance and certainty in situations of default or disputes. 7. Ensure that margin or credit arrangements are well documented. All of the guidelines and information compiled from these components of the management control matrix will help an organisation to produce a risk management policy document (sometimes referred to as a risk management or derivatives usage procedure manual). This should be distributed to all heads of business units in the organisation and to all front office and back office staff. The policy document will enable staff to conduct their day-to-day activities effectively, referring to the document as required to ensure they are operating in line with their organisation’s operating procedures. A section on management reporting lines in the policy document should clearly inform staff who they should report to for special approval if they need to take any action involving derivatives contracts that is outside the normal boundaries set by the risk management policy document.

CORPORATE DERIVATIVES RISK MANAGEMENT POLICY AND PROCEDURES DOCUMENT The primary components of a sound risk management process are: ■ ■ ■ ■

A comprehensive risk measurement approach e.g. VAR. A detailed structure of position limits. Guidelines and other parameters used to control the usage of derivatives (either for hedging or speculative purposes). A strong management information system for controlling, monitoring and reporting risks.

By expanding on these primary components we can illustrate the key contents of a typical derivatives policy or manual. Example of key contents in policy document 1. What is the organisation’s purpose in using derivatives? ● Speculation (to take advantage of risk opportunities)? ● Hedging (to reduce price risk exposures)? ● Both?

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2. What type of derivative instruments is the organisation willing to utilise? ● On-exchange futures. ● On-exchange options (traded options). ● OTC swaps. ● OTC option (exotics). 3. Which markets can the organisation’s traders utilise? ● What are the limits of the derivatives positions? ● Overall company-wide position limits. ● Individual trader limits. ● Position limits for each of the energy derivatives markets that traders have access to, in order to control liquidity risk. 4. What percentage of the energy exposure should be hedged? ● The minimum amount to be hedged. ● The extra volume allowed for opportunistic hedging if prices are within budgets. 5. What are the limits on the tenure of derivatives utilised? ● This may be listed by energy derivatives market. The decision on how far forward traders can trade in a particular market will depend on counterpart credit worthiness and the general liquidity in the market. 6. Which counterparts are used for OTC? ● A list of authorised counterparts regularly updated and passed to traders (front office and back office) to prevent accidental unauthorised trades. ● Clear policy on credit quality required for counterparts in OTC markets. 7. Policy on types of legal documentation that must be in place prior to any derivatives trading commencing with new counterparts. 8. Management reporting lines ● A clear diagram showing reporting lines will help front and back office staff and management handle problems quickly and efficiently. 9. Reports to be generated daily ● A list of reports and who is to produce them on a daily basis; e.g. exception reports, position reports, profit and loss reports. 10. Exception reports ● Clear policy on who is to see these reports and who must sign off and be responsible for taking action to resolve matters.

BACK OFFICE SYSTEMS An organisation may succeed in putting in place a clear management and reporting structure, with a written risk management policy that all staff

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are familiar with, but all this effort will have been wasted if an appropriate back office system is not in place. The back office is vital for protecting an organisation, as it is where all data on trades are collected, where positions are valued each day and where core management information reports are generated (e.g. exception reports). Any back office or control system is only as good as the quality of the data inputted. These inputs can be summarised as follows: ■ ■ ■ ■ ■ ■ ■

New transactions. Exercises (options that expire and create a new swap/futures position or even exercise into physical). Market price data. Close-outs and settlements. Deliveries. Receipts and payments. Data on any documentary credits/guarantees from trading counterparts – values, expiry, type.

Controls of input data Whether a reporting/control system is manual or computerised, the proper control and validation (double checking) of input is essential (Figure 9.1). Responsibility for particular input tasks should be clearly allocated, with password control used for screen operators. Input routines should require a standard format containing all relevant detail for a new transaction (e.g. date, counterparty and full transaction data – volume, settlement and price). Source documents (trading tickets from trading desk) should be time-stamped, or otherwise marked to indicate the time of execution, and then also marked by the back office to indicate that they have been inputted. All input should be subject to validation routines (e.g. Back office retypes data into accounting system; Accounts then request guarantees from counterparty if required

Trader writes deal ticket

Back office collects trade ticket every 15 minutes or 30 minutes (banks)

Payment due so payment instruction then typed into banking system or manually requested

Back office inputs deal ticket in to system

Trade comes to settlement Information printed out Re-typed in to Accounts system

FIGURE 9.1 Controls of input data

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computer proof listings of new transactions entered requiring confirmation or validation prior to updating the main transaction records). A unique reference number should also be assigned within the system to each item of validated input – on most occasions this number is the actual ticket number written out and time-stamped by the trader on the trading desk. Straight through processing Some companies are already moving towards what is known as straight through processing, or STP for short (Figure 9.2). Futures markets are very close to this already with trades from the exchanges going into Clearing House systems and Clearing Broker member systems automatically. The OTC market is slowly moving this way too, with several organisations starting e-confirms for OTC derivatives transactions. These allow confirmations of deals done on and off electronic trading platforms to go straight into counterpart back office and risk management systems. OTC is generally still recapped by postal confirmations and faxes. By reducing the human involvement in the trade processing and back office management, companies are already trying to reduce the risk of human error in inputting deal data. According to the International Swaps and Derivatives Association (ISDA;Operational Benchmarking Survey Summary), many organisations are now well on the way to implementing STP as a key part of their back office systems. The Association’s 2002 Operational Benchmarking Survey

Back office monitor STP Systems sends request to Accounts/ Treasury, perhaps to request Documentary Credit against a particular counterparty position Trader types in deal information direct in to back office system

All system records updated and reports generated automatically

Deal comes to settlement System automatically invoices counterparty or notifies accounts of payment due and bank

Bank notified to make payment or receive payment confirms process actioned electronically

FIGURE 9.2 Controls of input data (reduction in human error risk through multiple to different systems)

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Summary was based on responses from 65 firms around the world and reported that: ■ ■

Front office trade data is available for same day processing as follows: 100% for forward rate agreements; 98% for plain vanilla swaps. Errors in front office trade data, which most commonly occur in dates, are more common for credit derivatives (21%) than for FRAs (10%) and plain vanilla swaps (17%).

It appears that plain vanilla swaps are more automated than credit and equity derivatives. It is also interesting that the most common results are either no automation or substantial automation, suggesting an ‘all or nothing’ approach: that is, once a firm institutes some automation for straight through processing, it applies it across the company. Functions with a high degree of automation include the transfer of data from the front office to the back office operations systems, transfer of trade data from the operations system to the general ledger and addition of data to the front office trade record. Reports and records Transaction records A back office system should create and maintain complete records of all transactions and should be able to break up reports between trader, counterparty (for OTC products), the product traded, trade/executed date, volume, time traded, and broker used, where appropriate. Position records With open positions, it is essential that each input transaction settlement is accurately reflected in statements of position. Margins and equity Exception reports assist effective monitoring by highlighting potential risk situations, such as: ■ ■ ■

Position limits being broken. Counterparty’s equity falling below a certain level. Contracts nearing delivery date (futures) or expiry (options), or pricing out (swaps).

Counterparty documentation Appropriate counterparty documentation should be generated for the confirmation of contract (on a daily basis) settlement account, to advise counterparty of details of contracts closed out (netted off) or priced out and the profit or loss agreed and then settled between counterparties. Management information/risk manager This individual should deal with:

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Exception reports and positions close to expiry. Critical area – knowledge of different delivery processes for onexchange derivatives such as futures is vital. Position reports. Profitability reports presented in various ways, e.g. ● by department/individual trader ● by market/product ● by period – showing performance trends ● value at risk for the firm – calculations

Who should look at the report and records? In most medium to large organisations, a corporate treasurer or risk manager is responsible for identifying and managing risk. Where the scale of the trading or risk management activity is not sufficient to justify a separate independent risk management function, responsibility for monitoring risk is usually allocated to members of management who are not directly involved in the day to day management of risk (e.g. traders). Derivative back office management It is essential to have tight security on back office systems. A company should not rely on just one risk manager or person to monitor or pick up errors. It should also have a system that prevents people who are active in the risk management and trading areas from altering records. To check for irregularities, some banks and brokers have asked their employees to take at least five consecutive business days as holiday at short notice. The person who takes over has a good chance of picking up on mistakes that have been made through operational error, losing positions which have been concealed or, indeed, fraud. This should certainly allow the organisation to expose skill shortages in the organisation and perhaps target staff for further training so that the organisation is not over reliant on any particular individual. Internal controls and the back office Here is the basic framework of internal controls that any back office system should be able to support: ■

■

Risks ● Business risks ● Position risks ● Human and operational risks ● Credit risks Fundamental controls ● Authority levels and limit setting features ● Automatic exception reporting and monitoring of position limits ● Profitability reporting

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■

■

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Organisational controls ● Legal considerations ● Policy monitoring ● Segregation of duties and the operation of internal checking Position risk ● Trading, types of derivative ● Limits in markets ● Limits with counterparties (OTC swaps) ● Monitoring and reporting against limits ● Hedge reporting Counterparty authorisation ● Back office system should preferably be integrated with the trading desk in order to stop trades being finalised with counterparties who have already exceeded credit limits or position limits. ● Remember that when your traders agree the deal, it doesn’t matter whether it is a futures trade or OTC swaps trade on the telephone: your firm is committed! Counterparty setup ● The credit department or risk manager should be the only people able to set up new counterparts on the system. They should also be the only people with access to setting trader and counterpart position limits.

Ideally the back office system should be able to automatically produce an alert or print-out of exception reports (e.g. loss limits, counterpart credit limit breaches and internal trader position limit breaches). Operational risk and the back office It is difficult to talk about internal control systems without looking at the structure of back offices. Operational risk then comes into play when designing the back office. One definition of operational risk is the risk of loss caused by failures in operational processes or the systems that support them, including those adversely affecting reputation, legal enforcement of contracts and claims. Thus it is important to structure the back office system in such a way as to help prevent underlying causes of operational risk and, in turn, to keep internal controls and risk management processes operating effectively. (Refer to Chapter 11 for more data.)

ROLE OF EXTERNAL OR INTERNAL AUDIT AND COMPLIANCE Derivative operations should be subject to periodic reviews (e.g. quarterly, half yearly) by the company’s internal audit function or external auditors if in-house expertise for this is not available.

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It should be the responsibility of the Board of Directors of the company to ensure that internal audit and compliance department (if applicable) are staffed with personnel with sufficient skill and expertise to undertake reviews of the company’s derivative operations. The exact role of external auditors and the processes that they use will vary from country to country. However, auditors should check that financial statements are free from material misstatements, and check the derivative transactions and records supporting financial statements and balances and disclosures. An external auditor should assess the accounting principles used for derivatives, and also comment on the scope, adequacy and effectiveness of a company’s internal control system and derivative pricing methodologies (if any), including any internal audit approach/system that exists. Reconciliation and accounting: key points for management to consider Large profits that are not properly understood can often be a bigger danger than large losses that are understood all too well. Derivatives disasters have shown that people who never take holidays or who always stay late are not necessarily great examples of dedication to their jobs. Their ‘work lifestyle’ may be covering negative business realities. Accounting entries can be manipulated; cash disbursements cannot. Cash is the fundamental control, so make sure it adds up. Unfortunately, more often than not, accounting losses reflect a business reality. Last but not least, computer systems should be carefully monitored. Computers are an open door to the very nerve centre of a business. It is important to ensure that there is good security on the network and that computer data is backed up as often as possible, preferably off-site.

A RISK MANAGEMENT REVIEW A risk management review is something that should be done on an annual basis at the very least. Its purpose is to gather guidance for management on ways to improve existing operational procedures and controls, or to highlight lack of controls in specific areas where regulations may have changed since the last time risk management policies were reviewed. This review is usually carried out by an independent external consultant or, if available, risk management staff from another office could take up this task if you operate in a large international organisation, as long as those conducting the review are considered independent of the operation they are reviewing. Risk management reviews, unlike audits, focus on providing valuable feedback to management so that they can improve processes and controls to keep up with the latest industry and (where appropriate) financial

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regulatory guidelines. They tend to rely more on verbal representations from staff than an audit. Most large accounting firms, when auditing companies, look at trading controls and reporting structures and quite often auditors will make comments or notes in their annual accounting reports. An example of a risk management procedure review can be found in Appendix 1.

THE COLLAPSE OF ENRON, 2001 No single factor brought Enron crashing down to earth from its sky high success. The involvement of key individuals like Jeffrey Skilling (the former CEO of Enron), Kenneth Lay (the former chairman and CEO), and Andrew Fastow (the former Chief Financial officer of Enron) is already well documented so this section is not going to focus on individuals but on the general failure. So, what were the possible combinations of factors in the failure of risk management processes that were contributory factors to Enron’s downfall? The framework of the five key internal controls as illustrated in Figure 9.3 can be used to answer this question. Management oversight Control culture

Information and Communication

Controls

Risk assessment

Monitoring

FIGURE 9.3 Internal controls consist of five key interrelated areas

Management oversight control culture The problems at Enron were top-down; no single rogue trader was present as in the case of Barings Bank. There were position controls and state-of-the-art risk management systems in place to document sophisticated derivatives instruments and trades. However, management had been spurred on by stock option profits to develop an expansionist culture at (it would appear) any cost. For Enron, this meant expansion in terms of

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revenue and markets covered, and new market activities were seen as positive and good for public relations. Also, in the boom years of the dotcom era, stock investors were focusing on percentage revenue increases to boost stock prices. Enron’s employment culture affected its risk management culture. Its hire-and-fire policy meant that employees had to operate in an internal cut-throat environment where they not only had to compete with the outside market, but were in constant strong competition with colleagues with the threat of unemployment continually hanging over them. In this working culture, most employees were afraid to express their opinions or to question unethical and potentially illegal business approaches. If they reported these to the senior managers who were creating this environment, they risked getting fired. No reporting structure can save a company if the top management are the ones at fault. Shareholders of trading companies should ensure that the management are operating truly independent audit operations, not only for accounting but also for risk management procedures and the handling of derivatives. One possible route for restoring shareholder confidence in a shaken-up industry could be to offer the staff and management of trading companies access to external auditors if they feel they ever have a concern over business practices in their organisation. It has also become even more popular to introduce business ethics training across trading organisations postEnron.

Risk assessment Enron may have had sophisticated risk management systems, but the expansionist policy pushed by senior management to generate bigger and bigger revenues to fuel the share price accelerated Enron’s move into markets in which it had little experience. It was reported that in every Enron trading room around the world there was a price ticker screen showing the Enron stock price to staff. This policy flouted the fundamental principle of risk management: ‘know your market’. It is essential for companies to ensure that they have sufficient internal expertise and resources to manage derivatives or trading in these new markets. However, because the focus at Enron was always on the share price, risk assessment took second place. The biggest illustration of this was Enron’s move into bandwidth trading (the trading of telecom time etc. via cable). Enron’s rapid expansion into new markets placed it at a disadvantage against more experienced players in those fields and in turn put Enron at risk of big losses. From Enron’s core business of natural gas, oil and power trading, it ended up in new, low liquidity rather esoteric markets such as sea freight, pulp and paper, Japanese aluminium, and Australian and Japanese weather derivatives, as well as bandwidth.

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Controls In the case of Enron one big failure of controls appears to have come from the lack of appropriate external regulatory controls that allowed Andersen Accounting to audit and also consult for Enron. This meant there was a clear lack of segregation of duties and, for fear of losing very profitable consulting business (compared to the lower fees from accounting auditing), it is thought that a lot of tough questions on how Enron was operating were never asked by Andersen. What can we learn from Enron? It is relatively easy for the management of a company to develop a risk culture that rewards people by increasing revenues in any way possible. The company can simply hire the brightest graduates and give them the resources they need. They will build revenues and push the stock price through the roof. However, as Enron shows, this is not a sustainable business practice. Enron has also shown that we must question how independent advisors and auditors really are. Truly independent external auditors have a key role to play in the trading arena to help ensure that shareholders are notified if companies overstep the mark. Shareholders can then make an informed decision as to whether or not to support the company. Ultimately, it is up to the owners, the shareholders of companies, to ensure that their interests are being served correctly by an auditor. If we look at Enron, shareholders were blinded by massive returns on their shares, with the share price moving from around US$20 per share in the early 1990s to a peak of around US$90 per share in 2001. In the case of Barings Bank, management did not hear the concerns and questions raised by the British Treasury about the large amounts of money being sent to Barings Singapore, as they were blinded by the huge false profits they thought were being made by Nick Leeson. It would seem that a pattern is emerging here. A lot of people rode on the success of Enron, and a lot of questions were not asked because everyone thought it was doing so well that they did not want to rock the boat. But it is also important for management to create a balance. Excessive controls can lead to an oppressive control culture in a firm and that in turn can inhibit new ideas and creative thinking which can positively benefit an organisation. It is not easy for management to create the right balance. However, it seems that some basic truths have emerged. When a firm starts producing 250% increases in revenues (as was the case at times for Enron) or when a firm starts creating massive profits from a small division in an overseas subsidiary in the case of Barings, ask questions! In the Enron case, questions have been raised about the role of Andersen who were both consulting and also auditing for them. To restore shareholder confidence over financial statements, management

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could ensure external auditing activities are carried out by firms not serving the company in other ways that may create a perception of conflicts of interest. In the case of risk management using derivatives, if financial auditors do not have the expertise, a specialised external risk management auditing firm could be employed to review mark-to-market methodologies and to highlight any shortcomings of these methodologies that may create potential risks for the organisation. Post Enron, politicians and regulatory bodies are calling for senior management of organisations to be far more accountable if things go wrong. So it is now more important than ever to have regular risk management reviews and an open culture where people can question what the company is doing and how it is doing it. Firms should also foster a culture where management are seen to be receptive to well-founded and constructive criticism as well as new ideas from staff.

CHAPTER 10

An Eavesdropper’s Guide to Hedging

Perhaps the only people who truly understand hedging are those who see it as a branch of horticulture. Certainly, there are many myths and misunderstandings that surround hedging in the financial world. Here are a few things overheard in the corridors, boardrooms, back offices and trading pits of the world’s corporations and exchanges. The names, of course, have been withheld to protect the guilty parties!

NINE GREAT SAYINGS ON HEDGING HEARD IN THE MARKET – WITH COMMENTS 1. ‘We’re not hedging this year because we lost money doing it last year’. Hedging is not about making money all the time. For consumers of energy, it is about consistently reducing balance sheet volatility. For traders, hedging may be to lock in profits or to reduce loss exposure, and as a producer of energy it could be part of an overall strategy to hit sales and profit targets. Hedging should not ‘lose’ an organisation money. It may generate loss of opportunity in economic terms, but if it is true hedging that is being conducted, there should be an almost equal and opposite cash flow in the energy physical consumption or production activities of the company. It is very important that management and shareholders fully appreciate this. 2. ‘Go ahead and hedge... just don’t do anything stupid!’ I guess the manager who said this had not put together a risk management policy! It is very important that before embarking on any hedging (or derivatives speculation, for that matter), that an organisation has a clear written policy of ‘do’s and ‘don’t’s, including a clear written reporting structure and control structure to ensure trading or hedging

164

NINE GREAT SAYINGS ON HEDGING

165

does not get out of control and too big. There is more detail on this in Chapter 9. 3. ‘Our risk management committee can’t agree on whether energy prices are going to get stronger or weaker.’ Now, hold on a minute! The main reason for hedging is that no one knows where prices are going to move over the next financial year. In fact, just trying to predict energy prices over the time frame of one week is pretty impossible. Looking at operating budgets as a consumer or targets as a producer should enable management to work out some strategy for hedging some percentage of exposure or profit margin now, and to develop some game plan around ‘What if?’ scenarios for further hedging activity subject to market price movements. 4. ‘Sometimes we hedge 0% and sometimes we hedge 100%. Other times, we go back and forth.’ Again, this is not a very effective risk management policy. Either hedge or don’t hedge at all and take the risk. By having no clear policy you can create many other problems for an organisation including proper cash flow management and forex management etc. 5. ‘We only hedge when we have strong views on the market.’ Only hedging when you have a strong price view is not hedging but speculation. It is probably fair to say that an organisation should have some overall percentage volume hedge locked in before going into its next financial year (as an end-user consumer). Even large oil majors who control a lot of energy market infrastructure – pipelines, refineries, oil fields – do not always get the market direction right! Sometimes a hedger may initiate some additional hedges if there are strong views that an upcoming event could create a very big market move. In this case, it may be worth examining option strategies so the loss of opportunity risk is reduced to premiums paid for the options. 6. ‘Our hedging program is great. It consistently makes us money!’ I would be worried if my hedging program always made money. It would mean there could be something very fundamentally wrong with the way I was trading physical markets, or buying or selling my physical energy as a consumer or producer. 7. ‘Our management is in favour of doing some hedging, but not at these prices.’ If only the management had looked at hedging before the market got to these prices! In cases where either profit margins are negative or margins are expected but not guaranteed to improve in the near term, option hedging structures can enable companies to protect against the situation becoming worse, while still gaining from improvements in

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margins and or prices. For example, for an extended period of time in Asia, oil refiners experienced reasonable margins on middle distillates such as gasoil and jet fuel. However, fuel oil was a loss maker. In this instance, refiners could look at an option structure which protected them against fuel oil versus crude oil margins becoming still worse, but would allow them to benefit from an improvement in the margin back to profitability. 8. ‘Hedging is too expensive; I cannot afford more staff to conduct this hedging business.’ Which is really more expensive: seeing the organisation’s profit margin disappear and become negative altogether, or having some comfort knowing that some of your profit margin/revenue has been safely guarded against the unknown? 9. ‘We never speculated. We just simply over-hedged our physical requirements.’ There is not such thing as over-hedging. If an organisation or trader deliberately hedges using a greater volume of derivatives versus physical energy flow this is over-hedging. The only exception to this rule is when an organisation is having to ‘proxy hedge’. This could mean that they are having to use a derivative contract on a different energy product than the energy they are actually physically exposed to or wish to trade in. Sometimes, because of basis risk, traders are forced to use a greater volume in the derivative than in the underlying physical energy, to try to compensate for the basis risk between the two. In other words, the energy derivatives contract may be less volatile than the underlying physical that the organisation is trying to hedge.

CONCLUSION October is a particularly dangerous months to buy the market. Other particularly dangerous months are July, January, September, April, November, May, March, June, December, August and February! The truth is that most people who try to predict the movement of the energy market get it wrong some of the time – and there are some people who always get it wrong!

CHAPTER 11

Operational Risk

Operational risk: ‘Risk of loss caused by failures in operational processes or the IT systems that support them, including those adversely affecting reputation, legal enforcement of contracts and claims’. Until fairly recently, energy price risk management focused mainly on market risk, liquidity risk and credit risk. But over the past few years, there has been a new focus on operational risk, particularly after some big failures in the financial commodity markets, like the Barings Bank collapse in 1995 and the Sumitomo Corporation’s losses in metals in the late 1990s. Most organisations can be affected by operational risk in a number of ways, both directly and directly. Direct financial losses can be caused by a lack of operational capability to transact business. For example, losses could result from a fire at an organisation’s offices, or from a back office computer system being unavailable due to a hardware failure. An error in a transaction can also lead to direct losses: if an organisation loses the data that proves a deal has been transacted, the company may be exposed to market price movement and lose money in this way. Indirect losses may be the result of damage to an organisation’s reputation or client relationship. For example, if a broker has an online trading system which breaks down, this could have both a revenue loss and also an indirect loss as customers lose confidence in the system and don’t come back to use it again.

KEY COMPONENTS OF OPERATIONAL RISK Core operational capability The most obvious kind of operational risk concerns the risk of loss or damage to an organisation’s core operational capacity. This can be the result of a number of events, including: ■

Damage caused by fire, bombs, technical problems or all manner of natural disasters. 167

168

■ ■ ■

ENERGY PRICE RISK

Loss of utilities such as power, water or transportation. Loss of key operational personnel. Inadequacy or loss of systems capabilities, e.g. due to computer viruses.

Human risk People are a company’s most important resource, but they have often been overlooked when evaluating operational risk, as it is difficult to apply a mathematical model to measure the risks of human error. However, it is possible to make a brief list of the most probable reasons for human error: ■ ■ ■ ■ ■ ■

A lack of integrity and honesty. A lack of segregation of duties and the risk of collaboration. A lack of professionalism. A lack of teamwork and respect for the individual. Over-reliance on a few key individuals who may go on holiday or be sick at crucial times, or who may leave the company altogether. Insufficient skills, training, management or supervision.

Human error continues to be the major contributory factor to many dramatic corporate failures. For this reason, it must be targeted, despite the difficulty of measuring it. It is certainly a common cause of problems in the back office, so a well-designed system and a process of internal control to pick up on any input errors quickly will save a lot of time chasing problems later on. Transaction processing systems The quality of data is vital in risk management. Any sound risk management program relies heavily on accurate, prompt and efficient capture of trade data and the creation of management reports from processing this data. The most important areas to look at under transaction processing system risks are (Figure 11.1): ■ ■ ■ ■

Processes associated with the execution of trades. Trade capture (sometimes referred to as data capture) and the processing of data. Trade confirmation (contracts). Settlement operational risk.

Here, settlement operational risk is different from settlement risk. Settlement risk is associated with the credit risk of a counterpart – the risk that someone may not pay up on a settlement of a trade. However, settlement operational risk focuses on losses that can be caused by errors in the settlement process.

ASSESSING AND CONTROLLING OPERATIONAL RISK

169

Derivatives trade execution and ‘Order capture’ Credit risk control system

Trading book accounts system treasury system

Price risk management system

Collateral/ margining system

Trade settlement processing system

Contracts and confirmations

FIGURE 11.1 Derivatives process environment in which OR exists.

Reconciliation and accounting A well-structured back office system that is integrated with an accounts system is crucial for managing risks associated with reconciliation and accounting. It is important for treasury or accounts people to have at least read-only access to back office transaction data in order to anticipate any foreign currency requirements against derivatives margin payments or realised losses on hedges and to allow them to ensure that adequate forex hedging risk management is carried out. The reconciliation of settlement data with funding and accounting results is also a key process in protecting the user of derivatives against undisclosed positions or undisclosed losses within its organisation. See Figure 11.2 for a summary of operational risk.

ASSESSING AND CONTROLLING OPERATIONAL RISK The core objective of an operational risk program should be to avoid financial and non-financial losses through operational risk failures. To do this, the program should enable the organisation to anticipate risks by more efficient and effective measurement and reporting of operational risk. This can be achieved through the following five-step approach. Step 1: Identify the risks An organisation must identify its operational risks. It can identify these by looking at the tasks its department has to handle and the processes

170

ENERGY PRICE RISK

Operational risk

Business environment strategy risk

Operational failure

• People • Technology (IT systems) • Organisation/business processes

Risk of choosing the wrong business strategy in response to factors including: • Tax • Government • Regulations • Competition

AREAS THAT MAY CONTAIN OPERATIONAL RISK ■ Process risks ■ Human risks ● Marketing ● Fraud ● Selling ● Collusion between people to ● New customer commit fraud ● Trade execution/processing ● Unauthorised use of error information ● Trade fraud ● Rogue traders ● Contract/trade recapping risk ● Staff competency/skill sets ● Product complexity ● Over-dependency on a few key personnel ● Health and safety ■

Technology risk (process risk) ● Data corruption (either by accident or deliberately) ● Programming errors ● Viruses ● Telecommunication failures ● System capacity risks ● System failure ● Strategic risks, i.e. the system provider goes bankrupt and cannot support a system any further ● Security breach, e.g. external hacker attack

■

External business environment risk ● External supplier risk ● Physical security ● Compliance ● Money laundering ● Tax ● Financial reporting/ accounting standards ● Natural disaster – fires, floods, weather ● Strikes – transportation problems ● Legal risk (litigation) ● Terrorist threat

FIGURE 11.2 Operational risk

ASSESSING AND CONTROLLING OPERATIONAL RISK

171

undertaken by the organisation in its day-to-day trading and business operations. Step 2: Assess the risks Once this has been completed, the operational risks need to be categorised in terms of possible severity (e.g. if the core risk management system went down, it would take around 5 hours to get a backup system running) and in terms of the probability of these operational risks actually happening. Step 3: Assess possible risk control measures An organisation should then list the operational control choices it can make that can help reduce the identified operational risk. The four main control decisions that can be made by an organisation are as follows: ■ ■

■

■

Avoid the risk Totally avoid the business activity that is creating the risk. Transfer the risk An organisation could look to transfer the risk. A prime example of this is where a firm takes out ‘rogue trader’ insurance. This transfers the operational risk of fraudulent trading into a credit risk with the counterpart to the insurance policy. Insurance is a key way to transfer a large majority of operational risks. Reduce the risk Changes in the way business is conducted in the organisation (referred to by experts as the ‘transaction chain’) can help to reduce risk. The other key way is by allocating more cash or capital to systems and human resources (skills training updates and more personnel to cover risk areas). Accept the risk An organisation’s research may have found that the probability of a particular operational risk event occurring is so remote that the company decides just to accept the risk. This normally happens when the cost of implementing new procedures or systems far outweighs the risk to the company.

Step 4: Execute control measures If action of some kind is taken, someone needs to follow up and make sure that implementation of new measures is executed correctly. Step 5: Create supervisory role(s) to monitor the ongoing risk A supervisory role needs to be established. The person or persons responsible for the operational risk program should write management progress reports (see Figure 11.3) and comparison studies on any reduction of losses associated with operational risk, to illustrate the effectiveness of the

ENERGY PRICE RISK

172

Page 1 Losses

Current month

Year to date

Operational losses Credit losses Market losses Subtotal: Loss/revenue ratio:

Page 2 Risk events Event 1 IT system failure

Exposure

Response

Lost revenue of US$2 million

New backup system put in place

2 3 4 5 6 7 8 FIGURE 11.3 Monthly risk reporting example (incorporating OR)

program. Management should discuss these reports and if no appropriate response is taken to any risk event, they should, of course, create some strategy to prevent it occurring again. Operational risk programs should also be reviewed regularly (probably at least twice a year) to accommodate any changes in external business environments, the general business activities of the company and the size of those activities.

GATHERING INFORMATION ON OPERATIONAL RISK It is essential that organisations gather as much information as possible on operational risks. This can be done by interviewing business and operational

OPERATIONAL RISK REDUCTION, CONTROL AND CONTAINMENT

173

line managers who may reveal concerns over potential operational risks that have not yet occurred but could unless action is taken. The following company reports and documents should also be reviewed with operational risk in mind: ■ ■ ■ ■ ■ ■ ■

■ ■

Management reports (these may have highlighted operational problems and issues in the past). Budgets. Business plans. Operations plans. Disaster recovery plans (if an organisation does not have one, this is an immediate source for operational risk – business recovery). External reports. Audit reports (increasingly, financial auditors are looking at operational risks in an organisation that may add potential points of failure. Rating agencies also focus a lot on operational risk issues when assessing a company’s credit rating). Any regulatory reports (if an organisation is a regulated entity in some way). Historical data on losses (especially in transaction errors etc., where losses were posted against specific operational failures).

OPERATIONAL RISK REDUCTION, CONTROL AND CONTAINMENT Risk reduction In any operational risk program, the first steps that management can take are to reduce the risks inherent in the organisation’s business processes. Wherever possible, retyping of data by human operators should be eliminated from the process, by integrating existing IT systems or investing in new ones. Hiring additional staff will also help to reduce dependency on key individuals and reduce the pressure on understaffed areas of the business process. Risk control Appropriate preventative measures can be taken to minimise the chance of an operational risk situation occurring. For example, operational system risk could be controlled by introducing or improving firewalls, passwords and authorisation processes surrounding trading and who is allowed to trade. Internal audit checks can be introduced and control functions can be assigned to specific staff with a responsibility for maintaining control standards.

174

ENERGY PRICE RISK

Risk containment and transfer Tightening up procedures and investing in IT systems, automation and staff will certainly reduce an organisation’s operational risk. But such risks can never be completely eliminated, which means that it is also important to have ways of containing those operational risks that still remain. An organisation can buy insurance against loss of revenue from fire, flood or other natural disasters at the organisation’s office. Insurance like this transfers operational risk over to a credit risk of the insurance company. It can also look at computer disaster recovery procedures and business continuity planning. For trading companies this could entail setting up a hot backup site which staff could move to if the primary office location was non-functional. The importance of this was seen in the aftermath of the disaster of 9/11 in which the World Trade Center was destroyed. A lot of businesses ground to a halt as financial markets closed, but companies still had to process trades from around the world and keep their back offices running, which could only be done by activating their backup sites. Trends in operational procedures Many financial institutions are now adopting automation to tackle human error by implementing what is known as ‘straight through processing’ (STP). STP, at its most integrated level, allows a derivative trade to be executed by a trader on an electronic trading platform and for the information to feed from there directly into the organisation’s back office and administration systems. The removal of the repeated manual typing of trade data eliminates one area of consistent problems for operational risk. However, the energy industry appears to be lagging behind this trend at the moment. According to the Bank for International Settlements Survey Report 2001, the oil majors have sophisticated back office systems in place permitting STP of physical and derivative transactions. However, international traders are not all so up to speed with the latest technology advances, and end-users even less so. This situation will undoubtedly change rapidly over the next few years. According to the BIS: Overall, the results of the interviews indicate that practices for processing trades and managing counterparty risks are broadly similar in all the G-10 countries. Standard legal agreements and confirmation templates (especially those developed by the International Swaps and Derivatives Association (ISDA) but also some national master agreements) are used to document most transactions. Transaction processing, from data capture through confirmation and settlement, is increasingly automated, although the more structured transactions still usually require manual intervention.

SUMMARY

175

Netting and, to a growing extent, collateral agreements are used to mitigate counterparty credit risks. Finally, the vast majority of OTC transactions are settled bilaterally between the counterparties; within the G-10 countries.

SUMMARY The term ‘operational risk’ covers some of the most serious and dramatic risks that an organisation faces: for example, natural disasters, fraud and failures of technology. It might seem that there is little an organisation can do to plan for such unexpected catastrophes. However, an assessment of operational risk and the development of appropriate systems can go a long way towards controlling and reducing it. An assessment may also show that, where risks which cannot be controlled, they can be contained by measures such as the adoption of insurance cover.

CHAPTER 12

Derivatives Contracts Application Listing and Some Hedging Scenario Examples

WHAT IS HEDGING? Hedging is the process in which an organisation with energy price risk will take a position in a derivative instrument (swaps, options, futures) that gives an equal and opposite financial exposure to the underlying physical position to protect against major adverse price changes. The volumetric price exposure of the derivatives hedging instrument should be equal and opposite to the price exposure of the physical energy commodity that the organisation wishes to reduce its price risk exposure in. Energy consumers such as power stations, airline companies using jet fuel, shipping companies using bunker fuel or metal ore smelters using coal, natural gas, oil or electricity do not normally hedge all of their physical volume consumption; nor do they ignore hedging altogether. The majority of active hedgers in the energy markets typically hedge up to a maximum of 50% of their physical volume in order to reduce their company’s balance sheet volatility. They hedge more than 50% only when the market is extremely volatile, for example during periods like the Gulf War. However, most of the time an end-user consumer of energy may only hedge 30% to 50% of energy requirements and as far forward in the future as the end of its next financial year-end. The only regular exceptions to this rule are charter airlines which have already sold all seats on flights to travel agencies, so their income is fixed and they have 100% exposure to jet fuel movements. In this case, charter airlines tend to hedge 100% (or close to it) of their planned consumption volume. There is no such thing as ‘over-hedging’ or creating a derivatives position greater than your physical consumption or production volume (if you are a producer of energy). If an organisation is doing this it is simply 176

GENERAL RECAP ON ENERGY DERIVATIVES

177

speculating! Companies should ensure that any derivatives activity remains within the parameters agreed by the Board of Directors and the risk management committee or risk manager.

GENERAL RECAP ON ENERGY DERIVATIVES ■

■

■

■

■

■ ■

■

■

Swaps usually settle as calendar monthly, against the average of the daily commodity price in that period. For example, January will cover the pricing period 1 January to 31 January. Quarterly and annual structures are possible, but even these settle out every month. For example, in a quarterly contract, one third will be settled out each month during the pricing period. Energy futures contracts tend to have expiry/termination dates during the month they are named. So January IPE Brent will expire 3 days prior to the 15th day of January. It is important to make sure that the futures contract chosen will give price coverage for the required time window. In swaps pricing against oil markets, there are half month contracts (for example, 1st–14th of the month, and 15th through to the last trading day of the month), but these are not as liquid and are usually only available for relatively prompt dates. Natural gas is typically traded on spot markets, then calendar month contracts in the future and winter/summer month periods trade as packages. Coal markets typically are traded as calendar monthly contracts as well both in OTC and futures (where available) Power markets around the world trade in off-peak, peak and monthly forwards, and weekly periods, and spot markets (like day ahead) are generally traded in 30 minute blocks, so there are 48 contracts in one 24 hour day. Weekends tend to trade at different prices from weekdays. Payment due dates tend to differ, so for petroleum products in Asia payment due dates on OTC derivatives tend to be between 10 business days to 14 business days after the last settlement date of the contract (this is always specified in the contract confirmation). Cash flow risk should be predicted and planned for when hedging so that provisions can be made for it. This kind of risk can be created when the timing of payables/receivable on physical energy buying/selling and derivatives hedges do not match up.

ENERGY DERIVATIVES SELECTION TABLE Anyone who thinks the number of energy derivatives can be counted on the fingers of two hands should think again. Table 12.1 highlights some of

178

ENERGY PRICE RISK

the more liquid energy derivatives that I have been able to identify around the world. It is a non-exhaustive listing, since many more OTC contracts are created on an almost weekly basis. This is a dynamic and rapidly growing industry with the prospect of oil futures markets in China perhaps as early as 2003, the creation of petrochemical hedging tools in Europe, and some brokers trying to develop petrochemicals in Asia. To use this listing, select the energy cash market you are interested in hedging from the left-hand columns. Note that this is a guideline to point you in the right direction. Further analysis as to the suitability of the derivatives contracts for trading or hedging needs should then be undertaken.

HEDGING APPLICATION EXAMPLES The following examples can be applied across airlines, shipping companies, and in fact anyone consuming energy, oil, gas, coal etc. All that is required is to replace the example given with a different pricing reference index. Example 1: fixed price swap hedge by an airline In Figure 12.1, an airline buys a fixed price swap from a bank or trader against its jet fuel price exposure. It trades this swap under its ISDA Master agreement with its counterpart. In the majority of cases, airlines will hedge into the next financial accounting year, so from 1 month up to around 18 months forward. Hedging volumes vary from airline to airline, but in general at least 20% to 30% of volumes are hedged ahead of the start of the next financial year around the annual budgeted price, with additional volumes of 10% to 20% of total annual requirements locked in as Jet fuel physical cost

Airline buys fixed price Jet/Kero swap counterpart

Airline Airline sells floating price

Sells the fixed price to the airline

Net cost Jet fuel hedge cash flow +/–

Airlines are naturally short of jet fuel as consumers. Therefore they are exposed to price risk if jet prices move higher

FIGURE 12.1 Fixed price swap hedge by an airline

USD/bbl

0.5% Sulphur Singapore Gasoil swap USD/bbl

IPE Gasoil 1st line swap

Heating oil bullet swap

Heating Oil 1st line swap

GO 1st line/Brent 1st line swap

HO 1st line/WTI 1st line swap

HO bullet swap/WTI bullet swap

0.5% Sing/Dubai 1st line swap

13

14

15

16

17

18

19

20

USD/bbl

USD/bbl

USD/bbl

USD/bbl

USD/gal

USD/gal

USD/mt

USD/bbl

USD/bbl

USD/bbl

USD/bbl

USD/bbl

Tapis 1st line/Dubai 1st line swap

WTI 1st line/Brent 1st line swap

8

12

WTI bullet/Brent bullet

7

USD/bbl

Tapis 1st line/Brent 1st line swap

Tapis 1st line swap

6

USD/bbl

USD/bbl

11

Dubai 1st line swap

5

Brent 1st line/Dubai 1st line swap

Brent bullet swap

4

USD/bbl

Dated/Brent 1st line swap

Brent 1st line swap

3

USD/bbl

USD/bbl

10

WTI bullet swap

2

UNIT MEASUREMENT

9

WTI 1st line swap

1

DERIVATIVE CONTRACT

TABLE 12.1 Energy derivatives selection grid

PLATTS/ PLATTS

NYMEX/NYMEX

NYMEX/NYMEX

IPE/IPE

NYMEX linked pricing

NYMEX linked pricing

IPE Linked pricing

PLATTS

APPI/PLATTS

APPI/PLATTS

PLATTS/IPE

IPE Linked pricing

NYMEX linked pricing

HEDGING REFINERY MARGIN IN MIDDLE DISTILLATES USING DUBAI RELATED CRUDES

HEDGING USA MIDDLE DISTILLATE REFINERY MARGIN

HEDGING USA MIDDLE DISTILLATE REFINERY MARGIN

HEDGING EUROPEAN MIDDLE DISTILLATE REFINERY MARGIN

USA HEATING OIL (GASOIL) HEDGING AND TRADING

USA HEATING OIL (GASOIL) HEDGING AND TRADING

WHOLE MONTH AVERAGE OF IPE GASOIL FRONT LINE - HEDGING TRADING EUROPEAN GASOIL

HEDGING ASIAN GASOIL PRICES

LOCKING IN ECONOMICS OF TAPIS CRUDE USE VERSUS DUBAI RELATED CRUDES

LOCKING IN TAPIS VERSUS BRENT LEVEL - MOVING PRICE EXPOSURE TO BRENT A MORE LIQUID CONTRACT

HEDGING BASIS RISK BETWEEN DATED BRENT AND IPE BRENT FUTURES

HEDGING WEST AFRICAN CRUDES ROUTED TO ASIA

CRUDE EXPORT ARBITRAGE BETWEEN EUROPE/WEST AFRICA AND USA

CRUDE EXPORT ARBITRAGE BETWEEN EUROPE/WEST AFRICA AND USA

ASIA CRUDE IMPORTS

http://www.gvsi.com/ press_releases/prAPPIfinal.htm NYMEX linked pricing

ASIA CRUDE IMPORTS

GLOBAL CRUDE

GLOBAL CRUDE

GLOBAL CRUDE

GLOBAL CRUDE

COMMON USAGE

PLATTS linked pricing

IPE Linked pricing

IPE Linked pricing

NYMEX linked pricing

NYMEX linked pricing

PRICING LINK

HEDGING APPLICATION EXAMPLES 179

EN590 new CIF/GO 1st line swap

EN590 GASOIL MEDITERRANEAN (MED) CIF/GASOIL FUTURES related 1st line swap

Gasoil (GO) MED FOB/Gasoil (GO) Futures related 1st line swap

GO Rdam Barges/GO 1st line swap

GO new CIF/GO 1st line swap

ULSD Rdam Barges/GO 1st line swap USD/mt

ULSD new CIF/GO 1st line swap

0.5 Singapore Gasoil /GO 1st line swap

180cst Sing Fuel Oil swap

1% Rdam FOB Barges Swap

1% new FOB Cargo swap

3% USGCW swap

3.5% Rdam Barges swap

1% NYH Cargo swap

3.5% MED FOB Cargo/3.5% Rdam Barges swap

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

USD/mt

USD/bbl

USD/mt

USD/bbl

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

USD/mt

NYH Barges LS number 2/HO 1st line USD/bbl swap

22

USD/bbl

NYH Barges number 2/HO 1st line swap

UNIT MEASUREMENT

21

DERIVATIVE CONTRACT

PLATTS

PLATTS

PLATTS

PLATTS

PLATTS

PLATTS

PLATTS

PLATTS/IPE GASOIL FUTURES

PLATTS/IPE GASOIL FUTURES

PLATTS/IPE GASOIL FUTURES

PLATTS/IPE GASOIL

PLATTS/ IPE GASOIL

PLATTS/IPE

PLATTS/ IPE

PLATTS/ IPE

PLATTS/NYMEX

PLATTS/NYMEX

PRICING LINK

HEDGE 3.5% MEDITERRANEAN FREE ON BOARD (FOB) VERSUS ROTTERDAM MARKET

HEDGE 1% NEW YORK HARBOR FUEL OIL CARGOES

HEDGE EUROPEAN 3.5% FUEL OIL

HEDGE US GULF COAST 3%

HEDGE EUROPEAN 1% FUEL OIL

HEDGE EUROPEAN 1% FUEL OIL

HEDGE ASIA FUEL OIL MARKETS

TRANSFER OR LOCK IN SPREAD RISK BETWEEN SINGAPORE GASOIL AND IPE GASOIL FUTURES

HEDGING BASIS RISK BETWEEN NORTH WEST EUROPE GASOIL CARGOES AND THE IPE GASOIL FUTURES

HEDGING BASIS RISK BETWEEN ROTTERDAM GASOIL BARGES AND THE IPE GASOIL FUTURES

GASOIL NORTH WEST EUROPE HEDGING OF SPREAD AGAINST IPE GASOIL FUTURES 1st LINE FUTURES

HEDGING BASIS RISK BETWEEN ROTTERDAM GASOIL BARGES AND THE IPE GASOIL FUTURES

HEDGING THE DIFFERENTIAL SPREAD BETWEEN MEDITERRANEAN GASOIL AND IPE GASOIL FUTURES

TRADING/HEDGING SPREAD BETWEEN EN590 IN MEDITERRANEAN AND IPE GASOIL FUTURES

TRADING/HEDGING SPREAD BETWEEN EN590 AND IPE GASOIL FUTURES

HEDGING BASIS RISK BETWEEN PLATTS AND NYMEX HEATING OIL

HEDGING BASIS RISK BETWEEN PLATTS AND NYMEX HEATING OIL

COMMON USAGE

180 ENERGY PRICE RISK

PLATTS PLATTS/NYMEX

1% New York Harbor Fuel Oil Cargo/ USD/bbl 3% USGCW swap

180cst Singapore Fuel Oil /Dubai Crude 1st line swap

3.5% Fuel Oil Rotterdam Barges/ Brent 1st line swap

1% new FOB Cargo/Brent 1st line swap FUEL OIL

1% NYH New York Harbor CIF Cargo/WTI 1st line swap FUEL OIL

3% USGCW/WTI 1st line swap FUEL OIL Versus WTI Crude Futures Swap

Singapore Jet Kerosene swap

Singapore Regrade swap (The spread USD/bbl between Jet Kerosene and Gasoil)

US Gulf Coast (USGC) 54 Jet/Heating USD/gal oil NYMEX Futures (HO) 1st line swap

new CIF Cargo/GO 1st line swap

Rdam Barges FOB/NWE CIF Cargo swap

MED Cargo FOB/NWE CIF Cargo swap

USGC 54 Jet/WTI 1st line swap

41

42

43

44

45

46

47

48

49

50

51

52

USD/bbl

USD/mt

USD/mt

USD/mt

USD/bbl

USD/bbl

PLATTS/NYMEX WTI

PLATTS

PLATTS/PLATTS

PLATTS/NYMEX

PLATTS

PLATTS/NYMEX

PLATTS/NYMEX

PLATTS/IPE BRENT

USD/bbl USD/bbl

PLATTS/IPE BRENT

PLATTS

USD/bbl

USD/bbl

PLATTS

PLATTS

40

USD/mt

1% Rotterdam Fuel Barges/1% new FOB Cargo

PLATTS

39

USD/mt

PRICING LINK

180cst Singapore Fuel Oil Caroges/ 3.5% Rotterdam Fuel Barges swap

UNIT MEASUREMENT

38

DERIVATIVE CONTRACT

US GULF COAST JET REFINERY MARGIN AGAINST WTI CRUDE OIL

HEDGE/LOCK IN MARGIN BETWEEN MEDITERRANEAN GASOIL CAROES AND NORTH WEST EUROPE GASOIL CARGOES

TRADE/HEDGE BASIS BETWEEN BARGE SIZE GASOIL PARCELS AND CARGO SIZE GASOIL

TRADE/HEDGE BASIS RISK BETWEEN NORTH WEST EUROPEAN CIF GASOIL CARGOES AND IPE GASOIL FUTURES

HEDGE OR TRADE BASIS RISK SPREAD BETWEEN US GULF COAST AND NYMEX FUTURES

HEDGE PRICE SPREAD BETWEEN GASOIL AND JET FUEL

HEDGE ASIAN JET FUEL/KERO PRICES

HEDGE/TRADE USA REFINERY MARGIN FOR FUEL OIL

HEDGE/TRADE USA REFINERY MARGIN FOR FUEL OIL

HEDGE/TRADE EUROPEAN REFINERY MARGIN FOR FUEL OIL

HEDGE/TRADE EUROPEAN REFINERY MARGIN FOR FUEL OIL

HEDGE/TRADE ASIAN REFINERY MARGIN FOR FUEL OIL

TRADE/HEDGE DIFFERENCE BETWEEN NEW YORK/US GULF , 1% GRADE VERSUS 3% GRADE

LOCK IN BASIS RISK BETWEEN BARGE QUANTITY VERSUS CARGO SIZE PRICE

LOCK IN/TRANSFER PRICE RISK FROM SINGAPORE FUEL OIL TO 3.5% EUROPEAN MARKET

COMMON USAGE

HEDGING APPLICATION EXAMPLES 181

Gasoline 1st line swap

USGC Conv Unl 87/WTI 1st line swap

Rdam Barges Eurograde/Brent 1st line swap

Gasoline bullet swap/WTI bullet swap

Gasoline 1st line/WTI 1st line swap

US Gulf Coast Conv Unl 87/USGC number 2 HO swap

Gasoline 1st line/Heating Oil 1st line swap

HU (Gasoline) bullet swap/HO (Heating Oil) bullet swap

NYH (New York Harbor) Barges Unl 87 RFG/HU 1st line swap

NYH (New York Harbor) Barges Unl 87/HU 1st line swap

USGC US Gulf Coast (USGC) Conv Unl 87/HU 1st line swap

Rotterdam Barges Eurograde/GO 1st USD/mt line swap

Naphtha Singapore FOB Cargo swap USD/bbl

55

56

57

58

59

60

61

62

63

64

65

66

67

USD/gal

USD/gal

USD/gal

USD/gal

USD/gal

USD/gal

USD/bbl

USD/bbl

USD/bbl

USD/bbl

USD/gal

USD/gal

Gasoline bullet swap

USD/mt

Rdam Barges Eurograde swap

54

UNIT MEASUREMENT

53

DERIVATIVE CONTRACT

PLATTS

PLATTS/IPE GASOIL FUTURES

PLATTS/NYMEX GASOLINE FUTURES

PLATTS /NYMEX

PLATTS/ NYMEX

NYMEX

NYMEX

PLATTS

NYMEX GASOLINE/ NYMEX WTI

NYMEX GASOLINE/ NYMEX WTI

PLATTS/IPE BRENT FUTURES

PLATTS/NYMEX WTI FUTURES

NYMEX GASOLINE UNLEADED

NYMEX GASOLINE UNLEADED

PLATTS

PRICING LINK

HEDGE NAPHTHA ACROSS ASIA PACIFIC REGION INCLUDING JAPAN

LOCK IN TRADE SPREAD BETWEEN EUROPEAN GASOLINE AND IPE GASOIL FUTURES

HEDGE BASIS RISK BETWEEN PLATTS GASOLINE/NYMEX GASOLINE FUTURES

HEDGE BASIS RISK BETWEEN PLATTS GASOLINE/NYMEX GASOLINE FUTURES

HEDGE BASIS RISK BETWEEN PLATTS GASOLINE/NYMEX GASOLINE FUTURES

LOCK IN PRICE SPREAD BETWEEN GASOLINE/HEATING OIL

LOCK IN PRICE SPREAD BETWEEN GASOLINE/HEATING OIL

LOCK IN PRICE SPREAD BETWEEN GASOLINE/HEATING OIL

HEDGE IN USA FOR REFINERY MARGIN FOR GASOLINE VERSUS WTI CRUDE OIL

HEDGE IN USA FOR REFINERY MARGIN FOR GASOLINE VERSUS WTI CRUDE OIL

HEDGE FOR REFINERY MARGIN ON GASOLINE IN EUROPE AGAINST BRENT CRUDE OIL

US GULF COAST UNLEADED GASOLINE GRADE 87 MARGIN AGAINST WTI CRUDE OIL

HEDGE FOR USA GASOLINE

HEDGE FOR USA GASOLINE

HEDGE FOR EUROGRADE GASOLINE IN EUROPE

COMMON USAGE

182 ENERGY PRICE RISK

Naphtha new (North West Europe) CIF Cargo swap

Naphtha Singapore FOB Cargo/ Dubai 1st line

Naphtha new CIF Cargo/Brent 1st line swap

Natural Gas Firm Physical, Fixed Price

Natural Gas Firm Physical, IntercontinentalExchange Daily

Natural Gas Firm Physical, Gas Daily Daily

Natural Gas Firm Physical, Inside FERC

Natural Gas Firm Physical, Natural Gas Intelligence

Natural Gas Firm Physical, Canadian Gas Price Reporter

Natural Gas Firm Physical, NYMEX LD1

Fixed Price for Intercontinental Firm Physical Natural Gas Price Bulletin

Natural Gas Swing Swap, Fixed for Gas Daily Daily

Natural Gas Swing Swap, Inside FERC for Gas Daily Daily

Natural Gas, Fixed for Float (Inside FERC)

Natural Gas, Fixed for Float (NGI)

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

DERIVATIVE CONTRACT

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/MMBtu

USD/bbl

USD/bbl

USD/mt

UNIT MEASUREMENT

PLATTS/IPE BRENT FUTURES

PLATTS/PLATTS

PLATTS

PRICING LINK

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

HEDGE REFINERY MARGIN BETWEEN NAPHTHA AND BRENT RELATED CRUDES

HEDGE REFINERY MARGIN BETWEEN NAPHTHA AND DUBAI RELATED CRUDES

HEDGE NAPHTHA IN EUROPE

COMMON USAGE

HEDGING APPLICATION EXAMPLES 183

Natural Gas Basis Swap, NYMEX LD1 USD/MMBtu for Inside FERC

Natural Gas Basis Swap, NYMEX LD1 USD/MMBtu for Natural Gas Intelligence

Natural Gas Swing Swap, Gas Daily Daily for NYMEX LD1

Canadian Natural Gas Firm Physical, Fixed Price

Canadian Natural Gas Firm Physical, Canadian Gas Price Reporter

Canadian Natural Gas Firm Physical, Gas Daily Daily

European Natural Gas Firm Physical, Fixed Price

European Natural Gas Firm Physical, p/Therm Fixed Price, Spread Zeebrugge versus NBP

UK National Balancing Point indexed p/Therm OTC Swaps basis NBP97 contract

LPG Swaps Europe – Propane swaps against BP index

LPG Mid East/North Africa/Asia – Saudi CP Pricing used as Index for OTC Swaps

85

86

87

88

89

90

91

92

93

94

95

Mid East

Europe

p/Therm

CAD/GJ

CAD/GJ

CAD/GJ

USD/MMBtu

USD/MMBtu

Natural Gas Swap, Fixed for NYMEX LD1, Spread

84

USD/MMBtu

Natural Gas Swap, Fixed for NYMEX LD1

UNIT MEASUREMENT

83

DERIVATIVE CONTRACT

PRICING LINK

LIQUID PETROLEUM GAS HEDGE FOR MIDDLE EAST & ASIA REGION

LIQUID PETROLEUM GAS HEDGE IN EUROPE

NATURAL GAS HEDGE IN THE UNITED KINGDOM

NATURAL GAS HEDGE/TRADE IN EUROPE

NATURAL GAS HEDGE/TRADE IN EUROPE

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

NATURAL GAS HEDGE USA

COMMON USAGE

184 ENERGY PRICE RISK

Global

UNIT MEASUREMENT

PRICING LINK

USD/MWh

101 Mead 230

USD/MWh USD/MWh USD/MWh USD/MWh

112 Into SoCo, Seller’s Daily Choice

113 Into AEP, Seller’s Daily Choice

114 Into FPL, Seller’s Daily Choice

115 Into FPC, Seller’s Daily Choice

USD/MWh USD/MWh

111 Ercot-North Zone

USD/MWh

109 Ercot-West Zone

110 Ercot-South Zone

USD/MWh USD/MWh

108 Ercot-Houston Zone

USD/MWh

106 NEPool Seller’s Choice

107 Ercot

USD/MWh USD/MWh

105 NEPool Mass Hub

103 Into TVA, Seller’s Daily Choice

104 NEPool PTF

USD/MWh USD/MWh

102 PJM-West

US East Peak Power (physical delivery forward contracts)

USD/MWh USD/MWh

99

USD/MWh USD/MWh

South Path 15

North Path 15

100 Mid Columbia

Palo Verde

98

US West Firm LD Peak Power (physical delivery forward contracts)

LNG with Crude related pricing – proxy hedging in Crude futures/ related OTC derivatives markets

97

96

DERIVATIVE CONTRACT N/A

COMMON USAGE

HEDGING APPLICATION EXAMPLES 185

UNIT MEASUREMENT

PRICING LINK

USD/MWh USD/MWh USD/MWh USD/MWh USD/MWh USD/MWh

130 Ercot-North Zone Bal-Day

131 Ercot-South Zone Bal-Day

132 NP 15, FP for Intercontinental Exchange (www.theice.com)

133 SP 15, FP for Intercontinental Exchnage (www.theice.com)

134 Mid Columbia, FP for ICE

135 Palo Verde, FP for ICE

136 NYPOOL Zone A

USD/MWh

US East Financial Swap Off Peak Power (cash settlement no physical delivery)

USD/MWh USD/MWh

129 Ercot-Houston Zone Bal-Day

USD/MWh

128 NYPOOL Zone J Bal-Day

127 NYPOOL Zone G Bal-Day

USD/MWh

124 NYPOOL Zone G USD/MWh

USD/MWh

123 NYPOOL Zone A (New York power pool)

USD/MWh

USD/MWh

122 Cinergy, FP for ICE

126 NYPOOL Zone A Bal-Day

USD/MWh

121 PJM-West, FP for ICE

125 NYPOOL Zone J

USD/MWh USD/MWh

118 PJM-West Bal-Day

120 NEPool PTF Real Time

USD/MWh

117 PJM-West Real Time

119 NEPool PTF Bal Day

USD/MWh USD/MWh

116 PJM-West Day Ahead

US Financial Swap Peak (cash settlement no physical delivery)

DERIVATIVE CONTRACT

COMMON USAGE

186 ENERGY PRICE RISK

USD/MWh

PRICING LINK

EUR/MWh EUR/MWh

143 St Peter Grid, Austria

144 TenneT Grid, Holland

EUR/MWh

150 TenneT Grid, Holland

www.tfsenergy.com www.nymex.com

152 Financial Swap Coal, FP for TFS API 4 USD/Tonne

153 NYMEX Coal Futures www.nymex.com (USA) USD/Tonne

www.tfsenergy.com

www.eex.de & www. theice.com

151 Financial Swap Coal, FP for TFS API 2 USD/Tonne grade (the more popular grade for swaps)

Coal Swaps

EUR/MWh EUR/MWh

149 St Peter Grid, Austria

147 UK Grid, UK - under NETA contract

148 Laufenburg Grid, Switz

EUR/MWh GBP/MWh

146 RTE Grid, France

EUR/MWh

145 RWE Grid, Germany under EFET agreement www.efet.org

European Firm Baseload Power (physical delivery forward contract)

GBP/MWh EUR/MWh

142 Laufenburg Grid, Switz

140 RTE Grid, France

141 UK Grid, UK

EUR/MWh EUR/MWh

139 RWE Grid, Germany

European Firm Peak Load Power (physical delivery forward contract)

USD/MWh

138 NYPOOL Zone J

UNIT MEASUREMENT

137 NYPOOL Zone G

DERIVATIVE CONTRACT

COMMON USAGE

HEDGING APPLICATION EXAMPLES 187

UNIT MEASUREMENT

USD/Barrel USD/Gallon USD/Gallon USCents/BTU Yen Yen Yen USD/Barrel

156 NYMEX West Texas Intermediate crude oil futures www.nymex.com

157 NYMEX Heating Oil (Gasoil) Futures www.nymex.com

158 NYMEX Gasoline Unleaded Futures www.nymex.com

159 NYMEX Natural Gas Henry Hub Futures www.nymex.com

160 TOCOM Tokyo Middle East Crude Oil Futures www.tocom.or.jp

161 TOCOM Kerosene Futures domestic market Japan www.tocom.or.jp

162 TOCOM Gasoline Futures domestic market Japan www.tocom.or.jp

163 Singapore Exchange (SGX) MECO Middle East Crude Oil Futures contract www.sgx.com

USD/MT USD/MT USD/MT USD/MT

164 Ethylene Europe

165 Ethylene Singapore (www.ginga.com. sg)

166 Benzene

167 Xylene

Petrochemical Swaps

USD/Barrel

155 IPE Gasoil Futures www.ipe.uk.com

154 IPE Brent Crude Futures www.ipe.uk. USD/Barrel com

Oil Futures

DERIVATIVE CONTRACT

also swaps priced against the Platts prices also available www.platts.com

www.icislor.com

ICIS LOR Pricing

PRICING LINK

COMMON USAGE

188 ENERGY PRICE RISK

HEDGING APPLICATION EXAMPLES

189

opportunistic or protective hedges whenever prices drop below the annual jet fuel purchasing budget price target. In ‘disaster’ scenarios airlines hedge prices for up to 100% of short-term requirements (shortterm – present day to, say, around 3 months forward). This can happen in a situation like the Gulf War, which would prompt oil prices to move higher on Middle East tension. Long-term large hedging of 100% of volumes is only seen in the market by charter airlines which have fixed income through forward seat sales to holiday companies. This means they have no way to increase prices later to accommodate higher jet fuel prices and therefore need to protect their usually thin and fixed profitability by fully hedging the price of forward jet fuel requirements. In the above example, an airline buys US$25 fixed price swap for 50,000 barrels per month, against Singapore MOPS as the pricing reference (Mean of Platts Singapore; http://www.platts.com/) for the calendar year 2003. In ISDA contract terminology, the airline is the ‘fixed price payer’. Total volume is 50,000 barrels × 12 months = 600,000 barrels. Remember that when asking for quotes from traders directly or via brokers the quote is normally good for 50,000 barrels per month for products quoted in barrels or 5,000 MT per month for products quoted in barrels (unless otherwise specified). In oil swaps there is a financial settlement every month (unlike financial markets like interest rates which usually have a settlement at the end of the swaps whole pricing period; e.g. a 3 month interest rate swap would have a settlement at the end of the 3rd month). Taking this into consideration the cash flow of this 12 month hedge would look something like Table 12.2. As this is an Asian-based swap (Mean of Platts Singapore) the cash settlement is normally going to be due on the 10th business day of the month preceding the month already priced out (e.g. for January 2003 the last pricing day would be Friday 31 January 2003). Payment for the cash settlement would be due on 14 February 2003 (subject to any banking holidays). Example 2: collar structure for end-user hedging This is more flexible because airlines normally want protection against a disaster scenario increase in jet prices. Using the swaps market means they must lock in their minimum net price receivable at the current perceived swap value (e.g. US$25 in Example 1). However, by using a collar structure as shown in Example 2 the airline can still protect itself from a worrying price increase, but can keep its minimum net price receivable locked in at a lower rate than the current swap price. Using a collar structure you can tailor the protection point to suit your jet fuel budget level. It is created by buying a cap and selling a floor option. The purchase of the cap protects you against jet fuel prices rising above the strike

190

ENERGY PRICE RISK

TABLE 12.2 Cash flow of a 12 month hedge 50,000 barrels per month Jet Kero Calendar 2003

A

B

C

Monthly settlement

Volume

Fixed price

‘MOPS’

(C – B) × A

Jan-03

50,000

25

24

Feb-03

50,000

25

25

Mar-03 Apr-03

50,000 50,000

25 25

26 26.5

–50000 0 50000 75000

May-03

50,000

25

27

100000

Jun-03

50,000

25

27

100000

Jul-03

50,000

25

25

0

Aug-03

50,000

25

23

–100000

Sep-03 Oct-03

50,000 50,000

25 25

22 24

–150000 –50000

Nov-03

50,000

25

26

50000

Dec-03

50,000

25

28

150000

Total vol.

600,000 barrels

175000

of the cap, which in the example is US$24. The sale of the floor reduces the cost of the premium in the purchase of the cap (which can be sizeable given the usual 12 month or more tenures in airline hedging programs). A popular approach by end-users is to create a zero cost collar by selling enough floor options and receiving enough premium from these sales to compensate for the cost of the cap purchase (Figure 12.2). The US$24 collar gives you 100% upside protection on any month that the average price of the market moves above US$24. The sale of the floor locks in the minimum net price you will receive on your jet fuel but at a lower level than the swap price you would have received at the same execution time point at this collar. By playing with the level of the cap and the floor and also the volumes of the cap and/or floor it is possible to create a zero cost collar where the purchase of the cap is 100% subsidised by the sale of the floor (Figure 12.3). Table 12.3 is an example cash flow for the collar hedge structure using the prices illustrated above, with 50,000 barrels per month as the contract volume.

Example 3: electricity producer risk profile In this example, a power producer (utility) has a more complex risk than an airline, which is only worried about jet fuel price risk (and maybe forex

HEDGING APPLICATION EXAMPLES

191

$28

$26 Buy cap $24 Jet fuel physical cost

$22 NO PROTECTION OR EXPOSURE WITHIN THE PARAMETERS OF THE COLLAR

$20

Airline

$18

$16

Net cost Jet fuel hedge cash flow +/–

Sell floor

$14

FIGURE 12.2 Zero cost collar $28

aaaaaaaa aaaaaaaa aaaaaaaa aaaaaaaa US$2 payout to airline aaaaaaaa aaaaaaaa

$26 Bought $24 cap $24

US$26 $22

US$24

US$22 US$21 MOPS monthly average

$20 $18 $16

Sold $16 floor

$14 Jan03

Feb03

Mar03

Apr03

May03

Jun03

FIGURE 12.3 Collar hedge structure

risk). A power producer (except nuclear) may have up to four different types of fuel for power production: coal, fuel oil, gasoil, and natural gas, as shown in Figure 12.4. Because of this a power producer will have to observe movements in the spark spread, which is the term used to

192

ENERGY PRICE RISK

TABLE 12.3 Cash flow for the collar hedge structure Collar Calendar 2003 Jan-03 Feb-03

Monthly settlement

A

FLOOR

CAP

C

Volume

Strike

Strike

‘MOPS’

50,000 50,000

16 16

24 24

14 21

–100000 0

Mar-03

50,000

16

24

22

0

Apr-03 May-03

50,000 50,000

16 16

24 24

26 24

100000 0

Paid/ received Coal

Fuel oil/ Gasoil

Nat. gas

0

Jan– March

Output prices Fixed/floating risk Electricity producer (utility)

Power

Input prices – floating price risk

FIGURE 12.4 Risk profile for an electricity producer

describe the gross margin (excludes cost of power company operation) between the cost of the chosen fuel for power production and the resale price of the forward electricity/power produced. A utility can control some of its price risk or profit margin risk (depending on the type of power stations it operates) by switching fuels if, for instance, gasoil looks more cost effective than fuel oil or vice versa. It will depend on the types of facility it operates. A coal power station would not switch over to oil-based products, nor would it switch from coal to natural gas and vice versa. On rare occasions when utilities are very close to a refinery they may sometimes utilise naphtha for power production. In normal circumstances, though, naphtha is not a cost-effective fuel and either coal, or fuel oil/gasoil or natural gas is utilised. In America there are coal futures on NYMEX and swaps, good liquidity in the NYMEX natural gas futures and there is also the OTC derivatives market. The OTC power market is USA is very well developed, so there are no issues there. Also for heating oil (gasoil) and fuel oil the OTC markets

HEDGING APPLICATION EXAMPLES

193

are very well developed and on the East Coast USA there is the possibility of using heating oil futures, although the majority of utilities will trade the natural gas versus the electricity spark spread. In Europe utilities have a well developed oil petroleum product swaps markets to utilise for hedging purposes and the IPE futures market also offers gasoil futures which may offer some protection. On the natural gas side, UK utilities can hedge in the IPE natural gas futures, and there is also a well developed natural gas NBP (natural balance point) UK gas swaps markets (trading circa mid-2002 approximately 6 times the volume of IPE NBP UK Nat Gas futures). Spark spreads are available from OTC traders as well, allowing the trading of the profit margin between natural gas piped in from the European North Sea and UK NETA forward power markets. In Continental Europe utilities and traders are able to utilise electricity futures markets as detailed in Chapters 3 and 4. Natural gas markets are not very deregulated in continental Europe. In most parts it has allowed countries to keep a control on overall power prices by controlling utility feedstock prices. This is changing gradually, though. Coal can be hedged in Europe by using coal swaps based on APi2 grade mainly as detailed in Chapters 3 and 4. UK spark spread recap When a spark spread order is given it is usually quoted as a spread price in £/MWh (UK pounds per megawatt hour). A preferred power price will be given and negotiation will develop from there via brokers or directly with another principal. Obviously, natural gas is not traded normally in MWh, so the natural gas price has to be converted into an electricity equivalent. In the UK spark spread market a conversion rate of 49.1349% is used (representing 100,000 therms/60MWs). Once a preferred fixed price on the power is confirmed, the gas price is then calculated in pence/therm correct to three decimal places: Gas price in p/therm = =

(Power price - Spread) ´ 24 ´ 100 ´ Volume of power Volume of gas (Power price - Spread) ´ 24 ´ 100 ´ 60 100 , 000

Contracts are based on the Standard GTMA (Grid Trading Master Agreement mentioned in Chapter 17 on legal risk) and the NBP 1997 Terms (which is the contract under which natural gas is traded in the UK). The trade (if reported by brokers) is reported in as the spark spread price level, and the fixed prices agreed for the gas and power (creating the spread) are not normally disclosed by OTC brokers.

194

ENERGY PRICE RISK

Example 4: metal producer In the situation shown in Figure 12.5, the metal producer can lock in the spread by using swaps or options between the energy markets utilised and the finished metal. Raw metal ore

Output prices Fixed/floating risk

Metals smelter

Finished metal

Electricity Fuel oil

Input prices – floating price risk

Coal

FIGURE 12.5 Risk profile for a metal producer

Some banks can offer structures that give metal producers power prices/ energy prices for their operation in a price related to the finished metal they produce. This is achieved by locking in the spread by selling forward metal derivatives and buying forward energy derivatives. The smelter is exposed to energy prices going up which is protected by the long (purchased) energy derivatives. The smelter’s profit margin is protected by the short (the sale) of metal derivatives. Example 5: crude oil hedge from Middle East to Asia Typically, for crude oil cargoes you would be given a 3 or 5 day pricing window. Take an example of a cargo of 500,000 barrels which is destined for Singapore 1–5 December 2002. Using January 2003 futures you can sell 500 contracts of the SGX Middle East Crude oil futures (equivalent of 500,000 barrels of crude). A trader might typically sell these contracts 100,000 barrels per day on 1, 2, 3, 4, 5 December as your crude cargo was pricing out against the Mean of McGraw-Hill Platts physical market assessment price (Figure 12.6). Now imagine that in this scenario the refinery has put the crude oil into storage after the long journey from West Africa/Middle East to Singapore for refining. The refinery in this example is consuming 50,000 barrels a day, so during the course of 10 days × 50,000 (500,000 barrels) the trade will wish to remove (close out) the futures (or indeed swaps) hedge against the physical crude oil, otherwise the crude oil will be consumed, leaving the trader with a naked derivatives position (i.e. with no physical commodity), so that overnight it would turn into a speculative trade (Figure 12.7).

HEDGING APPLICATION EXAMPLES 500,000 barrels pricing out over 5 days, i.e. 100,000 barrels per day MECO futures contract 1000 barrels per contract – so 100 contracts per day must be sold to lock in a hedge December barrels contracts 1st 100,000 100 2nd 100 3rd 100 4th 100 5th 100 so by close of business 5th December you are long (bought) 500,000 barrels of physical and also now 6th short (sold) 500,000 barrels or 500 contracts of MECO futures Journey Time 16th 17th 18th 19th

December the cargo is sold at this point you wish to close out the hedge by buying back 500 contracts in the market or via EFP

FIGURE 12.6 Crude oil hedging (1)

500,000 barrels pricing out over 5 days, i.e. 100,000 barrels per day MECO futures contract 1000 barrels per contract – so 100 contracts per day must be sold to lock in a hedge Selling Selling Selling Selling Selling

December barrels 1st 100,000 2nd 3rd 4th 5th 6th

contracts 100 100 100 100 100 so by close of business 5th December you are long (bought) 500,000 barrels of physical and also now short (sold) 500,000 barrels or 500 contracts of MECO futures

Journey Time 16th 17th 18th 19th 20th Buying Buying Buying Buying Buying Buying Buying Buying Buying Buying

21st 22nd 23rd 24th 25th 26th 27th 28th 29th 30th

21st December – As a user of the crude oil you may have storage facilities and use the oil slowly over another 10 days time period in which case every day you buy back 50 lots or 50,000 barrels of hedge as you consume the oil 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50 50,000 50

FIGURE 12.7 Crude oil hedging (2)

195

196

ENERGY PRICE RISK

Example 6: hedge cash flow for a crude oil import hedge Table 12.4 shows an example of where a refinery which is naturally short crude, since a refinery must consume crude oil and can’t be switched on or off. In fact, most refineries have to run at a minimum of 60% capacity, otherwise they have to be shut down, and that plus restarting a refinery is an extremely expensive and dangerous process. The risk profile here is that the refiner is exposed to crude oil prices moving higher and threatening its profit margin on refining crude oil into petroleum products. TABLE 12.4 Hedge cash flow for a crude oil import hedge

1st to 5th

Bought fixed cash

Sold fixed futures

26

26.35

Sold cash

Bought futures

21st to 30th

25

25.35

Gross profit (loss)

–1

1

Net position

0

So the US refiner buys NYMEX WTI Crude futures (or whole month average swaps based against WTI pricing). In this example the refiner wants to protect its January crude physical requirements from a price increase. 1 October Buys January NYMEX WTI Futures @ US$23.00 10 December The refiner purchases its crude oil @ US$24.75 Sells same volume futures Profit on futures US$ 1.75

@ US$24.75

The effective netted buying price is: Hedge + physical purchase price

= US$24.75 – US$1.75 hedge profit = US$23.00

Example 7: crude oil producer hedge A simple crude oil producer hedge would be as follows. A crude producer is naturally long crude because it has crude in the ground, so it is exposed to prices going down. It therefore needs to create a short position in a derivatives hedge structure. For this example the producer sells its crude oil on a Brent crude oil related price basis, so its price exposure is in terms of Brent crude oil. The

HEDGING APPLICATION EXAMPLES

197

producer has seen crude prices reach a high level due to some Middle East political tension and related concerns, so it is too expensive to buy some put options (floor) on their own. One possibility is to do the following: ■

■

Sell Brent-related futures, e.g. IPE Brent Futures in London. This is a good idea if the producer wishes to remain anonymous and not scare the market that they are selling. Sell Brent-related OTC swaps with other oil companies and banks. This may be more flexible, but given that this is a key producer hedging they might not wish to reveal their intentions directly with other traders in the OTC market place.

An example using IPE Brent Futures: 5 December Sells January IPE Brent Futures

@ US$ 29.50 per barrel

15 January Sells Physical crude

@ US$30.50 per barrel Buys back same volume of futures @ US$30.50 per barrel Futures loss @ US$ 1.00 per barrel Effective netted crude sale price is Hedge + physical sale price

= US$30.50 + US$1.00 loss = US$29.50 per barrel

Example 8: crude producer hedge using floors with a knock-out The other alternative which can be applied not only to a crude oil producer but to any energy producer situation is using floors (puts) with a knock-out option. In this scenario, the producer had found that because the oil price had been moving higher, and it thought that prices would continue to move higher, it did not wish to sell futures or swaps and lock in the price, creating some potential loss of opportunity if prices continued to rise (as shown by the previous example with a loss on the hedge). A more appetising solution is to buy floors (puts). In this scenario we will say that the cost of buying a floor is too expensive, so the producer could look at introducing a knock-out into the floor (put) structure in order to try to reduce the overall cost of the option. In a hedging scenario, whatever the type of energy product being produced, you would look to buy an ‘out-of-the-money’ floor (put) and request a knock out above the market. In the scenario of Figure 12.8 the trader or market maker has given the producer a cheaper floor option to protect against prices going down,

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ENERGY PRICE RISK 32 Knock-out at US$31.00 chosen by producer

31 30 29

Current market price 28 27 26

Floor Purchased @ strike price of US$27.00

25 Price

FIGURE 12.8 Hedging using a floor with a knock-out

because the producer has given the seller some optionality. This optionality is the knock-out. What the producer has said to the seller of the floor is that if the market goes up to US$31.00 during the lifetime of the option, the option is automatically cancelled. So the seller of the option has the added chance – the added potential – of receiving a premium for a long-term option, which may actually be cancelled before it reaches maturity or expiry date. This lets the seller of the option off the hook without any more exposure to the producer. A rebate structure can also sometimes be negotiated. In this instance, if the option were cancelled, the producer who is hedging might receive back some percentage of the original premium it had paid out for the option.

Example 9: refinery margin hedge when margin positive on some products and negative on others In this example (see Figure 12.9) a refinery has good margins on jet kero and gasoil, but fuel oil margins are negative (fuel oil makes up to 25% of Energy inputs

Energy outputs Naphtha Jet Kero

Crude oil feedstock

Gasoil Oil refiner

Fuel oil Gasoline

FIGURE 12.9 Energy inputs and outputs for an oil refinery

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the output of some older refineries, although newer ones tend to reprocess a lot of fuel oil and a modern refinery may only produce an estimated 10% fuel oil). This refinery is using crude oil from the Middle East, pricing against the average of Platts Oman crude oil. To hedge the crude oil imports for the refinery the traders will sell OTC crude oil swaps pricing against Platts Oman average. Thus the refinery buys 2,000,000 barrels of Middle East crude priced against Oman on 1–5 January. Since not all of the petroleum product output is being hedged, the first thing to do is to add up the volume of the products (convert into barrels where necessary) and make sure that only this amount of crude is hedged. For example, see Figure 12.10. Crude Oil Import Feedstock

January

TOTAL

1st 2nd 3rd 4th 5th 6th

Petroleum Product Production Hedge Sold Swaps Sold Swaps FUEL OIL CRACK OPTION Jet Kero Gasoil BOUGHT FLOOR @ US$110 per MT Physical Hedge Short Volume (using 6.7 conversion from MT to barrels) 25 24.95 125,000 50,000 75,000 0 24.89 24.84 125,000 50,000 75,000 0 24.86 24.81 125,000 50,000 75,000 0 24.5 24.45 125,000 50,000 75,000 0 24.65 24.6 500,000 50,000 75,000 375,000 24.78 24.73 1,000,000

FIGURE 12.10 Petroleum product production hedge

Using the figures above we are hedging 1,000,000 barrels of product, so we also need to lock in 1,000,000 barrels of the crude. So every day for 5 days during the pricing window 1–5 January, the traders will sell 125,000 barrels of Platts Oman related swaps, except for the last day, which is 500,000 barrels, since the crack option on the fuel oil is placed in the option market all in one go. By day 6, the trader will have a cargo of physical on the water on its way to the refinery and a paper hedge of 1,000,000 barrels notional quantity protecting the value of the crude. At the same time as hedging the crude oil cargoes, the trader starts hedging the future production of the refinery from this crude oil that is on its way to the refinery. For jet fuel and gasoil, the margin is looking healthy, so the trader may just sell the forward swaps to lock in the value of the jet fuel and gasoil. He makes sure that he sells swaps which cover the time period that the refinery will be producing petroleum products from the crude on the water on its way to the refinery. For example, if someone bought West African crude and shipped it to Japan for refining, it could take four weeks to get there. So, if you were hedging the crude oil you would want to make sure that the derivatives contract would not expire before the products could be produced from the crude. Also, it might mean that the products would not actually be sold from the refinery for several months after the crude was purchased. The issue in this scenario is that the fuel oil has a negative refining margin. They cannot shut the refinery down, so they need to protect

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against this margin getting still worse. However, if they were to sell the swaps markets in fuel oil it would lock in the price 100%, and if the refinery margin improved they would not be able to benefit from that improvement. However, the refinery in this scenario decides to utilise a crack option. As discussed in earlier chapters, you can buy (or even sell) crack options on refinery margins (the same thing in the power industry would be considered spark spread options – the spread between input energy like natural gas, gasoil, fuel oil, or coal and the output of electricity in MWh). So, the refinery could buy a floor (put) option against the margin getting worse. The benefit of the option is that if the refinery margin improved, the refinery could benefit from 100% of the improvement (after the margin has improved enough to cover the cost of the option for the hedge). To reduce the cost of the crack option strategy, the refiner could ask market makers, banks and traders to quote a zero cost collar crack option structure. In this case the refiner would still buy a floor (put) on the crack margin against fuel oil, but would also sell some caps (calls) on the crack margin against fuel oil to generate some cash premium and subsidise or totally net out the cost of the floor crack option. In doing this the refiner would put a limit on the amount of improvement of the crack margin it can benefit from, but at least the cap can be placed higher than the current swap level. So the refiner would still have more chance to benefit from improvement than if it merely sold the fuel oil swaps at current market levels.

CHAPTER 13

Risk Management Process and Policy Creation Guidelines

THE RISK MANAGEMENT PROCESS The primary components of a sound risk management process are: ■ ■ ■ ■

A comprehensive risk measurement approach. A detailed structure of derivative position limits. Clear guidelines and other parameters used to govern risk taken by officers of the organisation. A strong risk management information system for: ● Controlling risk. ● Monitoring risk. ● Reporting risk.

These components are fundamental to both derivatives and non-derivatives activities. The underlying risks associated with derivatives activities, such as credit, market, liquidity, operations and legal risk, are not unique to the energy trading sector, but their measurement and in turn their management can be more complex than physical energy deals. As with all risk-bearing activities, the risk that an organisation takes in its derivatives activities should be properly supported by adequate working capital. The organisation should also ensure that its capital base is sufficiently strong to support all derivatives risks on a fully consolidated basis and that adequate capital is maintained in all of its group entities which are engaged in these activities. This is of even more importance if an organisation’s subsidiaries or any of its affiliates are ‘Specified Entities’ in any of its ISDA agreements. Any default, perhaps on a loan or even derivative contract payment from one of its group companies, could impact on its own trading position in the markets and see counterparts closing out its positions due to a group company’s default (see Chapter 17 for more details about Specified Entities). 201

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An organisation’s system for measuring the various risks of derivatives activities should be both comprehensive and accurate. These are some of the key points on risk recording: ■ ■ ■

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Risk should be measured and aggregated across all derivatives activities to the fullest extent possible. An organisation that uses derivatives should have a system in place that enables management to assess exposures on a consolidated basis. The risk measurement system used, e.g. VAR, should be good enough to reflect accurately the multiple types of risks facing the organisation. (This will vary depending on the types of derivatives used.) Risk measurement standards should be understood by relevant personnel at all levels of the organisation – from individual traders to the Board of Directors – and should provide a common framework for limiting and monitoring risk-taking activities. The process of marking derivatives positions to market (for fair value accounting and management control purposes) is fundamental to measuring and reporting exposures accurately. An organisation speculating in energy OTC derivatives and other traded derivatives should aim to have the ability to monitor the following on a daily basis: ● Credit exposures. ● Physical and derivative trading positions. ● Market price movements.

Derivative position stress testing should also be included in any risk management policy. VAR can be a good system for clearly illustrating the US dollar risk that an organisation may take overnight within a certain level of confidence (e.g. 95% confidence level). However, VAR only predicts a possible reality and does not show exactly what that reality will be. For this reason, it is prudent to use stress testing alongside a VAR system. This should be conducted on a regular basis to assess the impact on the organisation should a disaster occur. For example, if there were a large standard deviation move from normal market situations (perhaps a 3 standard deviation market move), would the organisation survive the cash flow crunch? In the oil industry, the Gulf War period in the early 1990s provides a good real life scenario to run through a system using historical data. Sound risk measurement practices should include identifying possible events or changes in market behaviour that could have unfavourable effects on the institution and assessing the ability of the institution to withstand them. These analyses should consider not only the probability of an adverse event but also ‘worst case’ scenarios. It should also be noted that these same reports can help management and accounts departments to write up narrative disclosures for derivatives accounting disclosures, in

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line with more recent disclosure requirements (see Chapter 18 for information on international accounting standards for derivatives). Ideally, such ‘worst case’ analysis should be conducted on an organisation- or group-wide basis by taking into account the effect of unusual changes in prices and or volatilities. It should also look at ‘What if?’ scenarios of market liquidity and the ‘What if?’ scenario created by early termination events under ISDA OTC Derivatives via a key default of a large counterpart across the derivatives and the physical energy trading portfolio. This scenario should include input from the organisation’s legal department to ensure that contingency plans for disaster scenarios are understood fully by all line managers. For a risk management process to be complete, these regular stress tests should not be limited to quantitative computation of potential losses or gains. They should include more qualitative analyses of the action plan that management might take under particular ‘disaster’ scenarios. It is certainly better for both management and traders to have a written policy for guidance in ‘What if?’ scenarios. These can be used to develop contingency guidelines and plans outlining operating procedures and lines of communication, both formal and informal. If something bad happens, the panic that follows could cost more in terms of lost reputation and money than the original problem. However, with forethought and contingency planning it is possible to bring some calm to such a situation. Even if the contingency plans don’t exactly meet the demands of the situation faced, they will make everyone focus on resolving the issue rather than allowing the problem to get worse.

TRADING CONTROLS – POSITION LIMITS A sound system of integrated organisation limits and risk-taking guidelines are essential components of the risk management process. This is the first line of defence against internal fraud, as well as enabling derivative position control, risk management reporting and subsequent action plans by management and traders alike. The system may require a big investment in terms of both human resources and cash, but it will pay for itself many times over, especially if it is implemented from the start of derivatives trading. Such a trading/position limit system should set boundaries for organisational risk-taking and risk-reduction through hedging and should also ensure that positions that exceed certain predetermined levels receive prompt management attention. Any position control breach should trigger the creation of what is termed an ‘exception report’ which management should review on at least a daily basis. The derivative position limit system should be consistent with the effectiveness of the organisation’s

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overall risk management process and with the adequacy of its capital position. Just because an organisation is not speculating but hedging does not mean that position controls are not needed. It is important that management can make sure the extent of hedging is within board-approved remits and policy. If derivative position limits are breached, such occurrences should be made known to senior management and the position should be reduced immediately or the larger position approved only by authorised personnel. Although position limits are not restricted to the size of a position, they also include the types of derivatives used and the choice of energy products in which derivatives can be used by the organisation. Clear details should be written in the risk management policy and made available to traders so they know which derivatives in which energy products they can use, and sometimes for hedging which risks. If the organisation is also speculating then the policy would go through in detail the size limits of positions based on tenure (how far forward). Due to liquidity concerns an organisation may, for example, say that a trader can trade Naphtha Swaps up to 6 months forward but no further. An accurate and timely management information system is essential to the proper operation of derivatives activities, the more real-time the better. In terms of accuracy, as they say, garbage in, garbage out: a system is only as good as the quality of the data going in to it. (This is discussed in Chapter 9.) In speculative trading operations, there should be reports across all markets on the gross plus net exposures broken down by energy market and counterpart, showing the net position on each market and the overall VAR or other risk measurement result for the organisation. This report plus profit and loss statements should be reported at least daily to managers not active in trading (i.e. those who supervise but who do not

POSITION LIMITS ■ By energy product/type, e.g. Dubai crude, UK NBP Gas, Singapore Gasoil

0.5%, New York Harbor Unleaded Gasoline ■ By type of derivative – swaps, futures, options, exotic options ■ By tenure – how big a position can be put on and how far forward, e.g.

Dubai Crude swaps 2 million barrels – 1 to 6 month forward and 1 million barrels 7 months to 12 months forward. ■ By division or office ■ By individual trader ■ By group of offices/divisions (depending on size of operation)

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themselves conduct trading activities) to ensure an adequate segregation of duties. End users who are using derivatives infrequently for long-term hedging are still advised to generate profit and loss statements (i.e. fair value marked-to-market calculations of their hedge versus underlying energy market exposure to ensure that their hedge is effective and how it is performing on a close of business basis every day). Any other position and disaster scenario reporting may seem excessive and lots of additional reporting and assessment of cash-flow risk and risk reduction through hedging may not be necessary. However, it is up to the management of the organisation to make a final choice as to what level of reporting seems appropriate and what level seems excessive, given their firm’s level of derivatives usage. Reports on derivatives positions for higher levels of senior management and the Board may occur less frequently, but the frequency of reporting should provide these individuals with adequate information to assess the changing nature of their organisation’s risk profile. After all, they are ultimately responsible to shareholders if anything goes wrong. For companies using derivatives for hedging purposes for long-term energy exposures who do not frequently change their derivatives position, quarterly reporting to the Board is probably sufficient in most cases. If an organisation is changing or adding to its derivatives positions on a more frequent basis, then monthly reporting to the Board may be more prudent. Better still, if an organisation implements a computerised risk management system, it will allow the Board members at any time to view a snapshot of the organisation’s derivatives and (if applicable) physical energy portfolio as well as the resultant risk profile of the firm. This should be backed up with a mandatory update to the board, perhaps every quarter or when felt appropriate to the organisation’s specific needs. Risk management information systems should ideally translate the measured risk for derivatives activities (combined with physical energy trading activity if applicable) from a technical and quantitative format to one that can be easily read and understood by senior managers and directors. VAR methodologies can be very useful in this situation as, by their very nature, they present risk as a monetary value over a given time period within a certain percentage probability.

SOME KEY GUIDELINES FOR A RISK MANAGEMENT POLICY The following is a non-exhaustive list of guidelines for a risk management policy. It tries to capture both the spirit of what a risk management policy

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should be aiming to cover and the core contents of a policy for any organisation, whatever its purpose of using derivatives. Of course, every organisation’s needs are different, but this should give a flavour of what is required. ■

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Approve risk management policy at Board level. This level of approval should include the scope of the organisation’s usage of derivatives and the general policies to be applied. What is the goal of the organisation by using derivatives? Hedging or trading? Value derivatives positions on a daily basis at fair value/market value, at least for risk management reporting purposes. Quantify the organisation’s market risk under adverse market conditions against limits by performing stress testing simulations. Assess the credit risk arising from derivatives activities based on frequent measures of current and potential exposure against credit limits and counterparts. Is there too much exposure to any single counterpart? Is there a credit risk mitigation and control policy? Can the organisation utilise credit derivatives or credit insurance? Do not become involved in a product at significant levels until senior management and all relevant personnel (including those in risk management, internal control, legal, accounting and auditing) understand the product and are able to integrate the product into the organisation’s risk measurement and control systems. Reduce credit risk by broadening the use of multi-product master agreements with netting provisions. Establish market and credit risk management functions with clear authority independent of the front office derivatives trading function (segregation of duties). Authorise only professionals with the required skills and experience to transact and manage the energy risks, as well as to process, report, control and audit derivatives activities. Establish management information systems sophisticated enough to measure, manage and report the risks of the types of derivatives used. Adopt fair value derivatives accounting and disclosure practices (e.g. FAS 133 or IAS39) Value derivatives portfolios of dealers based on mid-market levels less specific adjustments, or on appropriate bid or offer levels. Mid-market valuation adjustments should allow for expected future costs such as unearned credit spread, close-out costs, investing and funding costs, and administrative costs. Once a method of risk measurement is in place, market risk limits must be based on factors such as: management tolerance for low probability extreme losses versus higher probability modest losses, capital resources, market liquidity, expected profitability, trader experience and business strategy.

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An organisation using derivatives should use a consistent measure to calculate on a daily basis the market risk of their derivatives positions and compare it to market risk limits. Market risk is best measured as ‘value at risk’ using probability analysis based upon a common confidence interval (e.g. two standard deviations) and time horizon (e.g. a one-day exposure). Dealers should regularly perform simulations to determine how their portfolios would perform under stress conditions. Dealers should have a market risk management function, with clear independence and authority. Stress testing should be included in any sound risk management policy. These simulations should reflect both historical events and future possibilities. Stress scenarios should include not only abnormally large market swings but also periods of prolonged inactivity. The tests should consider the effect of price changes on the mid-market value of the portfolio, as well as changes in the assumptions about the adjustments to mid-market (such as the impact that decreased liquidity would have on close-out costs). Dealers should evaluate the results of stress tests and develop contingency plans. Dealers should periodically forecast the cash investment and funding requirements arising from their derivatives portfolios. The frequency and precision of forecasts should be determined by the size and nature of mismatches. A detailed forecast should determine surpluses and funding needs by currency over time. It also should examine the potential impact of contractual unwind provisions or other credit provisions that produce cash or collateral receipts or payments. There have been instances of currency problems for hedgers using derivatives. One highly publicised case in the late 1990s was Korean Airlines, which hedged Jet Fuel using US dollar-denominated swaps. However, the core cash flow of the company was in Korean won. Unfortunately, the won versus US dollar currency rate moved dramatically and Korean Airlines wound up with compounded losses via forex risk on derivatives hedges as it had to buy additional US dollars at a bad exchange rate to meet settlements on maturing Jet Fuel swaps. Independent risk managers should ensure that the following responsibilities are carried out: ● The development of risk limit policies and the monitoring of transactions and positions for adherence to these policies. ● The design of stress scenarios to measure the impact of market conditions, however improbable, that might cause market gaps, volatility swings, or disruptions of major relationships, or might reduce liquidity. ● The monitoring of any variance between the actual volatility of portfolio value and that predicted by the measure of market risk (e.g. VAR).

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The review and approval of pricing models and valuation systems used by front- and back-office personnel, and the development of reconciliation procedures if different systems are used. Organisations are advised to set up a market risk management function. This is usually headed by a Board level or near Board level executive in the organisation. ● The market risk manager should act as a catalyst for the development of sound market risk management systems and procedures. He or she should review trading performance by deciding whether results are consistent with those suggested by analysis of value at risk (if this is the risk measure employed by the organisation). The market risk manager is rarely involved in actual risk-taking decisions. End users could have someone on the Board who is trained on derivatives and who can act as another backstop to questioning the success of risk management or trading programmes. End-users should adopt the same valuation and market risk management practices that are recommended for speculative traders (as appropriate to the nature, size and complexity of their derivatives activities). Specifically, they should consider: regularly marking to market their derivatives transactions for risk management purposes, periodically forecasting the cash investing and funding requirements arising from their derivatives transactions, and establishing a clearly independent and authoritative function to design and assure adherence to position and or risk limits set by the organisation. Most end-users may not expect any significant change in the combined value of their derivatives positions and the underlying energy exposure, as they are hedging an underlying or future exposure to energy price. But even if this is expected to be the case, an end-user should establish hedge performance assessment and derivatives/management control procedures that are appropriate for their derivatives activities. Speculative traders and end-users hedging using derivatives should measure their credit risk exposure on derivatives in two ways: ● Current exposure, which is the replacement cost of derivatives transactions, that is, their market value. ● Potential exposure, which is an estimate of the future replacement cost of their derivatives transactions. It should be calculated using probability analysis based upon broad confidence intervals (e.g. two standard deviations) over the remaining terms of the transactions. This allows them to answer the following important questions about credit risk: ● If a derivatives counterpart was to default today, how much would it cost to replace the derivatives transaction with that counterpart? ● If a counterpart defaults in the future, what is a reasonable estimate of the future replacement cost? ●

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Any credit risk on derivatives, and all other credit exposures to a single counterpart should be aggregated, taking into consideration any enforceable netting arrangements. Credit exposures should be calculated regularly and compared to credit limits. In calculating the current credit exposure for a portfolio of transactions with a counterpart, the first question is whether netting applies. If it does, the current exposure is simply the sum of positive and negative exposures on transactions in the portfolio. Master netting agreements which cover both physical energy and derivatives positions are still in the early stages of development, but they are possible. More common are the netting agreements for derivatives within ISDA master agreements. Traders and end-users of derivatives should have an independent credit risk management function with analytical capabilities in derivatives, responsible for: ● Approving credit exposure measurement standards. ● Setting credit limits and monitoring their use. ● Reviewing credits and concentrations of credit risk with counterparts. ● Reviewing and monitoring risk reduction arrangements and working with legal departments or lawyers to check their enforceability. (This may vary, depending on the jurisdiction of the counterpart.) The credit risk management function should continually review the creditworthiness of counterparts and their credit limits. Traders and end-users should have a policy to use one master agreement as widely as possible with each counterpart to document existing and future derivatives transactions. Master agreements should provide for payments netting and close-out netting, using a full two-way payments approach (see Chapter 17). All users of derivatives should have a clear policy on credit risk reduction arrangements that can be useful in the management of counterpart credit risk (e.g. collateral and margin arrangements, and third-party credit enhancement such as guarantees or letters of credit – see Chapter 1). Organisations using derivatives must ensure that their derivatives activities are undertaken by professionals in sufficient numbers (to reduce operational risk via dependence on single individuals) and with the appropriate experience, skill levels, and degrees of specialisation. These professionals should include specialists who transact and manage the risks involved, their supervisors, and those responsible for processing, reporting, controlling and auditing the activities. Financial statements of derivatives users should contain sufficient information about their use of derivatives to provide an understanding of: ● Why derivatives transactions are undertaken. ● The extent of the transactions, in which markets and how much volume is transacted.

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The degree of risk involved or how much this activity aims to reduce the overall risk of the organisation, if hedging. ● How the transactions have been accounted for (i.e. which accounting standard the organisation has adopted for accounting its derivatives positions on its balance sheet). Know the market; have a policy for assessing new derivatives markets and whether they are appropriate for the organisation’s trading or risk management needs. From this assessment an organisation should be able to answer key questions like: ● Is the new market appropriate for the organisation? ● Does it offer effective hedges? If so, against which exposures of the organisation? ● What are the liquidity issues? ● Who are the main participants in this market? Are there any credit issues with these counterparts? ●

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CHAPTER 14

Applied Technical Analysis in the Energy Markets

Timing is the key to any successful trading or hedging program. But getting the timing right will always be more of an art than an exact science. However, there are some tools that can help to build up a clearer picture of when the market price trend may change, which in turn should provide an idea of market direction and timing. There are two main types of analysis that can be carried out: fundamental analysis and technical analysis. Fundamental analysis deals with the supply and demand factors of the physical energy world, whereas technical analysis is concerned with the price history of the market. In reality, most people use a combination of the two – what could be termed ‘techno-fundamental’ analysis. In other words, when a general technical picture of market direction and timing has been established, any new fundamental information can be incorporated into the picture as it is announced. If a trader starts with a clear technical picture, then whenever news or information comes into the market during the trading day, he or she should ask three key questions: Is this new news? Is this fresh news? Has the market already seen this? The last question is important, because sometimes information or events are rumoured in the market and, as the saying goes, people ‘buy the rumour and sell the fact’. The can sometimes lead to a situation in which the market will fall on bullish news or rise on bearish news. In these instances the news or information was already in the price, so the confirmation of the news gave the signal for people who were speculating on the rumour to take their profit and close out their position. This chapter presents the key technical approaches and tools that work well together when applied to major energy futures markets. Note the word ‘together’: technical analysis is a bit like detective work, in that it requires ongoing attention to all evidence that might support any theory on the direction of price trend and the timing of entry and exit. 211

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FIGURE 14.1 Technical analysis – bar chart. A bar chart displays a security’s open (if available), high, low, and closing prices. Bar charts are the most popular type of security chart

WHAT IS TECHNICAL ANALYSIS? Figure 14.1 is a typical futures bar chart, each bar representing a single time period. The example above is a daily bar chart, so each bar represents one trading day. The line on the left-hand side of the bar represents where the market opened (first traded price of that trading day) and the top of the bar is the high of the day and the lowest level of the bar is the low of that day. The line on the right-hand side of the bar represents the closing price (last traded price/official settlement price). The arithmetic scale is the most popular one used for bar chart construction showing price and time. The logarithmic scale is of little use for technical analysis, although it can be useful for bringing different commodities down to the same scale for analysing which markets are taking the lead in percentage terms. There are a number of ways of defining technical analysis, but, in a nutshell, it is the study of market prices, with price charts being the primary tool (see Figure 14.1). It is based on the idea that historical price movements of a commodity can be used to predict the sentiment and the expectations of market participants with regard to the future price trends. Another way of looking at technical analysis is to see it as applied social psychology, because it sets out to recognise trends and changes in crowd behaviour. In many ways, technical analysis is all about trying to predict what the majority of traders believe will happen next, in terms of the price direction of the market. In fact, one of the main reasons that technical analysis works is simply that everyone believes it works. The majority of people trading in the markets are influenced by technical analysis, so its predictions can be, to some extent, self-fulfilling. It therefore follows that

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we must examine the key technical analysis tools that the majority will be basing their decisions on. One thing is certain: technical analysis can help when making timing and market direction predictions. However, it is not enough to rely on a single technical tool; a combination of five or six technical tools and approaches is needed to help build up a good picture of market trend price targets and timing. It should also be remembered that there are certain types of market price movement that can render some technical analysis tools useless and too unreliable to follow. The key here is to recognise when technical analysis tools should be treated with caution.

THE PRINCIPLES OF TECHNICAL ANALYSIS Technical analysis works on some key principles. These are:■

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That all known market fundamentals (news in the market) are accounted for and are reflected in market prices. The market has absorbed all the news, and the price represents a consensus on where price should be, based on all known data. This is certainly true in efficient markets which have good trading volume (liquidity). That prices move in trends and trends persist. That market action is repetitive or cyclical. If we accept the fact that human emotions and expectations play a role in commodity pricing, we should also admit that our emotions play a role in our decision making.

The key rules for anyone looking to use technical analysis are: ■ ■

Keep it simple. Go with technical analysis tools and approaches that most of the world will be looking at. After all, you are trying to predict what the majority of traders are thinking. So it is important to watch the tools that they will be looking at, which in turn will affect their own perspective on future price trends to some extent. It is also useful to refer to news agency reports on the market, as these often discuss technical analysis tools on the market. You can be sure that these tools will have some bearing on perceptions of future trends.

THE TECHNICAL ANALYSIS BAR CHART A history of technical analysis The roots of modern-day technical analysis are in the Dow Theory, developed around 1900 by Charles Dow. Stemming either directly or indirectly

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BULLS AND BEARS

The origins of the terms bull trend (market moving higher) or bear trend (market moving lower) come from the days of the early commodity markets In London. At the time, bull fighting and bear fighting were both popular spectator sports in the city. The terms for the direction of financial and commodity markets are based on the way in which bulls and bears fight. A bull will attack with its horns, pick up its opponent and throw him up in the air, whereas a bear will stand up on its back legs and drop down on top of its opponent, crushing him with its weight.

from the Dow Theory are principles such as the trending nature of prices, prices discounting all known information, volume mirroring changes in price and support and resistance. Of course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow Theory. The price of a commodity represents a consensus. It is the price at which one person agrees to buy and another agrees to sell. The price at which an investor is willing to buy or sell depends primarily on his or her expectations. If she expects the security’s price to rise, she will buy it; if the investor expects the price to fall, she will sell it. These simple statements are the cause of a major challenge in forecasting commodity prices, because they refer to human expectations. As we all know, humans are not easily predictable. This fact alone will keep any mechanical trading system from working consistently. Because people are involved, many investment decisions are based on criteria that might be considered not strictly relevant. After all, our confidence, expectations and decisions in the market can all be influenced by a large number of factors: relationships with family, neighbours and employer – or even traffic, income or previous success and failures, none of which could ever be successfully quantified in a statistically based model!

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Trendlines Before getting into any mathematical analysis calculations, there is a lot of information and guidance on future price movements that we can extract from the basic open, high, low, close price chart (Figure 14.2). H O

C

L

FIGURE 14.2 Trendlines

The concept of a trend is essential to this approach to technical analysis. Generally, the trend is simply the direction of the market. More precisely, market moves are usually a series of zigzags, resembling a series of waves with fairly obvious peaks and troughs. It is the overall direction of these peaks and troughs which constitute market trend. Most of the time, traders watch for a change in trend and subsequent confirmations that the trend is changing or has changed before acting on that information. Trendlines play an important part in illustrating that a change has been made and also give traders an indication of the price levels that might trigger a price change or a new buying or selling interest. Trendlines should be drawn off two price points – a high or low and the earliest price points that can be found. The trendline should then be confirmed by a third test as illustrated in Figures 14.3 and 14.4. Other notes on trendlines The relative steepness of the trendline is also important. In general, most trendlines tend to approximate to an average slope of 45°. Such a line reflects a situation where prices are advancing or declining at such a rate that price and time are in perfect balance. It is rare to find a trendline which is exactly at a 45° angle, but we can say that, in a bullish market, if the trendline is too steep (above 45°), it indicates that prices are advancing too rapidly and that the current steep move up will not be sustained. Figures 14.5 and 14.6 show some features of trendlines. For trendline A, the support trendline initially holds as support but is then broken.

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Rising trendline

FIGURE 14.3 Uptrend or bull trend chart sourced from and © FutureSource UK Inc.

Trendline

FIGURE 14.4 Downtrend or bearish trend chart sourced from and © FutureSource UK Inc.

For trendline B, the support trendline holds as support and then resistance and then support again (it is quite common for a trendline to offer both support and resistance). For trendline C, the resistance trendline then becomes support a few months later.

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C A

B

FIGURE 14.5 IPE Brent Crude Oil; chart sourced from and © FutureSource UK Inc.

= Successful test and confirmation of Trendline

A

C B

FIGURE 14.6 NYMEX WTI Crude Oil; chart sourced from and © FutureSource UK Inc.

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Trendline and breakout A breakout is where a trendline is finally broken (see Figure 14.5, line A), indicating that if good trading volume is seen at the same time, a change in price trend could be taking place. Other indicators help to identify when a trend change may take place, which is usually followed by a break in the trendline, giving confirmation of a trend change; see Figure 14.7. It is important to remember that the more times a trendline is tested and held, whether as resistance or support, the greater will be the subsequent market price move or reaction away from that trendline when it is finally broken with the inevitable breakout. Breakout

1

2

3

4

5

FIGURE 14.7 Breakout

Support and resistance Alongside trendlines on charts, clear patterns of support and resistance can also be spotted. If the energy price is thought of as an ongoing war between the bull (the buyer) and the bear (the seller), then support and resistance levels can be seen as the battlefields in that war. In other words, support and resistance levels represent barriers to change. A good way to quantify expectations following a breakout from a trendline or from resistance or support levels is to look at the volume associated with the price breakout. If prices break through the support/resistance level with a large increase in volume (Figure 14.8) and the move back is on relatively low volume (resistance becomes support) it implies that the new expectations will rule (a minority of traders are unconvinced). Conversely, if the breakout is on moderate volume and the move-back period is on increased volume, it implies that very few traders’ expectations have changed and a return to the original expectations (i.e. original price trend) could be seen. Volume Low volume levels are characteristic of indecision (if there are no major international holidays at the time!) or an expectation of possible change. This typically occurs during price consolidation periods – periods when prices move sideways in a trading range. Low volume also often occurs in the indecisive period during market bottoms or tops. Sometimes traders and brokers will refer to the market ‘bottoming out’ or ‘looking toppy’. This means the market may reverse its previous trend.

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Resistance Support

FIGURE 14.8 Breakout and increasing volume

On the other hand, high volume levels are characteristic of market tops when there is a strong consensus that prices will move higher. High volume levels are also very common at the beginning of new trends (i.e. when prices break out of a trading range). For example, just before market bottoms, volume will often increase due to panic-driven selling. Volume can also help determine the health of an existing trend, by indicating whether it is a strong or weakening. A healthy uptrend should have higher volume on the upward legs of the trend and lower volume on the downward (corrective) legs. A healthy downtrend usually has higher volume on the downward legs of the trend and lower volume on the upward (corrective) legs

OTHER TYPES OF CHART Candlestick charts In the 1600s, the Japanese developed a method of technical analysis to analyse the price of rice contracts. This technique is called candlestick charting. Candlestick charts display the open, high, low and closing prices in a format similar to a bar chart, but in a way that highlights the relationship between the opening and closing prices (Figure 14.9). Candlestick charts are simply another way of looking at prices that don’t involve any calculations. They have their uses, especially for traders in markets such as bonds, but in the energy markets there is only one key formation that is worth

220

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The opening or closing price, whichever is greater The centre section (‘real body’) is filled in if the close is lower than the open. Otherwise it is left empty. The opening or closing price, whichever is less

The lowest price (‘upper shadow’)

FIGURE 14.9 A candlestick chart

looking out for, as it can give an early warning of a major trend change. This is the ‘DOJI’ formation as illustrated in Figure 14.10. I have noticed this ‘DOJI’ formation on three or four occasions over the past seven years, and when it has shown up in Nymex or IPE Futures contracts, it has been followed by a trendline support break, and in one instance the market dropped some US$3 a barrel on IPE Brent in just a few days. Dollars 14.00 13.90

Open and close at the same level

13.80 13.70 13.60

OR

13.50 13.40 13.30 13.20 13.10 13.00

Of particular interest on a trading day when a new price extreme has been tested but the has failed to close towards it

FIGURE 14.10 The DOJI formation

The VIP relationship (volume, open interest and price) It is possible to build up a good picture of what the market is thinking from a combination of trendline analysis (using charts, support/resistance levels), volume (using the total market volume) and open interest information.

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Volume is a simple but key aid when analysing the market. It can give a good real-time signal as to the level of interest in a new trend starting or an old trend finishing. This, combined with open interest (which is available in futures markets contracts but not equities), gives a very good combination tool to analyse whether a trend could continue or may be coming to an end. Open interest is the net number of futures or option contracts in existence on an exchange, counting a bought contract and a sold contract as one open contract, or a figure of 1 in open interest terms. Table 14.1 lists the various VIP relationships. TABLE 14.1 The VIP relationship Price

Volume

Open interest

Market is...

Rising

Increasing

Up

Strong bullish

Rising

Decreasing

Down

Trend weakening; watch for reversal

Falling Falling

Increasing Decreasing

Up Down

Strong bearish Trend weakening; watch for reversal

Figure 14.11 is a graphical illustration of the VIP relationship. In section (1), the market is moving higher, volume is increasing and open interest is increasing. This shows that the bullish uptrend is well supported with new buyers coming into the market. In section (2), the market is moving higher, but volume and open interest are decreasing. This shows that there is no new interest in continuing the bullish trend and in fact, with open interest decreasing, the market looks like it is closing out of (selling out of) previously bought (1)

(2)

(3)

(4)

Price

Volume

Open interest Trend

Strong

Weak Strong

Weak

FIGURE 14.11 The VIP relationship

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(long) positions which could be showing a profit. This market trend is showing signs of weakness, so watch out for a change in direction. In section (3), the market has changed direction and started moving lower. Volume and open interest both increased, illustrating new selling interest coming into the market, which in turn supported the bearish trend. In section (4), the market is moving lower still but on lower volume; open interest is also reducing, showing that some players are slowly losing confidence in the current trend continuing. As a result, they are buying back previously sold positions, taking profits and closing out their positions, which is reducing open interest.

End of trend signal The end of a trend is often signalled when volume becomes progressively smaller and smaller each trading day and the price range of trading days (the distance between the high and low price of the day) is also reduced. The period between one trend nearing its end and a new trend starting can be a time when the market is waiting to make a decision on a new trend. The decision is made once a trendline is broken or key support or resistance triggers renewed trading interest with increased volume. It is also worth emphasising that a significant increase in volume should always be seen when a trendline or a key support/resistance level is finally broken. If not, then it may be a false breakout. This can sometimes occur when markets are very quiet. Indeed, some speculators may be tempted to force the market on low volume through a well-publicised trendline level in an attempt to trigger some reaction in the market.

PRICE GAPS AS PRICE TARGETS Another good way of determining where the market may head is to look out for price gaps on price charts (Figure 14.12). Energy futures markets often use price gaps as targets. A question many traders ask is how far back in time they should look for price gaps. I have found that on daily bar charts (where each bar represents one trading day) you can often see that price gaps that have occurred as much as three months in the past are still watched by the market. But price gaps are not just indicators of price targets. They can also indicate whether an old trend is going to start again. This can be seen in the case of a bullish trend, when a market breaks support and then comes down to aim for a price gap. If the market fills the price gap and holds the

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ISLAND REVERSAL TOP

EXHAUSTION GAP

DOWNSIDE BREAKAWAY GAP

RUNAWAY (or measuring) GAP

BREAKAWAY GAP

FIGURE 14.12 Example of price gaps

bottom of the gap (as in Figure 14.13) then it can be expected that buyers will come back and that the bullish trend will have a lease of new life. In Figure 14.13 the market has been in a bullish trend, but corrects downwards. The price gap is filled, but the market holds the bottom of the gap to continue the original bullish trend. In a case like this, renewed buying interest can normally be seen.

Price gap

FIGURE 14.13 Price gap in a bullish trend

In Figure 14.14, the market has been in a bearish trend and corrects upwards. The price gap is filled, but the market holds the top of the gap to continue the original bearish trend. In this case, renewed selling pressure can normally be seen.

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Price gap

FIGURE 14.14 Price gap in a bearish trend

FIBONACCI RETRACEMENT LEVELS So far we have looked at trendlines which can help to identify trends and establish key support or resistance levels which can highlight a trend being broken. We have seen how volume data, open interest data and price data (VIP relationship) can give early warnings of trends coming to an end and how much interest there is from market participants to help continue the current trend. We have also looked at price gaps as price targets that give traders an idea of how much the market might move in a particular direction. Another good way to predict price targets is by using Fibonacci percentage retracement. Fibonacci was the nickname of the thirteenth century mathematician, Leonardo Pisano, who (re)discovered what is today known as the Fibonacci sequence. This is calculated by adding 1 + 1 and then continuing to add the sum to the previous number in the equence. The sequence gives rise to the following numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 and so on. Ratios of these numbers to each other give us important values: 61.8%, 50% and 38.2%. The prevalence of these ratios can be found all around us – from the double helix of DNA to spiral galaxies. The pioneering work of traders like W. D. Gann (Gann lines) and R. N. Elliott (Elliott wave theory) also showed that these ratios are prevalent in the financial markets. When properly applied to energy futures markets, they are surprisingly reliable and the market watches these retracement levels avidly. Energy futures markets (e.g. IPE, NYMEX) tend to reverse or consolidate once they reach one of these ratio levels (measured from the distance of the previous trends reversal). This means that they can be very useful as position entry and exit levels. There is a tendency for the energy futures markets to retrace down (during a bullish trend) or recover (during a bearish trend) by 50% before continuing the original trend. In the example given in Figure 14.15, the market retraces 50% then carries on the original bullish trend. Besides this 50% retracement, there are minimum and maximum retracements that should be allowed for: 38.2% and 61.8% respectively. What this means is that in a correction of a very strong trend, the market may only retrace 38. 2% of the previous move. If a trader is looking for a buying or selling opportunity (depending on the trend) the trader can compute the

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200 190 180 170

38.2% Retracement

160 50% Retracement

150 140

61.8% Retracement

130 120 110 100

FIGURE 14.15 Fibonacci retracement levels

Fibonacci retracement levels and use them as a reference point to enter or exit the market. Chart reading To identify Fibonacci retracement levels, the most recent highest point and lowest point in the futures chart should be identified. Once this is done, you are ready to measure the retracement percentages. Most energy futures contracts, after making long sustained moves in one direction, will eventually retrace a portion of the move, before continuing on to extend it. Most commercially sold stock-charting software packages will automatically draw in Fibonacci levels between short, medium, and long-term pivot points using traditional 38.2%, 50%, 61.8% and 100% retracement levels. These levels can be watched as price targets or resistance points when selling (profit-taking on long positions) or, when calculating levels in the opposite (downward) direction, price targets as support points where short covering (buying back) may occur and fresh buying interest should come in to the market. For technical analysis, the important thing is that, in the oil markets, people follow Fibonacci percentage retracements and in fact it works so well that sometimes the market has been seen to touch the Fibonacci target level exactly and then hold and recover its trend.

MATHEMATICAL INDICATORS There are many types of mathematical indicators in the technical analysis field, but here we focus on some key ones which work on a consistent basis

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for the energy futures markets. These indicators can give a trader a simple yet very effective tool for building up a view on price direction and timing, when used in parallel with bar charts, support/resistance levels, gaps, trendlines, volume and open interest information. The RSI (Relative Strength Index) The easiest way to describe how RSI reflects the market is to say that RSI treats the futures market price as if it were a rubber band. The rubber band can be stretched just so far, but after a certain point, unless it breaks, it is forced to contract. The idea was developed by J. Welles Wilder and presented in his 1978 book, New Concepts in Technical Trading Systems. The RSI is a fairly simple formula: æ ö 100 ÷÷ RSI = 100 - çç è 1 + (U / D ) ø where: U = An average of upward price change D = An average of downward price change Basically, the RSI equals the average of the closes of the up days divided by the average of the closes of the down days. The time frame specified determines the volatility of the indicator. A lot of technical analysis books and even news reports talk about a 9 period, or 14 period and/or a 21 period time span for analysis. These time periods are usually applied most effectively to daily bar charts; however, there is nothing to stop you from applying the RSI to longer or shorter time frames. It is probably a good idea to use two RSIs rather than one. Using one short time period and one longer time period can help a trader to assess how much an energy futures market is overbought or oversold. (For energy futures, a 3 day RSI and a 14 day RSI are suggested.) ‘Overbought’ means that the market price has moved higher too quickly in the time period under analysis on the RSI, while ‘oversold’ means that the market price has moved lower too quickly in the period. RSI simple calculation method example For a 14 day RSI calculation, the following steps are involved: 1. Add the closing values for the up days and divide this total by 14. 2. Add the closing values for the down days and divide this total by 14. 3. Divide the up day average by the down day average. This results in the what we term the RS factor in the formula. 4. Add 1 to the RS. 5. Divide 100 by the number arrived at in Step 4 above.

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6. Subtract the number arrived at in Step 5 above from 100. = 14 period RSI% RSI periods recommended for energy futures (14 day and 3 day) ■ 14 day RSI ● If the RSI is over 75%, the futures contract is overbought and it may be difficult for prices to move any higher. Prices should soon correct to the downside more severely than if the 3 day RSI were overbought. ● If the RSI is below 35%, the futures contract is oversold and prices should find support i.e. the market should find it difficult to move lower. Prices should correct to the upside ■ 3 day RSI – a very useful short-term entry/exit indicator ● If over 90%, the market is very overbought and if the market is trading technically it will probably struggle to move higher and the market should have a good intra day correction to lower prices. ● If below 20%, the market is very oversold and if the market is trading technically it will struggle to move lower. In this case, the market should have a good intra day recovery to higher prices. The guiding principle of the combined use of the 3 day and 14 day RSI is that if the market is looking overbought/oversold on the 3 day and the 14 day RSI you can gauge that more than just a one-day price correction may be seen; a price correction could be seen over several days. Figure 14.16 shows an example.

Nymex WTI Crude Oil [A] The 3 day & 14 day RSI gave very overbought reading, signalling a correction to lower prices 2 days before it happened at point [A] Trendline

3 day RSI

14 day RSI

FIGURE 14.16 NYMEX WTI Crude Oil; chart sourced from and © FutureSource UK Inc.

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MOVING AVERAGES There are three types of moving average available: simple, weighted and exponential. The critical element in a moving average is the number of time periods used in calculating the average. When using hindsight, it is always possible to find a moving average that would have been profitable. The 39 week moving average has an excellent track record in timing the major (long-term) market cycles. In energy markets on daily bar charts, a 13 day moving average based on closing (or last) traded price gives a very good buy/sell signal. A 13 day simple moving average (based on last market close price) can also prove very profitable as a buy/sell indicator for the oil futures markets. It is a Fibonacci number, but the reality is probably that this moving average has been highly publicised in the energy market and plenty of traders watch it closely. As with all technical indicators, simple moving averages should never be used on their own as they do have some disadvantages. One such disadvantage is that you have to wait for the market close to get the final indication whether to buy or sell! However, it can be a very valuable confirmation tool to add to your other indicators and build up your view of the market. Interpretation The most popular method of interpreting a moving average is to compare the relationship between a moving average of the commodities price with the commodities price itself. A buy signal is generated when the security’s price rises above its moving average and a sell signal is generated when the security’s price falls below its moving average; see Figure 14.17. The drawback to moving averages is that they can create false signals if the market is ‘range bound’, although they work really well in a trending market. The length of a moving average should fit the market cycle you wish to follow. Table 14.2 shows typical moving average periods.

CHART PATTERNS What is a price chart pattern? Chart patterns are formations which appear on price charts of futures contracts (in this context) that can be classified into different categories. The type of chart pattern observed can give some big clues as to whether the market is going to continue its current price trend or whether it might

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229

13 day moving average on IPE Brent Crude Oil

Sell

Sell Rangebound market triggers Buy then Sell

US$7 dollar profit per barrel Buy

2002

FIGURE 14.17 13 day moving average on IPE Brent Crude Oil; chart sourced from and © FutureSource UK Inc.

TABLE 14.2 Typical periods for moving averages Trend

Moving average

Very short term

5–13 days

Short term

14–25 days

Minor intermediate

26–49 days

Intermediate Long term

50–100 days 100–200 days

reverse it. Some patterns will also give a clue as to how much the market may move. How many groups of chart patterns are there? There are two major groups of chart patterns: reversal patterns and continuation patterns. Reversal chart patterns indicate that a reversal in the market price trend is in the process of taking place. Continuation chart patterns suggest that the market is consolidating – it is resting perhaps because it was very overbought or oversold (this can be established by referring to the RSI level, as discussed earlier). Once this position has been relaxed the market will resume its original bull or bear trend.

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By examining charts on a regular basis, a trader can develop a professional intuition and observational skill as to whether or not a chart pattern that is forming is a reversal pattern or a continuation pattern. The earlier this can be detected, the better. Triangle formations During the development of triangle formations, volume should diminish as the price swings narrows within the triangle. The tendency for volume to contract is true of all consolidation patterns. The volume should increase significantly once the market breaks out of the triangle formation. A lack of volume increase may warn that the market is not confident of this market direction. A benefit of the triangle formation is that it gives both an indication of timing when a breakout will occur and also an idea of the direction of that breakout. Symmetrical triangle at the beginning of an uptrend (continuation pattern) The symmetrical triangle at the beginning of the uptrend in Figure 14.18 signals that a bigger uptrend is still to come. Notice the reduction in volume during the formation of the triangle and the sudden burst of volume trading activity on the breakout.

Volume reduces during formation of triangle Clearly increases on breakout

FIGURE 14.18 Symmetrical triangle at the beginning of an uptrend; chart sourced from and © FutureSource UK Inc.

Symmetrical triangle in the middle of an uptrend (continuation pattern) The symmetrical triangle at the beginning of the uptrend in Figure 14.19 signals a bigger uptrend still to come (continuation pattern). Notice the levelling of the volume during the formation of the triangle and the burst of activity on the breakout. All triangle formations not only give us an indication of a continuing trend but also an indication of a price target.

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Volume reduces during formation of triangle Clearly increases on breakout

FIGURE 14.19 Symmetrical triangle in the middle of an uptrend; chart sourced from and © FutureSource UK Inc.

Symmetrical triangle at the beginning of a downtrend (continuation pattern) Figures 14.20 and 14.21 show symmetrical triangles at the beginning and in the middle of a downtrend.

To gauge a target price, measure the height of the gap at the widest part of the triangle and project this distance from the breakout point

FIGURE 14.20 Symmetrical triangle at the beginning of a downtrend; chart sourced from and © FutureSource UK Inc.

Ascending triangle in an uptrend (bullish continuation pattern) Figures 14.22 and 14.23 show ascending triangles in an uptrend. Volume falls off during the formation, picks up and then expands on the breakout and following upmove.

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Volume reduces during formation of triangle then clearly increases on breakout

FIGURE 14.21 Symmetrical triangle in the middle of a downtrend; chart sourced from and © FutureSource UK Inc.

FIGURE 14.22 Ascending triangle in an uptrend; chart sourced from and © FutureSource UK Inc.

Notice flat top

FIGURE 14.23 Ascending triangle in an uptrend; chart sourced from and © FutureSource UK Inc.

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Descending triangle in a downtrend (bearish continuation pattern) Figures 14.24 and 14.25 show descending triangles in a downtrend. Volume reduces during formation of triangle then clearly increases on breakout

Notice flat bottom

FIGURE 14.24 Descending triangle in a downtrend; chart sourced from and © FutureSource UK Inc.

FIGURE 14.25 Descending triangle in a downtrend; chart sourced from and © FutureSource UK Inc.

Falling wedge – bullish pattern Figure 14.26 shows a falling wedge in an uptrend. After more than a $2.00 rally, the market pauses before continuing higher for bull run. Volume is reduced during this pause and then picks up on the final breakout. Again a useful thing about triangle formations is that they can help predict when a breakout will happen. A trader can extend the trendlines forming the triangle and see when the lines converge, and this will give a good idea of the latest date for the market to break out by default, even if it just continues to trade sideways.

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Volume reduces during formation of triangle then clearly increases on breakout

FIGURE 14.26 Falling wedge in an uptrend; chart sourced from and © FutureSource UK Inc.

Falling wedge in downtrend (bullish pattern) This pattern (Figure 14.27) was able to reverse the downtrend nicely. Volume drops off in the wedge and then comes back as the market moves out of the pattern.

FIGURE 14.27 Falling wedge in a downtrend

Rising wedge (bearish pattern) The rising wedge (Figure 14.28) will put a stop to an uptrend. Volume tails off as the trend struggles to continue. Finally, volume expands as the market falls through the bottom of the wedge and the new downtrend begins. The rising wedge of Figure 14.29 seemingly presented an area of indecision. However, within a few weeks, the market resolved itself in the direction of the trend (down.) As usual, volume increases on the breakout after diminishing during the pattern.

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FIGURE 14.28 A rising wedge

FIGURE 14.29 A rising wedge: indecision

The head and shoulders (reversal pattern) This is probably one of the most difficult chart patterns to spot, but it is a clear signal of impending change. Apart from being one of the more complex chart patterns, it is probably one of the best known and most reliable reversal patterns. Figure 14.30 shows an example. The head and shoulders pattern of Figure 14.31 reversed a one-yearlong bullish trend in the NYMEX WTI Crude Oil Futures Market. Referring back to gaps, this crude oil technical move even had a ‘breakaway gap’ as well which triggered even more aggressive selling pressure, than a mere break of the ‘neckline’ trendline of the head and shoulders reversal pattern. Inverted head and shoulders (reversal pattern) The inverted head and shoulders pattern of Figure 14.32 reversed a minor downturn in NYMEX Unleaded Gasoline Futures and we could even see a

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At this point (head) an experienced technician may spot that the rally to new highs is on smaller volume than on the last rally (shoulder)

Uptrend proceeding with no signs of a top

Correction to this low level below the left shoulder followed by a move to develop the right shoulder completed the formation and warns of a major trend reversal

Correction to this level on lighter volume

FIGURE 14.30 Head and shoulders pattern

Neckline trendline

Breakaway gap

FIGURE 14.31 Head and shoulders pattern reversing a bull trend

breakaway gap, showing real momentum for the new uptrend. Volume increased on the breakout of the neckline trendline. Notes on head and shoulders formations The left and right shoulders should be about the same height, most importantly the right shoulder should not be above the left. The head should be higher than both shoulders. Volume should be declining during the formation of this pattern. The neckline can be drawn from the lows made after the formation of the left shoulder and the head. Once this neckline is broken, the formation is completed. This formation gives an idea of market direction and also an idea on price targets. A trader can take the distance from the head to the

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Left shoulder Head

Right shoulder

FIGURE 14.32 Inverted head and shoulders pattern

neckline, and project this downward from the point that the neckline was broken to give us a price target indication. In the oil markets though, the head and shoulder pattern has been seen to work except that only about 75% of the price target was reached. This is fairly common and a lot of people watch out for the formation, so many traders pre-empt and trade ahead of the price target being reached. Head and shoulders (bearish continuation pattern) This bearish continuation pattern cannot be confused with the reversal head and shoulders (although the pattern is identical) because the pattern is preceded by a bearish market. The same volume patterns apply and volume should decrease during the formation of the shoulders and head.

Flag formations (continuation pattern) The flag formation is quite common in the oil futures market. The flag represents a brief pause in a large market move. In fact, one of the requirements for the flag is that it is preceded by a sharp and almost straight line move. It represents situations where a steep advance or decline requires a pause, before running off again in the same direction The flag should slope against the trend. Volume should reduce during the formation and build up again on the breakout. The flag usually occurs near the midpoint or halfway mark of the move. Bull flag in an uptrend (halfway mark) This chart pattern (Figures 14.33) indicates that the trend has only reached half of its potential. The market could be consolidating due to RSIs being overbought before carrying on with its trend.

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FIGURE 14.33 Bull flag in an uptrend

Bear flag in a downtrend (halfway mark) Figure 14.34 shows a bear flag in a downtrend.

FIGURE 14.34 Bear flag in a downtrend

Pennants Pennants are a continuation pattern. In Figure 14.35, the bullish pennant is preceded by a bull trend. In Figure 14.36, the bearish pennant is preceded by a downtrend. Double tops and bottoms Figure 14.37 – a double top – is an example of a trend reversal. The failure of prices to exceed the previous peak followed by a downside break of the previous low constitutes a downside trend reversal. Figure 14.38 is an example of a bottom reversal pattern, Usually the first sign of a bottom is the ability of prices to hold a previous very recent low.

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FIGURE 14.35 A bullish pennant

FIGURE 14.36 A bearish pennant Double top

FIGURE 14.37 A double top

This is then confirmed once recent resistance is broken. Volume should look to increase and the speed of the market moving away from the bottom should increase.

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Double bottom

FIGURE 14.38 A double bottom

SUMMARY There are a large number of tools that can be used for technical analysis of the market and it is important that they be used in combination with each other. But even if the five or six most appropriate analytical tools have been chosen to study the prevailing conditions, the results may still not always prove utterly reliable. The truth is that in the real world there are some days when technical factors drive the market and others when it is driven by fundamentals. The key is to identify and keep asking the same questions over and over again: What is driving the market – technical factors or fundamentals? Is there fundamental news that has not yet been absorbed by the market price in turn, by the technical analysis? Successful traders know that important fresh news will always have to be absorbed into the price before it turns up in the charts.

CHAPTER 15

After Enron – A Practical Guide to Credit Control and Risk Mitigation Methods

The energy industry is the lifeblood of global economies, and a key lesson that the energy industry has learnt from the Enron situation in 2001 is that credit is the lifeblood of the energy industry. Keeping a strong credit rating should be central to an energy firm’s goals. It is fair to say that since the collapse of Enron far more energy companies have been managing their credit lines in similar ways to banks, by stressing the role of margining. This chapter reviews some of the established and new methods that corporations have at their disposal to manage credit risk exposure effectively.

THE COLLAPSE OF ENRON Enron never had a particularly good credit rating, but its standing in the market was as a key player; companies in the energy markets had to be able to trade with Enron. This often meant that energy players were commercially forced into a position where they had to take larger credit risks than they might have normally with a BBB+ rated entity, otherwise they would lose profitable trading opportunities. The advent of Enron Online made it even more difficult for energy market participants to have any chance of avoiding credit exposure with Enron. What is quite stunning and also rather unnerving was the speed at which Enron, a company held in high regard by the energy market, went from BBB+ to Chapter 11: 15 October 2001 to 3 December 2001: ■

15 October 2001: Enron released earnings announcing a $2.2 billion equity write-down, including $1.2 billion stemming from the erroneous accounting of various financial partnerships. 241

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TABLE 15.1 Worst historic yearly default rates. Source: Moody’s Investors Services, ‘Historical Default Rates of Corporate Bond Issuers 1920–1997’ Ratings

Worst historic annual default rate (%) for 1970–1997

Aaa

0.0

Aa A

0.61 0.26

Baa Ba

1.33 5.30

B

■

■

■

23.38

16 October 2001: Rating agencies reaffirmed Enron’s BBB+ rating. Standard & Poor’s press release stated: ‘The equity account reductions will have no direct effect on Enron’s cash flow. However, the company’s financial flexibility may be impaired because of the decline in Enron’s equity value, which could lead the company to rely more on debt for its future financing needs. Capital expenditures over the near to medium term are manageable and can be financed out of operating cash flow, which will ease any liquidity concerns and help maintain credit quality. Asset sales, such as the recently announced Portland General Electric Co. deal, should therefore be fully available to enable Enron to strengthen its balance sheet and other credit measures in a timely manner.’ 25 October 2001: Enron’s BBB+ rating holds, but rating agencies revised the outlook for Enron to negative. Standard & Poor’s press release stated: ‘Despite the negative outlook, several factors supportive of Enron’s credit quality have been sustained throughout the uncertainty surrounding the company. The fundamental strength of Enron’s energy marketing and trading franchise has remained steady. Standard & Poor’s has detected no lapses in the company’s risk management practices and trading discipline. No significant deterioration in trading volumes or willingness of counterparties to transact with Enron has been revealed to Standard & Poor’s in contacts with major energy market participants.’ 1 November 2001: Enron’s rating is lowered by S&P to BBB and they place Enron on CreditWatch Negative. Standard & Poor’s press release stated: ‘The downgrades indicate Standard & Poor’s determination that Enron’s plan to employ asset sales and other means to repair its damaged balance sheet will be insufficient to restore its long-term credit quality to the historical triple-B-plus level. The negative CreditWatch listing recognises the uncertainties that surround the company and its credit quality in the short run due to the possibility of further unanticipated developments in the capital markets.’

THE COLLAPSE OF ENRON

■

■

■

■ ■

■

243

8 November 2001: Enron files an 8K with the SEC disclosing the severity of the non-cash impact to earnings (cumulatively restating earnings going back to 1997 by approximately $600 million), and the negative impact on its balance sheet from the effects of various financial vehicles that should have been consolidated in Enron’s financial statements pursuant to GAAP. Following Enron’s 8K filing, Dynegy publicly confirms that it was discussing a possible business combination with Enron. 9 November 2001: S&P lowers Enron’s rating down to BBB– and retains its CreditWatch Negative status. Standard & Poor’s press release stated: ‘The Enron downgrade is prompted by the credit implications of the company’s restatement of financial statements going back to 1997 due in part to a legal and accounting review of certain related-party transactions by a special committee of Enron’s board of directors. The investment-grade rating is predicated on the prospect for improvement of credit quality with the acquisition by the financially stronger Dynegy and the near-term liquidity enhancement, through the injection of $1.5 billion of equity capital, that came with the signing of the merger agreement.’ 19 November 2001: Enron 10-Q filing is made disclosing a ratings trigger event (at BBB–) involving the acceleration of a $690 million note to 26 November 2001 from 2003. 21 November 2001: Dynegy issues statement on the Enron merger status. 28 November 2001: Standard & Poor’s lowers its Enron rating to B– and places the rating on CreditWatch Developing. Standard & Poor’s press release stated: ‘The rating action is based on Standard & Poor’s loss of confidence that the Dynegy merger will be consummated. The willingness of Dynegy to complete its planned acquisition of Enron has been compromised by the continued drop in confidence in the capital markets that the transaction would hold. The market reaction has spread to the energy markets, where Enron’s trading and marketing franchise has, in Standard & Poor’s opinion, sustained significant damage that, together with rising potential legal liabilities, weakens Dynegy’s commitment to purchase Enron.’ 30 November 2001: Standard & Poor’s lowers Enron’s rating to CC and places the rating on CreditWatch Negative. Standard & Poor’s press release stated: ‘The rating action reflects Standard & Poor’s expectation that following the dissolution of Enron’s announced merger with Dynegy Inc., burdensome debt restructuring requirements, negligible liquidity, and limited access to capital will likely cause Enron to seek bankruptcy protection. The change in CreditWatch implications to negative reflects Standard & Poor’s belief that such a filing in the very near term is probable.’

244

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3 December 2001: Enron’s rating lowered to D following Enron’s 2 December 2001 filing for Chapter 11 bankruptcy protection.

Fortune magazine criticises accounting. Enron just says ‘sour grapes’ by stock analysts Who failed to get investment banking business.

Kenneth Lay, CEO & Chairman ‘Incredibly cheap stock’

‘…customers continue to put their confidence in us and our core businesses are strong and performing well.’ Kenneth Lay, CEO & Chairman Enron in a press release dated 25 October 2001 2 December 2001 Enron files for Chapter 11 bankruptcy protection

FIGURE 15.1 Fall in Enron’s share price; chart data courtesy of http://www. StockCharts.com/

METHODS FOR MANAGING CREDIT RISK EXPOSURE Master netting ■ Reduces credit risk exposure through netting. This is discussed in more detail later in this chapter under ‘Reducing credit risk via the ISDA Master Agreement & Schedule’. ■ The cost of this is low. Collateralisation ■ Collateralisation of credit exposures in the OTC derivatives market has increased rapidly in recent years. Most dealers now collateralise exposures arising from OTC derivatives business to some degree. Dealers use collateral to mitigate their credit exposures and thereby engage in more transactions than would otherwise be possible. Collateralisation agreements are now usually documented under ISDA’s credit support annex (see Chapter 17 for an example) which is added to an ISDA master agreement between two counterparts. This provides for collateralisation of the

METHODS FOR MANAGING CREDIT RISK EXPOSURE

■

245

net current exposure on the portfolio of transactions covered by the ISDA master agreement. The cost of this is low.

Financial guarantee ■ In the energy markets this is normally an Irrevocable Standby Letter of Credit from the other counterpart. ■ It is sometimes possible to buy silent guarantees where, for example, counterpart ‘A’ concerned with the credit of counterpart ‘B’, goes to a bank and buys cover against counterpart ‘B’ defaulting (this is usually priced like a letter of credit risk). The cover is normally against a specific exposure – for example, a particular swap or energy contract. In a silent guarantee, counterpart ‘A’ pays for the guarantee and counterpart ‘B’ never knows that ‘A’ has bought this protection; hence the term ‘silent guarantee’. ■ The cost of this approach varies and depends on the tenure of the deal, the credit quality of the counterpart and the size of the deal (in US dollars). Credit insurance ■ Transfers counterpart credit risk to an insurance firm. ■ Partial coverage, long lead time on payout (30–90 days can be longer) and then the organisation claiming against the insurance usually has to exhaust other routes of getting its money back before the insurance will pay out. ■ The terms and conditions of credit insurance can include a lot of provisions against which the insurance will not pay out. ■ The cost varies, but this is usually cheaper than credit derivatives. However, in practice, credit derivatives are seen as having much more transparency in terms of the events that trigger payout. It is also not easy to obtain credit insurance against derivatives deals. Credit insurance is more suited to ‘nuts and bolts’ transactions like physical energy assets, e.g. a specific oil cargo or energy supply contract. Credit derivatives ■ Transfers single (sometime a basket of counterpart) credit risk. ■ Cost varies, but it is reputed to be more expensive in terms of basis point equivalent charge than credit insurance. However, there are very clear trigger events for payout. ■ One problem is that energy sector names covered are usually large names, and even this is a developing market and liquidity can be an issue. It is normally decided on a case by case basis.

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Assignment ■ This is not very common. It involves the assignment of an OTC derivatives deal to a third party. The industry did see this happening in the Enron collapse, where Enron, to try to reduce its net loss exposure to the energy industry, assigned profitable swaps in its trading book to third parties who they had loss-making swaps positions with. The tricky thing here is that it requires the consent of the other original counterpart to the deal and they have to accept the credit risk of the new third party who takes over as their counterpart to the deal. ■ It is also difficult to administer, requires approvals and can sometimes (depending on the jurisdiction of the counterparts involved) create tax liabilities. This may be the biggest cost of using this alternative. Clearing OTC energy derivatives ■ This reduces credit risk and transfers the credit risk. It achieves this by novating a trade (transferring the buy and sell of an OTC trade to a clearing house) to a highly creditworthy clearing house who then become the central counterpart to both the buy and sell of the OTC transactions. Several initiatives have been launched in this area by London Clearing House (http://www.lch.com/) and the New York Mercantile Exchange (http://www.nymex.com/). ■ The cost of this is high compared to the other routes. ■ Not all OTC energy derivatives are supported by clearing houses.

WAYS TO REDUCE CREDIT RISK VIA THE ISDA SCHEDULE Trading before an ISDA is agreed Although many dealers aim to complete a master agreement before executing their first derivatives deals, many energy traders sometimes undertake trades with new counterparties before signing a master agreement (although this is increasingly uncommon due to the increased credit risk for a firm, as discussed here). The failure to complete a master agreement prior to trading can exacerbate credit risks by jeopardising a dealer’s ability to close out transactions and net obligations in the event of a counterparty’s default. However, a properly completed ISDA agreement can really help to reduce counterparty credit risk exposure. Close-out netting provisions in ISDA agreements are powerful tools for mitigating credit risk. A master agreement typically provides that, in the event of a counterparty’s default, the non-defaulting counterparty can accelerate and terminate all outstanding derivatives transactions and net the transactions’ market values so that a single sum will be owed by, or owed to, the non-defaulting counterparty. Legally enforceable netting provisions

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247

reportedly can reduce aggregate counterparty credit exposure by 20% to 60%! Not bad. Whether a netting provision in an ISDA agreement is enforceable or not will depend on the jurisdiction of the counterpart in default. ISDA spends a lot of time and resources obtaining opinions on the enforceability of ISDA agreements and netting provisions. ISDA regularly updates a list of countries for which they have received netting opinions. It is up to each counterpart to interpret the opinions themselves. Table 15. 2 shows the list of countries at 1 September 2002 that ISDA has received an opinion on. (To obtain these opinions contact ISDA http://www.isda. org/.) Ensuring the enforceability of the netting provisions of the ISDA Master Agreement remains a key initiative for ISDA because of its importance in reducing the credit risk arising from the business. ISDA has expanded the number of countries solicited to 38. The scope of the opinions includes the enforceability of the termination, bilateral close-out netting and multibranch netting provisions of the 1992 Master Agreements. ISDA updates these annually to comply with requests from various central banks. It also continues to expand its efforts related to the enforceability of netting provisions in emerging markets jurisdictions, working with the relevant legislative and regulatory representatives. Reducing credit risk via the ISDA Master Agreement & Schedule The ISDA Master Agreement and Schedule are discussed in much more detail in Chapter 17. However, it is worth highlighting some ways in which the ISDA Schedule can be used to advantage in reducing possible credit risk. With reference to the ISDA Schedule and 1992 ISDA Master Agreement: ■

■

■

Specified Entities ● Under Section 5 of the ISDA agreement (events) the other counterpart’s affiliates or group of companies can be added as ‘Specified Entities’. Threshold amount/cross default ● Put a low threshold amount in for the other counterpart to the ISDA Schedule. A low threshold dollar value means that the defaulting counterpart’s affiliates etc. who are ‘Specified Entities’ do not have to default on much (e.g. loans, other deals perhaps) before breaking the threshold dollar level and triggering a default. This event then allows the non-defaulting counterpart to terminate all deals under the ISDA Schedule. Collateral/credit support in ISDA Schedules ● Take collateral in the form of Irrevocable Standby Letters of Credit which are very popular in the OTC Swaps trading arena (as good as cash) or cash. If other forms of collateral are accepted (e.g. bonds or

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TABLE 15.2 Countries on which ISDA has received an opinion (at 1 Sept 2002) Country

Received

Counsel

Australia Austria Bahamas Belgium

Yes Yes Yes Yes

Bermuda British Virgin Islands Canada Cayman Islands Denmark England Finland France Germany Hong Kong Indonesia Ireland Italy Japan Luxembourg Malaysia Mexico The Netherlands Netherlands Antilles New Zealand Norway Philippines Portugal Scotland Singapore South Africa South Korea Spain Sweden Switzerland

Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes

Taiwan Thailand Turkey United States

Yes Yes Yes Yes

Mallesons Stephen Jaques Schönherr Barfuss Torggler & Partners Higgs & Johnson Coudert Brothers; Coppens Van Ommeslaghe & Faurès Appleby, Spurling & Kempe Walker Smiths Stikeman, Elliott Maples & Calder Gorrissen Federspiel Kierkegaard Allen & Overy Hannes Snellman Gide Loyrette Nouel Hengeler Mueller Weitzel Wirtz Allen & Overy Ali Budiardjo, Nugroho, Reksodiputro McCann FitzGerald Ughi e Nunziante Mitsui, Yasuda, Wani & Maeda Beghin & Feider Shearn Delamore & Co. Ritch Heather y Mueller De Brauw Blackstone Westbroek Clifford Chance Bell Gully Wiersholm, Mellbye & Bech SyCip Salazar Hernandez & Gatmaitan Abreu & Marques, Vinhas Dundas & Wilson Allen & Gledhill Webber Wentzel Bowens Kim & Chang Allen & Overy Wistrand Prof. Dr Dieter Zobl and Dr Thomas Werlen Lee and Li Baker & McKenzie Pekin & Pekin Cravath, Swaine & Moore

COLLATERALISATION

●

249

gold), you should allow for the possible cost of selling these assets to get your cash back and also the possible price volatility of these assets. In banking terminology, a ‘haircut ‘ is applied to the collateral (e.g. for bonds you might only take 95% of the face value of the bond in to account). Credit support documents – These could be a parental guarantee for subsidiaries which on a standalone basis may represent too big a credit risk. USA companies frequently give parental guarantees against their overseas subsidiaries. The majority of trading companies will not highly capitalise their overseas trading operations but instead for control purposes support the company via parental guarantees or by securing banking facilities for the subsidiary by giving them access to standby letters of credit. Funds may be received more quickly under an Irrevocable Standby Letter of Credit since no proof is needed – it is simply submitted to the bank branch. Obtaining funds under a parental guarantee will take longer and require a lot more paperwork.

The ISDA Master Agreement gives strong protection to users. The addition of some of the measures touched upon in this section will further strengthen the credit risk benefits of trading under an ISDA legal framework. Beyond simple ISDA-based netting of derivatives transactions, some companies are now working on ‘Master Netting Agreements’ (sometimes in liaison with ISDA). This nets financial and physical deals between different energy types/commodities, contract types and even across affiliates and subsidiaries. This is something not practised widely yet, and, in the case of American companies, there is still a lack of a clear opinion providing for netting of physical and financial deals in the US bankruptcy code. Watch out for more developments in MNA (Master Netting Agreements)! Given tight credit and the cost of credit in the energy sector, anything that frees up capital and trading lines to permit more business is good for the industry, and it will no doubt be pursued by more counterparts in the future.

COLLATERALISATION Credit exposure reductions can also be made via collateralisation of trades. In the energy derivatives industry most counterparts who require collateral will request Irrevocable Standby Letters of Credit from their counterpart (this form of collateral having already been listed in their credit support annex to their ISDA Master Agreement or other Master Agreement form).

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Unfortunately, this is not very efficient and Letters of Credit can also be expensive, and difficult to modify and distribute. The wording and procedures of Letters of Credit (LCs) were built to cover specific trade finance exposures which do not change (e.g. if a cargo of crude oil is purchased at a cost of US$15 million, the payment can be covered by an LC). This type of document is not very well suited to covering derivatives exposures which change daily, and amending Letters of Credit is time-consuming. Some banks have created specific LCs with flexible wording in an attempt to give cover on the daily variable exposures of unrealised/realised losses on OTC swap positions, although some LCs with this flexible wording have paid out up to ten times the amount they were originally issued for! There are also some legal issues over whether this type of LC could really be tested in a court of law in terms of forcing a bank to pay out more than the stated face value of the LC. Commercially though, the bank may wish to try to accommodate the counterpart when it tries to draw more than the face value of the LC with this flexible type of value wording in order to avoid loss of face and loss of future business. Collateral requirements The size of collateral required will depend on whether or not the trader requiring collateral has also granted some unsecured credit line to the other counterpart or not. However, if we can take an example of a first tier market maker bank supplying a fuel oil swaps hedge to a shipping company, they would typically require a 10% cover of notional cover as an LC. The Bank for International Settlement (http://www.bis.org/) states that a bank’s internal cover against commodity derivatives exposures should not really exceed 10% of notional. However, most internal risk models used by banks create a capital charge of around 6% to 8% of notional on trade date. The capital charge can be compared to the initial margin a futures exchange charges when a trader opens a futures position. There are some instances of a few very conservative banks using an addon methodology and charging 15% of notional value for deals 1 to 12 months forward + MTM re-valued on a daily basis.

GUIDELINES FOR TAKING COLLATERAL FROM COUNTERPARTS Financial instruments used as collateral Where a financial instrument is used as collateral, market practice suggests that most firms apply one or more ‘haircuts’ on its value to reflect market and FX risk – this offers protection if it is necessary to liquidate the financial instrument to realise the cash against a loss.

GUIDELINES FOR TAKING COLLATERAL FROM COUNTERPARTS

251

EXAMPLE STANDBY LETTER OF CREDIT WORDING WITH FLEXIBLE WORDING ON VALUE OF THE LC AGAINST AN OTC DERIVATIVE POSITION Typical Standby Letter of Credit Wording issued by bankers against its customer’s OTC Swap exposure with another counterpart. TO: XYZ BANK LTD We hereby open our irrevocable standby letter of credit no 12345 dated 10 January 2003, as follows: Applicant: Beneficiary: Amount: Expiry date:

ABC SMALL TRADER LTD XYZ BANK LTD USD 100,000.00 (United States Dollars One hundred thousand only) 10 JANUARY 2003

Available for payment at our counters at sight against presentation of the following documents: [A] Copy of Telex Invoice showing actual settlement amount or marked to market exposure calculation. [B] Beneficiary’s statement signed by authorised signature reading as follows: ‘We, XYZ BANK LTD, certify to you that the amount covers the outstanding amount due to us by ABC SMALL TRADER LTD pursuant to the following paper swap transactions: 1. Contract Ref: 12345abc Deal date: 20 December 2002 Product: Singapore HSFO 180 CST Quantity: 5,000 MTS Exactly Fixed price: USD 134.50 Per MT Floating Price: From and including 1–31 MAY 2003 Special conditions: 1. Multiple/partial drawings are permitted. 2. All banking charges at Beneficiary’s bank for Beneficiary’s account. All Bank charges at Opener’s Bank for opener’s account. 3. The amount of this Standby Letter of Credit is automatically adjusted for any increase/decrease in the marked to market exposure calculations (including adjustment for any increase to any amount in excess of the amount initially available and payable under this standby letter of credit) without further amendment on our side. Reimbursement instructions:

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TABLE 15.3 Suggested collateral haircuts. Source: ISDA Report February 2002 £ 5 year

> 5 year

Cash

0%

0%

Sovereigns rated AA and above(1)(2)

0.5%

1%

Other investment grade sovereigns

2%

5%

Non-investment grade sovereigns

10%

15%

Corporates rated A and above(1) Corporates (BBB) (1)

7% 10%

10% 15%

Non-investment grade corporates

20%

25%

Equity main index: – Investment Grade Issuers

20%

– Others

30%

Precious metals

10%

FX haircuts: – In major currencies (3) – In others

5% 10%

(1) Or equivalent (2) Sovereigns are broadly defined to include supra-nationals (3) A major currency is a floating currency, following the International Monetary Fund approach. The use of financial assets not covered in this table should be reviewed by supervisors as part of Pillar II.

The purpose of the ‘haircuts’ is to protect against price declines during the holding period, as well as the costs likely to be incurred in liquidating the collateral. ‘Haircuts’ are typically expressed as a percentage deducted from the value of the collateral. The level of ‘haircut’ an organisation may use is up to them, but Table 15.3 can help as a starting point.

CREDIT INSURANCE The insurance market also has some solutions for transferring credit risk. However the clarity of payment triggers is not always very clear. Credit insurance is usually limited to trade credit insurance against physical trade and it is very difficult to find insurance cover against credit default on derivatives positions such as swaps and options. It is more suited to general cover with a counterpart which has a regular flow of physical energy. Users of insurance should pay attention to indemnity clauses,

THE NEW TOOL OF THE TRADE – CREDIT DEFAULT SWAPS (CDS)

253

default triggers and liquidity. Unlike Standby Letters of Credit, where a beneficiary can just apply to the bank for the funds without having to prove the monies owed, insurance will normally require a significant amount of documentation. In addition, a beneficiary will normally have had first to exhaust all normal methods of trying to recover the monies owed before applying for payout from the insurance policy. Payouts on a default usually take 30 to 90 days, so there is a cash flow risk for the beneficiary to consider as well. However, payout on default via insolvency or Chapter 11 can be much quicker because of public record stating the fact that a company has gone into bankruptcy; payout for this type of default can be within 1 day to 10 days. More Information on credit insurance can be found at http://www. eulergroup.com/ and information on bunker fuel supply insurance is at http://www.bunkerinsure.se/.

THE NEW TOOL OF THE TRADE – CREDIT DEFAULT SWAPS (CDS) A Credit Default Swap (CDS) is the most straightforward type of credit derivative. It is a contract that transfers credit default risk from one party to another. In a nutshell, one counterparty is selling insurance and the other counterparty is buying insurance against the default of the third party. The buyer of a CDS pays a premium to the seller, usually in the form of a basis point (like an interest rate) charge per annum on the notional of the contract. A payment is due to the buyer when there is what is termed a ‘credit event’. There are three main types of credit event: ■ ■ ■

Bankruptcy. Restructuring. Failure to pay.

If no credit event takes place, the buyer of the CDS pays the basis point charge on the notional cover from the contract to the seller. For example, US$10 million CDS against XYZ Bank Ltd costs 95 basis points (0. 95% per annum charge), so the buyer would pay US$95,000 per year for this cover of US$10 million dollars. If XYZ Bank actually triggers a credit event then the CDS will cover the buyer for US$10 million of credit default (Figure 15.2). In a CDS the buyer of protection (‘Buyer’) typically pays a periodic fee in exchange for the seller of protection (‘Seller’) contracting to make a payment should a pre-agreed corporate or sovereign (‘Reference Credit’)

254

ENERGY PRICE RISK If no credit event takes place then X basis points is paid by the buyer to the seller Protection Seller

Protection Buyer

If a credit event stated in the CDS takes place then the seller has to pay the buyer the stipulated $ cover in the swap 3rd Party entity the CDS is against Also referred to as the “Name” or “Reference Credit” or sometimes as the “Reference Entity”

FIGURE 15.2 Credit Default Swaps

suffer some kind of pre-agreed credit crisis as mentioned in brief earlier (‘Credit Event’). The use of credit derivatives is broadly divided between risk management and investor applications. Risk management use applies to situations where the user is a buyer and so is reducing credit exposure (although not necessarily motivated entirely by risk reduction) and investor/trader applications where the user is a seller and wants to increase its credit exposure. With CDSs, even if you have a portfolio of credit risk with investment grade firms, you may have a large percentage of that risk with just a handful of firms. Part of any credit policy should be to spread out risk and have maximum limits on any one counterpart or group of companies. The most commonly used credit derivative is the CDS on either a single company (also referred to in the credit market as a ‘name’) or a basket of names. A company could use a CDS against a basket of names as a general credit risk hedge against a portfolio of regular credit risk that it takes in the energy market. In the context of this chapter on credit risk control and mitigation we will focus on the following uses of CDSs: ■ ■

Risk reduction Credit line management

Risk reduction through CDSs The most obvious and indeed common use of a CDS is to reduce credit risk in a situation where the user is concerned for the quality of the credit that is being hedged. This could arise where some commercially negative news

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255

about a reference credit (name/entity) has been released by newswires etc. and the organisation with the exposure chooses to hedge actual exposure. Speculative traders may buy a CDS to take a negative position on a particular sector, region or specific entity’s creditworthiness becoming worse. Credit line management through CDSs In contrast to risk reduction, CDSs are often used to reduce credit exposure in a situation where the user is very positive about the credit quality of the credit being hedged, but, due to factors such as internal limit issues, there is insufficient credit line to allow a planned transaction. A prime example is Petronas, the Malaysian State oil company, which is a very actively traded CDS. However, it has a very high rating and solid financial foundation and trades very actively in the energy markets with many counterparts. So the CDS is used to manage the credit line of the borrower in question and the need for a hedge arose because of a positive view of the reference credit and the need to free up some more credit to enable more trading. In the example of Figure 15.3, company A sells 500 MW of power, electricity, per month to company B. Let us say that this involves a monthly payment from company B to company A of about US$1 million. In order to mitigate the risk it has against a credit default by company B, company A enters into a credit default swap with a CDS provider. The CDS will involve periodic payments being made to the swap provider – what might be termed the fee (not for tax purposes!) for the credit protection given through the swap structure. Typically, this payment would be made up of a credit spread plus other costs. In the example given, if company B had a rating of BBB and the CDS counterparty (i.e. the provider) was an AA rated bank, the credit spread would be derived from the difference in the rating of BBB versus AA. Other costs might include the cost of funding and the capital cost from the use of the CDS provider’s balance sheet.

Credit premium CDS Counterparty

Company A Contingency payment Payments

Electricity

Company B

FIGURE 15.3 Credit default swap example: electricity market

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Obstacles and limitations: counterparty credit risk The transacting of CDSs often suffers from the so-called ‘credit paradox’ whereby you can never totally eradicate credit risk. Credit risk from credit derivatives can appear in the following ways: 1. A protection buyer creates a counterparty credit risk with the CDS seller. More often than not an organisation using CDSs may be able to spread its credit risk better by reducing overall exposure to any one entity or sector. A trader in the energy sector is going to be exposed to a lot of energy traders, but by using CDSs some of this credit risk might be transferred to the credit risk of banks or investment funds who are market-making in CDSs. Note the use of the term ‘transfer’: the trader does not eradicate credit risk altogether, but shifts some of its energy sector exposure over to the financial/banking sector or fund sector. 2. The theory goes that it may be the case that the best quote on a CDS may come from the least suitable counterparties in terms of credit risk. In other words, it may come from those CDS counterparts that are likely to have existing exposures to the reference entity and therefore may present increased correlation risk. This means that the CDS seller may have large exposure to the reference entity. If the reference entity defaults it could cause problems for the CDS seller and in turn leave the buyer with zero protection. In this situation, there are two defaults instead of just one with the reference entity whose credit risk was being hedged in the first place. If the credit quality of the protection seller (the CDS seller) starts to get worse after an organisation has bought a CDS from it, and there has not yet been a credit event affecting the reference entity (so no payout has been made yet on the CDS), the buyer has the choice of trying to terminate the CDS early (although this could be difficult, since early termination provisions apparently are not normally included in CDS deals under ISDA), or the CDS buyer could buy credit protection against the CDS seller. The decision rests on the creditworthiness of the reference entity and on the correlation between a default by the CDS seller and a default by the reference entity. This could be the case if they are in the same country that has just had its rating downgraded, or perhaps there is some potential war or conflict close to the country of the reference entity and the CDS seller. It is important, especially as a buyer, to check prior to the execution of a CDS that the credit risks of the reference entity are not strongly positively correlated with the seller of the CDS. For traders and investors who are CDS sellers, the risk is much simpler, as they do not receive the premium due on the CDS. Non-payment of the basis point premium will normally enable the seller to terminate the contract.

THE NEW TOOL OF THE TRADE – CREDIT DEFAULT SWAPS (CDS)

257

Basic overview of pricing and valuation mechanics A common approach is to use the asset swap spread for the reference credit in the maturity of the CDS contract and to adjust it up or down, based on factors such as expected financing rate and liquidity. This can be illustrated by the following example. Suppose that the benchmark interbank rate is Libor and that the funding rate for a risky bond is also Libor. Consider a transaction where an investor has a long position (they have bought the bond) in a risky bond earning Libor +80 basis points (bps) hedged with a CDS. Ignoring counterparty risk, the net effect of this transaction is to mitigate the trader’s default risk exposure to this risky bond. Hence, the default protection should cost the investor 80 bps. If the CDS spread is less than 80 bps, the investor in a perfect world could buy the bond, finance it at Libor and buy default protection to earn a small positive return for no risk. Similarly, if the default swap spread is higher than 80 bps, the investor can short the bond, sell default protection and receive a small positive return. It is fair to say that this basic approach is the favoured starting point for pricing and is likely to become more meaningful as liquidity moves from the bond market to the credit derivative market. What credits can be traded? Although market participants do trade CDSs on non-rated entities, it is still not that common. Furthermore, most market participants insist on a reference obligation which is normally a fixed rate bond issued by the reference entity. In the absence of a rating and any relevant bond issuance, potential liquidity for that ‘name’ or company diminishes significantly. However, some traders are willing to look at almost any credit and decide whether they want to make a price on it, so it is worth asking around. The fallback to CDSs would be Letters of Credit from the counterpart, silent guarantee or credit insurance (certainly for physical energy transactions, although tricky to obtain cover against derivatives markedto-market loss coverage). See Appendix 2 for a list of some of the main energy sector and transportation names traded in the CDS market. Documentation for credit derivatives The documentation for credit derivatives has become both more sophisticated and more standardised. ISDA (International Swaps and Derivatives Association http://www.isda.org/) has helped to speed up documentation time for new deals and reduce documentation risk. The majority of credit default swaps or CDSs are traded on an ISDA basis. ISDA’s drive to assist the credit derivatives market is also illustrated by the inclusion in 2001 of its Derivatives Market Activity Survey. ISDA

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1999 Credit Derivatives definitions (plus supplements) are used with standard ISDA Master Agreements. These guides are available from ISDA.

THE DEVELOPMENT OF THE CDS MARKET Enron and CDSs The Credit Default Swaps market proved its worth in the Enron crisis of 2001 by sounding alarm bells about the energy giant several months before it collapsed. Enron’s stock did not begin its most breathtaking plunge until mid-October, when the company’s offshore partnerships were uncovered. But two months before that the trouble signs showed up in the credit derivatives markets. On 15 August the day after Enron chief Jeffrey Skilling abruptly resigned, Enron stock barely budged, closing just above the $40 mark. But on the same day, the price of an Enron credit contract jumped 18%. Contracts bought that day were priced at 185 basis points ($185,000 annually for protection against default on a $10 million loan). And by 25 October, as the troubles sparked headlines, Enron stock had dropped more than 50%, while the credit contract had soared in price to $900,000 per $10 million annually. Even at the much higher price, it was actually a great deal! Of course, after Enron announced Chapter 11 in early December 2001, US energy companies were severely hit by the credit fall-out in the energy sector. In the week after the Enron collapse, the five year credit default swap spreads on El Paso widened to around 325 bps from 225 bps the week before Enron’s demise. Williams Energy also got hit with its credit spread widening to 295 bps from about 180 bps In the same week. But rather than halting developments in CDS, it seems that the Enron collapse has demonstrated the effectiveness of this new method of credit risk mitigation and the CDS market in the energy and transportation sector continues to grow at a rapid rate. As Figures 15.4 and 15.5 illustrate, growth dipped around the Enron collapse, but quickly rebounded and has not looked back since January 2002. Both the number of energy-related companies (names) quoted in the CDS market and the number of quotes requested in the market has been on a steady bull trend. Although it is impossible to eradicate credit risk completely, it is possible to enhance or upgrade the credit risk an organisation has to take. There is a cost to this process, but when balanced against the potential cost of taking the hit of a major default, it may appear cost-effective. This was also seen in the Enron scenario: Enron assigned profitable OTC deals to companies to whom they owed money, some OTC trades were converted

THE DEVELOPMENT OF THE CDS MARKET

900

70 Total number of quotes

60

800

Number of names priced

700

50

600

40

500

30

400

Quotes

Names

259

300 20 200 10 0

100 0

Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Oct-97 Apr-98 Oct-98 Apr-99 Oct-99 Apr-00 Oct-00 Apr-01 Oct-01 Apr-02

FIGURE 15.4 Market growth in the energy sector, 1997–2002. Source: data provided by CreditTrade. For further information please call London +44 (0)20 7400 5050 or visit http://www.credittrade.com/

300

14 Total number of quotes Number of names priced

12

250

200

8 150 6

Quotes

Names

10

100 4 50

2 0

Jul-97

Jan-98

Oct-97

Jul-98

Apr-98

Jan-99

Oct-98

Jul-99

Apr-99

Jan-00

Oct-99

Jul-00

Apr-00

Jan-01

Oct-00

Jul-01

Apr-01

Jan-02

Oct-01

0

Jul-02

Apr-02

FIGURE 15.5 Market growth in the transport sector, 1997–2002. Source: data provided by CreditTrade. For further information please call London +44 (0)20 7400 5050 or visit http://www.credittrade.com/

via EFS transaction (exchange futures for swaps) on to exchanges (OTC natural gas positions in USA Henry Hub GAS and also UK Natural Gas NBP (National Balance Point) were all seen EFSed over into the clearing

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ENERGY PRICE RISK

house mechanism with margins to keep counterparts happy and reduce OTC exposures. The size of the CDS market ISDA began reporting the size of Credit Default Swaps in 2001. In its end of year 2001 members survey findings (in which 80 members participated), it reported the Credit Default Swaps market’s outstanding notional value at $918.9 billion. This is small compared to the currency markets or interest rate derivatives, which are measured in trillions, but the growth in credit swaps is still remarkable; for the second half of 200, growth was recorded in the region of 45%. As Keith Bailey, the Chairman of the Board of ISDA said, ...The credit derivative numbers show impressive growth during a difficult period.... This is testimony to the value that these products bring to market participants in managing risk in times of volatility and uncertainty. Most active geographic regions for CDSs It may sound surprising, but Europe is taking the lead in terms of the number of counterparts active in CDS, with around 50 market makers in Europe compared to around 20 market makers in New York, who do about 90% of the business in the USA. America is in second place and Asia still continues to develop in third place. Up to 3 years swaps liquidity is good and it is possible on some names to get protection for 5 to 10 million per credit name for up to 5 years tenure. Ten years cover appears to be the maximum term really possible on good names.

TOTAL RETURN SWAPS A Total Return Swap (TRS) is a term for a credit derivative swap where one party agrees to pay the other the total return of a defined asset in return for receiving a stream of, typically, Libor-based cash flows (Figure 15.6). The underlying asset is typically a single stock or stock index, a bond or portfolio of credit instruments. The TRS is merely a mechanism for the user to enjoy the economic benefits of owning as asset without using the balance sheet and can be used to give general protection against country or political risk. TRS vs. CDS The difference between a TRS and a Credit Default Swap (CDS) is that a CDS simply transfers credit risk and requires a credit event default to

TOTAL RETURN SWAPS

261

Appreciation/depreciation Return Total return payer Libor + x Actual exposure or short position

Credit reference

Total return receiver

Synthetic exposure via total return swap

FIGURE 15.6 Total Return Swaps

trigger a payout by reference to some designated reference asset (usually a bond or other rated instrument issued by the reference entity). However, a Total Return Swap transfers all the risks of owning the designated asset. The TRS transaction keeps the reference obligation (e.g. the bond) on the investment/trading book of the counterpart who was originally holding it. The counterpart buying into the returns on the Reference Obligation is seeking those returns without buying the asset. Country risk application A CDS may look very like a TRS, but there are significant differences in the timing and the extent of coverage. Whereas a CDS needs to have its maturity set to be the same as the asset that is being hedged (if full protection is needed), a TRS does not. Whatever the time period, the TRS will cover any economic deterioration during that time, as well as paying out an economic benefit or appreciation. The buyer undertakes to pay the seller for each defined period the amount of any interest received on the asset, plus capital appreciation. In return, the seller commits to pay a floating interest rate plus any capital depreciation. In the energy industry an organisation may decide to use a TRS when it is concerned about political unrest in a country and wishes to reduce its exposure to that country, while still being able to trade with local counterparties. (In credit limit policies it is quite normal to have counterpart by counterpart limits and then overall country risk credit limits.) An example of this could be the exporter of oil cargoes or LNG/LPG cargoes to an emerging market who wants to protect against sovereign or political risk during a period of uncertainty. In this case, the TRS credit derivative could have as a reference asset a sovereign bond issued by that country. The great thing about the TRS (over the CDS) is that the TRS will generate positive returns for the buyer if the credit quality of the emerging

262

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market in question merely deteriorates. It does not actually need to default, unlike in the case of a CDS. Obstacles and limitations to TRSs The main problem holding back the growth of Total Return Swaps usage has been the difficulty of calculating the appreciation or depreciation of the reference obligation (e.g. the sovereign bond in the earlier example). In the absence of an actual market transaction or a default, a very illiquid bond/asset will present significant price discovery problems, and whilst there are a number of structuring solutions to this, the majority of credits do not have enough liquidity to enable TRS usage. Another impediment is the lack of a market standard structure. Whereas the credit default swap is now considered a standard product with similar documentation used by all (e.g. ISDA based agreements), the TRS is a long way from this status.

CREDIT RISK MITIGATION VIA CLEARING HOUSES The ultimate credit risk tool is a well-capitalised central clearing house. Centralised clearing provides multilateral netting, standard margining, and a highly rated guarantor in case of a default. This safety does not come cheap; it is also probably the most expensive route to guarantee an OTC derivative transaction. An overview for the process of a clearing house becoming a central counterpart to an OTC deal is: ■

■

■

■ ■ ■

Two OTC market counterparts, e.g. A and B negotiate and agree a deal with one another. This takes place in the normal manner either over the phone or via an electronic trading platform. Once the deal has been concluded on the basis of becoming a ‘cleared’ deal, it is automatically ‘novated’ up to the clearing house. This takes place under some master clearing agreement with the clearing house. This legal approach of novation allows the clearing house to take over as counterpart to the deal. From this moment onwards the clearing house is the legal counterpart to A and B, i.e. it replaces A as B’s counterpart, and replaces B as A’s counterpart to the OTC derivative deal. The OTC derivative is then subject to the terms and conditions and the rule book of the clearing house. ISDA terms no longer prevail. The clearing house will charge a fee on every contract cleared and financially guaranteed. The clearing house will normally charge a ‘good faith deposit’ on the opening of the OTC derivative (same as for futures contracts) called

CREDIT RISK MITIGATION VIA CLEARING HOUSES

263

CREDIT SWAPS TERMINOLOGY Buyer The buyer of protection or fixed rate payer refers to the party that is laying off credit risk by way of a credit derivative. Cash settlement Following a credit event a Credit Default Swap terminates, and if cash settlement is the form of settlement chosen, then a payment is due from the seller to the buyer equal to the notional of the contract multiplied by 100 minus the final price. Credit event A credit event is the event (or events) that triggers the termination and settlement of a Credit Default Swap. The standard events used are bankruptcy, failure to pay and restructuring. With the exception of bankruptcy, these events all apply to the reference obligation(s). Credit line An internal limit imposed on the amount of credit exposure that can be extended to a single corporate or sovereign borrower. Deliverable obligation An asset or assets as defined in the confirmation that can be delivered as part of a contract using physical delivery as a form of settlement. Economic capital The amount of capital that a portfolio model calculates is necessary to support the economic risk of a bank’s risky assets. The computation of economic capital is currently not a regulatory requirement. Failure to pay The failure by a reference credit, after the expiration of any applicable grace period, to make payments due under a reference credit. Physical delivery Following a credit event a Credit Default Swap terminates, and if physical delivery is the form of settlement chosen, then on the settlement date the buyer delivers a notional amount of the deliverable obligation equal to the notional of the contract to the seller in exchange for receipt of the notional of the contract from the seller. Reference credit The reference credit is the legal entity that is being hedged by way of a credit derivative. Reference obligation The reference obligation is an identified asset or assets, normally issued by the reference credit, that may be used to identify whether there has been a credit event and may be used to determine cash settlement following a credit event. Regulatory capital The amount of capital that a bank is required by its regulator to hold in support of its risky assets. The current rules (part of the 1988 Basle Capital Accord) generally require $8 of capital for every $100 of corporate exposure, $1.6 of capital for every $100 of OECD bank exposure, and $0 for capital for any OECD sovereign exposure. Restructuring A term referring to changes to a reference obligation that have a material impact on its economics. These are defined at length in the ISDA Credit Derivatives Definitions but are revised in the ‘Modified Restructuring’ language also available from ISDA. The market uses two definitions: ‘Mod R’ and ‘Old R’. Seller The seller of protection or floating rate payers refers to the party that is taking on credit risk by way of a credit derivative.

264

■

ENERGY PRICE RISK

Initial Margin, this needs to be maintained with the clearing house for the duration of the OTC contract being kept at the clearing house. On a daily basis the clearing house will perform marked-to-market calculations to determine the most reasonable fair value of a client’s positions. Any unrealised loss that is calculated on the open position of the OTC contracts with the clearing house will have to be financed. This is generally referred to as Variation Margin.

The cost of clearing trades via a clearing house is primarily made up of the cost of financing the margins placed at the clearing house against OTC derivatives positions and the fees charged per contract for clearing the trade. Also collateral placed with clearing brokers or with the clearing house directly against OTC positions may create other business costs. This working capital may not then be available to take advantage of business/ trading opportunities, so there is an opportunity cost which may be difficult to calculate. Summary of OTC clearing house initiatives Intercontinental Exchange electronic trading platform (ICE) and London Clearing House (http://www.theice.com/) – 2002 ■ Clears ICE executed swaps and option deals in some natural gas and power OTC derivatives in USA and Europe, with aims to offer oil derivatives clearing in 2003. ■ Deals are executed via the ICE electronic trading platform as cleared deals and automatically flow in to LCH system. ■ Users must have the tripartite OTC clearing agreement signed between them, their nominated clearing broker (an LCH member) and the LCH. ■ Users also have to members of ICE, once they have their ICE terminal log-in and password, they can nominate which clearing broker they want to clear their trades. ■ Then their nominated clearing broker will set up account details on their Clearing Administration ICE screen. ■ Once this is all set up, trades executed as ‘cleared’ trades will automatically flow into their clearing account at their broker. If a company already has a futures account with an LCH Clearing member, only the tripartite documentation will usually need to be signed. OTC cleared trades will be booked into their existing futures account. UKPX: http://www.ukpx.com/ – 1999 ■ UK Power Exchange (UKPX) is the energy market operated by OM London Exchange Limited, a recognised investment exchange in the UK. OM London Exchange is regulated by the Financial Services Authority as an investment exchange and in its operation of a clearing house. UKPX was established as Britain’s first independent power

CREDIT RISK MITIGATION VIA CLEARING HOUSES

■

■

265

exchange, and is unique in offering integrated trading and clearing for spot and futures contracts in power. UKPX’s clearing house offers its members a clearing service for OTC physical contracts in UK natural gas and power. In September 2002 it also launched clearing for German physical forward power contracts. The UKPX act as central counterparty to both sides of cleared contracts and will guarantee the financial performance of all such contracts. Since the UK and German power and gas markets are physical delivery contracts the UKPX also performs physical nomination and notification functions.

Nord Pool ■ Nord Pool began in 1996 through deregulation of power markets in Nordic countries (http://www.nordpool.no/) ■ Through NECH’s clearing service, clearing members are offered clearing of contracts traded over the Nordic Power Exchange and financial contracts traded in the bilateral market. Clearing means that NECH acts as an intermediary in contracts and as the clearing member’s counterparty. In doing this, sellers and buyers only have one legal counterparty, and NECH guarantees financial settlements. ■ NECH offers complete solutions for clearing of current products traded on and outside the Nordic Power Exchange. For financial electricity contracts, this means that standard contracts are evaluated together and the clearing member is given one net position in each contract series. This net position is the foundation for calculating the daily margin call and settlement. ■ Clearing of physical electricity contracts applies to contracts traded in Elspot and Elbas. Nord Pool Spot AS is contractual counter party for contracts traded on the physical delivery market. However, NECH administrates all clearing services. ■ For NECH to take on counterparty responsibility, each clearing member wishing to trade and clear its electricity contracts must provide collateral covering the daily margin call, which comes in addition to an initial margin call. ■ The volume of electricity contracts cleared by NECH in 2001, including all trade at the Nordic Power Exchange, was 2,769 TWh, at a value of NOK 412 billion (approx. US$54 billion). ■ At the end of 2002 NECH had 302 clearing members and clearing clients from a total of 11 countries. ■ NECH operates from the Head Office at Lysaker in Oslo and from its branch office in Stockholm with a total of 17 employees. EEX – European Energy Exchange (http://www.eex.de/) ■ This clearing house clears and guarantees spot and future transactions in German power. These contracts go to delivery. It is possible to post

266

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ENERGY PRICE RISK

OTC power trades on to the exchange for a reduced clearing fee than that of EEX futures contracts. The future of EEX is in question, as UKPX in September 2002 launched a cheaper clearing alternative to EEX for German power and UKPX is supported by a leading OTC Broker Spectron.

New York Mercantile Exchange (NYMEX) (http://www.nymex.com/) – 2002 ■ Clearing a range of OTC crude oil, oil products, gas, power and USA coal-related OTC derivatives trades via its online Internet-based system. ■ This system is not attached to any electronic trading platform and offers perhaps a bit more flexibility than the ICE–LCH approach. Since OTC brokers can give trades for their customers into the NYMEX clearing system, OTC brokers cannot participate really in the ICE–LCH approach.

MANAGEMENT GUIDELINES ON ESTABLISHING A CREDIT CONTROL FRAMEWORK Establishing a credit risk environment ■ The Board of Directors should have responsibility for approving and periodically reviewing the credit risk strategy and significant credit risk policies of the organisation. ■ Senior management should have responsibility for implementing the credit risk strategy approved by the Board of Directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels. ■ Organisations should identify and manage credit risk inherent in all products and activities. Organisations should ensure that the risks of products and activities new to them are subject to adequate procedures and controls before being introduced or undertaken, and approved in advance by the board of directors or its appropriate internal committee. Operating under a sound credit process ■ Organisations should establish overall credit limits at the level of individual counterparties and groups of connected counterparties. ■ Organisations should have a clearly established process in place for approving new credit lines and counterparts (even if they are going to place collateral with an organisation prior to trading) as well as the extension of existing credits. It is just as important for organisations to

ESTABLISHING A CREDIT CONTROL FRAMEWORK

■

267

know their counterparts really well to protect against fraud and money laundering as it is to assess counterparts as worthy credit risks. Organisations should have management information systems and credit analysis techniques that can enable senior management to measure the credit risk in all on- and off-balance sheet activities. The management information system should also provide information on any concentrations of credit risk, either in particular entities or group of companies or even country risk concentrations that may require attention.

Ongoing adequate controls over credit risk ■ Organisations should look to establish independent, ongoing credit review procedures and the results of such reviews should be communicated directly to the Board of Directors and senior management. ■ Organisations should establish and enforce internal controls and other practices to ensure that any exceptions to credit policies, procedures and credit limits are reported quickly to the right management who have a control function in the company. ■ Organisations should have internally approved contingency plans/ procedures in place for managing problem credit risks.

CHAPTER 16

Finance in Energy

CREDIT STATUS IN THE ENERGY SECTOR Financing for any business is affected by its credit status. In the energy industry, this is particularly the case, as it is generally perceived to be a high-risk sector. So it is crucial that energy organisations know how credit rating agencies such as Standard & Poor’s and Moody’s operate. They should also know what the key factors are when a rating agency or third party assesses them. In the energy sector, company rating agencies will often examine: ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

Business strategy. Energy market presence and the diversity of its energy business. Competitiveness of the company. Risk management operations. Management oversight of energy market and business risks. Risk tolerance: how a company manages its price risk (market risk). Methods of valuation of its derivatives portfolios. Credit risk policy. Business and risk management control systems. Supply access to energy markets, including operating costs, product pricing and diversity. Financial risk and performance.

The key to a profitable energy trading business is its risk management operations. Most credit agencies, when assessing risk management, concentrate on management supervision of the trading business, tolerance of risk, credit risk policies and the systems and reporting structure in place to control the risk management process. Analysis of these areas helps rating agencies to determine an energy trader’s ability to succeed in the market. This means that the effective implementation of an appropriate price risk management strategy with derivatives can help an organisation give a good impression to agencies assessing creditworthiness. 268

CREDIT STATUS IN THE ENERGY SECTOR

269

TABLE 16.1 Credit rating comparisons Investment Grade Moody

S&P

Probability of default

Aaa

AAA

0.001

Extremely strong capacity to pay

Aa1, Aa2, Aa3

AA+, AA, AA–

0.01

Very strong capacity to meet its financial commitments it differs from AAA only in a small degree

A1

A+

0.02

A2, A3

A, A–

0.04

Baa1

BBB+

0.15

Strong capacity to meet its financial commitments but more susceptible to adverse effects of economic changes Capacity to meet its financial commitments

Baa2

BBB

0.3

Baa3

BBB–

0.6

is adequate but could be weakened by adverse business conditions

Below Investment Grade/or speculative Ba1

BB+

0.90

Ba2

BB

1.25

Ba3

BB–

1.60

B1,B2,B3

B+,B, B–

5.00

The least vulnerable of speculative grade Very moderate protection of interest and principal payment Very moderate protection of interest and principal payment Capacity of meeting financial commitments is weak

Caa

CCC

14.00

Currently vulnerable to default

Ca, C,

CC, C

17.00

Currently vulnerable to default

D

D

100.00

Default, actual or imminent

Some rating agencies (e.g. Standard & Poor’s) consider a risk control system as an absolute necessity to gain an investment grade credit quality. This is typically anything above a BBB for S&P and Baa for Moody’s are considered investment grade. (See example of rating comparisons in table opposite.) The energy sector’s general business risks are high, given that there is a significant energy pricing risk and the expectation that traders will speculate. This means that the average energy sector credit quality assessment is at the low BB category, according to Standard & Poor’s.

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ENERGY PRICE RISK

Energy traders of higher credit quality tend to have that higher credit rating because they not only provide the physical energy to people, but these companies usually have some or all of the following: ■ ■

■ ■

A leading national and international market position (e.g. Shell, BP) Diversity in most aspects of the business and/or the integration of downstream and upstream activities, which reduces exposure to financial margin erosion. (Exxon for many years considered hedging as unnecessary because it had crude oil fields upstream and it has its own refineries and petrol stations downstream.) Advantages as low-cost providers of physical energy/feedstocks for industry (oil, gas, power, petrochemicals). Expertise in using and selling financial derivatives, and substantial physical liquidity.

Making the (investment) grade A rating agency will look at risk management operations closely as many consider this to be the cornerstone of a successful energy trading business. They would expect to see the effective monitoring and control of the following: ■ ■ ■ ■

Complete oversight of its trading business. Market risk. Credit risk policies. The systems used to control and monitor its physical and derivatives trading and settlement processes.

Agencies will also look for a clear management control structure for the use of derivatives. They will expect to see an established set of policies, ensuring that at least the following reports are produced and distributed to a senior management committee at the beginning of every business day: ■

A ‘daily position report’ including ● mark-to-market ● credit exposure to counterparts ● value-at-risk (VAR) report ● report detailing any exceptions that have occurred (violation of policies e.g. trading limit breaches)

Strong senior management involvement is noted by credit agencies (this is usually picked up in narrative disclosures in notes to accounts or via interviews with company officials). As discussed in the chapter on management controls, the Board of Directors should have overall responsibility for approving an organisation’s trading policy, including the trading procedures and portfolio limits

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271

endorsed by a risk management committee. Generally, a risk management committee will comprise designated Board members, senior ‘non-trading’ related management and trading managers. A risk management committee should clearly be responsible for reviewing any proposed changes to the trading policy and trading limits of an energy company. It should also evaluate new risk management techniques and hedging strategies, and it should approve new derivatives to be traded. Ideally, a credit rating agency will want to see that the Board of Directors are taking an active interest in overseeing trading operations. This can sometimes be illustrated by an organisation requiring board approval for large energy trades, and placing responsibility for internal and external audits of the organisation’s trading risk management policy with a Board subcommittee. Risk tolerance: managing the market risk An organisation’s management of market risk and valuation needs to be undertaken by adhering to established policies and procedures outlined in its trading risk management policy and this adherence needs to be illustrated in audits conducted, so that outside agencies can see this. Credit reference agencies do take note of how frequently an organisation’s trading policy is reviewed so this should happen at least twice a year to reflect any changes in the business, or to improve processes. If an energy company is speculating, its traders could expose the company to significant potential financial losses, so credit rating agencies look closely at how an organisation’s exposure is minimised and how strict adherence to established energy trading and risk management policies and procedures is maintained. A clear way to illustrate this to the outside world is for an organisation to show that it is producing trading reports, as highlighted earlier in this chapter. Valuation of derivatives positions Credit rating agencies have always looked at how a company keeps track of the value of its energy portfolio of both derivatives and physical assets, but since the spate of accounting mishaps in the energy sector (Enron being a key one), the outside world is even more concerned and critical of how an organisation values its portfolio. Companies should adopt a Monte Carlo simulation VAR methodology to quantify their exposures associated with derivatives risk portfolios. The VAR model output is a standard and it allows credit rating agencies to compare the risk a company is taking with any other energy sector company also using VAR. Credit risk management policy Rating agencies will be looking for counterparty credit exposure associated with OTC trades to be managed by establishing dollar credit limits.

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Not many companies use credit VAR yet and the simpler US dollar unrealised loss limit is seen in the majority of cases in the energy sector. Credit agencies will also be looking out for the use of ‘netting arrangements’ on payments due from derivatives activities, as this can reduce credit risk (Chapter 17 covers this in greater detail). Business and risk management control systems A rating agency (or counterpart to an organisation, for that matter) will be looking at systems, and checking that the organisation can professionally manage its positions in the market. The outside world will want to know what sort of IT infrastructure is in place and whether there are any disaster recovery plans and backup systems to maintain business continuity. A company with its core risk management system shut down for a long period of time will find it difficult to operate effectively or manage its trading positions. Any organisation in the energy sector using derivatives should create business continuity plans so that it can state in its accounts or reports that if IT infrastructure did become inoperative or unavailable for any reason, the monitoring, confirmation of trades, billing and settlements can also be completed manually. Some companies put into their narratives to accounts that ‘Interruptions to the company’s electronic systems can be managed through easy access to documentation and the cross-training of personnel’. For example Standard & Poor’s considers sophisticated computer systems essential to controlling an organisation’s risk. It would look for a system that keeps track of all transactions (credit, trading and other limits) and performs exposure calculations daily. Traders should ideally be equipped with systems that model transactions and keep track of shifting market prices, demand, and inventory. Another important feature is the automatic notification to traders of trading limits and the appropriate pricing of a transaction. The system should also link accounts receivable information with trading programs, prohibit a transaction that exceeded any limits and require senior management authorisations to complete the deal. An even more sophisticated system would calculate all risk positions and forward pricing curves on a transaction-by-transaction basis. In addition, all branch office transactions and multiple trading sites should be linked to one trading and risk management system to capture the full risk exposure and hopefully limit or prevent any rogue trading. The closer to real-time the better, as this gives a level of control and transparency that allows management to make better informed decisions and gives positive signals to the outside world when people are assessing credit risk. A company with an antiquated risk management system that breaks down all the time and calculates values and invoices incorrectly is a big risk for an energy trader.

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273

Market standing An organisation’s size of operation and its share of sales within geographic markets are important because there are economies of scale in trading in the energy markets. Large organisations also have an advantage in terms of information and intelligence on that market. A company which is at the centre of the information flow is at a big advantage because it has a better chance of knowing the direction of the market in the very short term. Size is usually related either to sales or by the number of known active counterparts that an organisation has. It can also be judged by the number of sales contracts and ISDA agreements with counterparties. (ISDAs are discussed in more detail in Chapter 17.) Generally, greater size is a positive credit factor because larger participants in the energy markets gain more knowledge of many different transactions in the market. Diversity of an energy company’s market activity Another important feature of the higher credit quality energy companies is strong diversity and reliability of products and services. These are companies which should be able to provide either oil, natural gas or power any time, anywhere, and at fixed or variable prices and volumes. A key to a successful energy trading operation is delivering exactly what the customer wants and needs. It may be old fashioned to say that owning assets is good, but when looking at the overall credit rating risk of an organisation, assets still count. This is because an energy company will normally have more control over an energy commodity if it actually owns natural gas reserves, some gas storage, power generation plants, refineries, petrochemical plants etc. Of course, the downside is that the organisation would also have the risk of operating the facilities, and the credit risk assessors will look at the quality and experience of the staff and management to try to quantify whether there is any cause for concern in terms of operational risk. Rented assets, such as purchased power and gas contracts, tolling agreements, and commitments to use transmission or storage capacity, offer less control over the energy market, but have no operational risks. However, there is credit risk; that is, the risk that a supplier will default on its obligation to deliver the oil, or gas, or power. This leads neatly to supply sources. When looking at the credit risk of an organisation, third parties will check out the sources of supply, and if an organisation is buying energy from a high credit risk company, this may affect the rating of the organisation. Most credit rating agencies view assets favorably, but the only real way to measure an energy trader’s skill at generating profits is through performance. If an organisation proves it can create more sales with fewer assets, then credit rating benefit will be given in the analysis.

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Energy companies certainly benefit from having a large number of traders with good trading relationships in the market. Traders are an energy trading company’s core assets. The depth of their experience, their ability to trade physical and or derivative products, and their ability to source trading information are all critical factors in an energy trading firm’s competitive position.

Management track record Credit rating agencies will often scrutinise a firm’s management by examining factors such as the following: ■ ■ ■ ■ ■

■ ■ ■

Level of risk management background. Knowledge of trading. Familiarity with derivative products. Does top management have a background in managing price risk? Does management understand the risks of using financial derivatives? Are they aware of the funding requirements that could be associated with cash flow surrounding date mismatches over physical trade settlements and derivative trade settlements? They should also know about the collateralisation of derivatives with exchanges or counterparts. Is day-to-day funding actively monitored? What does top management do to ensure that proper controls are in place before trading new products? Segregation of duties (highlighted in Chapter 9). Anyone assessing credit risk will look at the controls in place to prevent fraud within an organisation. An example is that the internal credit department should be physically separated from the trading floor. A rating agency will take note of this, as would a bank assessing a customer for credit lines.

Capital reserves The other important factor that anyone assessing credit will look at are capital reserves. In other words, they will check how much capital liquidity an organisation has compared to its credit exposures with counterparts in the energy market. An organisation should check that it has enough capital reserve to cover its trading activities by evaluating its counterparties in the market, assigning a rating to each and then examining the total credit lines that exist at each credit rating. Table 16.2 applies Standard & Poor’s default risk probabilities by their respective S&P rating category to generate some hypothetical credit limits and so produce a weighted average credit exposure to each rating group, using a one year default probability.

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TABLE 16.2 Weighted average credit exposure; source: Standard & Poor’s and Tom James Rating US$ millions credit lines

% Default probability Capital at risk US$

AAA

200,000,000

0.00100

2,000

AA

125,000,000

0.01000

12,500

A

100,000,000

0.04000

40,000

BBB

100,000,000

0.30000

300,000

BB

50,000,000

1.25000

625,000

CCC

25,000,000

14.00000

3,500,000

Total

600,000,000

4,479,500

The appropriate amount of risk capital an organisation sets aside should incorporate these embedded risks. It is worth noting that whether with Standard & Poor’s or with any other credit rating agency, any energy trading firm wishing to gain a higher credit rating should carry multiples of this ‘capital at risk’ in terms of credit lines with counterparts. Note that this capital at risk is not a replacement for, but is in addition to, any VAR calculation which assesses market risk.

Credit status: summary To be considered a good company for financing purposes or for pure counterparty credit purposes, a company needs to make sure it has sufficient working capital to cover exposures in: ■ ■ ■

Credit, which we have discussed already in this chapter. Price risk, which VAR or the organisation’s chosen risk methodology can help managers determine Operational risk: the organisation should allocate capital for disaster recovery, new systems, more personnel based on increased in turnover etc.

It is fair to say that an energy market participant who has a proven ability to hedge open positions would have lower market exposure. Also, an energy market participant who had a robust credit risk management program (see Chapter 15 for more details) could reduce their credit exposure. Therefore if the management of a firm wants to make sure their organisation is seen as a good credit risk, they should ensure they develop a capital structure which is appropriate to their organisation’s stated business strategy and the level of risk it expects to incur in the three risk types just mentioned.

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FINANCING USING DERIVATIVE STRUCTURES Derivatives are proving to be an increasingly popular funding method for organisations in the energy sector. Here, we review some of the more common ways of using derivatives to achieve this end. Energy indexed loans An index linked loan is a way of wrapping price hedging and financing into one package. The major benefits of debt indexed to fixed amounts of energy exposure include: ■

■

Additional security for lenders and creditors This security comes as a result of a reduction in the volatility of the producer’s cash flows and its exposure to energy prices. A price hedge for the borrower/issuer of the debt The energy price link creates a hedge for the consumer as illustrated in the term sheet example below. It may be better to create this type of hedge (a sort of synthetic hedge because derivatives are not directly traded, but the same result is achieved), since it may permit a hedge to be created for a longer period of time than is available in the derivatives market directly due to lack of liquidity in far forward transactions. It may therefore be more cost effective in terms of the price a borrower is able to achieve for its hedge protection, in addition to being more credit efficient. This is because it combines the hedge with funding via the loan, effectively collateralising the hedge.

For example, if a consumer of natural gas seeks a hedge for its gas price exposure in the form of a gas indexed loan, the structure for the loan would look like the following. The borrower may be a power station; the lender could be the producer of the gas, or a trader who arranges funding for the power station to buy into a long-term supply contract. Via this loan structure, the borrower gets a hedge against the natural gas price being higher on maturity of the loan and the lender would have exposure to prices moving higher, so would need to hedge somehow, either with a back-to-back physical contract or through some derivatives structure with another counterpart. Natural Gas indexed loan for Natural Gas consumer: Principal amount: GBP10,000,000 Term: 10 years Repayment: In full at maturity Commodity index: UK NBP Natural Gas Index Fixed commodity price: 20 pence per therm (GBP0.20) Under this loan transaction, the borrower (the consumer of natural gas, e.g. a power station) receives GBP10,000,000 at the start of the financing.

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This is the cash equivalent of an agreed GBP0.20 pence per therm basis price (notional natural gas position of 50,000,000 therms equivalent, 10,000,000 × 20 pence per therm). The borrower’s principal (amount borrowed) repayment has a link to movements in UK natural gas prices in accordance with the following simple formula: Principal repayment – [(Natural gas price (at maturity) – Fixed commodity price) × Notional commodity position] Assuming the natural gas price has moved to 25 pence per therm, the cash amount due at maturity would be: GBP10,000,000 – [(25 pence per therm – 20 pence per therm) × 50,000,000 therms] = GBP7,500,000 The principal repayment at maturity in this scenario is GBP2,500,000 less than the face value of the loan. This saving can provide a hedge against the increased operational costs from the higher natural gas price of 25 pence per therm for the borrower. Energy indexed bonds An attraction for investors to the following structure, which has been seen in metals and energy markets in the past, is that it offers investors an interest rate return plus an exposure linked to an energy price. The key advantage for the issuer of the bond is that it appreciates from a hedge against its underlying energy risk, since with increasing interest rates of the bond, the bond issuer is benefiting from increases in cash flow due to the higher revenues from its physical oil sales. The reverse of this is a consumer situation: for example, airlines sometimes look at this type of funding for aircraft, where the interest rate is linked to jet fuel prices, which can account for up to a third of an airline’s operating costs. In this case the bond would be structured so that if jet fuel prices rise then, based on a formula, the interest rate would decrease, easing the tighter cash flow situation due to higher jet fuel prices. When jet fuel prices went down below a certain level then interest rates would increase (usually with a cap set in the agreement). Energy producer bond issuer example Issue: Maturity: Specified energy amount: Principal amount of the bond:

Energy producer 10 years X amount of energy Principal amount equal to the market value of the specified energy amount as at the date of issue

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Interest rate: Interest:

Principal redemption:

Security interest:

X% of the principal bond amount Interest is payable in US$ at the interest rate calculated on the basis of the average market value of the energy for an agreed number of days prior to the interest payment The bonds will be redeemed in US$ based on the specified amount of energy calculated on the basis of the average market value of the energy for an agreed number of days prior to redemption. The bonds are fully secured by mortgage/lien over the energy source (perhaps an oil field?)

Airline/shipping company bond/loan issue In an airline or shipping company bond/loan scenario, banks can offer to buy a bond or issue a loan on the basis that if jet fuel prices increase for an airline, the interest rate on the bond or loan decreases (with some floor). However, if jet fuel prices decrease then, since the airline will appreciate from better operating revenue and operating profit, the interest rate on the bond or loan increases with some pre-agreed cap. Sometimes this sort of financing approach can be linked to specific aircraft or ship financing deals. Banks offer this kind of deal because they can hedge their exposure using derivatives in the oil markets. Also, by easing cash flow for their customers when their energy prices are high, they can reduce the inherent credit/business risk for that entity and in turn reduce the potential default risk to the buyer of the bond or the lender. Inventory financing example This sort of structure can be useful for producers, traders, and consumers with an energy exposure. It is mainly restricted to energy types that can be stored easily, for example gas or petroleum. Electricity presents more problems, although it may be possible to structure something around hydroelectric power (the water at higher ground being considered the inventory needed to introduce some weather swaps – in this instance to protect against adverse weather conditions). In the power markets, compressed air storage tanks have sometimes been used as a synthetic storage of power. Off-peak power is used to create the compressed air in storage and it is then released to generate more expensive peak load power at the appropriate moment. (This is the same principle as pumped water storage used by hydroelectric power stations.)

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Common uses of inventory financing ■ A consumer, e.g. an industrial user, has to keep strategic stock of fuel oil or gasoil etc. on-site to ensure business continuity. However, this ties up important working capital that might be better off applied to other business development or research and development work. Using inventory financing the company can normally maintain the energy source on-site at its factories. However, this is hedged using derivatives and a percentage of the value of the energy stored on-site is released back (minus structure and financing costs) to the industrial user. The loan is collateralised by the energy in storage onsite. This can be a lower cost route of funding for corporates. ■ Energy producers or traders with energy in storage can approach financial institutions to lock in the value of this energy using forward markets such as derivatives. Again the advantages may be cheaper forms of releasing working capital in the business as the stored energy and the hedge is used as collateral. This approach also creates a collateralised hedge.

Tripartite financing Even if a company is not looking to borrow funding against stored and hedge funding, if it can show both sides of this transaction equation to its bankers it may appreciate from lower costs of funding. But energy companies that do not have huge amounts of capital to play with can look at sourcing tripartite financing lines (Figure 16.1). This can allow traders to trade more and bankers to lend more. An energy trader gives its funding organisations lien over the derivatives hedge cash flow and also the cash flow from the physical energy transaction. The bank that is funding the deal has lower risk because it has a balanced position – a hedge on a physical energy transaction. It just has to contend with whatever basis risk may Physical market counterpart

Bank

Tri-partite agreement

Skilful energy trader

Derivatives market counterpart

FIGURE 16.1 Tripartite financing. In effect, the energy trader assigns rights over the cash flows of both the physical deal and the derivative hedge to the bank, which guarantees the credit performance of the energy trader to its physical market counterpart and its derivative market counterpart. The bank can feel comfortable to do this as it has rights over both sides of the transaction and has a balanced book (subject to any basis risk on the hedge.

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be present between the hedge and the underlying energy product. This approach can usually permit a bank to lend much more to energy traders and for energy traders to gear up on their capital base much more. The bank will focus on the skill set and track record of the traders and management of an organisation closely when evaluating whether or not to extend this type of funding arrangement. Another key advantage here is that tripartite lines of credit automatically guarantee lines for the hedge. Counterparts may not ask for cash up front, but any trading derivative contracts or physical energy uses up an organisation’s credit capacity in the market. However, it uses up much less credit capacity if a counterpart (like a bank who is funding the organisation) can see the hedge and the physical side of the cash flow. Pre-payment financing example In the past, several OPEC and non-OPEC countries have used pre-payment structures to realise future cash flow on physical sale agreements today. These structures are a form of forward contract where the buyer agrees to pay the seller the present value of the price of the oil in advance. In effect, the buyer has provided a loan to the seller based on the subsequent supply at the forward date. Sometimes the forward physical purchase and the funding is handled by a trader or one energy organisation. More commonly, due to the lack of investment grade entities in the energy sector, an energy trader works with a group of banks to structure this sort of deal for a producer. Pre-payment structures are normally left for medium term financing (five years or more), because of the initial setup costs of establishing the structure. Producers of energy, such as a crude oil producing nation or an oil

Contractors Oil buyer (lifter)

Oil producer

Derivatives hedge counterparty

Agent and security trustee

Lender

FIGURE 16.2 Pre-payment financing structure

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281

refiner, can obtain a structure where forward production of crude oil or petroleum products is hedged in the derivatives markets (usually with the assistance of a trader who agrees to buy the oil produced and dispose it in the oil markets for the bank). In this case, banks will pay the producer value today a percentage of the forward value of the energy production which has been hedged. The bank uses the forward production as collateral. With this method of funding, there may be funding cost advantages in long-term funding arrangements. It can also be useful in cases where straight corporate financing may not be possible for the entity due to its bad credit rating. This type of pre-payment does not have to go on the accounting books of a firm or sovereign entity as a debt because it is a prepayment on a commercial deal to purchase physical energy. The advantages of this structure are: ■ ■

Oil does not need to be project linked. Payment risk offset for financers. Major offtaker (buyer) pays for the oil and in doing so repays the loan principal and interest.

The disadvantages are: ■ ■ ■

It is a complex structure, so legal costs can be high. A willing and acceptable off taker/buyer has to be found (since credit risk is transferred to the buyer of oil). Delivery risk remains (but this is the case in any financing structure built around a physical commodity).

Figure 16.2 shows how the agent and security trustee oversee the whole process as a neutral third party, assisted by contractors who report oil flows and deliveries. This data should match against cash flows. The lender via the trustee passes the loan of money which is collateralised

Contractors Oil buyer (lifter)

Oil producer

SPV

Lender

FIGURE 16.3 Pre-payment financing with SPV

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ENERGY PRICE RISK

against the forward production of the oil to the oil producer in the above scenario. If this were a national oil company, it might pass the funds directly to the government’s treasury. The forward oil value is locked in via a hedge which the oil producer locks in itself, or sometimes the lender organises this as part of the package. The hedge may be made up of futures, swaps and/or options. The cash flow of the hedge is pledged to the agent and security trustee/lender, as is the cash flow of the oil sales. The oil company receives cash flow from its oil sales minus repayment fees and interest and costs from the agent and security trustee. The lender receives the repayment of principle and interest from the agent and security trustee. The oil buyer or lifter or sometimes called the offtaker of the oil sends any payment of the oil to the agent and security trustee, who then pays out monies to the lender, the oil company and hedge counterparty if any losses on the hedge are due and payable. The Special Purposes Vehicle (Company) in respect to pre-payment structures In case of default under the terms of a pre-payment structure, the lender will normally have some rights over the oil production and possibly other assets. So, sometimes, companies or countries wishing to raise money in this manner try to ensure that the only assets that a lender has rights over, are very specific oil fields or other assets. In this instance an SPV or Special Purposes Vehicle may be set up. This is normally done for the following reasons: 1. For prepayment financing flexibility for the borrower to sell the oil to any potential lifter, not fixed to sell the oil to only one dedicated lifter as in the previous case. 2. Sometimes certain countries or banks cannot have a direct contract with certain other countries. 3. To ring fence the finance project. The SPV has no assets other than its rights against the ‘real’ borrower of the money. 4. It may assist to raise the overall credit rating of the transaction by moving the lending to the SPV away from the ‘real’ borrower behind the SPV. As Figure 16.3 shows, the Special Purposes Vehicle becomes the actual legal counterpart to the whole deal, with its asset being its rights against the ‘real borrower’ which is, in this case, the oil producer. The SPV sells the physical oil to the oil buyer and has a back-to-back physical contract with the oil producer. The SPV pays the lender capital repayments and interest out of the oil sale cash flow. The remaining cash is paid to the oil producer for the oil. The contractor checks that everything is operated in accordance with lending agreements and acts on behalf of the lender. This is a

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283

complex structure which often requires a lot of tax advice as well as legal structuring. Loans with embedded option structures (structured notes) Loans with embedded option structures can be used to reduce the overall cost of borrowing by generating cash flow, otherwise known as premium (as discussed in Chapter 5). This can be used to a borrower’s advantage by placing an option inside a loan structure to reduce the basis point cost of funding. Example of an oil-linked structured bond This is an example of an oil option-based note issue. The redemption value of the bond is linked to the price of WTI Crude. The bond has an embedded 1 year European style floor (put) option on WTI. The sale of the option allows the issuer to create a Libor minus 1 funding rate. Key terms: Amount: Maturity: Coupon: Issue price: Commission charges: Redemption:

US$100 million 1 year 20% per annum 100.875% 0.875% The redemption value of the bonds linked to the a formula e.g. ■ If the price of the oil index at maturity is greater than the redemption strike price of the oil index, then the redemption of the bond is at par value. ■ If the price of the oil index is below the redemption strike price per barrel then the bond holder will receive less than par on his principal determined as below per US$1,000 bond: 1,000 × (Redemption strike price/ reference price)

For the redemption formula: Redemption strike price:

Reference price: West Texas Intermediate crude The New York Mercantile Exchange Settlement price per barrel on 13 August 2002, for the WTI light sweet crude oil futures contract for delivery during the month of October 2002, as quoted in the price source. US$17.50

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ENERGY PRICE RISK

Reference price:

Price source: Settlement:

The arithmetic average of New York Mercantile Exchange Settlement Prices for WTI light sweet crude oil futures contract for delivery during the month of October 2003, as quoted in the price source, for the three NYMEX trading days immediately preceding but excluding two days prior to the maturity date. Wall Street Journal Cash payment as per redemption formula

The redemption formula embeds a 1 year European style floor option on WTI crude oil at a strike price of US$17.50 per barrel. The floor option was sold by the bond buyer in favour of the bond issuer. At maturity, if the reference price for WTI is above the redemption strike price of US$17.50, then there is no cash flow under the option and the issuer repays the bond holder the par value of the bonds. However, if the WTI price is below US$17.50 (for example US$16), then the cash flow would look like this: ■

The energy company that issued the bonds repays the bond holder in accordance with the redemption formula: 91.428% of par calculated as follows: 1000 × (16/17.50) = 914.2857. ● This is equivalent to US$91,428,570. ● The difference between the par value of US$100 million and US$91,428,570 redemption value of US$8,571,430 is paid by the energy company who issued the bonds to the floor option counterpart representing the value of the option at maturity (European style).

The use of this structure creates cheaper up-front funding, while the downside exposure for the bond issuer can be protected through other derivative hedging structures. For example, if there is an implied volatility on the embedded floor option sold by the bond buyer of around 23% and the prevailing market level for the volatility of comparable options is around 30%, this would represent a difference in option premium of potentially several million dollars (based on WTI). This difference would benefit the bond issuer and this premium profit could be put towards funding interest payments, and this is where the bond issuer is able to potentially get a NET – a negative Libor funding rate. Example of oil index notes Oil index notes issued by a trader (effectively caps/call options on oil)

FINANCING USING DERIVATIVE STRUCTURES

Maturity: Value: Strike price:

285

15 years US$37.5 million US$25 per barrel

For the buyer of the notes from the energy trader, if the oil price is above US$25 dollars per barrel, the investor will receive an amount reflecting the price increase of the value of the call option that the energy trader is in effect issuing via this oil index note. However, in the event that the oil price is at US$25 or below the options will expire unexercised and the investor will just receive back the face value of the notes. These notes are useful for investors who want the potential for much higher returns than interest rates can offer, but who are willing to take the risk of only getting their original capital invested back. Financing trade receivables Many companies wish to finance their trade receivables in order to make cash immediately available and so retain their ability to borrow money. A typical energy physical deal has a minimum value of several million US dollars. As credit is quite expensive for the majority of the sector (with the average credit rating not being above a BB), energy traders and producers can release much needed working capital tied up in trade receivables. Specialised financing companies have emerged in this area to finance these trade receivables; one of the leaders in this field is the Euler Group, probably due to its link with the general reinsurance and credit insurance markets: http://www.eulergroup.com/corpo/en/corpo1/services.cfm. This approach can also help companies to give longer credit terms to its customers, which can be pushed as a competitive advantage, both as a way of attracting new customers and a way of keeping them.

CHAPTER 17

OTC Derivatives Legal Risk Control and Documentation

The International Swaps and Derivatives Association (ISDA) is the global trade association that represents leading participants in the privately negotiated derivatives industry and the so-called ‘ISDA Master Agreement’ provides the main legal framework for energy derivatives markets. There are some players in the market who may wish to use their own nonISDA based agreement, but these days it is very rare to meet one. ISDA’s 2002 Operational Benchmarking Survey found that the use of master agreements has been steadily increasing. ISDA members reported that signed master agreements are in place with over 92% of their OTC derivatives counterparties; an increase from 85% in 2001. ISDA Master Agreements now cover products such as interest rate swaps, currency swaps, forward rate agreements, commodity swaps (for energy derivatives), equity/equity index swaps, options including caps, collars, floors, forex, credit derivatives and gold bullion. It is worth noting that swaps (i.e. purely cash-settled derivative instruments with no physical delivery) are mainly traded under ISDA Master Agreements. However non-financial power and gas markets, such as UK power and gas markets, trade under the GTMA (General Trading Master Agreement) produced by Allen & Overy (http://www.allenovery.com/) and European power and gas normally under the European Federation of Electricity Traders (EFET). The fact that derivatives contracts use money (cash) settlement is important when it comes to accounting for these contracts and it affects the operational risk of these contracts. There is much more risk when dealing with GTMA- and EFET-based OTC contacts which on expiry go to physical delivery. This means that there are fewer financial traders like banks involved in these physical delivery markets. Since its creation in 1985, ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. Among its key achievements have been: 286

THE ISDA AGREEMENT

■ ■ ■ ■ ■

287

Developing the ISDA Master Agreement (the energy industry tends to utilise the 1992 Master Agreement). Publishing a wide range of related documentation materials and instruments covering a variety of transaction types. Producing legal opinions on the enforceability of netting (available only to ISDA members). Securing recognition of the risk-reducing effects of netting in determining capital requirements. Promoting sound risk management practices, and advancing the understanding and treatment of derivatives and risk management from public policy and regulatory capital perspectives.

THE ISDA AGREEMENT ISDA agreements are made up of two important parts: the ISDA Master Agreement is a standard format which does not change (an example is included at the end of this chapter for your reference) and the ISDA Schedule to the Master Agreement. The Schedule is the part that is negotiated between counterparts and contains information such as procedures on settlement, early termination, default, netting arrangements (if any) and banking details for both organisations party to the Master Agreement. Sometimes the Credit Support Annex is attached to this, an example of which is also included at the end of this chapter. (This Annex could be replaced in the near future by a new Margin Annex: see notes later on about this.) The majority of crude oil, petroleum products, and financial power and gas over-the-counter derivatives (i.e. derivatives that are money settled, not involving any physical delivery of the commodity – OTC Swaps/ Options) use the 1992 ISDA Master Swaps Agreement Multi-currency Crossborder version. In addition to this, counterparts in the market generally use this Master Swaps agreement with 1993 ISDA Commodity Derivatives definitions and the 2000 supplement to the 1993 ISDA commodity derivatives definitions.

THE ISDA MASTER AGREEMENT Any non-legal manager taking their first look at an ISDA agreement usually has a shock. It’s a big document and consists of fourteen sections, as follows: 1. Interpretation. 2. Obligations.

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3. Representations. 4. Agreements. 5. Events of default and termination events. (An event is anything that has to happen to trigger some action in the contract. For example, when a counterpart goes bankrupt, it is considered to be an event and this may then allow certain action to be taken under the ISDA agreement.) 6. Early termination. 7. Transfer. 8. Contractual currency (in the energy industry this is normally always US dollars). 9. Miscellaneous. 10. Offices. 11. Expenses. 12. Notices. 13. Governing law and jurisdiction (normally English law). 14. Definitions.

ISDA PUBLICATIONS ISDA publishes some very useful books to help business managers understand the meanings of the contract sections of its agreements, in particular the meaning of the 1993 and 2000 Supplementary ISDA agreements and terms. 1993 ISDA Commodity Derivatives Definitions These definitions are designed to facilitate the documentation of commodity transactions under the 1992 Master Agreements. Sample forms of confirmation are included. 2000 Supplement to the 1993 ISDA Commodity Derivatives Definitions The Supplement is an update of the 1993 ISDA Commodity Derivatives Definitions (the ‘1993 Definitions’), which many participants in the overthe-counter commodity derivatives markets have incorporated into existing confirmations or other agreements. As is the case with the 1993 Definitions, the Supplement is designed for use by participants in the markets for commodity derivatives transactions in documenting cashsettled commodity swaps, options, caps, collars, floors and swaptions or such other cash-settled commodity derivatives transactions as the parties desire. The Supplement includes additional Commodity Reference Prices for Energy, Metals and Paper. The Supplement may not include all the

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commodity reference prices available for a particular commodity and used by market participants, but it adds significantly to the number of commodity reference prices set forth in the 1993 Definitions and includes the Commodity Reference Price Framework from the 1993 Definitions, which facilitates the definition of a commodity reference price that is not set forth in the Supplement. In addition to an expanded Commodity Reference Price Section, the Supplement allows parties to incorporate price materiality into the Price Source Disruption Event defined in Section 7.4 2000 ISDA Definitions and Annex This is what the majority of players In the energy market are using at the moment, although this may change in the not-too-distant future.

PRE-CONFIRMATIONS AND LONG-FORM CONFIRMATIONS Banks and financial institutions aim to have ISDA Agreements negotiated and signed off within 3 months, although it can often take between 3 and 6 months to have an ISDA put in place with a counterpart. Because of the time it takes to set up an ISDA, it is common to see counterparts trading with one another on the basis of an ISDA being put in place eventually (or under negotiation whilst trading). Most risk management policies prohibit any trading before an ISDA has been signed off by both parties; however, the commercial need to trade sometimes takes precedence over this policy (with management approval). But trading without an agreement does add considerable legal risk to a business and if trading must go ahead with a counterpart it may be better to use what is termed a ‘preconfirmation’ and or a ‘long-form confirmation’. A ‘pre-confirmation’ states the terms of the derivatives transaction and choices of provisions that would appear in the ISDA Master Agreement. The idea behind this is to commit counterparties to this wording before the agreement is signed. However, these are becoming less common due to a tightening of risk management policies over documentation and controls over trading prior to ISDA Master Agreements. These days ‘long-form confirmations’ are far more frequently used. (They get their name from the fact that they usually consist of about nine feet of telex roll or fax paper!) Basically, this is a one-off derivatives contract for a specific deal which covers all the main eventualities. This type of confirmation is probably best for dealing with entities which are not regular trading partners and so do not warrant the legal cost of creating an ISDA. It can also be helpful in situations in which there is an

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urgent need to trade, but an ISDA has not been signed off yet. ‘Long-form’ contracts should be used for short dated ‘plain vanilla’ derivatives, with a counterpart in a familiar jurisdiction.

ISDA DOCUMENTATION PROCESSING Figure 17.1 shows the ISDA documentation required. When entering into an ISDA agreement, one of the counterparts will usually take the initiative and send its standard ISDA Schedule draft wording for the other party to review and comment on. As mentioned earlier, the ISDA Master agreement is not changed by counterparts; the ISDA Schedule is the negotiated document. At this stage of proceedings, no negotiation has begun on the specific terms in the ISDA Schedule. Prior to negotiation on terms, the credit department must first process the counterpart details and pass the details of internally approved credit terms to the legal department who need this for inclusion in the ISDA Schedule; this also affects whether or not Credit Support Annexes are required. Before rushing into the expense of processing legal documentation with a new OTC counterpart, it is useful to check the memorandum and articles of association of the counterpart’s organisation. These are known as the ‘M&As’ and provide the legal incorporation details of the organisation, specifying what business functions it can carry out and sometimes what it is prohibited from doing. It is very important to check that there is nothing

Credit support documents offering protection against credit risk: • 1994 Credit support annex New York Law • 1995 Credit support annex English law • 1995 Credit support annex Japanese law

1992 MASTER AGREEMENT (multi-currency cross border) • Incorporates Confirmations • Includes representations and events of default/termination events • Specifies early termination provisions

Definitions

Confirmations – Short Form confirmations are made possible by the signing of a Master Agreement • • • •

• 1993 commodity derivatives Definitions and Year 2000 supplement • 2001 margin provisions

Incorporate definitions Refer to signed master agreement Specify economic terms of each transaction Include any individual modifications

FIGURE 17.1 ISDA documentation for energy

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in the M&As of the firm that prevents it from entering into OTC derivative contracts with other companies. If the M&As are satisfactory then both parties should be ready to put together an ISDA agreement. Although the ISDA Master Agreement is a standard document there are areas of it which give rise to different types of risk for counterparts and are therefore often areas of negotiation in the Schedule. (Remember that the Schedule is where counterparts make the choices of how certain areas of the Master Agreement will effect their derivatives transactions.) These areas are as follows: ■

Legal risk ● Section 1(b) Inconsistency – Where there is any inconsistency between the ISDA Master Agreement text and the ISDA Schedule (which is negotiated between the counterparts to the agreement) the Schedule will prevail. Also a key point is that if there is any conflict between a Confirmation and the ISDA Master and the Schedule, the Confirmation will prevail for the trade the Confirmation is recapping. This can contribute to operational risk, so trade confirmations must go out correctly. ● Section 1(c) Single Agreement – If trades are closed out, this section makes sure the values of all trades between the two counterparts are calculated and netted off against each other, so only one payment is required between the two counterparts. This avoids a situation called ‘cherry picking’, where if a company has gone bankrupt, the liquidator can call in payments on trades that are profitable for the bankrupt client, but refuse to pay out on trades which are not profitable. For example, imagine that Counterpart A and Counterpart B do two derivatives trades, with Counterpart A making US$2 million dollars on one deal (this is a zero sum game, so Counterpart B is losing US$2 million), and on the other deal Counterpart B is making US$1.5 million dollars (with Counterpart A losing US$ 1.5 million dollars). In this situation, if Counterpart B went bankrupt and Section 1(c) was not in place (because it had been deliberately excluded via the wording in the ISDA Schedule), then Counterpart A could end up being forced to pay to Counterpart B US$1.5 million dollars (even though the net position is that Counterpart B owes Counterpart A US$500,000). The single agreement concept reinforces the position that a liquidator cannot do this. It collapses and nets out the entire portfolio of derivatives trades into one single payment due to one counterpart or the other. ● Section 5(a) Events of Default is a key area – This covers a party’s failure to make any payment or delivery under Section 2 of the Master agreement which covers the counterparts’ obligations. In the past, the energy industry adopted a grace period of 3 days; however, this is

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increasingly being shortened to sometimes just 1 day grace period on payments. The section also covers Credit Support Default, Misrepresentation, Default under Specified Transactions (we look at this in more detail in the ISDA Schedule example later in this chapter), Cross Default, Bankruptcy, Merger, Illegality and Credit Event upon Merger. ● Section 7 Transfer of the Agreement – Normally, counterparts are not allowed to transfer the ISDA Agreement or any rights and obligations under it without written consent from the other party. There are a few exceptions to this rule but these are rare instances where a counterpart wants to transfer the agreement to avoid an ‘event’ (e.g. Illegality, Tax Event, certain cases surrounding a Merger) and a counterpart transfers the close-out money payable to it by a defaulting counterpart to another firm. ● Section 8 Contractual Currency – This protects counterparts from foreign exchange losses on settlement and close-out payments. ● Section 9(d) Miscellaneous (Remedies Cumulative) – When a counterpart is faced with another counterpart defaulting, it should not forget that the termination of derivatives trades is not the only course of action. A counterpart can leave the trades open or even sue for damages, if it chooses to do so. ● Section 13 Governing Law and Jurisdiction – The majority of energy derivatives trades under ISDA outside the USA, even with American companies, are conducted under English Law and the jurisdiction of the English courts. Under ISDA there is a choice between English Law and English Courts or State of New York Law and the jurisdiction of the courts of the State of New York and the US District Court located in the Borough of Manhattan in New York. Counterparty risk ● Section 5 Events of Default and Termination Events – This is examined from a practical standpoint in the ISDA Schedule example later in this chapter. Market risk ● Section 6 of the ISDA Master Agreement – This covers early termination especially with Automatic Early Termination. We look at this in the ISDA Schedule example later in this chapter. Documentation risk ● Section 4 Agreements – This covers the agreement of what documents both counterparts agree to provide one another (e.g. company certificates of incorporation, copies of licenses and renewals). It also covers agreement that in some case counterparts must maintain certain licenses and also pay any stamp duty taxes on any agreements etc.

TRADING BEFORE AN ISDA IS SIGNED

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293

Payment on settlement risk ● Section 2 – This key area is where counterparts agree on details of how payments are to be made and how netting is performed, and also covers provisions protecting counterparts against withholding tax deductions.

TRADING BEFORE AN ISDA IS SIGNED There is a documentation risk in the time period between the execution of an OTC derivatives trade and an agreement being agreed upon and signed. If a trade does take place prior to an ISDA being signed between the two counterparts (which is not advisable unless there are considerable commercial pressures to put a hedge on very quickly) then the Trade Confirmation sent out will normally state that both counterparts to the deal must use ‘best endeavours’ (a legal term as to the amount of effort used to achieve an agreement) to enter into an ISDA agreement. In the Confirmation it usually states that the derivatives trade is subject to the terms of an ISDA Master Agreement without a Schedule, so it is basically unamended. The lack of a Schedule, though, means that the two counterparts cannot make their own choices over key issues in the Master Agreement. These issues would include: choices over what triggers automatic early termination of derivatives deals, payment netting and methods, what happens if a company merges with another, termination currency, tax representations (regarding withholding taxes on settlement payments), credit support (any parent companies willing to support the credit exposure on the derivatives trades) and which entities are included in Specified Entities (the other companies that for the purposes of triggering a default are included in the agreement). The biggest risk for an organisation if it trades without an ISDA Agreement is that if the other counterpart goes into bankruptcy or liquidation, a liquidator could end up ‘cherry picking’ any profitable deals.

ISDA MASTER AGREEMENT SCHEDULE The ISDA Master Agreement Schedule basically states which sections of the Master Agreement will be in force between the two parties to the agreement. As this is the case, it is often the centre of much discussion and negotiation. Although ISDA Schedules will differ slightly from one another in commercial terms, there are still key parts that turn up again and again, so in this chapter we will go through an example of an ISDA

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Master Agreement between a bank and a non-financial institution energy trader. The ISDA Schedule is always executed (signed off) at the same date as the Master Agreement it refers to. If an organisation updates a Master Agreement Schedule at a later date and it has some OTC derivatives currently outstanding with the other firm under its old agreement, it is common practice for energy trading companies to backdate the new ISDA Schedule agreement with the same date as the old one so that old transactions are covered by the updated ISDA Schedule. The Schedule is made up of the following core sections: ■ ■ ■ ■ ■

Termination provisions Tax representations Agreement to deliver documents Miscellaneous Other provisions

In the following section, we go through an ISDA Master Agreement Schedule and note some of the key areas.

STEP BY STEP EXPLANATION OF A TYPICAL ISDA MASTER AGREEMENT SCHEDULE BETWEEN A TRADER AND A BANK AGREEMENT DATED AS OF 15 December 2002 BETWEEN ABC SMALL TRADER LIMITED (Party A) AND XYZ BANK LIMITED (Party B) [First of all, the Schedule names the two counterparts to the agreement: the two organisations (or groups) that want to trade with one another]

PART 1 TERMINATION In this Agreement: 1. ‘Specified Entity’ means in relation to Party A for the purpose of: Section 5(a)(v): [Default under specified transactions] Section 5(a)(vi): [Cross Default] Section 5(a)(vii): [Bankruptcy] Section 5(b)(iv): [Termination event – credit event upon merger]

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‘Specified Entity’ means in relation to Party B for the purpose of: Section Section Section Section

5(a)(v): 5(a)(vi): 5(a)(vii): 5(b)(iv):

Not Not Not Not

applicable applicable applicable applicable

[This is about Party B getting as much credit cover as possible against Party A in the event of defaults. In this example Section 5 XYZ Bank Ltd does not have to give these assurance back to ABC Small Trader Ltd. ABC Small Trader Ltd though is basically agreeing that if it defaults on any OTC contract with XYZ Bank, XYZ Bank has the right to close out all transactions under this agreement. Note that Credit Support providers of ABC Small Trader Ltd (e.g. its parent company) are automatically joined to this provision in the 1992 ISDA Master Agreement. The aim of the Specified Entity provision is to draw in those organisations whose capital is closely correlated with that of ABC Small Trader Ltd. Banks rarely offer this Specified Entity provision because most of the assets of its group will be in the bank itself and they see little point in opening themselves to the risk of ABC Small Trader Ltd, for example, closing out trades under this agreement through the default of a small bank subsidiary in another agreement with ABC Small Trader Ltd or one of its specified entities.]

2. ‘Specified Transaction’ will have the meaning specified in Section 14 of this Agreement. [Section 14 is in the Master Agreement and unless it states otherwise, which in this example it does not, it means any OTC Derivative transaction existing in another agreement between the parties to this Schedule or their Affiliates or specified entities. The bottom line is, if ABC Small Trader Ltd has lots of swaps and OTC options positions with XYZ Bank Ltd, and a subsidiary of ABC Small Trader Ltd called EFG Trader decides under another agreement with XYZ Bank Ltd to enter into a Swap with XYZ Bank Ltd, and this subsidiary EFG Trader then goes bust and defaults then, under this agreement, XYZ Bank Ltd could go back and close out ABC’s positions! Changes in Specified Transaction provisions are being proposed which could widen the scope beyond OTC transactions being in default to allow the party not in default to close out all transactions with the defaulting party.]

3. ‘Cross Default’: The provisions of Section 5(a)(vi) will apply to Party A and Party B. [This provision catches contractual terms and payment defaults in relation to borrowed money in agreements between the two parties to this ISDA agreement and their Specified Entities or Credit Support Providers with any third party. Such a default has to exceed a defined limit, termed the Threshold Amount. This means that if ABC Small Trader Ltd or any of its companies in its group, or any company that is providing Credit Support in this agreement to permit trading between ABC and XYZ, defaults on any agreement under which it has borrowed money, then XYZ Bank Ltd can close out the transactions under this ISDA Agreement.]

‘Specified Indebtedness’ will have the meaning specified in Section 14 of this Agreement except that (i) such term shall not include obligations

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in respect of deposits received in the ordinary course of a party’s banking business and (ii) there shall be added at the end thereof ‘or any money otherwise raised whether by means of issue of notes, bonds, commercial paper, certificates of deposit or other debt instruments, under financial leases, deferred purchase schemes or under any currency or interest rate swap or exchange agreement of any kind whatsoever or otherwise.’ [In this schedule XYZ Bank Ltd is extending what the borrowing of money is related to, e.g. noted, bonds, commercial paper or financial leases. XYZ Bank Ltd wants to protect itself against the higher risk of ABC Small Trader Ltd, working on the notion that a default somewhere else in some loan or lease etc. may be the early warning signs of a bankruptcy on its way. XYZ Bank Ltd then has the ability to close out its OTC positions and control its losses. In this section XYZ Bank has excluded the banking deposits it may receive from its bank customers, which is quite common. Technically, these deposits are money borrowed by the bank from its customers so some may argue over this. The usual problem faced by a bank is that its customer bank account deposits are very large and would easily breach any threshold amount level.]

‘Threshold Amount’ means with respect to Party A an amount of US$10,000,000 or the US dollar equivalent of any obligations stated in any other currency, currency unit or combination thereof, with respect to Party B, an amount equal to 5% of stockholders equity as of the end of its most recently completed fiscal year (or its equivalent in any currency). [The threshold amount is the amount of money or limit of specified indebtedness, below which XYZ Bank Ltd cannot trigger its close-out rights under this agreement’s Cross Default Clause. In this case, for ABC Small Trader Ltd, the limit is US$10,000,000. XYZ Bank Ltd is a huge entity and its capital base can be very variable, so instead of a fixed monetary amount, a formula based on a percentage of stockholders’ equity is used. This is quite common for Wall Street refiners, i.e. financial institutions trading in the energy derivatives markets.]

4. ‘Credit Event Upon Merger’: The provisions of Section 5(b)(iv) will apply to Party A and Party B as amended as follows: Whether, for the purposes of Section 5(b)(iv) of this Agreement, the resulting, surviving or transferee entity (hereinafter ‘Y’) is ‘materially weaker’ shall be a matter to be determined in the reasonable discretion of the other party. Notwithstanding the foregoing, the creditworthiness of Y shall not be determined to be materially weaker if Y agrees to and does within two local Business Days of demand provide Eligible Credit Support (as defined in the Credit Support Annex) in an amount equal to or in excess of the Delivery Amount (as defined in the Credit Support Annex) on the basis that the Threshold for Y shall be zero notwithstanding anything to the contrary in the Credit Support Annex and thereafter maintains such Eligible Credit Support in accordance with the Credit Support Annex as amended by this provision.

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[Sometimes, to avoid dispute, parties to an ISDA Schedule will be specific as to what ‘Materially weaker’ actually means for the purposes of their Schedule agreement. For example, ‘If either ABC Small Trader Ltd or XYZ Bank Ltd fails to maintain a long-term, unsecured and unsubordinated debt rating of at least BBB– as determined by Standard & Poor’s Ratings Group, or Baa3 as determined by Moody’s investors Service Inc. ’ These ratings are used because anything below these ratings is generally considered non-investment grade or perhaps even junk bond status. Terminology like this may be used in a Schedule between two large entities, perhaps two large banks. Enron almost certainly suffered as a result of OTC transactions being closed out when its rating was lowered, because others who had only put in their Schedule cover against default on a trade or borrowing of money had to wait while they saw Enron going down fast, but not defaulting on loans as banks tried to bail them out. Needless to say what defines a ‘Default’ has been under great scrutiny in the world of OTC derivatives since Enron.]

A credit Event shall also occur if: (a) any person or entity acquires directly or indirectly the beneficial ownership of equity securities having the power to elect a majority of the board of directors of X, any Credit Support Provider of X or any applicable Specified Entity of X or otherwise acquires directly or indirectly the power to control their policy making decisions; or (b) X, any Credit Support Provider of X or any applicable Specified Entity of X enters into any agreement providing for any of the Credit Events specified in Section 5(b)(iv) of the Agreement or in clause (a) above. 5. The ‘Automatic Early Termination’ provision of Section 6(a) will apply to Party A and Party B. [Automatic Early Termination – impacts Events of Default on Bankruptcy. The effect of this provision is that all Transactions under the agreement are deemed terminated as of a date immediately before a winding-up order is presented against the Defaulting Party and immediately at the time bankruptcy proceedings are instituted against the Defaulting party in all other cases. This means that the nondefaulting party can exercise its rights outside the insolvency proceedings. 80% of the time having this section included in a Schedule is a choice. There are some countries, though, where it is advisable to use this section 6(a) – a fully updated list of countries is available from ISDA (http://www.isda.org/).]

6. Payments on Early Termination. For the purpose of Section 6(e) of this Agreement: (i) The Market Quotation Method will apply. (ii) The Loss Method will apply. (iii) The Second Method will apply. [In the energy markets there are three choices on how to calculate the amount owed between the counterparts in the event that contracts are terminated early and payment is required: the Market Quotation Method, the Loss Method, and the Second Method. The Market Quotation Method is very popular as it is simple to use for plain vanilla instruments such as fixed for floating swaps, where there is typically good

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liquidity. It involves obtaining a series of usually three or four quotations from market makers (not brokers) for the replacement value of the derivatives to be terminated. If the derivatives to be terminated are more complex than plain vanilla swaps, you could encounter problems obtaining reasonable quotes from the market makers, in this circumstance loss could be used as a Fallback and put in the Schedule as a Fallback provision. Loss is the non-defaulting party’s ‘good faith’ determination of its losses and costs (minus its gains) in respect of replacing terminated transactions. Last but not least, the Second Method basically means the defaulting party has to pay anything it owes to the non-defaulting party, but if the non-defaulting party owes the defaulting party money it has no obligation to pay any amount to the defaulting party until it has received confirmation that all transactions have been terminated under this schedule, and that all obligations (matured or unmatured) of the defaulting party or any of its affiliates to the non-defaulting party or any affiliate of the non-defaulting party has been made.]

7. ‘Termination Currency’ means the currency selected by the party which is not the Defaulting Party or the Affected Party, as the case may be, or where there is more than one Affected Party the currency agreed by Party A and Party B. However, the Termination Currency shall be one of the currencies in which payments are required to be made in respect of Transactions. If the currency selected is not freely available, or where there are two Affected Parties and they cannot agree on a Termination Currency, the Termination Currency shall be United States Dollars. [Simply, the currency into which all derivatives transactions are converted to on close out and settlement. The above Section 7 illustrates very common wording in ISDA Schedules. It allows the non-defaulting to choose the currency. If the currency chosen for any reason is not freely available then the Schedule defaults to US dollars.]

8. ‘Additional Termination Event’ shall apply as follows: [Additional termination events include: Change of Control, Ratings Downgrade (like in the case of Enron), even Death or resignation of key staff (if you are dealing with a small entity or one controlled perhaps by key management), breach of agreements, sovereign event (maybe if you are dealing with a company that is based in a politically less stable region). This example Schedule shows Change of Ownership example wording and also wording for Ratings Downgrade.]

Change of Ownership. Mega Corporation either directly or indirectly ceases to own directly or indirectly 51% of the issued share capital of ABC Small Traders Ltd carrying voting rights in ordinary circumstances in a general meeting of shareholders or a comparable meeting of ABC Small Trader Ltd or otherwise directly or indirectly ceases to control the board of directors of ABC Small Trader Ltd and or ABC Small Trader Ltd cease to be a fully consolidated subsidiary of Mega Corporation. Downgrade (i) S&P or Moody’s or both rate the long term, unsecured, unsubordinated debt obligations of ABC Small Trader Ltd or

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XYZ Bank Ltd at least three modifiers (a modifier being 1, 2, or 3 for Moody’s or plus, neutral, minus for S&P) lower than the highest rating which had previously applied (from the date of this agreement) to the long term unsecured, unsubordinated debt obligations of ABC Small Trader Ltd, or XYZ Bank Ltd. (ii) ABC Small Trader Ltd or XYZ Bank Ltd cease to be rated by both S&P and Moody’s. For the purposes of the foregoing Termination Event, the affected party shall be the party that was downgraded or ceased to be rated. [This is self explanatory: if the rating gets too badly affected than OTC derivatives contracts under this agreement can be terminated by the ‘Affected’ party.]

PART 2 TAX REPRESENTATIONS [Tax representations are left over from the early years of OTC derivatives when there was even uncertainty in the USA as to whether a payer’s tax authority would levy a withholding tax on settlement payments made on OTC swaps transactions. The ISDA agreement covers both counterparts against any with-holding tax ever being required to be paid on any derivative settlements via Section 2(d) (i) (4) of the Master Agreement which makes it the responsibility of the payer (the company sending the payment) to ensure that the payee (the company receiving the payment) gets full payment. The payer must gross up the payment to the payee so that the payee receives, after deduction of the payer’s jurisdictional withholding tax, the full settlement required on the derivatives trade. I have only come across one such jurisdiction where there was a clear withholding tax issue for energy derivatives: Thailand. Any organisation entering into an ISDA agreement with a new counterpart should get a legal opinion on the country that they are going to be dealing through.]

Payer Tax Representations 1. For the purpose of Section 3(e) of this Agreement, both parties make the following representation: It is not required by any applicable law, as modified by the practice of any relevant governmental revenue authority, of any Relevant Jurisdiction to make any deduction or withholding for or on account of any Tax from any payment (other than interest under Section 2(e), 6(d)(ii) or 6(e) of this Agreement) to be made by it to the other party under this Agreement. In making this representation, it may rely on: [Relevant jurisdiction in the ISDA Schedule refers to the payer’s home jurisdiction, where the office actually executing the trades is based, the jurisdiction where it executed the Agreement and also the jurisdiction from which it makes payments including settlement payments for any transactions under this agreement.]

(i) the accuracy of any representation made by the other party pursuant to Section 3(f) of this Agreement; and (ii) the satisfaction of the agreement of the other party contained in Section 4(a)(i) or 4(a)(iii) and the accuracy and effectiveness of

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any document provided by the other party pursuant to Section 4(a)(i) or 4(a)(iii) of this Agreement; and (iii) the satisfaction of the agreement of the other party contained in Section 4(d). Provided that it shall not be a breach of this representation where reliance is placed on Clause (ii) and the other party does not deliver a form or document under Section 4(a)(iii) by reason of material prejudice to its legal or commercial position. [The Payer Tax representation actually does not include default interest payments or any interest that could be charged due to an early termination payment. This Payer Tax Representation section is very standard, and there are a few jurisdictions where ISDA may not have been tested and some where overseas payment and or tax regulations have been outpaced by the local adoption of derivatives instruments usage. If it does not appear in an ISDA Schedule you are being asked to agree to, query it!]

Payee Tax Representations 2. For the purpose of Section 3(f), both parties make the following representation: Each payment received or to be received by it in connection with this Agreement relates to the regular business operations of the party (and not to an investment of the party). [This section is not always included because of the existence of many double tax treaties around the world which have income and interest provisions giving protection against withholding taxes.]

OTHER REPRESENTATIONS 1. Each party represents and warrants to the other (which shall be deemed to be repeated by each party on each date on which a Transaction is entered into) that: (a) There has been no material adverse change in its financial condition since the last day of the period covered by its most recently prepared audited financial statement and that ‘Accuracy of Specified Information’ as provided for in Section 3(d) will apply to the financial information which a party is required to deliver to the other party under this Schedule. (b) It is entering into this Agreement and each Transaction as principal (and not as agent or in any other capacity, fiduciary or otherwise). 2. Each party will be deemed to represent to the other party on the date on which it enters into a Transaction that (absent a written agreement between the parties that expressly imposes affirmative obligations to the contrary for that Transaction): (a) Non-Reliance. It is acting for its own account, and it has made its own independent decisions to enter into that Transaction and as to whether that Transaction is appropriate or proper for it based

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upon its own judgment and upon advice from such advisers as it has deemed necessary. It is not relying on any communication (written or oral) of the other party as investment advice or as a recommendation to enter into that Transaction; it being understood that the information and explanations related to the terms and conditions of the Transaction shall not be considered investment advice or a recommendation to enter into that Transaction. No communication (written or oral) received from the other party shall be deemed to be an assurance or guarantee as to the expected results of that Transaction. (b) Assessment and Understanding. It is capable of assessing the merits of and understanding (on its own behalf or through independent professional advice), and understands and accepts, the terms, conditions and risks of that Transaction. It is also capable of assuming, and assumes, the risks of that Transaction. (c) Status of Parties. The other party is not acting as a fiduciary for or an adviser to it in respect of that Transaction. 3. Absence of Litigation. Section 3(c) of the Agreement is hereby amended by limiting the definition of ‘Affiliate’ for the purposes of this representation to such Affiliates, if any, as may be a Specified Entity for purposes of Section 5(a)(v). PART 3 DOCUMENTS TO BE DELIVERED For the purpose of Section 4(a)(i) and (ii) of this Agreement each party agrees to delivery of the following documents, as applicable: [Below is a standard list of documents often required by banks entering into an ISDA Agreement with a corporate entity before trading begins. Here it will also note what documents are exchanged after each derivatives trade/transaction. A certified copy of a board resolution authorising execution of the agreement is very important to get hold of, otherwise trade conducted may not be enforceable on one or both parties to the agreement. In practical terms, counterparts may say that it will take 3 months or more to get a Board resolution due to the infrequency of the Board of Directors meeting, but it is worth waiting for.]

Party required to deliver Document Party A

Form/Document/ Certificate

Date by which to Covered by be delivered Section 3(d) Representation

A certified copy of a board resolution authorising the execution, delivery and performance of this

On or before execution hereof and if any change in authority has

Yes

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Party A

Party A

Agreement and each Confirmation executed hereunder together with the names, titles and specimen signatures of the persons entitled to execute this Agreement and each Confirmation executed hereunder. In respect of each transaction an accepted Confirmation signed by an authorised signatory. A capacity certificate in the form attached to this Agreement as Appendix A.

occurred prior thereto, on or before the execution of each Confirmation.

Within 24 hours Yes of receipt of the relevant Confirmation from Party B. On or before Yes execution hereof.

PART 4 MISCELLANEOUS [Don’t be fooled by the term ‘Miscellaneous’; it is still important. In Part 4 parties set out their contact details for notices, mainly for admin purposes.]

1. Address for Notices. For the purpose of Section 12(a): Address for notices or communications to Party A: ABC Small Trader Address: Canary Wharf, London Attention: United Kingdom Telex No: 12345 Answerback: ABCSTrader Facsimile No: +44 123 456789 Telephone No: Address for notices or communications to Party B: Address: Attention: Telex No: Facsimile No:

XYZ Bank Limited, Bank of England Road, London, United Kingdom Swaps Back Office (Confirmations only) Mr N. Leeson (All other notices or communications) 98238 XYZ +44 207 681 1201 Telephone No: +44 207 12345678

2. Process Agent. For the purpose of Section 13(c): [A process agent will usually need to be appointed if a party is not incorporated in England, if the ISDA is under English Law (which is the preferred industry norm for the majority of OTC energy contracts outside the USA) or not incorporated in New York for a New York Law-based agreement. So if an organisation does not have an office or is

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not incorporated in these jurisdictions, it will need to nominate an organisation or lawyer in London or New York to act on its behalf. A process agent receives writs or termination notices or other legal documentation associated with the ISDA agreement.]

Party A appoints as its Process Agent: Party B appoints as its Process Agent: Not applicable [Not applicable for Party B indicated that XYZ Bank Ltd is incorporated in England (as this example is under English law), or it would indicate that it was incorporated under New York law if this contract was under New York Law. XYZ Bank can accept legal notices directly it does need a Process Agent.]

3. Offices. The provision of Section 10 (a) will not apply. [Section 10a provides that if one of the companies signing this Schedule enters into a derivatives trade through one of its branches, its obligations will be the same as if it had executed the trade through its Head Office.]

4. Multibranch Party. For the purpose of Section 10(c): Party A is not a Multibranch Party. Party B is not a Multibranch Party. [If Section 10c did apply then it would mean that both companies signing this Schedule were effectively providing an implied payment guarantee for any derivatives trades that their branch offices entered into. The benefit of Multibranch is that an organisation, via one ISDA agreement with its Head Office, can permit all is branches to trade with the other counterpart to this ISDA Schedule. It would look like this: ‘(d) Multibranch Party. For the purposes of Section 10 (c) of this agreement: Party A is a Multibranch and may act through the following Offices: Tokyo, Singapore, Frankfurt, London, New York, Houston.’ Party B can also put down whether it wants to use Multibranch or not.]

5. Calculation Agent. The Calculation Agent is Party B, unless otherwise specified in a Confirmation in relation to the relevant Transaction. [This is the counterpart in the agreement that has to determine the floating rate values and calculate payments. It is usual for a financial institutional trader like a bank to insist that it is the Calculation Agent where the agreement is with a corporate hedger or non-financial institution trader. Whoever is not the Calculation Agent will always have to double check the Calculation Agent’s figures and can dispute any big differences. Most of the time with Platts price-related energy derivatives, any difference in calculations often arises from the Calculation Agent simply not picking up on a change of the Platts price for a particular day, as the correction of the price may have been published much later in the contract month. If two counterparts cannot agree on who will be the calculation agent, they can agree to both be calculation agents, i.e. co-calculation agents. The Calculation Agent also has to establish whether a ‘Market Disruption Event’ has occurred and remedy it (see Section 5 later on in this example Schedule).]

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6. Credit Support Document. Details of any Credit Support Document: In respect of Party A: Parental Guarantee Dated 10th December 2002 In respect of Party B: Not applicable [This is where any form of unconditional and irrevocable credit support against derivatives transactions under this ISDA Schedule is specified. For example, in OTC Energy Swaps, the majority of companies utilise ‘irrevocable standby letters of credit (LCs)’ from a bank, a ‘bank guarantee’ or (less often) Parental Guarantees from their parent holding company, if a subsidiary. In this example Party A which is ABC Small Trader Ltd is offering a parental guarantee from its Parent ‘Mega Corporation’.]

7. Credit Support Provider Credit Support Provider means in relation to Party A: Mega Corporation [Mega Corporation is the parent company offering the Parental Guarantee noted in paragraph 6 above so it is named here.]

Credit Support Provider means in relation to Party B: Not applicable 8. Governing Law. This Agreement will be governed by and construed in accordance with the laws of England. [This example is showing English law – as mentioned earlier in the chapter, the two key laws and jurisdictions used are English and New York State in the USA. Any other jurisdictions should be avoided unless an organisation is prepared to get legal advice on the effect that the new jurisdiction’s law will not have an adverse impact on ISDA provisions and the Master Agreement. ISDA contracts are already well tested under English and New York State law. For reference, if this example ISDA Schedule were under New York Law, paragraph 8 would read ‘ This Agreement will be governed by and construed in accordance with the laws of the State of New York (without reference to choice of law doctrine).]

9. Netting of Payments. Subparagraph (ii) of Section 2(c) of the Agreement will not apply to all Transactions under this Agreement starting from the date of this Agreement. [This provision is where the counterparts choose the scope of payment netting to be applied to the agreement. The wording that is chosen is often limited by how advanced their risk management systems are. An organisation should not feel pressurised into any complex netting of payment wordings. Organisations should liaise with their Back Office to ensure systems can automate the netting required, or if not, that they are prepared to allocate human resources to process it. The wording in this example is the standard chosen by default by the majority of banks and traders in the energy derivatives arena. When ‘Subparagraph (ii) of Section (c) applies (as above)’ it means that ‘Single Transaction Netting’ applies. Single Transaction Netting = Same product, same currency, and same value date. This means that the two parties to this Schedule do not have to make payments to each other, but the one who owes the most money has to pay the difference between the two amounts to the other counterpart.

The other choices organisations can make on payment/settlement netting are:

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Cross-product netting For more than one derivatives trade, for different products, in the same currency and due for payment on the same date. Multiple transaction netting For more than one derivatives trade of the same type, in the same currency and due for payment on the same date.

If an organisation wants to leave its options open, starting with the simplest form of netting and then, if it can handle it operationally later on, move on to more complex netting, it could agree with its counterpart on the following wording: ‘Netting of Payments. (i) Subparagraph (ii) of Section 2 (c) will apply to all transactions under this agreement unless otherwise specified in a Confirmation in relation to the relevant transaction.’]

PART 5 OTHER PROVISIONS The following changes are made to this Agreement: 1. Definitions. This Agreement incorporates, and is subject to and governed by, unless otherwise specified in a Confirmation, the 2000 ISDA Definitions published by the International Swaps and Derivatives Association, Inc. (the ‘2000 Definitions’) and the 1993 ISDA Commodity Derivatives Definitions (‘1993 Definitions’). In the event of any inconsistency between the provisions of this Agreement and the 2000 Definitions and/or the 1993 Definitions, this Agreement will prevail. In the event of any inconsistency between the provisions of the 2000 Definitions and the 1993 Definitions, the 1993 Definitions will prevail. In the event of any inconsistency between the provisions of any Confirmation and this Agreement or the 2000 Definitions or the 1993 Definitions, such Confirmation will prevail for the purpose of the relevant Transaction. In the event of any inconsistency between the provisions of this Schedule and the Agreement this Schedule shall prevail. [Earlier in the chapter some of ISDA’s booklets were mentioned, some of which have a listing of definitions. This example Schedule operates under the latest year 2000 ISDA definitions and the 1993 ISDA Commodity Derivatives provisions, which cover Energy OTC derivatives transactions/trades.]

2. Change of Account. At the end of Section 2(b) add the following words: ‘provided that, if any new account of the notifying party is not in the same jurisdiction as the original account, the other party shall not be obliged to pay any greater amount and shall not receive any lesser amount as a result of such change than would have been the case if such change had not taken place.’ [Under the ISDA Master Agreement, both parties can give each other five local business day’s notice of a change of their banking account details for payments. The reason this Paragraph 2 has been included in this schedule example is to protect both parties from potential withholding tax charges and Foreign Exchange controls that

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might arise from the other counterpart moving its bank account to another jurisdiction.]

3. Pari Passu. Party A hereby agrees that it will ensure that its payment and delivery obligations under this Agreement rank at all times at least pari passu in all respects with all of its other unsecured and unsubordinated obligations (except for those which are mandatorily preferred by operation of law. [In this example XYZ Bank is getting ABC Small Trader Ltd to ensure that any unsecured debt it owes to XYZ Bank through settlement payments due on trades under this ISDA contract will rank equally with other unsecured and unsubordinated obligations in any winding up (liquidation) of ABC Small Trader Ltd. It is very important for corporates to understand this clause, as it can only be given if it is true. Advice should be taken on this clause if it turns up in a Schedule being proposed by another counterpart.]

4. Confirmations. Each confirmation shall be in the standard form used by Party B from time to time or in such other form as the parties may agree. With respect to each Transaction, Party B shall on, or promptly after the Trade Date, send Party A a Confirmation. Party A shall promptly sign and return a copy of the Confirmation or advise any discrepancy between the Confirmation and Party A’s own records whereupon the parties will promptly agree on the text of a replacement Confirmation for signature by Party A. [Self explanatory. However, it is worth noting that more and more wording for the acceptance of electronic confirmations in the energy trading industry is being placed into ISDA Schedules. Several organisations have launched electronic confirmations systems for Energy Swaps deals. These include SwapNet (http://www.swapnet.net/) working with Garban Intercapital and TFS, which are both OTC derivatives brokers, and launched a system called ‘Energy Checkpoint’. Intercontinental Exchange (http://www.theice.com/) has also launched an electronic confirmation system for trades executed via its ICE platform. NYMEX (http://www.nymex.com/) has electronic confirmation of OTC deals registered via its online system. Example wording to allow acceptance of Electronic Confirmations: ‘Electronic Confirmations. Where a Transaction is confirmed by means of an electronic messaging system that the parties have elected to use to confirm such Transaction such confirmation will constitute a ‘Confirmation’ as referred to in this agreement’.]

5. Automatic Early Termination. If Automatic Early Termination is specified as applying to a party in Part 1 paragraph 5 above, that Party shall upon the occurrence of an Event of Default notify it immediately to the other Party and provided further that Automatic Early Termination shall not apply to either party if the Event of Default concerned is the presentation of a winding up petition which is withdrawn without advertisement. In the event of absence of such notice on the day of the occurrence of the Event of Default, the Defaulting Party shall fully indemnify the Non-defaulting Party on demand against all expense,

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loss, damage or liability that the Non-defaulting Party may incur in respect of this Agreement and each Transaction as a consequence of movements in interest, currency, exchange or other relevant rates or prices between the Early Termination Date and the local Business Day on which the Non-defaulting Party first becomes aware that the Early Termination Date has occurred under Section 6 (a). The Non-defaulting Party may for this purpose convert any expense, loss, damage or liability to the Termination Currency. 6. Early Termination. At the end of Section 6 add the following Sections 6(f) and (g): ‘(f) Conditions of Certain Payments. Notwithstanding the provisions of Section 6(e), the Non-defaulting Party shall have no obligation to make any payment on Early Termination to the Defaulting Party unless and until the Non-defaulting Party shall have received confirmation satisfactory to it in its sole discretion (which may include an unqualified opinion of its counsel) that (i) in accordance with Section 6(c)(ii) of the Agreement, no further payments or deliveries under Section 2(a)(i) or 2(e) in respect of Terminated Transactions will be required to be made and (ii) each Specified Transaction shall have terminated pursuant to its specified termination date or through the exercise by a party of a right to terminate and all obligations owing under each such Specified Transaction shall have been fully and finally performed; and (g) (i) Without affecting the provisions of this Agreement requiring the calculation of certain net payment amounts, all payments under this Agreement will be made without set-off or counterclaim; provided, however that any amount (the ‘Early Termination Amount’) payable to one party (the Payee) by the other party (the Payer) under Section 6 (e) in circumstances where there is a Defaulting Party or one Affected Party in the case where a Termination Event under Section 5 (b) (i) to (v) inclusive has occurred, will, at the option of the party (‘X’) other than the Defaulting Party or the Affected Party (and without prior notice to the Defaulting Party or Affected Party), be reduced by its set-off against any amount(s) (the ‘Other Agreement Amount’) payable (whether at such time or in the future or upon occurrence of a contingency) by the Payee to the Payer (irrespective of the currency, place of payment or booking office of the obligation) under any other agreement(s) between the Payee and the Payer or instrument(s) or undertaking(s) issued or extended by one party to, or in favour of, the other party (and the Other Agreement Amount will be discharged promptly and in all respects to the extent it is so set-off). X will give notice to the other party of any set-off effected under this Section.

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(ii) For this purpose, either the Early Termination Amount or the Other Agreement Amount (or the relevant portion of such amounts) may be converted by X into the currency in which the other is denominated at the rate of exchange at which X would be able, acting in a reasonable manner and in good faith, to purchase the relevant amount of such currency. (iii) If an obligation is unascertained, X may in good faith estimate that obligation and set-off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained. (iv) Nothing in this Section 6(g) shall be effective to create a charge or other security interest. This Section 6(g) shall be without prejudice and in addition to any right of set-off, combination of accounts, lien or other right to which any party is at any time otherwise entitled (whether by operation of law, contract or otherwise).’ 7. Transfer. Rights and obligations under this Agreement or any Transaction may not be transferred, in whole or in part, except upon the prior written consent of both parties and any such transfer made without such consent shall be void. [Often counterparts, for reassurance that the other party will accept a reasonable transfer of rights and obligations under the ISDA Agreement, will insert the following sentence: ‘which consent shall not be unreasonably withheld’.]

8. Default Rate. The Default Rate shall mean 1% over LIBOR compounded on a daily basis where ‘LIBOR’ on any day shall mean the one-month London Interbank Offered Rate as reported in The Financial Times or if the Financial Times ceases publication temporarily or permanently, such other newspaper published in London as Party B may determine. [If one of the Counterpart defaults on a payment then the other counterpart is entitled to charge interest on monies owed.]

9. Physical Delivery. Unless specifically stated to the contrary in a signed Confirmation, no physical delivery by either party shall take place under the terms of this Agreement and Transactions entered into hereunder shall be settled in cash only. [ISDA OTC derivatives trades in energy are all cash settled.]

10. Telephone Recording. Each party to this Agreement acknowledges and agrees to the electronic recording of telephone conversations between the parties (including any director, officer, employee, agent or representative thereof) and whether by one or other or both of the parties and that any such recording may be submitted in evidence to any court or in any proceedings for the purpose of establishing any matters pertinent to any Transaction.

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[Electronic trading platforms are making progress in penetrating the OTC Energy market, but outside the USA, the market practice is still generally to trade over the telephone. Consent has to be given to telephone recordings if they are to be used for any legal purposes in the future.]

11. Designated Account Details for US Dollar Payments. (a) In the case of Party A: As specified by Party A when returning the Confirmation from Party B. [Or the counterpart can state its banking details under this agreement it can change them in the future by giving 5 local business days notice.]

(b) In the case of Party B: Name of Bank: XYZ Bank Ltd Account Number: 08231-89178236-73624-02 Account Name: XYZ Bank Derivatives Receipts 12. ‘Market Disruption Event’ means the occurrence of any of the following events in the reasonable determination of the Calculation Agent: (a) Price Source Disruption; [If a settlement price is not available for some reason, e.g. not published by the reference agency like Platts on a day it would normally be available.]

(b) Trading Suspension; [A look-a-like Swap would settle, for example, against a Futures Market settlement price each day during the pricing period if the Futures Market was suspended.]

(c) Disappearance of Commodity Reference Price; [If a publisher stops publishing, the price reference counterparts are using as the floating price reference on a derivative trade.]

(d) Material Change in Formula; (e) Material Change in Content; (f) Trading Limitation. 15. Disruption Fallbacks relating to Commodity Transactions: The following Disruption Fallbacks (as defined in the 1993 Commodity Definitions) shall be applicable in each case in the order in which they appear: (i) in respect of any Transaction having a Calculation Period or Calculation Periods which are greater than or equal to one calendar month: (a) Average Daily Price Disruption, with Maximum Days of Disruption equal to five; (b) Fallback Reference Price; (c) Negotiated Fallback; (d) The Parties shall appoint a single independent expert to determine an alternative pricing method. If the parties fail to

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agree on the appointment of an expert, the Chairman for the time being of the Institute of Petroleum in the United Kingdom shall be requested by either party to make such appointment within 2 days of request. An expert, if appointed, shall be deemed not be an arbitrator but shall render his decision as an expert and his determination shall be final and binding upon both parties save in the event of manifest error or fraud; and [In this example Schedule, where everything else fails, both Parties will in the end approach the Chairman of the Institute of Petroleum to be an expert to establish the price.]

(e) No Fault Termination. (ii) in respect of any Transaction having a Calculation Period or Calculation Periods which are less than one calendar month: (a) Average Daily Price Disruption, provided that the Maximum Days of Disruption shall be zero where the Calculation Period is less than or equal to two Commodity Business Days; one, where the Calculation Period is between three and five Commodity Business Days inclusive; two where the Calculation Period is between six and ten Commodity Business Days inclusive; three, where the Calculation Period is between eleven and fifteen Commodity Business Days inclusive; and four, where the Calculation Period is greater than sixteen Commodity Business Days inclusive; (b) Fallback Reference Price; (c) Negotiated Fallback; (d) The Parties shall appoint a single independent expert to determine an alternative pricing method. If the parties fail to agree on the appointment of an expert, the Chairman for the time being of the Institute of Petroleum in the United Kingdom shall be requested by either party to make such appointment within 2 days of request. An expert, if appointed, shall be deemed not be an arbitrator but shall render his decision as an expert and his determination shall be final and binding upon both parties save in the event of manifest error or fraud; and (e) No Fault Termination. All determinations and calculations hereunder by the Calculation Agent shall be made in good faith, in the exercise of its commercially reasonable judgement and only after consultation with the other party. 16. Commencement Date. This Agreement is deemed to have come into effect on 15th December 2002.

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ABC Small Trader Limited XYZ Bank Limited By: By: Name: Name: Title: Title: By: Name: Title:

By: Name: Title:

[End of ISDA schedule example]

ADDITIONAL NOTES Withholding tax and ISDA Counterparts should do detailed legal and tax analysis at the start of their business relationship to ensure that no withholding tax is likely to be charged in any of the jurisdictions through which the counterpart proposes to trade OTC derivatives. ISDA’s legal infrastructure makes provisions against being caught out by withholding tax by making the counterpart pay the net amount. (Net of any taxes payable in their home country.) Netting and ISDA agreements The ISDA Master Agreement has established international contractual standards governing privately negotiated derivatives transactions that reduce legal uncertainty and allow for reduction of credit risk through netting of contractual obligations. Ensuring the enforceability of the netting provisions of the ISDA Master Agreement remains a key initiative for ISDA, because of its importance in reducing the credit risk arising from the OTC derivatives business. ISDA’s work in this area has resulted in a series of laws being passed in various countries that ensure legal certainty surrounding the process of netting in those nations. Around 36 countries have already confirmed acceptance of netting procedures in OTC transactions via the ISDA Master Agreement, and this number continues to grow. See ISDA’s website (http://www.isda.org/) for regular updates on country legal opinions.

PROPOSED ISDA CHANGES Many changes are proposed to the ISDA agreements and more will surely follow in the wake of the Enron collapse, although it is difficult to predict precisely what these might be. At the time of writing, the general view is

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hat key changes may be in what constitutes ‘Default’ and other clauses related to this. ISDA is trying to produce a new 2002 version of ISDA to replace the 1992 version. The main clauses in the new 2002 version proposed are as follows: ■

■

■ ■

■ ■

Change in ‘default’ grace period from 3 days to 1. Some agree with this as risk is reduced. Others disagree, as there is insufficient time to take action and any delay would result in a disadvantage in the market if others call a default before you. Expect a move to 1 or 3 days with a grace period for errors or technical faults Extension of default under ‘specified transactions’ – in the past it was always understood that if you defaulted on one of your OTC Energy derivatives contracts with a counterpart you were automatically in default with that counterpart on your entire position with that counterpart. The proposed changes mean that if a party defaults under any broad range of transactions, it triggers a default under ISDA of all trades. If this is adopted into a new ISDA Master agreement and you are party to an agreement under it, it could mean that if you default on an OTC energy derivative with your counterpart, you could end up being in default on all your other deals with that counterpart e.g. futures contracts, forex contracts, bond repos, or whatever is put in as ‘specified transactions’ in the agreement. If a party has no outstanding obligations, it cannot call a default against the other party, even if that other party defaults with someone else. Merger event wording could be extended to cover additional takeover situations and organisation changes, capital restructure etc. If a company gets taken over by another firm or restructures this may effect credit ratings, and if the wording in the ISDA agreement permits, counterparts could be able to terminate deals, cancel deals or at the very least call in collateral. New force majeure event – results in termination of trades under ISDA. Change to method of calculation of trades upon default. Most participants currently have ‘market quotes from leading market makers’ or if this fails, they resort to loss (i.e. calculate the loss; this needs to be reasonable and proof will be required, etc.). ISDA is proposing a third method: ● ‘Replacement Value’ means, with respect to each Terminated Transaction or group of Terminated Transactions, as the case may be, and a Determining Party, an amount that the Determining Party or its agent determines in good faith using commercially reasonable procedures to be the amount of the costs (expressed as a positive number) or gains (expressed as a negative number) of the Determining Party that would be incurred or realised to replace, or to provide the economic equivalent of the remaining payments, deliveries or option rights in

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respect of, that Terminated Transaction or group of Terminated Transactions. A Determining Party (or its agent) may determine Replacement Values for all Terminated Transactions, any group of Terminated Transactions or individual Terminated Transaction, and may apply different valuation methods to different Transactions or groups of Transactions, but, in aggregate, the Determining Party (or its agent) will determine Replacement Values for not less than all Terminated Transactions. Each Replacement Value shall be determined as of the relevant Early Termination Date, or, if that would not be commercially reasonable, as of the latest date or dates before or the earliest date or dates after the Early Termination Date as would be commercially reasonable under then prevailing circumstances. A Determining Party (or its agent) may determine a Replacement Value by reference to information either available to it internally (including from any Affiliates) or supplied by one or more third parties including, without limitation, quotations (either firm or indicative) of relevant rates, prices, yields, yield curves, volatilities, spreads or other relevant market data in the relevant markets. If information is obtained from internal sources, it should be the same type of information as used by the Determining Party for the valuation of similar transactions for purposes of its own books and records. A Determining Party (or its agent) may use such information to determine a Replacement Value either directly or through application to such information of pricing or other valuation models that are used by the Determining Party in pricing or valuing similar transactions at the time of the determination of Replacement Value. Third parties supplying such information may include, without limitation, dealers in the relevant markets, end-users of the relevant product, information vendors, [brokers] and other sources of market information that are used by the Determining Party in pricing or valuing similar transactions at the time of the determination of Replacement Value. A Determining Party (or its agent) may take into account, or may require third parties supplying such information to take into account, the current creditworthiness and relevant documentation and credit policies of the Determining Party, the size of the Terminated Transaction or Terminated Transactions, market liquidity and other factors relevant under then prevailing circumstances. [!] A Determining Party’s (or its agent’s) determination of Replacement Value may reflect one or more of the following, but without duplication: (a) any cost or gain (whether or not incurred or realised) of entering into one or more transactions that would have the effect of preserving for the Determining Party the economic equivalent of payments, deliveries or option rights in respect of such Terminated Transaction or

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group of Terminated Transactions that would, but for the occurrence of the relevant Early Termination Date, have been required or exercisable Terminated Transactions, any group of Terminated Transactions or individual Terminated Transaction, and may apply different valuation methods to different Transactions or groups of Transactions, but, in aggregate, the Determining Party (or its agent) will determine Replacement Values for not less than all Terminated Transactions. Each Replacement Value shall be determined as of the relevant Early Termination Date, or, if that would not be commercially reasonable, as of the latest date or dates before or the earliest date or dates after the Early Termination Date as would be commercially reasonable under then prevailing circumstances. A Determining Party (or its agent) may determine a Replacement Value by reference to information either available to it internally (including from any Affiliates) or supplied by one or more third parties including, without limitation, quotations (either firm or indicative) of relevant rates, prices, yields, yield curves, volatilities, spreads or other relevant market data in the relevant markets. If information is obtained from internal sources, it should be the same type of information as used by the Determining Party for the valuation of similar transactions for purposes of its own books and records. A Determining Party (or its agent) may use such information to determine a Replacement Value either directly or through application to such information of pricing or other valuation models that are used by the Determining Party in pricing or valuing similar transactions at the time of the determination of Replacement Value. Third parties supplying such information may include, without limitation, dealers in the relevant markets, end-users of the relevant product, information vendors, [brokers] and other sources of market information that are used by the Determining Party in pricing or valuing similar transactions at the time of the determination of Replacement Value. (b) any cost of funding; or (c) any loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position (or any gain resulting from any of them), whether in one or a group of transactions. Unpaid Amounts in respect of a Terminated Transaction or group of Terminated Transactions and legal fees and out-of-pocket expenses referred to in Section 11 are to be excluded in all determinations of Replacement Value but payments or deliveries that would, but for the relevant Early Termination Date, have been required (assuming satisfaction of each applicable condition precedent) after the Early Termination Date may be included

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THE ADVENT OF INDEPENDENT SOURCES OF DATA THAT CAN BE APPLIED TO REPLACEMENT VALUE CALCULATIONS The introduction of independent forward curve valuation and value reports by companies such as Totem Risk (http://www.totem-risk.com/) and McGraw-Hill Platts (http://www.platts.com/) Platts Forward Curve – PFC help the market have a source of backup pricing information, in case ‘replacement value’ is introduced.

ARBITRATION Main causes of disputes in contracts There is a lot of information available on how to ensure that a company is covered legally in contracts, and most of the time people try to avoid thinking about ever having a dispute. But disputes are unavoidable from time to time and it is important to know how to deal with these situations. Of course, how disputes are handled will depend on the relationship between the two (or more) organisations involved. However, it is possible to give some basic guidance on this. History has shown that the most common causes of disputes are as follows: 1. Documentation or exchanges of communication which have not been carefully drafted. 2. Ambiguous terms of a contract. 3. Material omissions or even misunderstandings among the parties to the contract. 4. Language may be a problem. If documentation is translated into other languages, make sure the documentation includes a note stating which contract in which language is the legally binding contract and that any other language translations are just for information purposes. Disputes have occurred in the energy markets because one party thought the English version was the binding version and the other party, who also signed the English version, had based their signing of this version on the foreign language translation provided by the other party. Situations like these can create all sorts of legal headaches. 5. Early termination of a contract. The start of a dispute – what can be done? Of course, every dispute will be different in some way, but there are a few key points that should be considered. First, does the contract mention the subject of dispute?

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If it does then there is a course of action to follow with the counterpart(s) to the deal. Second, is the resolution of disputes mentioned in the contract? Third, know your organisation’s aims. In other words, you should know what your objectives are in this situation. Your concerns here might include: ■ ■ ■ ■

A determination to avoid publicity. The desire to continue working with the other party. Concerns about the amount of money and time the organisation willing to spend on this dispute. The desirability of following what the contract states for ‘resolution process’, if available.

Resolution of disputes The main methods of resolving commercial disputes are: ■ ■ ■ ■ ■ ■ ■ ■

Negotiation and consultation Mediation Conciliation Mediation – arbitration Mini-trial Neutral fact-finding expert Formal arbitration panel Litigation

CHAPTER 18

International Accounting Standards for Derivatives

INTRODUCTION These days, no one doubts the importance of accurate reporting of derivatives in a company’s accounts. The demise of Enron highlighted not just the credit risk associated with derivative instruments but also the need for transparent reporting standards for derivatives transactions. This is especially true since a large part of the information that makes up credit risk assessment is what the world can see in a company’s accounts and balance sheet. Everyone who trades in the physical or derivatives world of energy takes counterparty credit risk as some point in time. Without the implementation of solid accounting standards, showing not just the physical side of deals but the derivatives hedges and speculative trades as well, energy sector companies cannot properly and fairly evaluate the credit risk they are being exposed to. In the past, derivatives accounting was, at best, a quagmire of non-standards, inconsistent guidelines and general confusion. Developments in the derivatives market seemed to consistently outpace the development of financial regulations and accounting standards to control and account for them. This lack of clear accounting standards meant that users of derivatives had to interpret GAAP (Generally Accepted Accounting Practices) to cover derivatives as best they could and sometimes, in doing so, opened themselves up to criticism. The area that caused particular difficulties was how to account for hedges (derivatives used to control the price risk in commodity inventory/stock, oil cargoes, forward cost of production/ consumption). However, two accounting standards emerged in 2001 that finally began to clarify matters: the FAS 133 (from the USA-based FASB) and the IAS 39 (from the London-based International Accounting Standards Committee) 317

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and these are the two standards that are focused on in this chapter. Although they were developed separately, they adopt a similar overall approach to derivatives reporting and accounting. The choice of standard that an organisation follows will be up to the jurisdiction it falls under or may be the decision of the Board of Directors, as advised by its accountants or auditors. From a practical standpoint of implementation and associated ongoing maintenance, my preference is IAS 39 for companies/end users hedging with derivatives. European listed companies have to prepare accounts in line with the IASC standards by the year 2005, but nothing stops them from adopting them now. Although there are some minor differences between FAS 133 and IAS39, both standards require derivatives to be marked-to-market (MTM – obtaining fair value) and reported on the balance sheet. Of course some risk managers and accounting staff are concerned about the implications of these new accounting standards. Since accounting regulations sometimes do not allow assets and liabilities to be marked-tomarket, volatility in the income statement of an organisation could be increased due to the addition of the derivatives hedge profit and loss now having to be added to the income statement in certain circumstances. In the past, the majority of users of derivatives (even end-users such as airlines and utilities) marked-to-market their derivatives positions, which entailed taking the buy/sell position executed price and comparing that to the current day’s value for the same contract. Through this process, companies could keep informed of unrealised profit or loss on their derivatives book (positions). With the new standards, the difference is that they have to report these figures on their balance sheet. For example, if company ABC buys an OTC jet fuel swap and pays a fixed price of US$20 for 100,000 barrels a month over 12 months (total 1.2 million barrels), the notional value (NV) of this trade is US$24 million: (100,000 barrels per month × 12) × fixed price US$20 = US$24 million (NV) So the traded price is the fixed price of US$20 per barrel and the markedto-market value is the difference between the trade price and the current or last known market price. If the jet fuel price goes down to US$18 dollars, then the derivative position’s MTM value is now negative US$2.4 million: (100,000 barrels × 12 months) × MTM of –US$2 per barrel = US$2.4 million Before FAS 133 or IAS39, companies would not have had to report this US$2.4 million unrealised loss anywhere in their balance sheet. The derivative and, in turn, its unrealised loss would stay ‘off-balance sheet’ until its expiry and settlement or when the position was closed out by a trader. At this stage, the amount paid out or received by the company on the

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derivative position would have been subtracted or added to the company’s earnings statement. This is no longer the case, as the new accounting regulations require companies using derivatives to report their portfolio’s marked-to-market value. This means that companies have to report the unrealised loss or profit from derivatives on their balance sheet rather than just the final cash figure that is paid out or received at settlement of the transaction. If you were hedging against some physical energy risk and having to report your derivatives hedge profit and loss in your balance sheet, it could create counterproductive volatility in your company’ s statements. For this reason, FAS 133 and IAS39 go into a lot of detail on special ‘Hedge Accounting’ methods to handle reporting of derivatives if they are used as a hedging tool against some physical energy transaction. However, if you are just investing in the market and trading derivatives for speculation and profitable gain, the unrealised profit and loss of your derivatives portfolio needs to go straight to the balance sheet, whatever accounting standard the company chooses to follow. Hedge accounting under these new accounting rules is certainly much clearer. This chapter takes a derivative user’s and management viewpoint on how to interpret the new accounting standards sweeping across the industry. It focuses on the key accounting scenarios that the majority of companies may face. Of course, all companies already involved in or looking to embark on the use of derivatives for trading or hedging purposes should get expert advice from accountants for auditors for their specific derivatives usage. Such advice is particularly crucial for organisations that are hedging for risk management purposes due to the greater complexity of hedge account regulations.

CONSOLIDATION AND CLARIFICATION OF ACCOUNTING STANDARDS SINCE 2001 The main work on the consolidation and clarification of standards has been done by the Financial Accounting Standards Board (FASB) in the USA and the International Accounting Standards Committee (IASC) in the UK. Both these organisations have made clear progress in creating standards for derivatives market participants and both accounting standards provide useful guidelines for management to work from. The details are as follows: ■

FAS 133 – Federal Accounting Standards (http://www.fasb.org/) ● FAS 133 ‘Accounting for Derivative Instruments and Hedging Activities’. ● Effective from the beginning of 2001.

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IAS 32 and IAS 39 – International Accounting Standards Commmittee (http://www.iasc.org.uk/) ● IASC framework expected to become the international standard on derivatives and hedge accounting. ● ISBN 0 905625 99 4 (Exposure draft)

Before FAS 133, IAS 32 and IAS 39 were introduced, the Generally Accepted Accounting Principles (GAAP) only created enhanced footnote disclosures (‘footnote’ – the note of reference, explanation, or comment usually placed below the main accounting report entries). They did not focus on the actual issue of accounting for derivatives and, as a consequence, many derivatives contracts remained off the balance sheet. Under the new accounting rules for derivatives, users of derivative instruments (contracts) not only have to report accounting entries for derivatives but also have to be able to answer key questions about: ■ ■

What derivative instruments they choose for their hedging practices. How they calculate that these instruments are effective hedges.

These have been the two biggest issues for corporations to administer since most banks and financial institutions have always written detailed internal papers on their derivatives usage because of bank and financial regulator regulations and guidelines. The upside for the industry as a whole is that it forces all participants at all levels to take a serious look at the derivatives they are using and the reasons for using them. Of key concern from a risk management perspective is how to conduct proper accounting for hedges (derivative transactions entered into for the purposes of reducing price risk exposure). In the past, this has been a grey area due to lack of standardisation. Before FAS 133, IAS 32 and IAS 39, GAAP had different accounting methods for different types of hedge, depending on the types of underlying energy risk. Hedge accounting is a key issue because if you are hedging using derivatives you wish to illustrate in your financial statements that you are reducing or eradicating certain price risk exposures. However, if you are speculating with derivatives that could be gearing up your company for a potentially big gain or big loss, this risk needs to be properly reported so that management and investors can monitor it and properly control it.

FAS 133 – EFFECTIVE FROM 1 JANUARY 2001 IN THE USA Under FAS 133 all derivatives instruments appear on the balance sheet at what is termed ‘fair value’ (A market price that is impartial to both buyer and seller. Such a price is often determined by reference to a pricing model.) FAS 133 focuses on ‘hedge’ accounting for risk management purposes.

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FAS 133 introduces rules to determine whether a derivative qualifies for hedge accounting and which instruments do not qualify or cannot be used to hedge a position (because now companies have to prove hedge effectiveness so the choice of which derivatives to use for hedging their energy exposures is very critical). The use of derivatives falls under one of the following categories: ■

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For speculative purposes. In this case, derivatives gains and losses must be marked-to-market and will be recognised in the ‘current earnings’ of the financial statement. To hedge the exposure associated with the price fluctuations of an asset, liability, or firm commitment. The carrying value of the item being hedged – the asset, liability, or firm commitment – is adjusted to reflect the change in its market value due to the risk being hedged, and this change is posted to earnings. Corresponding profits or losses on the derivatives used to hedge the risk are also posted to earnings, just as they are for non-hedge derivatives applications. To hedge the exposure associated with an uncertain forecasted cash flow. For cash flow hedges, derivatives results must be evaluated and a determination made as to how much of the result is ‘effective’ and how much is ‘ineffective’. The ineffective component of the hedge result must be realised and posted in current income. The FASB recognises hedges as ineffective for accounting purposes only when the hedge effects exceed the effects of the underlying forecasted cash flow (on a cumulative basis).

The ‘Fair Value’ accounting method is used for fair value hedges, which are derivatives used to hedge an underlying energy production or consumption. The accounting treatment of the hedge (the derivatives position) follows the accounting treatment of the asset (the energy production or consumption). Both are marked-to-market and the cash flows from both the derivatives hedge and the physical energy exposure are recognised in current earnings and recorded in earnings. The accounting for the derivative hedge is the same as that for speculative derivative positions except that, due to the risk of the physical energy being hedged, the hedged physical energy exposure must also be markedto-market. Once this is done the results of the derivatives hedge and the physical energy exposure is reported to the ‘Current income’ statement. This is where the choice of derivatives contract for hedging purposes is very important. If the hedge is not a perfect hedge (meaning that price movements in the derivative contract does not reflect 100% movement in the underlying energy exposure that is being hedged) then there could be an impact on earnings.

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For cash flow hedges, any profits or losses on the derivatives hedge need to be evaluated and the organisation hedging needs to establish by how much it is ineffective. Any ineffective amount must be realised immediately in ‘current income’, while the effective portions of the hedge are initially put in a newly established income statement category, OCI. This category, OCI (Other Comprehensive Income), has been specifically created for derivative hedge accounting purposes. By introducing this new category and keeping the traditional current income category, profits and losses from derivative hedges are put into this OCI category until it is time to recognise them in ‘Current Income’ at the end of the whole transaction (the hedge and the underlying energy exposure). One new burden for corporate users of derivatives for hedging is that they have to show that the derivative instruments they are using for hedging show a close correlation with the underlying physical energy they are hedging. The FASB actually demands an ‘effectiveness test’ which has to be performed before the execution of the hedge and then on an ongoing basis every quarter. If the derivatives hedge proves to be effective, then the derivatives contracts used for the hedge qualifies for hedge accounting. Hedge example If the derivatives hedge is making a profit of US$1,000,000 but the physical energy position is losing US$750,000, then there is US$250,000 that has to be reported straight onto the current income/earnings statements. The other US$750,000 would be posted to the OCI (the Other Comprehensive Income statement) until the overall trade has been completed. In energy markets we often see unstable price correlation patterns caused by seasonal effects or political problems and issues in the Middle East. Under FASB rules, it is important to remember that you need to prove that the price reference of your derivatives hedge is closely correlated with the underlying that you are hedging. Effectiveness testing required by the FASB using statistical methods such as ‘regression analysis’ does not guarantee that the correlation will remain strong and effective in the future, which is why FASB requires firms to check at least every three months on the continued effectiveness of the hedge. To make things easier, FASB has not endorsed any particular methodology. Any user of derivatives is going to want to have effective hedges because, as shown earlier, any ineffectiveness is reflected immediately in income/earnings statements and can cause additional volatility in a companies overall balance sheet. As a measure of effectiveness, the FASB chose to apply the 80/20 offset ratio as standard. If the correlation does not show the required effectiveness then the hedge is supposed to be terminated and the profits/losses posted to the earnings of the company, leaving the user looking for another derivatives market from which to obtain a better hedge.

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All of this could mean too much administrative work for a small trader or corporate end user of derivatives and there are also headaches in the industry over effectiveness testing. If regression analysis is used to work out whether a hedge will prove to be effective for hedge accounting to apply, an organisation then has to decide whether it uses data on price levels or price changes and whether to utilise daily, monthly or quarterly data intervals. Another concern over the implementation of FAS 133 is that is could increase volatility of reported earnings in the income statements of a company. Some in the derivatives industry may argue that changes in the marked-to-market value (fair value) do not provide any revenue to an entity and therefore should not be included in the income statement of a user. The other side of the argument though is that FAS 133 now creates reporting for volatility that always existed before for a user but which was never reported before under previous accounting standards. From a practitioner’s standpoint, the IAS standards discussed later in this chapter may be more straightforward for end users and corporates to adopt, given the grey areas in the FAS 133 regulations. However, other international standards such as IAS 39 are trying to eliminate the differences with United States GAAP – and the convergence between FAS 133/ US GAAP probably makes it the leader for standards at this point in time.

INTERNATIONAL ACCOUNTING STANDARDS BOARD (IAS) The IAS can be found at http://www.iasc.org.uk/ or http://www.iasb. org.uk/. IAS 32 – financial instruments disclosure and presentation Before looking at the IAS 39 accounting standards for derivatives, it is necessary first to clarify what a derivative contract is for the purposes of IAS 39. In the IAS 32 guidelines, it defines a financial instrument as ‘any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity’. It goes on to define financial instruments by saying that they include ‘...derivative instruments such as financial options, futures and forwards... swaps’. Derivative financial instruments (e.g. swaps and options) meet IAS 32’s definition and are subject to this accounting standard. ‘Derivative financial instruments’, in terms of definition, should create rights and obligations that have the effect of transferring between the parties to the contract one or more of the financial risks inherent in an underlying primary financial instrument. In energy markets, the main

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underlying financial risk is the market price. Derivative financial instruments do not generally result in a transfer of the underlying primary financial instrument on inception (just like an oil price swap under the ISDA Master Agreement which is cash-settled, so no exchange of the physical oil takes place, nor is the full notional value of the contract ever transferred), and such a transfer does not necessarily take place on settlement or closing out of the contract. The latest proposed amendments to IAS 32 (dated June 2002) say that if a trader buys or sells a non-financial item, e.g. a commodity futures contract that has physical delivery of the commodity as its final settlement on expiry, for a fixed price and at a future date, this will not meet the definition of a ‘financial instrument’ under IAS 32. In the context of energy futures markets, this means that a firm’s derivatives futures position does not fall under IAS 32 reporting requirements if it is using a derivative futures instrument that can go to physical delivery on final settlement. So it is worth noting what contracts should be excluded from these derivative accounting regulations under the latest proposed amendments to IAS 32: ■

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NYMEX WTI Crude Futures ● Heating Oil NYMEX Futures ● Unleaded Gasoline ● Henry Hub Gas ● Electricity IPE Gasoil IPE Nat Gas NBP

IPE Brent, for example, is excluded from this list since it is a cash-settled futures contract and no physical delivery can take place via the futures expiry/settlement. An organisation’s positions would also fall under IAS 32 reporting guidelines if it regularly settles its futures contracts by trading out of them with an offsetting buy/sell futures position, and/or is usually taking delivery of the physical commodity and sells out of it within a short period after delivery for the prime reason of generating a profit from short-term market price movements. This would indicate that the futures contract is entered into for speculative/trading purposes and not for its own physical purchase, sale or usage requirements. Under IAS 32 all ISDA-based swaps specify settlement through cash payments, determined according to a formula in the contract. The swap is indexed to a commodity price but is settled only in cash. Therefore ISDA based swaps on energy prices constitute a financial instrument and must be disclosed. (Further reading on this can be found in the June 2002 Exposure Draft of proposed amendments to IAS 32 published by International Accounting Standards Board in London, UK; http://www.iasb.org.uk/.)

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IAS 39 financial instruments: recognition and measurement IAS 39 became effective for financial years beginning on or after 1 Jan 2001 and all listed companies in Europe may be required to produce accounts in accordance with IAS by the year 2005 (proposal by European Commission). IAS 39 is a supplement to the disclosure requirements of IAS 32 for financial instruments. Under IAS 39, all financial assets and financial liabilities are recognised on the balance sheet, including all derivatives. They are initially measured at cost, which is the fair value. After the initial recognition on the balance sheet, all derivatives are revalued on a fair value (marked-to-market) basis. It is quite similar in many respects to FAS 133 and organisations looking to implement IAS 39 can learn from their American cousins as to the issues at hand. In fact, IASB is working on the convergence of IAS 39 standards with FAS 133 more and more each year.

Implementing IAS 39 The first step that a firm needs to take is to educate itself on IAS 39, as it contains some of the most complicated rules introduced so far. A firm will then have to look at implementing a formal risk management policy. Basically, a firm needs to be able to give a lot of detail on its hedging activities in order to be able to book derivatives as hedge transactions. Many users of derivatives may find that for the first time they need to implement an automated accounting/risk management system in order to deliver required IAS 39 documentation for accounts on, for example, marked-tomarket valuation of derivatives positions (current market value of the derivative). They will also have to produce documentation on the derivative positions, provide ‘effectiveness testing’ of how effective a hedge is and if it is not within certain parameters then it will not qualify for hedge accounting.

What is a hedge item under IAS 39? A hedged item can be an asset or liability, a firm commitment, or a highly probable forecasted future transaction that exposes the company to a risk of changes in fair value or future cash flows. For example, a buyer of LPG Cargoes which bottles the LPG for retail re-sale may normally just buy its LPG on a spot basis and have no contractual commitments to take regular cargoes from anyone. This organisation may, however, have a highly probable forecast future purchase of LPG to resell on to a retail network, and unless it uses derivatives to hedge its price risk it could face competitive risk against other suppliers, not to mention profit exposure. Under this standard, a hedge qualifies for hedge accounting:

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If the hedge relates to a specific and identified risk, and not merely an overall business risk, and it must ultimately affect the organisations profit or loss. If the hedge is expected to be highly effective in achieving offsetting changes in fair value or cash flows. (If the derivatives contract moves in line with the underlying asset or the cash flow it is trying to protect.) If an organisation at the beginning of the hedge has put together internal documentation of the risk management objective and the strategy for the hedge: ● Identification of the hedging instrument (the type of derivative the organisation is planning to use to hedge the underlying energy exposure). ● Details of the energy exposure being hedged. ● The nature of the risk being hedged. ● How the organisation is going to assess the derivatives’ effectiveness for hedging the changes in the hedged item’s fair value or the hedged transactions’ cash flows that is attributable to the hedged risk. ● Effectiveness of hedging should be assessed at a minimum when the organisation prepares its annual or interim financial statements.

What is considered a highly effective hedge under this accounting standard? A hedge is regarded as highly effective if, throughout the life of the hedge, the organisation should expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the derivatives instrument creating the hedge. Like FAS 133, this standard does not specify a single method for assessing hedge effectiveness, but says that an organisation’s documentation about the hedge should include its procedures for assessing effectiveness. This should be evaluated at a minimum at the time the user prepares its annual or interim financial statements. If the key terms of the derivatives instruments and the hedged asset or liability or hedged forecasted transaction are the same, an organisation can conclude that changes in fair value or cash flows of the price risk being hedged are expected to offset each other fully at execution of the hedge and on an ongoing basis. For example, an organisation may assume that in the case of a derivatives hedge on a forecast purchase of some physical oil, gas, power etc. with a futures or swap which has the same pricing reference as the underlying oil, gas or power being hedged, that the hedge will be highly effective and that there will be no ineffectiveness in profit or loss protection. This is the benefit of OTC derivatives, as more often than not you can obtain a swap or options contract that is priced against the same reference price as the physical energy you are trying to hedge. Then there is only the timing basis risk, if the timing of the derivatives contract does not match the underlying physical energy which is being hedged.

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Although IASB does not specify a single method for assessing a hedge effectiveness in its IAS 39 documentation it does give an example to work from. If the organisation using the derivatives for hedging can expect changes in the fair value/cash flows of the hedged item to be almost fully offset (protected) by the changes in the fair value/cash flows of the derivatives hedge and if actual results of effectiveness assessments are within a range of 80% to 125% the organisation can conclude that the hedge is highly effective. For example, if the loss on the hedging instrument is 120 dollars and the gain on the energy price being hedged is 100 dollars, the offset/level of protection/correlation can be measured by 120/100 = 120% or by 100/120 which is 83 per cent. Both results are within the 80% to 125% range, so this could be covered as an effective hedge. If a fair value hedge meets these conditions it would be accounted for under IAS 39 in the following way: ■

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The gain or loss from marked-to-market revaluation of the hedging instrument at fair value (for a derivative hedging contract) should be recognised immediately in profit or loss. The profit or loss on the hedged item (the underlying energy exposure) attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognised immediately in profit or loss (the underlying energy exposure).

Since the value of derivatives hedges and the hedged item are both reported to profit and loss it is important that user choose wisely the type of derivatives for hedging. Ineffective hedges will certainly add volatility to a user’s balance sheet. What is evidence of fair value for marked-to-market? Currently IAS 39 states: ‘quoted price normally being the best evidence of fair value’. It has been proposed that this wording will be amended in the future to ‘quoted market price is the best evidence of fair value’. IAS 39 is generally similar to that under US Generally Accepted Accounting Principles (GAAP) and the International Accounting Standards Board continues to propose amendments that will reduce further or eliminate altogether any differences.

FRS 13 – UK ACCOUNTING STANDARDS BOARD Derivatives and other financial instruments disclosures Most of this chapter focuses on the most recent international accounting standards. However the FRS 13 Financial Reporting Standard 13 by the Accounting Standards Board of the United Kingdom (released in 1998)

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should also be mentioned. It is getting a bit dated now due to the introduction of the more recent FAS 133 and IAS 39 (from 2001). The reason for mentioning it is that some major energy market participants and banks based in the UK and/or who have their shares listed on the UK stock markets are still required to utilise FRS 13. FRS 13 was the first step by the UK accounting authorities to provide a comprehensive disclosure requirement for derivatives and financial instruments. In this respect, FRS 13’s main focus is on disclosure of risk and derivatives in accounts rather than specifically the treatment of derivatives like the more recent FAS 133 and IAS 39 standards. The core purpose of FRS 13 is to provide users of annual reports and accounts with summary information on the risk profile of a company and, more importantly, how the company is utilising derivatives. Users of accounting reports in the UK under FRS 13 have the assurance that there is a set of disclosure tables that enables them to properly assess the risk profile of a company (as stock analysts, rating agencies, credit control managers). Some oil majors, like BP plc, whose shares are listed on the UK stock market, have to utilise this standard at the moment. Excerpts from the ‘notes to accounts’ for the BP plc 2001 Annual report clearly illustrating risk disclosures on derivatives under FRS 13 can be found in Figure 18.1. (I would like to thank BP Plc for their permission to reproduce these notes.) FRS 13 disclosures are broken into three core parts: ■

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Narrative disclosures about financial instruments. ● These are designed to explain risk management policies. ● Descriptions of the risks associated with the financial instruments, e.g. derivatives used by the organisation. These risks will include: – Any credit risk – Any liquidity risk – Any currency risk ● Descriptions of how the organisation is managing these risks. Numerical disclosures of an organisation’s derivatives holdings. ● Numerical descriptions showing the exposure the organisation has in terms of type of derivative, size of positions, and financial exposure. Disclosure about the company’s accounting policies. ● Under this disclosure requirement an organisation needs to discuss how it actually records and values derivative positions.

CLOSING NOTE Now more than ever before, companies that hold assets (maybe an oil well or a power station) are encouraged and required to use mark-to-market accounting principles (MTM). These new accounting regulations that

CLOSING NOTE

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FIGURE 18.1 Extracts from BP’s accounts (With thanks to BP P.L.C. for the permission to reproduce these "notes to their account" 2001 Annual report © BP P.L.C.) Continues overleaf

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FIGURE 18.1 (continued)

demand fair value assessment (marked-to market valuations) of derivative positions and assets (if hedged) are great in theory, but in practice they can be abused. Some derivative contracts or assets in the energy business do not have unambiguous market prices, and sometimes a lot of judgment must be exercised when producing a suitable price for MTM fair value reporting purposes. Financial auditors are supposed to make sure that these mark-to-market valuations are credible and at least reasonable. In the collapse of Enron at the end of 2001, and the subsequent downfall of its auditors, Andersen, it would appear this auditing and control function was clearly defective.

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Accounting standards aim to produce transparency of an organisation’s activities and financial position. However, any accounting standard is only really as effective as the control functions surrounding it in an organisation and the external controls offered by truly independent auditing firms.

TOTEM RISK In this section Mr Tim Barker, CEO of Totem Market Valuations (http://www. totem-risk.com/), looks at how energy market participants have succeeded in responding to regulation such as new accounting standards, how they are managing the business risk of complex long dated derivatives positions and the focus on control processes. Totem is a leading valuations clearing house that provides securities houses and banks with a source of regular consensus prices and parameters for a wide range of OTC and listed instruments. The mid-1990s will probably be remembered as the low point in the development of the derivatives markets. Between 1995 and 1998 the markets were stunned by a series of losses. Nick Leeson crippled Barings with U$800 million losses, a well-publicised $150 million NatWest interest rate derivatives mispricing cost several board members their jobs and UBS lost $350 million in the Global Equity Derivatives Book. When the New York Federal Reserve stepped in to bail out losses of $4.6 billion at John Merriwether’s Long Term Capital Management, the talk in the markets was of meltdown or systemic risk and strict regulation seemed to be imminent. Derivatives losses are again making front page news. Enron has not left the headlines and derivatives trading losses at AIB are reminiscent of the mid-1990s. There are close similarities between the energy markets now and the financial markets of the mid-1990s (Table 18.1). The market for financial derivatives went through explosive growth from the late 1980s to the mid-1990s. Driven by a liberalisation of the banking sector and helped by the information technology revolution, the equities, forex and bond markets boomed. When those markets stumbled heavily in the mid-1990s, the regulators tried to tighten their grip. The Commodity Futures Trading Commission (CFTC), which had effective regulatory control over swaps and futures in the US, fought a long battle of rhetoric with the Securities Exchange Commission (SEC) over the jurisdiction of derivative regulation. Both the SEC and the CFTC were aiming to extend regulation, but each on their own terms. As this public battle wore on, regulation finally came from a different source, the Financial Accounting Standards Board (FASB).

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TABLE 18.1 Comparison of financial markets and energy markets Financial markets: late 1980s to mid- Energy markets: mid-1990s to 1990s present Growth of the markets From the late 1980s to the mid-1990s, the financial derivatives markets went through explosive growth in equities, forexand bonds/interest rates caused by liberalisation of the banking industry and aided by easier access to information technology and computing power

Liberalisation of the energy markets from the mid-1990s caused huge growth in trading using financial techniques pioneered by the banking industry half a decade previously. The energy markets have shown exponential growth in the use of lightly regulated OTC derivatives

Growth in complexity of products Explosion in sales-driven rather than demand-driven complex structures (knock-in, knock-out digital options)

Increasing use of special purpose entities such as Raptor and LJM2 or Dynegy’s recent Operation Alpha

Well-publicised losses $800 million Barings; US$138 million Enron’s market cap of US$70 billion NatWest; US$350 million UBS; US$4.6 evaporates over one year billion LTCM Regulatory clampdown Current SEC/FERC/CFTC close scrutiny Strong regulatory reaction post of Enron, Dynegy and other energy Barings/NatWest/UBS/LTCM losses, eventually leading to the introduction companies. of FAS 133/IAS 39

What has happened since the late 1990s? Derivatives had begun as vanilla tools, but by the mid-1990s they had become increasingly complex. NatWest opened up a can of worms when a case of mismarked interest rate derivatives positions were initially announced to have made a loss of $50 million, which soon turned into $90 million. Even the professionals could not keep up with the mathematics. CSFP were forced to withdraw from banking in Japan after marketing complex ‘window dressing’ derivatives to corporates as a way of avoiding reporting accounting losses. Since these incidents, although the trend in the financial markets has been towards the development of complex structures, there has been an increase in the trading volumes of vanilla products. Derivatives users such as corporate hedgers have developed a much better grasp of derivatives. They now have an understanding of the products and the management reporting infrastructure in place to be able to use vanilla derivatives to hedge much of their risk effectively.

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The trend towards simplicity has now reached the energy markets and recently we have seen how the markets themselves will punish a company that cannot demonstrate that it has the appropriate risk controls in place, or transparency in accounts. The share price of Dynegy dropped from over $30 at the end of April 2002 to just over $10 in mid-May 2002 on concerns over Operation Alpha involving complex transactions used to optimise tax payments. Recent regulatory reactions In the wake of Enron’s collapse we are again seeing a huge regulatory reaction as the SEC, FERC and CFTC are undertaking the expected and necessary post-mortem investigations. However, there is great pressure to make derivatives the scapegoat. US Senator Dianne Feinstein is just one of the loud voices calling for regulatory tightening – although her proposal for a bill to tightly regulate energy derivatives has been rejected: The Senate rejected a proposal Wednesday [10 April 2002], inspired by the Enron collapse, which would have required federal regulation of energy-related financial derivatives, an area of the electricity markets that Enron widely exploited. But opponents of the measure argued that it was too broad and would threaten the entire market in derivatives, a hedging mechanism used widely in commodity markets and other trading (http://www.cbsnews.com/stories/ 2002/04/10/politics/main505797.shtml) We tend to agree with the views of the International Swaps and Derivatives Association (ISDA), which concludes in a recent report that Enron’s collapse is the result of a failure of corporate governance, and that: ...although derivatives made appearances in the course of the governance failures, they played no essential role.... There is no evidence that existing regulation is inadequate to solve the problems that did occur. Had Enron complied with existing market practices, not to mention existing accounting and disclosure requirements, it could not have built the house of cards that eventually led to its downfall. Part of that regulation, FAS 133 and IAS 39, has recently come into force. Designed in the mid-1990s in response to the numerous derivatives problems already mentioned, its effects outside of the banking industry are really only becoming clear now. Brief descriptions of the standards and their implications are outlined in Table 18.2. Recent growth in energy trading has been concentrated in the over-thecounter (OTC) markets. Witness the growth in volumes at the Intercontinental Exchange, which has shown phenomenal growth in its OTC trading volumes over the last two years.

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TABLE 18.2 FAS 133 and IAS 39 FAS 133 and IAS 39 came into force on 15 June 1999 and 1 January 2001 respectively. The standards cover the accounting treatment of derivatives and require all derivatives to be valued in accounts using fair value (or mark-tomarket) accounting. The two standards are essentially the same, but introduced by different regulatory bodies. The Financial Accounting Standards Board (FASB) is responsible for US accounting standards and IASB for international standards. Before introduction Before the introduction of these standards, companies could elect to use fair value accounting (mark-to-market) or use historic-cost accounting to recognise income as it was realised. All major banks have been using mark-tomarket accounting for many years as the central pillar of their accounting systems. Many oil producers, mining companies or energy utilities have not. Changes FAS 133 and IAS 39 force all companies conforming to the standards to: ● Use fair value accounting and mark-to-market (MTM) all derivatives positions. ● Move all derivatives onto balance sheet. ● Value embedded options in physical and derivative contracts (such as gas swing contracts, or quantity tolerances in oil contracts) as derivatives. Exceptions Derivatives can be kept off balance sheet if nominated as hedging particular contracts (such as ore to be mined or future oil or gas production). However, this is extremely onerous to prove and many corporates find it easier simply to comply with MTM. Implementation ● Major banks have been using MTM accounting for some time now so although this is not quite ‘business as usual’, banks have long had the accounting and compliance infrastructure in place to cope with the new regulation. ● The biggest change is for companies who have not yet fully embraced MTM such as a number of merchant energy companies or energy utilities or mining companies, leading to huge investments in compliance accounting systems, infrastructure and staff. ● FAS 133 documentation runs to over a thousand pages, including various revisions and 166 interpretations which are constantly evolving. Unintended side effects ● Causes large problems in valuation of OTC trading positions which are difficult to mark-to-market due to lack of price and volatility information in OTC markets. ● Creates huge administrative and compliance burden which is much heavier for smaller companies or companies not previously using MTM techniques.

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TABLE 18.2 FAS 133 and IAS 39 (continued) ●

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Causes unintended profit and loss volatility for ‘hedgers’ who must now MTM a derivative trade being used to hedge an off-balance sheet asset (such as future oil production). Causes changes in trading behaviour as traders are forced to comply with accounting standards.

The danger is that despite massive investment in risk management and compliance systems the core problem is still not being addressed. Companies are coming under increasing pressure from regulators to put in place sophisticated risk management systems, yet without proper data on pricing, these systems are ineffective. OTC markets are not price transparent and price data and volatility data is often impossible to find. Our own experience of this originated in the mid-1990s in the risk management department at investment bank BZW, where I and my colleague Edward Barlow were responsible for the verification of the marked-to-market prices that the derivatives traders entered in the books. The riskiest positions were taken in the OTC markets – where buyers and sellers were matched through inter-dealer brokers at prices that often bore no relation to the advertised quotes – and there was no source of independently validated prices. Our resulting frustration led to our decision to set up a company to fill the gap through collecting and processing the information that investment banks needed. Totem Market Valuations has now recruited a team with extensive experience of the commodities markets, led by Tom Charlesworth, to extend our consensus pricing services to long dated oil, gas and power OTC derivatives. Banks have been using mark-to-market valuation techniques for some time. The standards have affected them in subtle ways. Mark-to-market has become the central pillar of accounting techniques, but in addition the banks’ attitudes to risk management have changed. Not only have the number of risk management staff within financial services grown strongly, but the power of the role has grown within the organisation. I believe that the larger investment banks have now, in general, put the requisite risk management controls in place. There has been a trend of strong growth over the last five years in the number of staff in risk management, the strength of the role within the organisation, the skills of the staff and techniques used. US Federal Reserve chairman Alan Greenspan recently stated that risk managers are now overtaking loan officers in the decision making hierarchy at financial institutions, with new quantitative risk management techniques a key factor behind this transition. Totem has played a key role in this development by providing the risk management tools for the independent verification of mark-to-market

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prices trading book. However, the control procedures and risk management techniques in place in the banking industry have not yet been successfully transferred to the energy and commodities industry. The energy industry has grown dramatically in recent years and drawn staff from the traditional financial markets. This in turn has led to a growing awareness of the importance of the risk management function within the energy industry as skills and techniques diffuse. Knowledge of the techniques pioneered by Totem are spreading. Before the US Senate, Frank Partnoy, Professor of Law at the University of San Diego and former Morgan Stanley derivatives salesman testified: It appears that Enron traders selectively mismarked their forward curves, typically in order to hide losses. Traders are compensated based on their profits, so if a trader can hide losses by mismarking forward curves, he or she is likely to receive a larger bonus. Certain derivatives contracts were more susceptible to mismarking than others. A trader would be unlikely to mismark contracts that were publicly traded – such as the natural gas contracts traded on NYMEX – because quotations of the values of those contracts are publicly available. However, the NYMEX forward curve has a maturity of only six years; accordingly, a trader would be more likely to mismark a ten-year natural gas forward rate. The energy industry can now use this as an opportunity to put in place the appropriate control measures to prevent a repeat of recent events. Moreover, it may avoid excessive external regulation by proving, as the financial markets have done in recent years, that it can regulate itself effectively. Energy and commodities markets players can now follow the financial institutions’ lead in implementing sophisticated risk management systems starting with the implementation of appropriate controls based on genuine market inputs.

Glossary of Terms

A Abandon To cease work on a well which is non-productive; to plug off the well with cement plugs and salvage all recoverable equipment. Also used in the context of field abandonment. ABC Elliott wave terminology for a three-wave countertrend price movement. Wave A is the first price wave against the trend of the market. Wave B is a corrective wave to Wave A. Wave C is the final price move to complete the countertrend price move. Elliott wave followers study A and C waves for price ratios based on numbers from the Fibonacci series. Absolute viscosity An observation of liquid’s rate of flow under pressure applied to neutralize density’s influence. This property, sometimes called dynamic viscosity, converts to kinematical viscosity by division. With density expressed in grams/cm, centistokes the units of kinematical viscosity, and centipoises the units of absolute viscosity, centipoises/density = centistokes Accrued interest Interest earned between the most recent interest payment and the present date but not yet paid to the lender. Accumulation 1. An addition to a trader’s original market position. The first of three distinct phases in a major trend in which investors are buying. 2. A single oil or gas deposit as defined by the trap, charge, and reservoir characteristics of the play Accumulation/distribution line See Chaikin oscillator Acidising Treatment of oil-bearing limestone or carbonate formations with a solution of hydrochloric acid and other chemicals to increase production. The acid is forced under pressure into the formation where it enlarges the flow channels by dissolving the limestone. Activity The level of a catalyst’s ability to do its work. The scale descends from fresh (full capacity right from the box or rejuvenator) to spent (coated, poisoned, or other wise neutralized). Actual specifications The quality reports on a specific parcel of fuel or feedstock. Such specifications do not constitute guarantees on the oil unless the seller says so. But they give a good description of the product available aboard a vessel or in a storage tank.

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Actuals Refers to actual physical commodities, as distinguished from futures. See also Cash commodity Adaptive filter Smoothing and/or forecasting prices with continuously updated weighting of past prices. Add-on method A method of paying interest where the interest is added to the principal at maturity or interest payment dates. Adjusted futures price The cash price equivalent reflected in the current futures price. This is calculated by taking the futures price times the conversion factor for the particular financial instrument (e.g. bond or note) being delivered. Adsorption The attraction exhibited by the surface of a solid for a liquid or a gas when they are in contact. AFRA Average Freight Rate Assessments. A monthly estimate of tanker rates issued by London tanker brokers, AFRA, quoted on a worldscale basis, assists large oil companies’ internal accounting, provides a freight element for some netback deals, and serves other purposes some what removed for the daily tanker business. Against actuals A transaction generally used by two hedgers who want to exchange futures for cash positions. Also referred to as EFP (Exchange Futures for Physicals). Aggregation The policy under which all futures positions owned or controlled by one trader or a group of traders are combined to determine reportable positions and speculative limits. Air draft The distance between the surface of navigable water, such as a channel, and the lowest point on some obstruction above it, a bridge for instance. A ship cannot use a waterway if it needs more vertical clearance than available. This consideration prevents certain tankers from reaching some terminals. AKA An acronym for ‘automated knowledge acquisition’. Refers to the use of programs to create knowledge needed by other programs (usually expert systems). Aliphatic Straight or branched chain carbon-based compounds; hydrocarbons that lack carbon ring structures. Aliphatics include three kinds of molecules: paraffins, olefins, and a particularly reactive sort called acetylenes, which contain triple carbon–carbon bonds. Alkylate A high-quality motor gasoline component made by combining isobutene and propylene or butylene. Butylene alkylate has a particularly high motor octane rating which suits it well for blending lead-free grades of automobile fuel and aviation gasoline. Both butylene and propylene alkylate boil fairly low in the gasoline range. This characteristic makes them good ‘front-end’ octane. Alkylation unit A piece of refining equipment that combines isobutane and an olefinic stream, usually butylene-rich, to make motor alkylate. American Depository Receipts (ADRs) Certificates that are issued by a bank of US origin and traded in the USA as domestic shares. The certificates represent the foreign securities that the bank holds in that security’s country of origin. Amortisation Accounting method in which an asset’s cost is spread out. Analysis of variance (Anova) The partitioning of total sum of squares into the sum of squares explained by the model and the remaining sum of squares unexplained.

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Anaume Candlestick formation. An exceptional exhaustion pattern (meaning ‘gap filling’) composed of five candles. The anaume occurs when the gap is filled in after a market price has changed directions. This pattern coupled with the other patterns indicate a strong potential for a bullish reversal and price advance. Anchoring-and-adjustment Behavioral finance. The tendency to evaluate current decisions in the context of past events. Andrews method A technique whereby a technician will pick an extreme low or high to use as a pivot point and draw a line, called the median line, from this point that bisects a line drawn through the next corrective phase that occurs after the pivot point. Lines parallel to the median line are drawn through the high and low points of the corrective phase. The parallel lines define the resistance and support levels for the price channel. Angle of deflection The angle, in degrees, at which a well is deflected from the vertical by means of a whipstock or other deflecting tool. Aniline point A specification, quoted in degrees Fahrenheit in the USA and Centigrade elsewhere, which reports the aromatic content of a hydrocarbon mixture. This quality consideration indicates the susceptibility of a vacuum gasoil to catalytic cracking because paraffins crack well but aromatics do not. The higher the temperature the better, since higher temperatures mean less aromatics, hence more paraffins. Annealing (simulated) Generally a metallurgical process, in artificial intelligence a process in which a neural net work searches for a set of weights to minimise errors; the search constantly shrinks as the weights find better values, analogous to the rearrangement of the molecules in a heated metal bar as the bar cools. Annual earnings change (%) The historical earnings change between the most recently reported fiscal year earnings and the preceding year. Annual net profit margin (%) The percentage that the company earned from gross sales for the most recently reported fiscal year. Annual sales change (%) The percentage change in sales between the most recently reported fiscal year and the preceding. Annualised Translating the figures for a given year into an annual rate. Annular space The space around a pipe (casing or tubing) suspended in a wellbore is often termed the annulus, and its outer wall may be either the wall of the borehole or the casing. Anthracite The highest rank of coal; used primarily for residential and commercial space heating. It is a hard, brittle, and black lustrous coal, often referred to as hard coal, containing a high percentage of fixed carbon and a low percentage of volatile matter. The moisture content of fresh-mined anthracite generally is less than 15%. The heat content of anthracite ranges from 22 to 28 million Btu per ton on a moist, mineral-matter-free basis. The heat content of anthracite coal consumed in the USA averages 25 million Btu per ton, on the as-received basis (i. e. containing both inherent moisture and mineral matter). Note: Since the 1980s, anthracite refuse or mine waste has been used for steam electric power generation. This fuel typically has a heat content of 15 million Btu per ton or less. Anthracite briquets See Coal briquets

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Anthropogenic Made or generated by a human or caused by human activity. The term is used in the context of global climate change to refer to gaseous emissions that are the result of human activities, as well as other potentially climatealtering activities, such as deforestation. Antiknock index The average of a motor gasoline’s or blending component’s RON and MON (RON + MON)/2, sometimes written (R + M)/2. Antithetic forecasts Two forecasts whose errors are negatively correlated. API The American Petroleum Institute, a trade association. API degrees (API) The units of API’s density scale. See below. API gravity An arbitrary scale expressing the gravity or density of liquid petroleum products, as established by the American Petroleum Institute (API). The measuring scale is calibrated in terms of degrees API. The higher the API gravity, the lighter the compound. Light crude oils generally exceed 38 degrees API and heavy crude oils are commonly labelled as all crude oils with an API gravity of 22 degrees or below. Intermediate crude oils fall in the range of 22 degrees to 38 degrees API gravity. Apparent consumption (coal) As used here, a calculated amount equal to primary coal production plus imports of coal and coke, minus exports of coal and coke minus changes in stocks of coal and coke. Notes: (1) For the USA, coal consumption data are reported by major end-use sector and do not have to be calculated; (2) a net withdrawal from stocks increases consumption and a net addition to stocks decreases consumption. Apparent consumption (natural gas) As used here, a calculated amount equal to dry natural gas production, plus imports of natural gas, minus exports of natural gas, minus changes in natural gas stocks. Note: A net withdrawal from stocks increases consumption and a net addition to stocks decreases consumption. Apparent consumption of refined petroleum products See Apparent consumption (petroleum) Apparent consumption (petroleum) As used here, a calculated amount that includes domestic inland consumption, refinery fuel and loss, and international bunker fuels. Also included, where available, are liquefied petroleum gases sold directly from natural gas processing plants for fuel or chemical uses. Appraisal well A well drilled as part of an appraisal drilling program which is carried out to determine the physical extent, reserves and likely production rate of a field. Aquifer A water-bearing rock stratum. In a water-drive field the aquifer is the water zone of the reservoir underlying the oil zone. AR American rate: tanker hire prices according to the American Tanker Rate Schedule. This system applies to voyages which begin and end in US ports. US law (the Jones Act) allows only US-flag ships in this domestic service. Arbitrage The simultaneous purchase and sale of similar commodities in different markets to take advantage of price discrepancy. Arbitration The procedure of settling disputes between members, or between members and customers. Aromatics A family of hydrocarbons characterised by a single or multiple ring structure containing unsaturated carbon-carbon bonds. Common aromatics

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which boil in the gasoline range (benzene, toluene, and xylenes, in particular) have a very high octane rating. Reformers produce high octane blend-stock by making aromatics. The ‘A’ in PONA and N+A stands for aromatics. Artificial intelligence The field of computer science dedicated to producing programs that attempt to mimic the processes of the human brain. Artificial lift Any system that adds energy to the fluid column in a wellbore with the objective of initiating and improving production from the well. Artificiallift systems use a range of operating principles, including rod pumping, gas lift and electrical submersible pumps. Ash Carbonaceous residue produced by burning crude oil and petroleum products. The industry tests fuels and other hydrocarbon mixtures in order to determine how much of this combustion by-product will form in ordinary use of its products. Refiners and others also use ash yield to deduce the presence of metallic soaps, abrasive solids, and other ash-causing contaminants in hydrocarbon mixtures. Asphalt A mixture of heavy carbon-based compounds containing a high percentage of multiple-ring aromatics, many of them involving sulphur, nitrogen and oxygen atoms. Some people use the word asphalt interchangeably with bitumen, the name of its characteristic constituent. Note: The conversion factor for asphalt is 5.5 barrels per short ton. Asphalt (refined) See Asphalt Asphalt cement A derivative, nearly or completely solid at room temperature, of certain crude oils. This black, tarry material usually comes from vacuum residue. It has several industrial applications. Pavers heat it to liquid form and mix in gravel to make road surface materials called blacktop, macadam, tarmac or ‘asphalt’. Builders use it to make and join bricks, to coat roofs, and to form shingles. It glues together various manufactured goods. Asphaltenes Complex molecules which reveal their ring structures by dissolving in aromatic liquids but not in paraffins. These compounds may influence the burning and blending characteristics of residual oils, if present in sufficient concentrations. They contribute to the high melting temperature and adhesion of bitumen and asphalt cement. Assay An elaborate laboratory report describing in detail the quality of grades of crude oil. The data presented includes, among other items, density, sulphur, naphthenicity, pour point, viscosity, distillation, and information on the quality of individual fractions. They tell a refiner what products can be made from a specific crude. Assign To make an option seller perform his obligation to assume a short futures position (as a seller of a call option) or a long futures position (as a seller of a put option). Associate Membership A futures exchage membership that allows an individual to trade financial instrument futures and other designated markets. associated/dissolved natural gas Natural gas that occurs in crude oil reservoirs either as free gas (associated) or as a gas in solution with crude oil (dissolved gas). See also Natural gas. Associated gas See Associated/dissolved natural gas and Natural gas Associated natural gas See Associated/dissolved natural gas and Natural gas

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Associated Person (AP) An individual who solicits orders, customers, or customer funds (or who supervises persons performing such duties) on behalf of a Futures Commission Merchant, an Introducing Broker, a Commodity Trading Adviser, or a Commodity Pool Operator and who is registered with the Commodity Futures Trading Commission.. ASTM American Society for Testing and Materials. An organisation which determines and publishes consensus standards of suitability and quality for a wide variety of materials including petroleum and refined products. ASTM develops and endorses methods of testing hydrocarbons properties as well as definitive specifications for such classes of refined product as fuel oils, aviation kerosene, burning kerosene and motor gasoline. ATM See At-the-money option Atmos Abbreviation of atmospheric pressure distillation, as in atmos bottoms and atmos gasoil. Atmospheric crude oil distillation unit See Distillation unit (atmospheric) Atmospheric distillation A technique for separating hydrocarbon mixtures which uses distillation apparatus operated at atmospheric pressure. Generally, the industry specifies ambient pressure to distinguish products of crude distillers, atmospheric fractions, from the products of vacuum flashers, which, as the name implies, distil atmospheric residue in a partial vacuum. Atmospheric gasoil The heaviest product boiled by a crude distillation unit operating at atmospheric pressure. This fraction ordinarily sells as distillate fuel oil, either in pure form or blended with cracked stocks. In blends, atmospheric gasoil, often abbreviated AGO, usually serves as the premium quality component used to lift lesser streams to the standards of saleable furnace oil or diesel engine fuel. Certain ethylene plants, called heavy oil crackers, can take AGO as feedstock. Atmospheric residue The portion of crude oil taken as a bottoms product in a crude distillation unit which operates at atmospheric pressure under several other names apply to this product including atmos (atmospheric) reside, atmos bottoms, atmospheric fuel oil long reside, straight-run heavy fuel oil and topped crude. At-the-money option (ATM) An option with a strike price that is equal, or approximately equal, to the current market price of the underlying futures contract. Attenuation The fractional part of reduced energy or lost power due to smoothing or filtering. Autocorrelation The correlation between the values of a time series and previous values of the same time series. AutoRegressive Integrated Moving Average (ARIMA) A linear stochastic model forecasting methodology described by Box and Jenkins in their book Time Series Analysis, Forecasting and Control. Autoregressive Using previous data to predict future data. Availability A quantity of crude or product that a supplier could sell. Average Directional Movement Index (ADX) Indicator developed by J. Welles Wilder to measure market trend intensity. Average reserve life index Ratio between the amount of reserves at the end of the year and total production for the year.

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Average true range A moving average of the true range. Avgas High octane aviation gasoline used in piston-type aircraft engines. Familiar designation of aviation gasoline. Aviation gasoline blending components Naphthas that are used for blending or compounding gasoline into finished aviation gasoline (e.g. straight-run gasoline, alkylate and reformate). Excluded are oxygenates (alcohols, ethers), butane and pentanes plus. Aviation gasoline (finished) A complex mixture of relatively volatile hydrocarbons with or without small quantities of additives, blended to form a fuel suitable for use in aviation reciprocating engines. Fuel specifications are provided in ASTM Specification D 910 and Military Specification MIL-G-5572. Note: Data on blending components are not counted in data on finished aviation gasoline. See also Jet fuel; Kerosene-type jet fuel; and Naphtha-type jet fuel. Aviation gasoline High-grade motor fuel blended to meet the requirements of piston-type aero plane engines. This specialty product differs in all critical respects from aviation turbine fuel (jet). Aviation turbine fuel (ATF) The fuel burned by aeroplanes’ jet engines. Civilian aircraft consume a kerosene-range product variously known as jet kero, jet A-1, avtur, DERD-2494, and JP1. Warplanes needed special fuels. Two military grades, JP-4 and JP-5, fall within the common notion of AFT.

B %b Indicates where the closing price is within Bollinger bands: Backhaul A tanker’s revenue-producing return voyage. Some ships shuttle between two tanker ports. They travel in one direction as dictated by normal oil flow patterns or refining system’s needs. Often they have no natural employment from when they discharge to their port of origin where another load awaits. They would like to find a cargo to pay their costs on this return trip. Otherwise, they must return in ballast. Charters often relet ships at bargain backhaul rates for these voyages. They prefer some income to none. Back month The out, or back, contract month, as opposed to the current contract month; the expiration month farther in the future than the current, or spot, month. Backpropagation network A feedforward multilayered neural network that is a commonly used neural network paradigm. Back-testing A strategy is tested or optimised on historical data and then the strategy is applied to new data to see if the results are consistent. Backwardation A futures market in which the relationship between two delivery months of the same commodity is abnormal. The opposite of contango. See also Inverted market. Bad oil Oil not acceptable for delivery to the pipeline purchaser; oil requiring additional treating. Baffles Plates or obstructions built into a tank or other vessel to change the direction of fluid flow.

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Balance of payment A summary of the international transactions of a country over a period of time including commodity and service transactions and gold movements. Ballast Water taken aboard a vessel to increase its draft, steady its motion, correct its trim, or otherwise make it more seaworthy when sailing without cargo. The trade uses this word to describe repositioning voyages or empty backhauls forced on ship. Hence phrases appear like ‘ballasting Trans-Atlantic’. Bank Investment Contracts (BICs) A negotiated-term deposit issued by a commercial bank. See also Guaranteed Investment Contracts (GICs). Bar chart A chart that graphs the high, low and settlement prices for a specific trading session over a given period of time. Barge lots Quantities of petroleum product accommodated in the sizes of barges in common use in a particular area. This term usually applies to small (less than cargo-size) volumes of product intended for regional distribution. On the US Gulf Coast, for instance, petroleum products barges typically range from 10,000 to 50,000 barrels. On the Rhine, barges typically carry lots as large as 1,000 tons. Barrel A unit of volume equal to 42 US gallons. Barrels of oil equivalent (BOE) Gas volume that is expressed in terms of its energy equivalent in barrels of oil. 6,000 cubic feet of gas equals 1 barrel of oil equivalent (BOE); or 42 US gallons of oil at 40 °F. Barrels per calendar day The amount of input that a distillation facility can process under usual operating conditions. The amount is expressed in terms of capacity during a 24-hour period and reduces the maximum processing capability of all units at the facility under continuous operation (see Barrels per stream day) to account for the following limitations that may delay, interrupt or slow down production: 1. The capability of downstream processing units to absorb the output of crude oil processing facilities of a given refinery. No reduction is necessary for intermediate streams that are distributed to other than downstream facilities as part of a refinery’s normal operation. 2. The types and grades of inputs to be processed. 3. The types and grades of products expected to be manufactured. 4. The environmental constraints associated with refinery operations. 5. The reduction of capacity for scheduled downtime due to such conditions as routine inspection, maintenance, repairs and turnaround. 6. The reduction of capacity for unscheduled downtime due to such conditions as mechanical problems, repairs and slowdowns. Barrels per stream day The maximum number of barrels of input that a distillation facility can process within a 24-hour period when running at full capacity under optimal crude and product slate conditions with no allowance for downtime. Base stock A hydrocarbon mixture which makes up much of the volume of a gasoline blend. Usually such stocks have properties not too far removed from finished fuel because the minor components have to bring the entire blend within accepted limits of gasoline quality. Base stocks in today’s US motor gasoline include cat gasoline, reformate and alkylate. Basis The difference between spot (cash) prices and the futures or derivatives contract price. Unless otherwise specified, the price of the nearby futures contract month is generally used to calculate the basis.

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Basis points The measure of yields on bonds and notes; one basis point equals 0.01% of yield. Basket trades Large transactions made up of a number of different stocks. Batch A definite amount of oil, mud, chemicals, cement or other material in a treatment or operation. Bayes decision rule A rule that states the strategy chosen from those available is that for which the expected value of payoff is the greatest. bbl One barrel of oil; 1 barrel = 35 Imperial gallons (approx.), or 159 litres (approx.); 7.5 barrels = 1 ton (approx.); 6.29 barrels = 1 cubic metre. bcf Billion cubic feet; 1 bcf = 0.83 million tons of oil equivalent. bcm Billion cubic metres (1 cubic metre = 35.31 cubic feet). B/D The abbreviation for barrels per day. Other related abbreviations are: BPD for barrels per day; BOPD for barrels of oil per day; BWPD for barrels of water per day; BLPD for barrels a of liquid per day Beam The breadth of a ship at its widest point. Beam well A well whose fluid is being lifted by rods and pump actuated by a beam pump rig unit. Bean A type of choke used to regulate the flow of fluid from a well. Different sizes of beans are used for different producing rates. Bear Someone who thinks that market prices will decline. Bear market (bear/bearish) A market in which prices are declining. A market participant who believes prices will move lower is called a bear. A news item is considered bearish if it is expected to result in lower prices. Bear spread In most commodities and financial instruments, the term refers to selling the nearby contract month and buying the deferred contract to profit from a change in the price relationship. Benzene The simplest aromatic. This unsaturated six-carbon ring forms the basis of a whole class of compounds. The coal processing business first produced benzene in commercial quantities. This source still provides some of the material on the market, but refinery and petrochemical plant reformers, toluene hydrodealkylators, and steam crackers now make most of the supply. The products of benzene range from egg cartons to pesticides to nylon stockings. Beta (coefficient) A measure of the market/nondiversifiable risk associated with any given security in the market. A ratio of an individual’s stock historical returns to the historical returns of the stock market. If a stock increased in value by 12% while the market increased by 10%, the stock’s beta would be 1.2. Bias The difference between the expected value of an estimator and the actual value to be estimated. Bid An expression indicating a desire to buy a commodity at a given price, opposite of offer. Bid and ask Highest price and lowest price that an investor will pay for a tradable. Bilateral energy trading Trading whereby two parties (for example a generator and a supplier) enter into a contract to deliver electricity at an agreed time in the future.

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Bill of lading Documentation associated with a specific cargo of oil and is signed by the captain of the ship and the contract supplier. Bimodal distribution In which observations are displayed as having two distinct peaks. Biodiesel A renewable fuel synthesized from soybeans, other oil crops or animal tallow that can substitute for petroleum diesel fuel. Biofuels Liquid fuels and blending components produced from biomass (plant) feedstocks, used primarily for transportation. Biogas A medium Btu gas containing methane and carbon dioxide, produced from the anaerobic decomposition of organic material in a landfill. Also called biomass gas. Biomass Nonfossil material of biological origin constituting a renewable energy resource. Included in wood and waste. Biomass gas See Biogas Biosphere The portion of the Earth and its atmosphere that can support life. The part of the global carbon cycle that includes living organisms and biogenic organic matter. Bit The cutting or boring element used in drilling oil and gas wells. Bitumen Mineral pitch rich in asphaltenes and other complex, high molecular weight molecules. These mixtures of heavy hydrocarbons and resins form the base of, and impart adhesive, semi-solid consistency to asphalt cement and tar. Bituminous briquets See Coal briquets Bituminous coal A dense coal, usually black, sometimes dark brown, often with well-defined bands of bright and dull material, used primarily as fuel in steamelectric power generation, with substantial quantities also used for heat and power applications in manufacturing and to make coke. Bituminous coal is the most abundant coal in active US mining regions. Its moisture content is usually less than 20%. The heat content of bituminous coal ranges from 21 to 30 million Btu per ton on a moist, mineral matter-free basis. The heat content of bituminous coal consumed in the USA averages 24 million Btu per ton on the asreceived basis (i.e. containing both inherent moisture and mineral matter). Black box A proprietary, computerised trading system whose rules are not disclosed or readily accessible. Black liquor A byproduct of the paper production process that can be used as a source of energy. Black–Scholes option pricing model A model developed to estimate the market value of option contracts. Blender Someone or some organisation which combines various components to produce motor gasoline. The term may accurately apply to refiners for they blend motor fuel from blendstock they produce or purchase. In many cases, however, the word designates gasoline makers who do not refine any crude oil and distinguishes them from the ‘refiners’ who do. Blendstock A component combined with other materials to produce a finished petroleum product. The term applies most frequently to motor gasoline ingredients. Block An acreage subdivision measuring approximately 10 × 20 km, forming part of a quadrant. e.g. Block 9/13 is the 13th block in Quadrant 9.

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Block trades Large transactions of a particular stock sold as a unit. Blow-down Condensate and gas produced simultaneously from the outset of production. Blow-off top A steep and rapid increase in price followed by a steep and rapid drop in price. Blow-out preventers (BOPs) High pressure wellhead valves, designed to shut off the uncontrolled flow of hydrocarbons. Board of Trade See Contract market Board of Trade Clearing Corporation An independent corporation that settles all trades made at the Chicago Board of Trade, acting as a guarantor for all trades cleared by it, reconciles all clearing member firm accounts each day to ensure that all gains have been credited and all losses have been collected, and sets and adjusts clearing member firm margins for changing market conditions. Also referred to as Clearing Corporation. An agency or separate corporation of a futures exchange that is responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Clearing houses act as third parties to all futures and options contracts, acting as a buyer to every clearing member seller and as a seller to every clearing member buyer. BOE See Barrels of oil equivalent Boiler A device for generating steam for power, processing or heating purposes; or for producing hot water for heating purposes or hot water supply. Heat from an external combustion source is transmitted to a fluid contained within the tubes in the boiler shell. This fluid is delivered to an end-use at a desired pressure, temperature and quality. Boiling range The temperature spread between the points where a material starts and finishes evaporating. This term has an abstract usage – naphtha-range, for example. It also has a specific one, such as ‘naphtha with a 140–350 °F range’. Bond A long-term debt security with a stated interest rate and fixed due dates, issued by a corporation or a government, when interest and principal must be paid. There are many variations. Book entry securities Electronically recorded securities that include each creditor’s name, address, Social Security or tax identification number, and dollar amount loaned, (i.e. no certificates are issued to bond holders; instead the transfer agent electronically credits interest payments to each creditor’s bank account on a designated date). Boolean Describes a variable that may have one of only two possible values: true or false. After George Boole, English logician, credited with the invention of ‘Boolean logic’. Bottoms Unvaporised material drawn from the lowest point of a fractionation column. Box–Jenkins linear least squares The additive structure of Box–Jenkins models with a polynomial structure. Box–Jenkins method From G.E.P. Box and G.M. Jenkins, who authored Time Series Analysis: Forecasting and Control. The method refers to the use of autoregressive integrated moving averages (ARIMA), which fit seasonal models and nonseasonal models to a time series.

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Bozu Literally ‘bald’ or ‘monk’ in Japanese; in candlestick terminology refers to a situation during which a trading cycle opens or closes on a high or low, indicating a victory for the bulls or the bears. Bracketing A trading range market or a price region that is non-trending. Breakaway gap When a tradable exits a trading range by trading at price levels that leaves a price area where no trading occurs on a bar chart. Typically, these gaps appear at the completion of important chart formations. Breakout The point when the market price moves out of the trend channel. Brine Water that has a large quantity of salt, especially sodium chloride, dissolved in it; salt water. Briquetting plant A facility where coal is converted into coal briquets. See Coal briquets. British Thermal Unit (Btu) See Btu (British Thermal Unit). Broker A company or individual that executes futures and options orders on behalf of financial and commercial institutions and/or the general public. Brokerage fee A fee charged by a broker for executing a transaction. Brokerage house An individual or organisation that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support such orders. Also referred to as a ‘commission house’ or ‘wire house’. Bromine number A measure of the olefins content of a hydrocarbon mixture. In the petroleum intermediates trade, it serves primarily to indicate the presence of cracked stock in a cargo or stream. California air pollution laws also make it an important specification for motor gasoline and blendstocks offered in Los Angeles. As a rule of thumb, a mixture’s bromine number equals roughly twice its olefin content. Btu (British Thermal Unit) A standard unit for measuring the quantity of heat energy equal to the quantity of heat needed to raise the temperature of 1 pound of water by 1 °F at or near 39.2 °F. The Btu is a convenient measure by which to compare the energy content of various fuels. See also Heat content of a quantity of fuel, gross and Heat content of a quantity of fuel, net. BTX An abbreviation for benzene, toluene and xylene. BTX extraction A solvent recovery process for capturing benzene, toluene and xylenes from refinery and petrochemical plant process streams (reformate and pyrolysis gasoline.) Bull Someone who thinks market prices will rise. Bull market (bull/bullish) A market in which prices are rising. A market participant who believes prices will move higher is called a ‘bull’. A news item is considered bullish if it is expected to result in higher prices. Bull spread In most commodities and financial instruments, the term refers to buying the nearby month, and selling the deferred month, to profit from the change in the price relationship. Bunker C A residual fuel used as ship’s fuel; usually has a high sulphur content and high viscosity. Bunker fuels Fuel supplied to ships and aircraft, both domestic and foreign, consisting primarily of residual and distillate fuel oil for ships and kerosene-

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type jet fuel for aircraft. The term ‘international bunker fuels’ is used to denote the consumption of fuel for international transport activities. Notes: (1) For the purposes of greenhouse gas emissions inventories, data on emissions from combustion of international bunker fuels are subtracted from national emissions totals. However, because it was often difficult to separate out international bunker fuels, this adjustment was not made in estimating the carbon dioxide emissions that appear here. (2) Historically, bunker fuels have meant only ship fuel. See also Vessel bunkering. Bunkers See Bunker fuels Burning kerosene Kerosene intended for use as domestic stove lamp fuel. Butadiene A four-carbon olefin. More precisely, a di-olefin, because the molecule has two double bonds. Synthetic rubber production consumes much of the butadiene supply. Smaller amounts find an outlet in high-strength resins manufacturing. Butane A normally gaseous straight-chain or branched-chain hydrocarbon (C4H10). It is extracted from natural gas or refinery gas streams. It includes isobutane and normal butane and conforms to ASTM Specification D 1835 and Gas Processors Association Specifications for commercial butane. Butterfly spread The placing of two interdelivery spreads in opposite directions with the center delivery month common to both spreads. Butylene An olefinic hydrocarbon (C4H8) recovered from refinery processes. Buy and hold The acquisition of a tradable for the long term rather than quick turnover. Buy/sell A swap in which, for accounting purposes or other reasons, company A sells a parcel to company B while B sells a second parcel to A. Each party buys one and sells another. Buying hedge Buyer futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased.

C Calendar spread The purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity on the same exchange. The purchase of either a call or put option and the simultaneous sale of the same type of option with typically the same strike price but with a different expiration month. Call option A contract that gives the buyer of the option the right, but not the obligation, to take delivery of the underlying security at a specific price within a certain time. Calmar ratio Takes the average rate of return for the last 36 months and divides it by the maximum drawdown for the same period. It is usually calculated on a monthly basis. A negative value for the Calmar ratio means that the system or trader had a negative performance over the last three years. Cancelling order An order that deletes a customer’s previous order.

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Candlestick charts A charting method, originally from Japan, in which the high and low are plotted as a single line and are referred to as shadows. The price range between the open and the close is plotted as a narrow rectangle and is referred to as the body. If the close is above the open, the body is white. If the close is below the open, the body is black. Capital losses Losses resulting from selling at a loss. Carbon budget The balance of the exchanges (incomes) and losses) of carbon between carbon sinks (e.g. atmosphere and biosphere) in the carbon cycle. See also Carbon cycle and Carbon sink. Carbon cycle All carbon sinks and exchanges of carbon from one sink to another by various chemical, physical, geological and biological processes. See also Carbon sink and Carbon budget. Carbon dioxide (CO2) A colourless, odourless non-poisonous gas that is a normal part of Earth’s atmosphere. Carbon dioxide is a product of fossil fuel combustion as well as other processes. It is considered a greenhouse gas as it traps heat (infrared energy) radiated by the Earth into the atmosphere and thereby contributes to the potential for global warming. The global warming potential (GWP) of other greenhouse gases is measured in relation to that of carbon dioxide, which by international scientific convention is assigned a value of one (1). See also Global Warming Potential (GWP) and Greenhouse gases. Carbon dioxide equivalent The amount of carbon dioxide by weight emitted into the atmosphere that would produce the same estimated radiative forcing as a given weight of another radiatively active gas. Carbon dioxide equivalents are computed by multiplying the weight of the gas being measured (for example, methane) by its estimated global warming potential (which is 21 for methane). ‘Carbon equivalent units’ are defined as carbon dioxide equivalents multiplied by the carbon content of carbon dioxide (i.e. 12/44). Carbon intensity The amount of carbon by weight emitted per unit of energy consumed. A common measure of carbon intensity is weight of carbon per British thermal unit (Btu) of energy. When there is only one fossil fuel under consideration, the carbon intensity and the emissions coefficient are identical. When there are several fuels, carbon intensity is based on their combined emissions coefficients weighted by their energy consumption levels. See also Emissions coefficient and Carbon output rate. Carbon output rate The amount of carbon by weight per kilowatt hour of electricity produced. Carbon residue The solid, impure carbon deposits (coke) left behind by burned hydrocarbon fuels. The industry uses two tests, Conradson carbon (ConCarbon) and Ramsbottom carbon, to measure oils’ tendency to form such solids. Carbon sequestration The fixation of atmospheric carbon dioxide in a carbon sink through biological or physical processes. Carbon sink A reservoir that absorbs or takes up released carbon from another part of the carbon cycle. The four sinks, which are regions of the Earth within which carbon behaves in a systematic manner, are the atmosphere, terrestrial biosphere (usually including freshwater systems), oceans and sediments (including fossil fuels).

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Carrying (clearing) broker A member of a futures exchange, usually a clearing house member, through which another firm, broker or customer chooses to clear all or some trades. Carrying charge For physical commodities such as grains and metals, the cost of storage space, insurance and finance charges incurred by holding a physical commodity. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of funds necessary to buy the instrument. Also referred to as cost of carry or carry. Carryover Grain and oilseed commodities not consumed during the marketing year and remaining in storage at year’s end. These stocks are ‘carried over’ into the next marketing year and added to the stocks produced during that crop year. Cash commodity An actual physical commodity someone is buying or selling, e.g. soybeans, corn, gold, silver or Treasury bonds. Also referred to as actuals. Cash contract A sales agreement for either immediate or future delivery of the actual product. Cash market A place where people buy and sell the actual commodities, i.e. grain elevator, bank etc. Spot usually refers to a cash market price for a physical commodity that is available for immediate delivery. A forward contract is a cash contract in which a seller agrees to deliver a specific cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and are not standardised. See also Forward (cash) contract and Spot. Cash settlement Transactions generally involving index-based futures contracts that are settled in cash based on the actual value of the index on the last trading day, in contrast to those that specify the delivery of a commodity or financial instrument. Catalytic cracker These refinery units, also widely known as cat crackers and FCCs (for fluid catalytic crackers) or FCCUs, convert heavy distillate, most commonly vacuum gasoil, to lighter fractions. Refiners use them, basically, to break molecules which boil in the heavy distillate range to shorter, more volatile hydrocarbon chains suitable for making motor gasoline. Catalytic cracking The refining process of breaking down the larger, heavier, and more complex hydrocarbon molecules into simpler and lighter molecules. Catalytic cracking is accomplished by the use of a catalytic agent and is an effective process for increasing the yield of gasoline from crude oil. Catalytic cracking processes fresh feeds and recycled feeds. Catalytic reforming A refining process using controlled heat and pressure with catalysts to rearrange certain hydrocarbon molecules, thereby converting paraffinic and naphthenic type hydrocarbons (e.g. low-octane gasoline boiling range fractions) into petrochemical feedstocks and higher octane stocks suitable for blending into finished gasoline. Catfeed The charge fed to a catalytic cracker. Common usage generally restricts this term to describing vacuum gasoils. Cat gasoline The motor fuel blending component produced by catalytic cracking units.

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Cat naphtha See Cat gasoline. Some refiners could, if their markets made it desirable, hydrotreat cat gasoline to make a naphtha suitable for some use other than motor fuel blending, such as steam cracker feedstock. CBOT Chicago Board of Trade. Centigrade degrees (°C) Also known as Celsius degrees. A temperature scale according to which water boils at 100 and freezes at 0. Centigrade, or Celsius, degrees convert to Fahrenheit degrees by the following formula: (C × 1.8) + 32 = F. Centistoke The unit, commonly abbreviated cSt, of kinematic viscosity, which reports a liquid’s resistance to flow in terms of its measured viscosity divided by its density. Central Limit Theorem From statistics, the theorem that the distribution of sample means taken from a large population approaches a normal, Gaussian, curve. Certificate of Deposit (CD) A time deposit with a specific maturity evidenced by a certificate. Cetane A paraffinic hydrocarbon used hydrocarbon used as an additive in diesel fuel. Cetane index (CI) An estimated diesel fuel performance rating which relies on samples’ API gravity and mid-point: CI = –420.34 + 0.016G2 + 0192G log M + 65.01 (log M)2 – 0.0001809M2 where G = API gravity and M = mid-point in °F Cetane number A performance indicator for diesel fuel analogous to the octane rating applied to gasolines. The more paraffinic the gasoil, the higher its cetane number. Cetane rating See Cetane number. CFD Contract For Differences. A type of crude oil swap. Chaikin oscillator An oscillator created by subtracting a 10-day EMA from a three-day EMA of the accumulation/distribution line. Chains This term has both chemical and commercial usages in the oil business. It describes the strands of carbon atoms (carbon chains) fundamental to hydrocarbon molecules. It also serves as a designation for the strings of transactions assembled to settle a period’s business in unregulated paper commodities, such as Russian gasoil. Channel In charting, a price channel contains prices throughout a trend. There are three basic ways to draw channels: parallel, rounded and channels that connect lows (bear trend) or highs (bull trend). Chaos theory Describes the behaviour of nonlinear systems. A subset of nonlinear dynamics analysis, chaos theory is a branch of mathematics focusing on irregular and complex behaviour that has an underlying order. In the stock market, chaos theory seeks to forecast the future path of stock prices, including sudden changes that occur during periods of intense market activity. Charge See Feedstock. Charter party A document in which a ship owner and a charterer state their agreement to terms for carriage of cargo.

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Charterer The party who contracts for use of a ship. He can do so for a voyage, a spot charter, or a period, a time-charter. Charting The use of charts to analyse market behaviour and anticipate future price movements. Those who use charting as a trading method plot such factors as high, low and settlement prices; average price movements; volume; and open interest. Two basic price charts are bar charts and point-and-figure charts. Analysts anticipate future price movement using historical prices, trading volume, open interest and other trading data to study price patterns. See also Technical analysis. Charts A display or picture of a security that plots price and/or volume (the number of shares sold). The chart is the foundation of technical analysis, and over the years many different types of charts have been developed. Cheap Colloquialism implying that a commodity is underpriced. Cheapest to deliver A method to determine which particular cash debt instrument is most profitable to deliver against a futures contract. Chemical carrier See Parcel tanker. Chlorides Chlorine-containing compounds. The oil trade pays most attention to these substances when discussing naphtha. Reformers need a specific amount of chloride on their catalyst to perform properly, any more or any less amounts to poison. Naphtha feedstock containing any significant amount of chlorides upsets the delicate balance and reduces reformat yield. Christmas tree spread The simultaneous purchase and writing of options with either a different strike price or expiration date or combination of the two. C.I.F. (Cost, Insurance and Freight) A sales transaction in which the seller pays for the transportation and insurance of the goods up to the port of destination specified by the buyer. Circuit A conductor or a system of conductors through which electric current flows. Circuit breaker A system of trading halts and price limits on equities and derivatives markets designed to provide a cooling-off period during large, intraday market declines. Classifier systems In artificial intelligence, these systems perform a type of machine learning that generates rules from examples. Clean Unleaded, when used to describe motor gasoline or blendstock. Clear The process by which a clearing house maintains records of all trades and settles margin flow on a daily mark-to-market basis for its clearing member. Clearing corporation An independent corporation that settles all trades made at the Chicago Board of Trade, acting as a guarantor for all trades cleared by it, reconciles all clearing member firm accounts each day to ensure that all gains have been credited and all losses have been collected, and sets and adjusts clearing member firm margins for changing market conditions. Clearing margin Financial safeguards to ensure that clearing members (usually companies or corporations) perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. See Customer margin. Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and

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sellers of options contracts to ensure fulfilling of contract obligations. FCMs are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performancebond margin. Clearing member A member of an exchange clearing house. Memberships in clearing organisations are usually held by companies. Clearing members are responsible for the financial commitments of customers that clear through their firm. Clearing house An agency or separate corporation of a futures exchange that is responsible for settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery, and reporting trading data. Clearing houses act as third parties to all futures and options contracts, acting as a buyer to every clearing member seller and a seller to every clearing member buyer. Climate The average course or condition of the weather over a period of years as exhibited by temperature, humidity, wind velocity and precipitation. Climate change A term used to refer to all forms of climatic inconsistency, but especially to significant change from one prevailing climatic condition to another. In some cases, ‘climate change’ has been used synonymously with the term ‘global warming’; scientists, however, tend to use the term in a wider sense inclusive of natural changes in climate, including climatic cooling. Closed trades Positions that have been either liquidated or offset. Closing price The last price paid for a commodity on any trading day. The exchange clearing house determines a firm’s net gains or losses, margin requirements and the next day’s price limits, based on each futures and options contract settlement price. If there is a closing range of prices, the settlement price is determined by averaging those prices. Also referred to as settlement price. Closing range A range of prices at which buy and sell transactions took place during the market close. Cloud point The temperature where wax crystals begin to appear in a cooled hydrocarbon mixture. This quality consideration, usually applied to gasoil, indicates how cold the air must become to make a stream form solids which block filters halting fuel delivery. The cloud point of gasoil resembles the freezing point of kerosene. Clustering Locating the presence of groups of vectors that are similar in some fashion. CME The Chicago Mercantile Exchange. CNR Charterer not revealed COA Contract of affreightment. An arrangement between a ship owner and a charterer for the carriage of a certain amount of specified grade or grades of cargo on named routes over a period of time. Owners may use any suitable ships at their disposable to meet the contract’s requirements. Coal A readily combustible black or brownish-black rock whose composition, including inherent moisture, consists of more than 50% by weight and more than 70% by volume of carbonaceous material. It is formed from plant remains that have been compacted, hardened, chemically altered and metamorphosed by heat and pressure over geologic time. See Coal rank.

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Coalbed A bed or stratum of coal. Also called a coal seam. Coalbed methane Methane produced from coalbeds in the same way that natural gas is produced from other strata. See Methane. Coal briquets Anthracite, bituminous and lignite briquets are secondary solid fuels manufactured from coal by a process in which the coal is partly dried, warmed to expel excess moisture and then compressed into briquets, usually without the use of a binding substance. Coal coke See Coke Coal production The sum of sales, mine consumption, issues to miners, and issues to coke, briquetting, and other ancillary plants at mines. Production data include quantities extracted from surface and underground mines, and normally exclude wastes removed at mines or associated preparation plants. Coal rank The classification of coals according to their degree of progressive alteration from lignite to anthracite. In the USA, the standard ranks of coal include lignite, sub-bituminous coal, bituminous coal and anthracite, and are based on fixed carbon, volatile matter, heating value and agglomerating (or caking) properties. Coal stocks Coal quantities that are held in storage for future use and disposition. Note: When coal data are collected for a particular reporting period (month, quarter, or year), coal stocks are commonly measured as of the last day of this period. Coefficient A constant used to multiply another quantity or series; as in 3x and ax: 3 and a are coefficients of x. Coefficient of determination R-squared. The proportion of the variation in the data explained by the model. Cogeneration The production of electrical energy and another form of useful energy (such as heat or steam) through the sequential use of energy. Cogenerator A generating facility that produces electricity and another form of useful thermal energy (such as heat or steam) used for industrial, commercial, heating, or cooling purposes. See Electric utility and Nonutility power producer. Coiled Tankers fitted with tubes which carry hot water or steam through viscous cargoes, such as heavy fuel oil and certain crudes, to keep them fluid. Coincidence In Gann theory, a projected reversal point. Coke Solid, almost hydrogen-free carbon made on purpose in fuel oil destruction units called cokers or inescapably in other processing hardware. Coke forms on the catalyst in cat crackers and in the furnaces of ethylene plants. The coke manufactured intentionally may go to the graphite industry if it meets certain quality requirements. Otherwise it sells as solid fuel. The incidental accretions require removal to keep process units efficient. Coke oven gas The gaseous portion of volatile substances driven off in the coking process after other coal chemicals are removed. Coke (petroleum) A residue high in carbon content and low in hydrogen that is the final product of thermal decomposition in the condensation process in cracking. This product is reported as marketable coke or catalyst coke. The conversion is 5 barrels (of 42 US gallons each) per short ton. Coke from petroleum has a heating value of 6.024 million Btu per barrel.

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Coke plant A plant where coal is carbonized in slot or beehive ovens for the manufacture of coke. Coker A thermal processing unit which cracks heavy refinery streams, such as vacuum still bottoms, into light products while reducing much of that feedstock to solid carbon. The liquids yielded by these units, often called coker naphtha and coker gasoil, usually pass through upgrading equipment on the way to finished fuels production. Coking coal Bituminous coal suitable for making coke. See Coke. Cold blender European producers of motor gasoline who have no distillation or other refining equipment go by this name. They make their product by mixing purchased ‘cold’ components. This term has the advantage over the simple ‘blender’ used in the USA of emphatically distinguishing a certain group of low-capital motor fuel makers from the refinery-based gasoline producers who also, of course, blend streams to obtain their finished products. See also Blender. Cold filter plugging point A measure of diesel fuel’s suitability for use in cold weather. Usually called by its initials, CFPP, this specification reports the temperature where clotted wax stops fuel from passing through a test filter. CFFP goes beyond cloud point, which indicates where the cause of problems appears. It tells the fuel temperature where real trouble, like a stalled truck, happens. Collinear See Multicollinearity. Colonial grade Light petroleum product which conforms to one of the specifications of Colonial Pipeline Company. Colonial pipeline The on-land pipeline system connecting US Gulf Coast refineries to Southeast and Atlantic Coast markets. The main artery runs from Deer Park, Texas, to Linden, NJ. It has the effective capability to carry roughly 2.1 million barrels per day of clean products, including gasolines, home heating oils, diesel fuels and kerosenes. The system serves more than 280 petroleummarketing terminals in thirteen states. Specifications required to move motor gasoline and No. 2 oil through the Colonial pipeline have become the quality standard for cargoes of these products imported on the US East Coast. Transporting a gallon of gasoline from Houston, Texas, to the New York harbor area via the Colonial pipeline costs about 2.3 cents. Moving product through roughly 1,550 miles of pipeline typically takes three to four weeks. Colour A spectrum which extends from absolutely colourless (usually described as water white) to dirty (black and opaque). This property only pertains usefully to light refined products and gas liquids. It makes a handy indicator of contamination or poor distillation for very pale substances such as naphtha and undyed motor gasoline. The industry uses several scales to report colour including Saybolt and ASTM. Combination carriers Vessels fitted to transport more than one type of cargo. The petroleum industry uses a good-sized fleet of OBOs, ships which transport dry cargo or oil. Combined cycle An electric generating technology in which electricity is produced from otherwise lost waste heat exiting from one or more gas (combustion) turbines. The exiting heat is routed to a conventional boiler or to a heat recovery steam generator for utilisation by a steam turbine in the production of electricity. Such designs increase the efficiency of the electric generating unit.

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Combined cycle unit An electric generating unit that consists of one or more combustion turbines and one or more boilers with a portion of the required energy input to the boiler(s) provided by the exhaust gas of the combustion turbine(s). Combined forecast The weighted average of two or more forecasts. Combined pumped storage electric power plant A pumped storage hydroelectric power plant that uses both pumped water and natural stream flow to produce electricity. See also Pumped storage hydroelectric power plant and Pure pumped storage hydroelectric power plant. Combustion Chemical oxidation accompanied by the generation of light and heat. COM membership A Chicago Board of Trade membership that allows an individual to trade contracts listed in the commodity options market category. Commercial field An oil and/or gas field judged to be capable of producing enough net income to make it worth developing. Commission fee A fee charged by a broker for executing a transaction. Also referred to as brokerage fee. Commission house An individual or organisation that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support such orders. Also referred to as ‘wire house’. See also Futures commission merchant. Commodity An article of commerce or a product that can be used for commerce. In a narrow sense, products traded on an authorised commodity exchange. The types of commodities include agricultural products, metals, petroleum, foreign currencies, and financial instruments and index, to name a few. Commodity Credit Corp. A branch of the US Department of Agriculture, established in 1933, that supervises the government’s farm loan and subsidy programs. Commodity Exchange Act (CEA) The US federal act that provides for federal regulation of futures trading. Commodity Futures Trading Commission (CFTC) A commission established in1974 that oversees the commodity exchanges in the USA. Commodity pool An enterprise in which funds contributed by a number of persons are combined for the purpose of trading futures or options contracts. The concept is similar to a mutual fund in the securities industry. Also referred to as a pool. Commodity Pool Operator (CPO) An individual or organisation that operates or solicits funds for a commodity pool. Commodity Trading Adviser (CTA) A person who, for compensation or profit, directly or indirectly advises others as to the value or the advisability of buying or selling futures contracts or commodity options. Advising indirectly includes exercising trading authority over a customer’s account as well as providing recommendations through written publications or other media. Comparative relative strength Compares the price movement of a stock with that of its competitors, industry group or the entire market. This is distinct from J. Welles Wilder’s Relative Strength Index, which compares current price movement to previous price movement of the same instrument.

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Comparator A device of some kind that compares two inputs. Compatibility The suitable of two or more residues for blending. Some stocks – certain visbroken resides and hydrotreated bottoms, for instance – do not combine well enough to yield stable fuel oils. Component One part of a blend. The word most commonly names streams combined to make motor gasoline. In that usage, it serves as short version of ‘mogas component’. Though not used casually, ‘gasoil component’, ‘heavy fuel oil component’ and similar designations make perfect sense. Completion Installation of permanent equipment for the production of oil or gas. If a well is equipped to produce only oil or gas from one zone or reservoir, the definition of a well (classified as an oil well or gas well) and the definition of a completion are identical. However, if a well is equipped to produce oil and/or gas separately from more than one reservoir, a well is not synonymous with a completion. See Well. Compounding The payment, through interest, based on the sum of the original principal amount and its accrued interest. Concession contracts Contracts currently applied mainly in Western countries regulating relationships between States and oil companies with regards to hydrocarbon exploration and production. The company holding the mining concession has an exclusive on mining activities, and for this reason it acquires a right on hydrocarbons extracted, against the payment of royalties to the State on production and taxes on oil revenues. Concurrent indicators Market indicators showing the general direction of the economy and confirming or denying the trend implied by the leading indicators. Condensate Natural gas liquids heavier than butane. The term condensates commonly covers two quite different kinds of streams: natural gasolines and heavy condensates. Natural gasolines come from LPG or LNG plants. They have properties similar to naphthas. Heavy condensates resemble very light crude oils. Sometimes called field condensates, they come from gas/oil separation plants which process the raw stream from a gas field. Since they come as a by-product of gas production, much as associated gas comes as a by-product of crude production, associated crude suits them as a description. Conference of the Parties (COP) The collection of nations that have ratified the Framework Convention on Climate Change (FCCC). The primary role of the COP is to keep implementation of the FCCC under review and make the decisions necessary for its effective implementation. See Framework Convention on Climate Change (FCCC). Confidence factor A measure of the degree of likelihood that a rule is correct, which may reflect the percentage of times that it has proven to be correct in the past or just a subjective measure of our confidence in its degree of reliability. Confidence level The degree of assurance that a specified failure rate is not exceeded. Confirmation Indication that at least two indices, in the case of Dow theory the industrials and the transportation, corroborate a market trend or a turning point. Confirmation Statement A statement sent by a Futures Commission Merchant to a customer when a futures or options position has been initiated. The

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statement shows the price and the number of contracts bought or sold. Sometimes combined with a Purchase and Sale Statement. Congestion area or pattern A series of trading days in which there is no visible progress in price. Conradson carbon (ConCarbon) A measurement of hydrocarbon mixtures tendency to leave carbon deposits (coke) when burned as fuel or subjected to intense heat in a processing unit such as a catalytic cracker. The ConCarbon test involves destructive distillation – subjection to high temperature which causes cracking, coking and drives off any volatile hydrocarbons produced – and weighing the residue which remains. A somewhat similar test, Ramsbottom carbon, also measures mixtures tendency to form coke. For reasons of laboratory convenience, analysts ordinarily restrict the Ramsbottom method to hydrocarbons which flow at 90 °C. To obtain a useful indication of carbon residue formation by light distillates, such as high-speed diesel, the industry often measures coke formation by the last 10% of the material to boil. This technique goes by names such as ‘ConCarbon residue on 10% bottoms.’ Consolidation Also known as a congestion period. A pause that allows participants in a market to reevaluate the market and sets the stage for the next price move. Consumer Price Index (CPI) A major inflation measure computed by the US Department of Commerce. It measures the change in prices of a fixed market basket of some 385 goods and services in the previous month. Consumption See Energy consumption. Contango A futures market in which prices in succeeding delivery months are progressively higher. The opposite of backwardation. Continuation chart A chart in which the price scale for the data for the end of a given contract and the data for the beginning of the next contract are merged in order to ease the transition of one contract to the next. Continuous-type deposit A hydrocarbon accumulation that is pervasive throughout a large area, that is not significantly affected by hydrodynamic influences, and for which the standard methodology for assessment of sizes and numbers of discrete accumulations is not appropriate Contract An agreement as in options in which rights are exchanged by law. Contract deal See Term deal. Contract grades The standard grades of commodities or instruments listed in the rules of the exchanges that must be met when delivering cash commodities against futures contracts. Grades are often accompanied by a schedule of discounts and premiums allowable for delivery of commodities of lesser or greater quality than the standard called for by the exchange. Contract market A board of trade designated by the CFTC to trade futures or options contracts on a particular commodity. Commonly used to mean any exchange on which futures are traded. Also referred to as an exchange. Contract month The month in which delivery is to be made in accordance with the terms of the futures contract. Also referred to as delivery month. Controlled account An arrangement by which the holder of the account gives written power of attorney to another person, often his broker, to make trading decisions. Also known as a discretionary or managed account.

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Conventional accumulation A discrete deposit, usually bounded by a downdip water contact, from which oil, gas or NGL can be extracted using traditional development practices, including production at the surface from a well as a consequence of natural pressure within the subsurface reservoir, artificial lifting of oil from the reservoir to the surface where applicable, and the maintenance of reservoir pressure by means of water or gas injection Conventional gasoline Finished motor gasoline not included in the oxygenated or reformulated gasoline categories. Note: This category excludes reformulated gasoline blendstock for oxygenate blending (RBOB) as well as other blendstock. See Motor gasoline (finished). Conventional mill (uranium) A facility engineered and built principally for processing of uraniferous ore materials mined from the earth and the recovery, by chemical treatment in the millÕs circuits, of uranium and/or other valued coproduct components from the processed one. Conventional thermal electricity generation Electricity generated by an electric power plant using coal, petroleum or gas as its source of energy. Convergence A term referring to cash and futures prices tending to come together (i.e. the basis approaches zero) as the futures contract nears expiration. Conversion Cracking molecules which boil above the threshold temperature into smaller ones which boil below it. Traditionally, the term is applied to catalytic crackers. They convert oil which boils above 430 °F to hydrocarbons which boil below that point. In other words, they convert gasoil to naphtha. The recent popularity of residue crackers has established another conversion standard around 720 °F. This point marks the elevation of fuel oil to light products. Loosely, the term refers to any processing step which breaks molecules into pieces which boil at lower temperatures. Conversion arbitrage Traders buy and sell two different securities (or synthetic securities), forcing equivalent prices for equivalent securities. Conversion factor A factor used to equate the price of T-bond and T-note futures contracts with the various cash T-bonds and T-notes eligible for delivery. This factor is based on the relationship of the cash-instrument coupon to the required 8% deliverable grade of a futures contract as well as taking into account the cash instrument’s maturity or call. Co-products Substances made in one processing unit at the same time. A lot of refining hardware, especially crackers, cannot help making an assortment of hydrocarbons. The industry uses ‘co-product’ when it does not want to designate one material a plant’s product and demean the rest by calling them byproducts. Its name gives a good clue why an ethylene cracker gets built. Petrochemical companies call the other olefins and the aromatics it makes its coproducts. COP See Conference of the Parties (COP) Cost, Insurance and Freight See C.I.F. (Cost, Insurance and Freight) Cost of Carry (or Carry) For physical commodities such as grains and metals, the cost of storage space, insurance and finance charges incurred by holding a physical commodity. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of funds necessary to buy the instrument.

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Coppock Curve Also Coppock Guide. A long-term price momentum indicator: a 10-month weighted moving aver age of the sum of the 14-month rate of change and the 11-month rate of change for the Djia. Correction Any price reaction within the market leading to an adjustment by as much as one-third to two-thirds of the previous gain. Correction wave A wave or cycle of waves moving against the current impulse trend’s direction. Correlation Coefficient Degree to which two series of numbers plot as a straight line. A correlation coefficient of 1 (or –1) indicates that the two series of numbers plot exactly along a straight line. A correlation coefficient of zero indicates that there is no straight line relationship between the two series of numbers. As applied to two portfolios, a high correlation coefficient for the relative returns indicates that the portfolio values have moved in tandem, and a low correlation coefficient means the opposite. When the correlation coefficient is high, one portfolio could have been used as a surrogate or a hedge for the other. Correlogram A numerical and graphical display of the test statistics of an autocorrelation diagnostic routine. Cost basis The cost of a given share or group of stock shares. Countermove A price bar showing movement opposite to the direction of the prior time period; a retracement. Coupon The interest rate on a debt instrument expressed in terms of a percentage on an annualised basis that the issuer guarantees to pay the holder until maturity. Covariance Multiplies the deviation of each variable from its mean, adds those products and then divides by the number of observations. Cover Purchasing back a contract sold earlier. Covered option A short call or put option position which is covered by the sale or purchase of the underlying futures contract or physical commodity. Covered write Writing a call against a long position in the underlying stock. By receiving a premium, the writer intends to realise additional return on the underlying common stock or gain some element of protection (limited to the amount of the premium less transaction costs) from a decline in the value of that underlying stock. COW Crude oil wash. A cleaning technique used by some ships. They spray a few tons of crude around their tanks to rinse off the remains of previous cargoes. This method cannot make a dirty vessel clean. But it can do enough good to prevent excessive darkening of not particularly colour-sensitive cargo. Crack spreads The spread between crude oil and its products: heating oil and unleaded gasoline plays a major role in the trading process. Cracked Broken by a thermal or catalytic process. This term frequently describes an oil product which contains cracked components made by such a process. Cracked component An ingredient in a hydrocarbon blend produced by a cracking process. The opposite of a virgin or straight-run component. Blends containing any cracked components do not qualify as straight-run. The presence of cracked components makes refinery streams unsuited for certain feedstock uses. The issue arises most frequently regarding heavy fuel oils.

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Companies buying such streams to produce catfeed want a virgin material containing no cracked components. Cracked cutters Cycle oils used to reduce the sulphur content or, especially, the viscosity of fuel oil. Cracked fuel Fuel oil containing molecules broken in a cracking unit. The term most frequently applies to residue. It distinguishes streams unsuitable for upgrading from straight-run material of interest as feedstock. Cracked gas See Unsaturated gases Cracked naphtha General term for any naphtha-range fraction produced by a molecule-breaking process. The category includes cat gasoline from a catalytic cracker, visbroken naphtha from a visbreaker, and coker naphtha from a coking unit. In ordinary usage, this term signifies streams with a high olefin content. That custom discourages its application to hydrocrackate and pyrolysis gasoline, known, respectively, for their naphthenes and aromatics concentrations. Cracked stock Cracking units produce cracked stocks such as cycle oils and cat naphthas used for blending finished products. See also Cracked component. Cracker A processing unit which breaks molecular bonds, usually to produce lighter hydrocarbons with lower boiling points. Commercial crackers (cracking units) include cat crackers, hydrocrackers, thermal crackers, visbreakers and stream crackers. Cracking The refining process of breaking down the larger, heavier, and more complex hydrocarbon molecules into simpler and lighter molecules. See also Catalytic cracking and Thermal cracking. Credit Terms of payment, e.g. 5 or 10 days. Credit spread The difference in value of two options, where the value of the one sold exceeds the value of the one purchased. Cross correlations The extent to which the revenue streams of individual traders within a single enterprise tend to exhibit similar patterns over time. Crop (marketing) year The time span from harvest to harvest for agricultural commodities. The crop marketing year varies slightly with each agricultural commodity, but it tends to begin at harvest and end before the next year’s harvest, e.g. the marketing year for soybeans begins 1 September and ends 31 August. The futures contract month of November represents the first major new-crop marketing month, and the contract month of July represents the last major old-crop marketing month for soybeans. Crop reports Reports compiled by the US Department of Agriculture on various agricultural commodities that are released throughout the year. Information in the reports includes estimates on planted acreage, yield and expected production, as well as comparison of production from previous years. Cross-hedging Hedging a cash commodity using a different but related futures contract when there is no futures contract for the cash commodity being hedged and the cash and futures markets follow similar price trends (e.g. using soybean meal futures to hedge fish meal). Crude oil A mixture of hydrocarbons that exists in liquid phase in natural underground reservoirs and remains liquid at atmospheric pressure after passing

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through surface separating facilities. Depending upon the characteristics of the crude stream, it may also include: 1. Small amounts of hydrocarbons that exist in gaseous phase in natural underground reservoirs but are liquid at atmospheric pressure after being recovered from oil well (casinghead) gas in lease separators and are subsequently commingled with the crude stream without being separately measured. Lease condensate recovered as a liquid from natural gas wells in lease or field separation facilities and later mixed into the crude stream is also included; 2. Small amounts of nonhydrocarbons produced with the oil, such as sulphur and various metals; 3. Drip gases, and liquid hydrocarbons produced from tar sands, Gilsonite, and oil shale. Liquids produced at natural gas processing plants are excluded. Crude oil is refined to produce a wide array of petroleum products, including heating oils; gasoline, diesel and jet fuels; lubricants; asphalt; ethane, propane and butane; and many other products used for their energy or chemical content. Crude oil (including lease condensate) See Crude oil Crude oil landed cost The dollar-per-barrel price of crude oil at the port of discharge. Included are the charges associated with the purchase, transporting, and insuring of a cargo from the purchase point to the port of discharge. Not included are charges incurred at the discharge port (e.g. import tariffs or fees, wharfage charges, and demurrage charges). Crude oil less lease condensate A mixture of hydrocarbons that exists in liquid phase in natural underground reservoirs and remains liquid at atmospheric pressure after passing through surface separating facilities. Such hydrocarbons as lease condensate and natural gasoline recovered as liquids from natural gas wells in lease or field separation facilities and later mixed into the crude stream are excluded. Depending upon the characteristics of the crude stream, crude oil may also include: 1. Small amounts of hydrocarbons that exist in gaseous phase in natural underground reservoirs but are liquid at atmospheric pressure after being recovered from oil well (casinghead) gas in lease separators and are subsequently commingled with the crude stream without being separately measured; 2. Small amounts of nonhydrocarbons produced with the oil, such as sulphur and various metals. Crude oil production The volume of crude oil produced from oil reservoirs during given periods of time. The amount of such production for a given period is measured as volumes delivered from lease storage tanks (i.e. the point of custody transfer) to pipelines, trucks, or other media for transport to refineries or terminals with, adjustments for (1) net differences between opening and closing lease inventories, and (2) basic sediment and water. Crush spread The purchase of soybean futures and the simultaneous sale of soybean oil and meal futures. The sale of soybean futures and the simultaneous purchase of soybean oil and meal futures. cSt Abbreviation of centistoke. CTI2 Market profile terminology for commercial clearing members, as opposed to CTI1, local floor traders.

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Cubic foot (cf), natural gas The amount of natural gas contained at standard temperature and pressure (60 °F and 14.73 pounds standard per square inch) in a cube whose edges are one foot long. Cull wood Wood logs, chips or wood products that are burned. Cup and handle An accumulation pattern observed on bar charts. The pattern lasts from seven to 65 weeks; the cup is in the shape of a ‘U’ and the handle is usually more than one or two weeks in duration. The handle is a slight downward drift with low trading volume from the right-hand side of the formation. Current (electric) A flow of electrons in an electrical conductor. The strength or rate of movement of the electricity is measured in amperes. Current ratio The current assets of a company divided by its current liabilities. Balance sheet strength indication. Current yield The ratio of the coupon to the current market price of the debt instrument. Curve The continuous image of the unit interval. Curve-fitting Developing complicated rules that map known conditions. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfilling of contract obligations. FCMs are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value.Also referred to as performance-bond margin. Financial safeguards to ensure that clearing members (usually companies or corporations) perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer segregated funds See Segregated account Cut To divide a hydrocarbon mixture into fractions by distillation. Also a name for the fractions obtained, as in kerosene cut or naphtha cut. Cutter (cutter stock) A refinery stream used to thin a fuel oil or gasoil. Viscosity reduction and sulphur level adjustment provide most of the requirement for the cutter. Cutoff frequency A point where higher frequency cycles will not pass through a filter (e.g. a 10-day SMA will eliminate cycles of 20 days or less). Cycle A variation where a point of observation returns to its origin. Cycle oil Cat cracking unit produced in the fuel oil or gasoil boiling range. The term light cycle oil generally describes products of this kind suitable for blending into diesel or home heating oil. Heavy cycle oil, accordingly, refers to the cat cracked material which boils at temperatures in the fuel oil range. Cycling The practice of producing natural gas for the extraction of natural gas liquids, returning the dry residue to the producing reservoir to maintain reservoir pressure and increase the ultimate recovery of natural gas liquids. Cycling plants See Natural gas processing plants.

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D %D A stochastics indicator that has had its values smoothed a second time, usually with a three-period moving average. Daily range The difference between the high and low price during one trading day. Daily trading limit The maximum price range set by the exchange cash day for a contract. Data preprocessing Altering data to some extent to be more accurately analyzed; smoothing, reducing unwanted data, removing trend. Processing data is mathematically transforming the data from one form into another with the goal of amplifying pertinent information for traders. Day order An order that if not executed expires automatically at the end of the trading session on the day it was entered. Day traders Speculators who take positions in futures or options contracts and liquidate them prior to the close of the same trading day. Dead cat bounce A rebound in a market that sees prices recover and come back up slightly. Deadweight tonnage (DWT) The standard measure of ships’ carrying capacity. The trade usually abbreviates this term to speak simply of tankers ‘deadweight’. This specification reports total weight, usually in long tons, of fresh water, stores, bunkers and cargo a vessel can carry. For oil tankers, cargo averages 95–96% of the total. Debit spread The difference in value of two options, where the value of the long position exceeds the value of the short position. Deductive logic Logic traditionally used in expert systems, which defines a method for reasoning from the general to the specific. Deep-in-the-money A deep-in-the-money call option has the strike price of the option well below the current price of the underlying instrument. A deep-inthe-money put option has the strike price of the option well above the current price of the underlying instrument. Deep waters Waters deeper than 200 metres. Default The failure to perform on a futures contract as required by exchange rules, such as a failure to meet a margin call or to make or take delivery. Deferred (delivery) month The more distant month(s) in which futures trading is taking place, as distinguished from the nearby (delivery) month. Deforestation The net removal of trees from forested land. Degrees API gravity (141.5/Specific Gravity at 60 °F) × 131.5 Degrees of Freedom The number of independent observations; the number of observations minus the number of parameters to be estimated. Delay The amount of time that elapses between a change in an input event and the resultant change in a related output event or time series. Delayed coker A coking unit (coker) which provides a drum where heated molecules crack and coke forms. Delayed coking A process by which heavier crude oil fractions can be thermally decomposed under conditions of elevated temperature and pressure to produce a mixture of lighter oils and petroleum coke.

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Deliverable grades The standard grades of commodities or instruments listed in the rules of the exchanges that must be met when delivering cash commodities against futures contracts. Grades are often accompanied by a schedule of discounts and premiums allowable for delivery of commodities of lesser or greater quality than the standard called for by the exchange. Also referred to as contract grades. Delivery The transfer of the cash commodity from the seller of a futures contract to the buyer of a futures contract. Each futures exchange has specific procedures for delivery of a cash commodity. Some futures contracts, such as stock index contracts, are cash settled. Delivery day The third day in the delivery process at the Chicago Board of Trade, when the buyer’s clearing firm presents the delivery notice with a certified check for the amount due at the office of the seller’s clearing firm. Delivery month A specific month in which delivery may take place under the terms of a futures contract. Also referred to as contract month. Delivery points The locations and facilities designated by a futures exchange where stocks of a commodity may be delivered in fulfilment of a futures contract under procedures established by the exchange. Delta The amount by which the price of an option changes for every dollar move in the underlying instrument. Delta hedged An options strategy that protects an option against small price changes in the option’s underlying instrument. These hedges are constructed by taking a position in the underlying instrument that is equal in magnitude but opposite in sign (±) to the option’s delta. Delta neutral This is an ‘options/options’ or ‘options/underlying instrument’ position constructed so that it is relatively insensitive to the price movement of the underlying instruments. This is arranged by selecting a calculated ratio of offsetting short and long positions. Delta position A measure of option price vs. the underlying futures contract or stock price. Demand See Energy demand Demand (electric) See Electricity demand Demand index An index that shows the buying and selling power of markets and stocks from mathematical calculations of volume and price ratios. Demand, law of The relationship between product demand and price. Demonstrated reserves See Energy reserves Demurrage The cost of delaying a ship. Busy channels, occupied berths, commercial considerations, lack of shore tankage, pumping limitations and a host of other eventualities related to how or where a charterer uses a vessel can prevent it from loading or unloading promptly. When they do, the ship’s owner charges for a waiting time. Density A description of oil by some measurement of its volume to weight ratio. The industry usually relies on two expressions of oil’s volume–weight relationship-specific gravity and API degrees. The larger a specific gravity number and the smaller an API number, the denser the oil. Density function For any measure m, a function that gives rise to m when integrated with respect to some other specified measure. A probability density

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function is a function whose integral over any set gives the probability that a random variable has values in this set. Dependence A relationship between two different experimental results in which the first result does not directly influence the chances of the second result occurring, but instead, the two results are indirectly related because they are subject to influences from a common outside factor. DERD Directorate of Engine Research and Development. It is a UK Ministry of Defence jet fuel specification. Derivative A financial instrument, traded on or off an exchange, the price of which is directly dependent upon the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement. Derivatives involve the trading of rights or obligations based on the underlying product but do not directly transfer property. They are used to hedge risk or to exchange a floating rate of return for a fixed rate of return. Derrick The tower-like structure that houses most of the hoisting and lowering equipment and drilling controls. Derrick hand Crew member whose work station is in the derrick while pipe is being hoisted or lowered into the hole. He is usually next in line of authority under the driller. Designated Self-Regulatory Organisation (DSRO) When a Futures Commission Merchant (FCM) is a member of more than one Self-Regulatory Organisation (SRO), the SROs may decide among themselves which of them will be primarily responsible for enforcing minimum financial and sales practice requirements. The SRO will be appointed DSRO for that particular FCM. NFA is the DSRO for all nonexchange member FCMs. See also Self-Regulatory Organisation. Deterministic (1) Known in advance when the sum of one-step ahead forecast mean squared errors is zero; (2) the fundamental continuous effect of an exogenous variable such as money supply that can be determined to be explanatory. Deterministic system A system in which the outcome is determined by an equation; a system in which cause and effect are easily determined. Detrend To remove the general drift, tendency or bent of a set of statistical data as related to time. Development Drilling and other post-exploration activities aimed at the production of oil and gas. Development well A well drilled within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive. Diesel index A measure of the ignition quality of a diesel fuel calculated from a formula involving the gravity of the fuel and its aniline point. Differencing Subtracting previous from current values to obtain a stationary (detrended) time series: Pstationary = Pt – Pt–1. Difference-in-means test A statistical test that indicates the likelihood of observing the difference if the true difference were zero. A large value of this statistic leads to nonacceptance of the null hypothesis that the true difference is zero. Differentials Price differences between classes, grades and delivery locations of various stocks of the same commodity.

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Diffusion equation A partial differential equation, used in solving a random walk problem. Diffusion index An index that measures the percentage of individual series that are positive compared with the aggregate group that is, the percentage of S&P groups that are above their 30-week moving average. Direct current An electric current that flows in a constant direction. The magnitude of the current does not vary or has a slight variation. Directional Movement Index (DMI) Developed by J. Welles Wilder, DMI measures market trend. Disclosure document The statement that must be provided to prospective customers that describes trading strategy, fees, performance etc. Discount (1) The amount a price would be reduced to purchase a commodity of lesser grade; (2) sometimes used to refer to the price differences between futures of different delivery months, as in the phrase ‘July is trading at a discount to May,’ indicating that the price of the July future is lower than that of May; (3) applied to cash grain prices that are below the futures price. Discount method A method of paying interest by issuing a security at less than par and repaying par value at maturity. The difference between the higher par value and the lower purchase price is the interest. Discount rate The interest rate charged on loans by the Federal Reserve Bank. Discretionary account An arrangement by which the holder of the account gives written power of attorney to another person, often his broker, to make trading decisions. Also known as a controlled or managed account. Distillate fuel oil (USA) A general classification for one of the petroleum fractions produced in conventional distillation operations. It includes diesel fuels and fuel oils. Products known as No. 1, No. 2, and No. 4 diesel fuel are used in on-highway diesel engines, such as those in trucks and automobiles, as well as off-highway engines, such as those in railroad locomotives and agricultural machinery. Products known as No. 1, No. 2, and No. 4 fuel oils are used primarily for space heating and electric power generation. 1. No. 1 Distillate: a light petroleum distillate that can be used as either a diesel fuel (see No. 1 Diesel Fuel) or a fuel oil (see No. 1 Fuel Oil). (a) No. 1 Diesel Fuel: a light distillate fuel oil that has distillation temperatures of 550 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 975. It is used in high-speed diesel engines, such as those in city buses and similar vehicles. (b) No. 1 Fuel Oil: a light distillate fuel oil that has distillation temperatures of 400 °F at the 10% recovery point and 550 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 396. It is used primarily as fuel for portable outdoor stoves and portable outdoor heaters. 2. No. 2 Distillate: a petroleum distillate that can be used either as a diesel fuel (see No. 2 Diesel Fuel) or a fuel oil (see No. 2 Fuel Oil). (a) No. 2 Diesel Fuel: a fuel that has distillation temperatures of 500 °F at the 10% recovery point and 640 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 975. It is used in highspeed diesel engines, such as those in railroad locomotives, trucks, and automobiles.

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(i) Low Sulfur No.2 Diesel Fuel: No. 2 diesel fuel that has a sulphur level no higher than 0.05% by weight. It is used primarily in motor vehicle diesel engines for on-highway use. (ii) High Sulfur No. 2 Diesel Fuel: No. 2 diesel fuel that has a sulphur level above 0.05% by weight. (b) No. 2 Fuel Oil (Heating Oil): A distillate fuel oil that has distillation temperatures of 400 °F at the 10% recovery point and 640 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 396. It is used in atomising-type burners for domestic heating or for moderate capacity commercial/industrial burner units. 3. No. 4 Fuel: a distillate fuel oil made by blending distillate fuel oil and residual fuel oil stocks. It conforms to ASTM Specification D 396 or Federal Specification VV-F-815C and is used extensively in industrial plants and in commercial burner installations that are not equipped with preheating facilities. It also includes No. 4 diesel fuel used for low- and medium-speed diesel engines and conforms to ASTM Specification D 975. (a) No. 4 Diesel Fuel: See No. 4 Fuel. (b) No. 4 Fuel Oil: See No. 4 Fuel. Distillation curve The boiling temperature distribution of a material’s component molecules. Tests report this characteristic as temperature at which various percentages of a sample have boiled or as the percentages which have boiled at various temperatures. Distillation unit (atmospheric) The primary distillation unit that processes crude oil (including mixtures of other hydrocarbons) at approximately atmospheric conditions. It includes a pipe still for vaporising the crude oil and a fractionation tower for separating the vaporised hydrocarbon components in the crude oil into fractions with different boiling ranges. This is done by continuously vaporising and condensing the components to separate higher boiling point material. The selected boiling ranges are set by the processing scheme, the properties of the crude oil and the product specifications. Distiller A term most often used as shorthand for ‘crude oil distillation unit’. See also Distillation unit. Distribution Any set of related values described by an average (that is, mean), which identifies its midpoint, a measure of spread (that is, standard distribution) and a measure of its shape (that is, skew or kurtosis). Distribution system The portion of an electric system that is dedicated to delivering electric energy to an end user. Distributors Inland wholesalers. Divergence When two or more averages or indices fail to show confirming trends. Dividend Stockholder payment of a share of a company’s profits. Dividend reinvestment plan A program offered by a publicly held company in which dividends are used to buy more shares of the company. Doctor test An indicator to detect the presence of significant amounts of mercaptan sulphur in light hydrocarbon mixture. Materials passing this test carry the designation, ‘Doctor negative’. Doctor negative stocks have sufficiently low mercaptan levels for use in motor gasoline. Doctor positive materials do not necessarily have too much mercaptan, but may require a more quantitative test.

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Doji A session in which the open and close are the same (or almost the same). Different varieties of doji lines (such as a gravestone or long-legged doji) depend on where the opening and close are in relation to the entire range. Doji lines are among the most important individual candlestick lines. They are also components of important candlestick patterns. Dollar cost averaging Using the same amount of funds to regularly invest (often quarterly or monthly) and not take into consideration whether the securities being purchased are high or low in price. By using this method, an investor will see an average between their investment costs and the market’s up and down movements. Domestic inland consumption (petroleum) The sum of all refined petroleum products supplied for domestic use (excludes international bunker fuels). Consumption is calculated product-by-product by adding production, imports and crude oil burned directly, and then subtracting exports and changes in primary stocks. Note: a net withdrawal from primary stocks increases consumption and a net addition to primary stocks decreases consumption. Double bottom The price action of a security or market average where it has declined two times to the same approximate level, indicating the existence of a support level and a possibility that the downward trend has ended. See also Double top. Double-smoothed A price series that has been smoothed by a mathematical technique such as a moving average. This first series of smoothed price data is then smoothed a second time. Double top A price pattern seen on a chart. The pattern occurs when prices rise to a resistance level on significant volume, retreats to a support level, and subsequently returns to the resistance level on decreased volume. Prices then decline and break through the support level, marking the beginning of a new downtrend in the price of the stock. See also Double bottom. Downstream A relative term, which indicates greater removal from origins than some point of reference. For example, a petrochemical plant which cracks naphtha lies downstream from a refinery. Money made by marketing products constitutes downstream profits compared to earnings on crude sales. The opposite of upstream. DPK Dual-purpose kerosene. Product suitable for use as burning kerosene and aviation turbine fuel. Draft The distance between a ship’s keel and waterline. The lowest part of a vessel lies this far below the surface of the water. Every ship’s draft changes with the amount of cargo aboard it, its trim and the temperature and salt content of the water in which it floats. A ship reaches its deepest draft when fully laden in warm fresh water. The shipping industry calls that distance ‘tropical fresh’ or ‘TF’ draft. ‘Fresh’ (F),’tropical’(T), ‘summer’ (s), and ‘winter’(W) report increasingly shallow drafts for a vessel, reflecting denser and denser water. Drawdown The reduction in account equity as a result of a trade or series of trades. Drunkard’s walk See Random walk Dry (coal) basis Coal quality data calculated to a theoretical basis in which no moisture is associated with the sample. This basis is determined by measuring

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the weight loss of a sample when its inherent moisture is driven off under controlled conditions of low temperature air-drying followed by heating to just above the boiling point of water (104–110 °C). Dry gas See Dry Natural gas Dry hole An exploratory or development well found to be incapable of producing either oil or gas in sufficient quantities to justify completion as an oil or gas well. Dry natural gas Natural gas which remains after: (1) the liquefiable hydrocarbon portion has been removed from the gas stream (i.e. gas after lease, field, and/or plant separation); and (2) any volumes of nonhydrocarbon gases have been removed where they occur in sufficient quantity to render the gas unmarketable. Note: Dry natural gas is also known as consumer-grade natural gas. The parameters for measurement are cubic feet at 60 °F and 14.73 pounds per square inch absolute. See also Natural gas. Dry natural gas production The process of producing consumer-grade natural gas. Natural gas withdrawn from reservoirs is reduced by volumes used at the production (lease) site and by processing losses. Volumes used at the production site include (1) the volume returned to reservoirs in cycling, repressuring of oil reservoirs, and conservation operations; and (2) gas vented and flared. Processing losses include (1) nonhydrocarbon gases (e.g. water vapour, carbon dioxide, helium, hydrogen sulfide, and nitrogen) removed from the gas stream; and (2) gas converted to liquid form, such as lease condensate and plant liquids. Volumes of dry gas withdrawn from gas storage reservoirs are not considered part of production. Dry natural gas production equals marketed production less extraction loss. Dry production See Dry natural gas production Dual fired unit A generating unit that can produce electricity using two or more input fuels. In some of these units, only the primary fuel can be used continuously; the alternate fuel(s) can be used only as a start-up fuel or in emergencies. Dual trading Dual trading occurs when (1) a floor broker executes customer orders and, on the same day, trades for his own account or an account in which he has an interest; or (2) a Futures Commission Merchant carries customer accounts and also trades, or permits its employees to trade, in accounts in which it has a proprietary interest, also on the same day. Durbin–Watson statistic The probability that first-order correlation exists. Ranges between zero and 4; the closer to 2.0, the lower the probability. Dynamic Data Exchange (DDE) Ability to automatically update an application from within another application. Dynamic Linked Library Refers to programming code that can be used (‘called’) by your main program while running under Windows.

E E-4 C.I.S. high sulphur straight-run feedstock. Formerly called F-10. Early entry A large price movement in one direction within the first 15 minutes after the open of the daily session.

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Earnings estimates The estimated earnings projected for a company for a fiscal year. Eavesdropper A person who secretly listens to other people’s conversations. Econometrics The application of statistical and mathematical methods in the field of economics to test and quantify economic theories and the solutions to economic problems. Efficient market theory All known information is already discounted by the market and reflected in the price due to market participants acting upon the information. Elasticity The ability to recover an original configuration. Electric plant (physical) See Electric power plant Electric power The rate at which electric energy is transferred. Electric power is measured by capacity and is commonly expressed in megawatts (MW). Electric power plant A facility containing prime movers, electric generators and auxiliary equipment for converting mechanical, chemical and/or fission energy into electric energy. Electric system Physically connected generation, transmission and distribution facilities operated as an integrated unit under one central management, or operating supervision. Electric utility A corporation, person, agency, authority or other legal entity or instrumentality that owns and/or operates facilities for the generation, transmission, distribution, or sale of electric energy for use primarily by the public. In the USA, utilities provide electricity within a designated franchised service area and file forms listed in the Code of Federal Regulations, Title 18, Part 141. Note: Facilities that qualify as cogenerators or small power producers under the Public Utility Regulatory Policies Act (PURPA) are not considered electric utilities. See Nonutility Power Producer. Electrical generating capacity See Generator capacity Electricity A form of energy characterised by the presence and motion of elementary charged particles generated by friction, induction, or chemical change. Electricity capacity The maximum load of electric power, commonly expressed in megawatts (MW), by which generators, turbines, transformers, transmission circuits, stations or systems are rated. Electricity demand The rate at which energy is delivered to loads and scheduling points by generation, transmission, and distribution facilities. Electricity generation The process of producing electric energy or the amount of electric energy produced by transforming other forms of energy, commonly expressed in kilowatt hours (kWh) or megawatt hours (MWh). Electricity generation, gross See Gross generation Electricity generation, net See Net generation Electricity installed capacity See Generator nameplate capacity (installed) Electronic communications network Independent execution systems set up by brokerage firms, matching new retail limit orders with compatible orders already in the system. Electronic order An order placed electronically (without the use of a broker) either via the Internet or an electronic trading system.

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Electronic trading systems Systems that allow participating exchanges to list their products for trading after the close of the exchange’s open outcry trading hours (i.e. Chicago Board of Trade’s Project A, Chicago Mercantile Exchange’s GLOBEX and New York Mercantile Exchange’s ACCESS). Elliott wave theory A patternrecognition technique published by Ralph Nelson Elliott in 1939, which holds that the stock market follows a rhythm or pattern of five waves up and three waves down to form a complete cycle of eight waves. The three waves down are referred to as a ‘correction’ of the preceding five waves up. EMA See Exponential Moving Average Emissions Anthropogenic releases of gases to the atmosphere. In the context of global climate change, they consist of radiatively important greenhouse gases (e.g. the release of carbon dioxide during fuel combustion). See also Greenhouse gases. Emissions coefficient A unique value for scaling emissions to activity data in terms of a standard rate of emissions per unit of activity (e.g. pounds of carbon dioxide emitted per British thermal unit (Btu) of fossil fuel consumed). Energy The capacity for doing work as measured by the capability of doing work (potential energy) or the conversion of this capability to motion (kinetic energy). Energy has several forms, some of which are easily convertible and can be changed to another form useful for work. Most of the world’s convertible energy comes from fossil fuels that are burned to produce heat that is then used as a transfer medium to mechanical or other means in order to accomplish tasks. Electrical energy is usually measured in kilowatt hours, while heat energy is usually measured in British thermal units. Energy consumption The use of energy as a source of heat or power or as a raw material input to a manufacturing process. Energy demand The requirement for energy as an input to provide products and/or services. Energy loss (power) See Power loss Energy production See production terms associated with specific energy types. Energy reserves Estimated quantities of energy sources that are demonstrated to exist with reasonable certainty on the basis of geologic and engineering data (proved reserves) or that can reasonably be expected to exist on the basis of geologic evidence that supports projections from proved reserves (probable/ indicated reserves). Knowledge of the location, quantity, and grade of probable/indicated reserves is generally incomplete or much less certain that it is for proved energy reserves. Note: this term is equivalent to ‘Demonstrated Reserves’ as defined in the resource/reserve classification contained in the US Geological Survey Circular 831, 1980. Demonstrated reserves include measured and indicated reserves but exclude inferred reserves. Energy source Any substance or natural phenomenon that can be consumed or transformed to supply heat or power. Included are petroleum, coal, natural gas, nuclear, wood and waste, electricity, wind, sunlight, geothermal, and water movement. Energy supply Energy made available for future disposition. Supply can be considered and measured from the point of view of the energy provider or the receiver.

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Engler A not particularly popular method of measuring and reporting viscosity. Enhanced recovery Techniques used to increase or stretch the production of wells over time. Enriched uranium Uranium in which the 235U isotope concentration has been increased to greater than the 0.711% 235U (by weight) present in natural uranium. Enrichment services See Separative work units Envelope Lines surrounding an index or indicator; that is, trading bands. Entry The point at which a trader gets into a position in the market. Equilibrium market A price region that represents a balance between demand and supply. Equilibrium price The market price at which the quantity supplied of a commodity equals the quantity demanded. Equity The value of a futures trading account if all open positions were offset at the current market price. Equity holders Companies entitled to some portion of an oil field’s production due to their investment in its development. Estimated EPS change (%) Change in estimated mean earnings for the current fiscal year from the last month, last three months and last six months to the current month. ETBE See Ethyl Tertiary Butyl Ether (ETBE) Ethane A normally gaseous straight-chain hydrocarbon (C2H6). It is a colourless paraffinic gas that boils at a temperature of –127.48 °F. It is extracted from natural gas and refinery gas streams. Ether A generic term applied to a group of organic chemical compounds composed of carbon, hydrogen, and oxygen, characterised by an oxygen atom attached to two carbon atoms (e.g. methyl tertiary butyl ether). Ethylene An olefinic hydrocarbon recovered from refinery processes or petrochemical processes. Ethylene is used as a petrochemical feedstock for numerous chemical applications and the production of consumer goods. Ethyl Tertiary Butyl Ether (ETBE) A colourless, flammable, oxygenated hydrocarbon blend stock. See also Oxygenates. EU See European Union (EU) Eurodollar US dollars on deposit with a bank outside of the USA and, consequently, outside the jurisdiction of the USA. The bank could be either a foreign bank or a subsidiary of a US bank. European Union (EU) Current members are: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain, Sweden and United Kingdom. Evening star pattern The bearish counterpart of the morning star pattern; a top reversal, it should be acted on if it arises after an uptrend. Exchange See Contract market Exchange for physicals A transaction generally used by two hedgers who want to exchange futures for cash positions. Also referred to as ‘against actuals’ or ‘versus cash’.

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Exchange-traded funds Collections of stocks that are bought and sold as a package on an exchange, principally the American Stock Exchange (AMEX), but also the New York Stock Exchange (NYSE) and the Chicago Board Options Exchange (CBOE). Ex-dividend date The day on or after which the right to receive a current dividend is not automatically transferred to a buyer. Exercise The process by which the holder of an option makes or receives delivery of shares of the underlying security. Exercise price The price at which the futures contract underlying a call or put option can be purchased (if a call) or sold (if a put). Also referred to as strike price. Exit The point at which a trader closes out of a trade. Expanded trading hours Additional trading hours of specific futures and options contracts at the Chicago Board of Trade that overlap with business hours in other time zones. Expert systems Dynamic but not adaptable, expert systems are rule-driven systems that cannot learn as the result of new information being fed into its system, as opposed to neural networks, which can. Expiration The last day on which an option can be traded. Expiration date Options on futures generally expire on a specific date during the month preceding the futures contract delivery month. For example, an option on a March futures contract expires in February, but is referred to as a March option because its exercise would result in a March futures contract position. Exploration Oil and natural gas exploration that includes land surveys, geological and geophysical studies, seismic data gathering and analysis, and well drilling. Exploratory well A hole drilled: (a) to find and produce oil or gas in an area previously considered unproductive; (b) to find a new reservoir in a field previously found to be producing oil or gas from another reservoir; or (c) to extend the limit of a known oil or gas reservoir. Exponential Moving Average The EMA for day D is calculated as: EMA = Close

S nj = 1Close j 2 ö 2 æ + ç100 ÷ n +1 n n + 1ø è

where n is the number of days. Exponential moving average is related to simple moving average. In other words it is a weighted simple moving average putting more weight on the today's closing price. It may be measured in percentage, which is the percentage that is applied to today's closing price weighting yesterdays simple moving average. The formula to convert exponential percentage into simple moving average number of span days is as follows: Exponential percentage =

2 number of days + 1

Exponential smoothing A mathematical–statistical method of forecasting that assumes future price action is a weighted average of past periods; a mathematical series in which greater weight is given to more recent price action. Exports (US) Shipments of goods from within the 50 States and the District of Columbia to US possessions and territories or to foreign countries. See United States of America (USA).

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Extreme The highest or lowest price during any time period, a price extreme; in the CBOT Market Profile, the highest/lowest prices the market tests during a trading day. Extraction loss The reduction in volume of natural gas due to the removal of natural gas liquid constituents, such as ethane, propane and butane, at natural gas processing plants. Extrinsic value The amount of money option buyer are willing to pay for an option in the anticipation that, over time, a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option’s intrinsic value can be considered time value. Also referred to as time value.

F Fabricated fuel Fuel assemblies composed of an array of fuel rods loaded with pellets of enriched uranium dioxide. Face value The amount of money printed on the face of the certificate of a security; the original dollar amount of indebtedness incurred. Fade Selling a rising price or buying a falling price. A trader fading an up opening would be short, for example. Fahrenheit A temperature scale on which the boiling point of water is at 212 degrees above zero on the scale and the freezing point is at 32 degrees above zero at standard atmospheric pressure. Failure swings The inability of price to reaffirm a new high in an uptrend or a new low in a downtrend. Failure In Elliott wave theory, a five-wave pattern of movement in which the fifth impulse wave fails to move above the end of the third, or in which the fifth wave does not contain the five subwaves. Fair values The theoretical prices generated by an option pricing model (i.e. the Black–Scholes option pricing model). F.A.S. value (Free Alongside Ship Value) The value of a commodity at the port of exportation, generally including the purchase price, plus all charges incurred in placing the commodity alongside the carrier at the port of exportation in the country of exportation. Fast Fourier transform A method by which to decompose data into a sum of sinusoids of varying cycle length, with each cycle being a fraction of a common fundamental cycle length. Fast market A declaration that market conditions in the futures pit are so disorderly temporarily to the extent that floor brokers are not held responsible for the execution of orders. FCCC See Framework Convention on Climate Change (FCCC) Federal Deposit Insurance Corporation A self-sustaining, independent executive agency established to ensure deposits of all US banks entitled to federal deposit insurance, as stated by the Federal Reserve Act.

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Federal Funds Rate The rate of interest charged for the use of federal funds. Federal funds Member bank deposits at the Federal Reserve; these funds are loaned by member banks to other member banks. Federal Housing Administration (FHA) A division of the US Department of Housing and Urban Development that insures residential mortgage loans and sets construction standards. Federal Reserve Bank The governing central bank of the USA. Federal Reserve System A central banking system in the USA, created by the Federal Reserve Act in 1913, designed to assist the nation in attaining its economic and financial goals. The structure of the Federal Reserve System includes a Board of Governors, the Federal Open Market Committee, and 12 Federal Reserve Banks. Federal Open Market Committee The policymaking committee of the Federal Reserve Bank. They meet on a regular basis to make decisions on economic policy. Feedforward computation Neural network in which neurons receive information only from the previous layer and send outputs only to the following layer. Feedstock Material used in a processing plant. Fibonacci ratio The ratio between any two successive numbers in the Fibonacci sequence, known as phi (f). The ratio of any number to the next higher number is approximately 0.618 (known as the Golden Mean or Golden Ratio), and to the lower number approximately 1.618 (the inverse of the Golden Mean), after the first four numbers of the series. The three important ratios the series provides are 0.618, 1.0 and 1.618. Fibonacci series The sequence of numbers (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233...), discovered by the Italian mathematician Leonardo de Pisa in the 13th century and the mathematical basis of the Elliott wave theory, where the first two terms of the sequence are 0 and 1 and each successive number in the sequence is the sum of the previous two numbers. Technically, it is a sequence and not a series. Field An individual producing unit consisting of a single pool or multiple pools of hydrocarbons grouped on, or related to, a single structural or stratigraphic feature. Field separation facility A surface installation designed to recover lease condensate from a produced natural gas stream usually originating from more than one lease and managed by the operator of one or more these leases. Fill An executed order; sometimes the term refers to the price at which an order is executed. Fill order An order that must be filled immediately (or canceled). Fill-or-kill A customer order that is a price limit order that must be filled immediately or cancelled. Filter A device or program that separates data, signal or information in accordance with specified criteria. Filter point The time at which a portfolio insurance program makes an adjusting trade. Financial Analysis Auditing Compliance Tracking System (FACTS) The National Futures Association’s computerised system of maintaining financial records of its member firms and monitoring their financial conditions.

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Financial instrument There are two basic types: (1) a debt instrument, which is a loan with an agreement to pay back funds with interest; and (2) an equity security, which is share or stock in a company. First Notice Day According to Chicago Board of Trade rules, the first day on which a notice of intent to deliver a commodity in fulfilment of a given month’s futures contract can be made by the clearing house to a buyer. The clearing house also informs the sellers who they have been matched up with. Fit criterion A quantitative comparable measure used to minimise model errors. Fixed carbon The nonvolatile matter in coal minus the ash. Fixed carbon is the solid residue other than ash obtained by prescribed methods of destructive distillation of a coal. Fixed carbon is the part of the total carbon that remains when coal is heated in a closed vessel until all volatile matter is driven off. 5% confidence Before conducting statistical tests, an analyst must select a confidence level that will be used to determine when to accept the null hypothesis. A 5% confidence level indicates that one is not willing to accept the null hypothesis when the average net return calculated from the sample could have occurred in only five of 100 samples if the null hypothesis were true. Flaglike Sideways market price action that has a slight drift in price counter to the direction of the main trend; a consolidation phase. Flash fill Order filled immediately by hand signal on the trading floor. Flash point The lowest temperature under very specific conditions at which a combustible liquid will give off sufficient vapour to form a flammable mixture with air in a standardised vessel. Assesses the volatility of the product. Flared Gas disposed of by burning in flares, usually at the production sites or at gas processing plants. Flared natural gas See Flared Flexicoking A thermal cracking process that converts heavy hydrocarbons such as crude oil, tar sands bitumen, and distillation residues into light hydrocarbons. Feedstocks can be any hydrocarbons, including those containing high concentrations of sulphur and metals. Float The number of shares currently available for trading. Floor broker (FB) An individual who executes orders for the purchase or sale of any commodity futures or options contract on any contract market for any other person. Floor trader (FT) An individual who executes trades for the purchase or sale of any commodity futures or options contract on any contract market for such individual’s own account. Fluid coking A thermal cracking process utilising the fluidised solids technique to remove carbon (coke) for continuous conversion of heavy, low-grade oils into lighter products. Flyers Speculative or high-risk trades. F.O.B. (Free On Board) A sales transaction in which the seller makes the product available for pick-up at a specified port or terminal at a specified price and the buyer pays for the subsequent transportation and insurance.

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FOD Fuel Oil Domestique. Forecast origin The most recent historical period for which data is used to build a forecasting model. The next time period is the first forecast period. Foreign exchange market An over-the-counter market where buyers and sellers conduct foreign exchange business by telephone and other means of communication. Also referred to as a forex market. Forex market See Foreign exchange market FORTIES The first substantial oil field in the British sector of the North Sea. Forward (cash) contract A cash contract in which a seller agrees to deliver a specific cash commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and are not standardised. Forward Rate Agreements (FRAs) Cash payments are made daily as the spot rate varies above or below an agreed-upon forward rate and can be hedged with Eurodollar futures. Fossil fuel An energy source formed in the Earth’s crust from decayed organic material. The common fossil fuels are petroleum, coal, and natural gas. Fossil fueled steam-electric power plant An electricity generation plant in which the prime mover is a turbine rotated by high-pressure steam produced in a boiler by heat from burning fossil fuels. Fossil fuel electric generation Electric generation in which the prime mover is a turbine rotated by high-pressure steam produced in a boiler by heat from burning fossil fuels. Fractal dimension From fractal geometry, used to describe the irregular nature of lines, curves, planes or volumes. Fractals Depiction of mathematical models that may be applied to identify data patterns. Fractionation The process by which saturated hydrocarbons are removed from natural gas and separated into distinct products, or ‘fractions,’ such as propane, butane and ethane. Framework Convention on Climate Change (FCCC) An agreement opened for signature at the ‘Earth Summit’ in Rio de Janeiro, Brazil, on 4 June 1992, which has the goal of stabilising greenhouse gas concentrations in the atmosphere at a level that would prevent significant anthropogenically forced climate change. See also Climate change. Framing or frame dependence Behavioural finance. The tendency to evaluate current decisions within the framework in which they have been presented. Making decisions based on perceptions of risk/return rather than pure risk and return. The usual example is categorisation of where money comes from and what it is ‘assigned’ to instead of recognising its fungibility. The alternative is to speak of frame independence, wherein behaviour is not influenced by how the decision is framed. Examples are loss aversion, hedonic editing, loss of selfcontrol, regret and money illusion. Free On Board See F.O.B. (Free On Board) Frequency The number of complete cycles observed per time period (i.e. cycles per year).

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Frequency component That part of a time series that may be represented as a cycle. Frequency distribution A chart showing the number of times (or ‘frequency’) an event occurs for each possible value of the event. The vertical or y-axis of the chart is the frequency axis and the horizontal or x-axis shows the different values that the variable being measured can take. Frequency domain Variation in a time series is accounted for by cyclical components at different frequencies. Frequency response The transfer of the frequency of the underlying data, usually prices, to the frequency of its moving average. Front-loaded Commission and fees taken out of investment capital before the money is put to work. Front month The first expiration month in a series of months. Front-running The practice of trading ahead of large orders to take advantage of favourable price movement. Brokers are prohibited from this practice. F-statistics The ratio of the variance explained by treatments to the unexpected variance. Fuel Any material substance that can be consumed to supply heat or power. Included are petroleum, coal, and natural gas (the fossil fuels) and other consumable materials, such as uranium, biomass and hydrogen. See also Energy source. Fuel cells One or more cells capable of generating an electrical current by converting the chemical energy of a fuel directly into electrical energy. Fuel cells differ from conventional electrical cells in that the active materials such as fuel and oxygen are not contained within the cell but are supplied from outside. Fuel ethanol An anhydrous, denatured aliphatic alcohol (C2H5OH) intended for motor gasoline blending. See also Oxygenates. Fuelwood See Wood energy Full carrying charge market A futures market where the price difference between delivery months reflects the total costs of interest, insurance and storage. Full Membership A membership that allows an individual to trade all futures and options contracts listed by the exchange. Fully disclosed An account carried by a Futures Commission Merchant in the name of an individual customer; the opposite of an omnibus account. Fundamental analysis The analytical method by which only the sales, earnings and the value of a given tradable’s assets may be considered. Fundamentals The theory that holds that stock market activity may be predicted by looking at the relative data and statistics of a stock as well as the management of the company in question and its earnings. Future volatility A prediction of what volatility may be like in the future. Futures Commission Merchant (FCM) An individual or organisation that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets from customers to support such orders. Futures contract A legally binding agreement, made on the trading floor of a futures exchange, to buy or sell a commodity or financial instrument at some time in the future. Futures contracts are standardised according to the quality,

GLOSSARY OF TERMS

381

quantity, and delivery time and location for each commodity. The only variable is price, which is discovered on an exchange trading floor. Futures exchange A central market place with established rules and regulations where buyers and sellers meet to trade futures and options on futures contracts. Futures Industry Association (FIA) The national trade association for Futures Commission Merchants. Futures market A trade centre for quoting prices on contracts for the delivery of a specified quantity of a commodity at a specified time and place in the future. Fuzzy systems A problem-solving method that can be applied to neural networks, expert systems and other computing methods. Fuzzy systems process inexact information inexactly and describe ambiguity rather than the uncertainty of an occurrence and are useful in performing control and decision-making tasks. Not Boolean.

G Gamma The degree by which the delta changes with respect to changes in the underlying instrument’s price. Gann theory Various analytical techniques developed by legendary trader W. D. Gann. Gap A day in which the daily range is completely above or below the previous day’s daily range. Gas condensate well A gas well that produces from a gas reservoir containing considerable quantities of liquid hydrocarbons in the pentane and heavier range generally described as ‘condensate’. See also Lease condensate. Gas (electric) A fuel burned under boilers and by internal combustion engines for electricicity generation. These include natural gas, manufactured gas and waste gas. Gasohol A blend of finished motor gasoline containing alcohol (generally ethanol but sometimes methanol) at a concentration of 10% or less by volume. Data on gasohol that has at least 2.7% oxygen by weight, and is intended for sale inside carbon monoxide nonattainment areas are included in data on oxygenated gasoline. See also Motor gasoline (finished) and Oxygenated gasoline. Gasoil European and Asian designation for No. 2 heating oil and No. 2 diesel fuel. Gasoline See Motor gasoline (finished) Gasoline blending See Motor gasoline blending Gasoline grades The classification of gasoline by octane ratings. Each type of gasoline (conventional, oxygenated and reformulated) is classified by three grades – Regular, Midgrade and Premium. Note: Gasoline sales are reported by grade in accordance with their classification at the time of sale. In general, automotive octane requirements are lower at high altitudes. Therefore, in some areas of the USA, such as the Rocky Mountain states, the octane ratings for the gasoline grades may be 2 or more octane points lower. 1. Regular gasoline: gasoline having an antiknock index, i.e. octane rating, greater than or equal to 85 and less than 88.

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2. Midgrade gasoline: gasoline having an antiknock index, i.e. octane rating, greater than or equal to 88 and less than or equal to 90. 3. Premium gasoline: gasoline having an antiknock index, i.e. octane rating, greater than 90. Gas to liquids (GTLs) A process that combines the carbon and hydrogen elements in natural gas molecules to make synthetic liquid petroleum products, such as diesel fuel. Gas turbine electric power plant A plant in which the prime mover is a gas turbine. A gas turbine typically consists of an axial flow air compressor and one or more combustion chambers where liquid or gaseous fuel is burned. The hot gases expand to drive the generator and then are used to run the compressor. Gas well A well completed for the production of natural gas from one or more gas zones or reservoirs. (Wells producing both crude oil and natural gas are classified as oil wells.) GDP See Gross Domestic Product (GDP) Generating facility An existing or planned location or site at which electricity is or will be produced. Generating unit Any combination of physically connected generator(s), reactor(s), boiler(s), combustion turbine(s) or other prime mover(s) operated together to produce electric power. Generation (electricity) See Electricity generation Generator A machine that converts mechanical energy into electrical energy. Generator capacity The maximum output, commonly expressed in megawatts (MW), that generating equipment can supply to system load, adjusted for ambient conditions. Generator nameplate capacity (installed) The maximum rated output of a generator, prime mover or other electric power production equipment under specific conditions designated by the manufacturer. Installed generator nameplate capacity is commonly expressed in megawatts (MW) and is usually indicated on a nameplate physically attached to the generator. Genetic algorithms Algorithms that mimic the characteristics associated with evolution and that are well suited to optimisation problems such as optimising neural network parameters. Genetic programming In artificial intelligence, this form of programming automatically generates a program from a set of primitive constructs. Geothermal Pertaining to heat within the Earth. Geothermal electric power generation Electricity derived from heat found under the Earth’s surface. Within the Earth, there are vast amounts of molten rock and metal, covered by succeeding layers of cooler material, up to the crust of the Earth’s surface. Underground rivers generate steam that is liberated in the form of geysers through fissures in the Earth’s surface. Geothermal energy Hot water or steam extracted from geothermal reservoirs in the Earth’s crust. Water or stream extracted from geothermal reservoirs can be used for geothermal heat pumps, water heating or electricity generation. Geothermal plant A plant in which the prime mover is a steam turbine. The turbine is driven either by steam produced from hot water or by natural steam that derives its energy from heat found in rocks or fluids at various depths

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383

beneath the surface of the Earth. The fluids are extracted by drilling and/or pumping. Giga One billion (109). Gigawatt (GW) One billion (109) watts. See also Watt. Gigawatt hour (GWh) One billion (109) watt hours. See also Watt hour. Gilsonite Trademark name for uintaite (or uintahite), a black, brilliantly lustrous natural variety of asphalt found in parts of Utah and western Colorado. GIM Membership (CBOT) A Chicago Board of Trade membership that allows an individual to trade all futures contracts listed in the government instrument market category. Give-up When a broker executes an order for another broker’s client and the two brokers split the commission; the client pays nothing extra. Global climate change See Climate change Global warming An increase in the near surface temperature of the Earth. Global warming has occurred in the distant past as the result of natural influences, but the term is today most often used to refer to the warming that some scientists predict will occur as a result of increased anthropogenic emissions of greenhouse gases. See also Climate change. Global warming potential (GWP) An index used to compare the relative radiative forcing of different gases without directly calculating the changes in atmospheric concentrations. GWPs are calculated as the ratio of the radiative forcing that would result from the emission of one kilogram of a greenhouse gas to that from the emission of one kilogram of carbon dioxide over a fixed period of time, such as 100 years. GLOBEX A global after-hours electronic trading system. Golden Mean or Golden Ratio The ratio of any two consecutive numbers in the Fibonacci sequence, known as phi and equal to 0.618; a proportion that is an important phenomenon in music, art, architecture and biology. See also Fibonacci ratio. Golden Section Any length divided so that the ratio of the smaller to the larger part is equivalent to the ratio between the larger part and the whole and is always 0.618. See also Fibonacci ratio. Grain terminal Large grain elevator facility with the capacity to ship grain by rail and/or barge to domestic or foreign markets. Grantor A person who sells an option and assumes the obligation to sell (in the case of a call) or buy (in the case of a put) the underlying futures contract at the exercise price. Also referred to as an option seller or writer. Greeks Jargon; a loose term encapsulating a set of risk variables used by options traders. Greenhouse effect The result of water vapour, carbon dioxide and other atmospheric gases trapping radiant (infrared) energy, thereby keeping the Earth’s surface warmer than it would otherwise be. Greenhouse gases within the lower levels of the atmosphere trap this radiation, which would otherwise escape into space, and subsequent re-radiation of some of this energy back to the Earth maintains higher surface temperatures than would occur if the gases were absent. See also Greenhouse gases. Greenhouse gases Those gases, such as water vapour, carbon dioxide, nitrous oxide, methane, hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and

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sulphur hexafluoride, that are transparent to solar (short-wave) radiation but opaque to long-wave (infrared) radiation, thus preventing long-wave radiant energy from leaving Earth’s atmosphere. The net effect is a trapping of absorbed radiation and a tendency to warm the planet’s surface. Grid The layout of an electrical distribution system. Gross Domestic Product Value of all goods and services produced domestically. Gross electricity generation See Gross generation Gross generation The total amount of electric energy produced by generating units and measured at the generating terminal in kilowatt hours (kWh) or megawatt hours (MWh). Gross heat content of a quantity of fuel See Heat content of a quantity of fuel, gross Gross input to atmospheric crude oil distillation units Total input to atmospheric crude oil distillation units. Includes all crude oil, lease condensate, natural gas plant liquids, unfinished oils, liquefied refinery gases, slop oils and other liquid hydrocarbons produced from tar sands, Gilsonite and oil shale. See also Distillation unit (atmospheric). Gross National Product Gross Domestic Product plus the income accruing to domestic residents as a result of investments abroad less income earned in domestic markets accruing to foreigners abroad. Gross processing margin The difference between the cost of soybeans and the combined sales income of the processed soybean oil and meal. Gross production, natural gas See Gross withdrawals, natural gas Gross withdrawals, natural gas Full well-stream volume of produced natural gas, including all natural gas plant liquids and all nonhydrocarbon gases, but excluding lease condensate. GW See Gigawatt GWh See Gigawatt hour

H Harami In candlestick terminology, a small real body contained within a relatively long real body. Head and shoulders When the middle price peak of a given tradable is higher than those around it. Heap leach solutions The separation, or dissolving-out, from mined rock of the soluble uranium constituents by the natural action of percolating a prepared chemical solution through mounded (heaped) rock material. The mounded material usually contains low grade mineralized material and/or waste rock produced from open pit or underground mines. The solutions are collected after percolation is completed and processed to recover the valued component. Heat content of a quantity of fuel, gross The total amount of heat released when a fuel is burned. Coal, crude oil and natural gas all include chemical compounds of carbon and hydrogen. When those fuels are burned, the carbon

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and hydrogen combine with oxygen in the air to produce carbon dioxide and water. Some of the energy released in burning goes into transforming the water into steam and is usually lost. The amount of heat spent in transforming the water into steam is counted as part of gross heat content but is not counted as part of net heat content. Gross heat content is also referred to as the higher heating value. Btu conversion factors typically used by the Energy Information Administration represent gross heat content. Heat content of a quantity of fuel, net The amount of usable heat energy released when a fuel is burned under conditions similar to those in which it is normally used. Net heat content is also referred to as the lower heating value. Btu conversion factors typically used by the Energy Information Administration represent gross heat content. Heating value See Heat content of a quantity of fuel, gross and Heat content of a quantity of fuel, net Heavy crude oil Has API gravity lower than 28 degrees. The lower the API gravity, the heavier the oil. Heavy gasoils Petroleum distillates with an approximate boiling range from 651 °F to 1000 °F. Hedge fund A mutual fund involving speculative investing in stocks and options. Hedger An individual or company owning or planning to own a cash commodity corn, soybeans, wheat, US Treasury bonds, notes, bills etc. and concerned that the cost of the commodity may change before either buying or selling it in the cash market. A hedger achieves protection against changing cash prices by purchasing (selling) futures contracts of the same or similar commodity and later offsetting that position by selling (purchasing) futures contracts of the same quantity and type as the initial transaction. Hedging 1. The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes. Selling (short) hedge – Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold. Purchasing (long) hedge – Buyer futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. Also referred to as a buying hedge. 2. In everyday speech, hedging is a gardening term which describes tending a row of bushes or trees that divides one garden or field from another. Herrick Payoff Index An index requiring two inputs, one of which is a smoothing factor known as the multiplying factor and the other of which is the value of a one-cent move. Heuristic bias The use of rules of thumb for decisions.

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Heuristic method Problem solving approached by trying out several different methods and comparing which pro vides the best solution. Heuristics In computer science, computational rules of thumb. Distinct from algorithms, which are programs guaranteed to generate the correct result under all circumstances, heuristics may only turn out to be correct only a certain percentage of time. HFCs See Hydrofluorocarbons Hidden node Elements that give a neural network the ability to learn nonlinear patterns. The hidden nodes mathematically transform inputs by passing weighted sums of those inputs through nonlinear functions. Hierarchical neural network In artificial intelligence, a neural network in which predictions derived from networks at one level of the hierarchy are incorporated as inputs at another level. This architecture lends itself to faster training, as each network focuses learning solely on its own output. High The highest price of the day for a particular futures contract. High pass frequency filter A detrending filter that lets pass the high-frequency noise and rejects low-frequency trend. Implemented by first applying a low pass filter to the data, then subtracting the filtered data from the original data. High Sulfur No. 2 Diesel Fuel No. 2 diesel fuel that has a sulphur level above 0. 05% by weight. High-temperature collector See Solar thermal collector, high-temperature High-ticking To pay the offered price. Hines ratio A modified put/call ratio that refines traditional option ratio analysis by including the open interest figures in the equation and can be defined as (Total put volume/Total put open interest) divided by (Total call volume/ Total call open interest). Historic volatility How much a contract price has fluctuated over a period of time in the past; usually calculated by taking the standard deviation of price changes over a time period. Historical data A series of past daily, weekly or monthly market prices (open, high, low, close, volume, open interest). Holder The purchaser of either a call or put option. Option buyers receive the right, but not the obligation, to assume a futures position. Also referred to as the option buyer. Hook day A trading day in which the open is above/below the previous day’s high/low and the close is below/above the previous day’s close with narrow range. Horizontal spread The purchase of either a call or put option and the simultaneous sale of the same type of option with typically the same strike price but a different expiration month. Also referred to as a calendar spread. Hydrocarbon An organic chemical compound of hydrogen and carbon in gaseous, liquid or solid phase. The molecular structure of hydrocarbon compounds varies from the simplest (e.g. methane, a constituent of natural gas) to the very heavy and very complex. Hydroelectric power generation Electricity generated by an electric power plant whose turbines are driven by falling water. It includes electric utility and

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industrial generation of hydroelectricity, unless otherwise specified. Generation is reported on a net basis, i.e. on the amount of electric energy generated after the electric energy consumed by station auxiliaries and the losses in the transformers that are considered integral parts of the station are deducted. Hydroelectric pumped storage Hydroelectricity that is generated during peak loads by using water previously pumped into an elevated storage reservoir during off-peak periods when excess generating capacity is available to do so. When additional generating capacity is needed, the water can be released from the reservoir through a conduit to turbine generators located in a power plant at a lower level. Hydrofluorocarbons (HFCs) A group of artificially made chemicals composed of one or two carbon atoms and varying numbers of hydrogen and fluorine atoms. Most HFCs have 100-year Global Warming Potentials in the thousands. Hydrogen A colourless, odorless, highly flammable gaseous element. It is the lightest of all gases and the most abundant element in the universe, occurring chiefly in combination with oxygen in water and also in acids, bases, alcohols, petroleum and other hydrocarbons.

I IEA See International Energy Agency (IEA) Implied volatility The volatility computed using the actual market prices of an option contract and one of a number of pricing models. For example, if the market price of an option rises without a change in the price of the underlying stock or future, implied volatility will have risen. Imports (US) Receipts of goods into the 50 states and the District of Columbia from US possessions and territories or from foreign countries. See United States of America (USA). Improved recovery Extraction of crude oil or natural gas by any method other than those that rely primarily on natural reservoir pressure, gas lift or a system of pumps. Impulse A sharply defined change in a series of input data being studied, such as market prices or volume. Impulse wave A wave or cycle of waves that carries the current trend further in the same direction. In play A stock that is the focus of a public bidding contest, as in a takeover or bear raid. In situ leach mining (ISL) The recovery, by chemical leaching, of the valuable components of an ore body without physical extraction of the ore from the ground. Also referred to as ‘solution mining’. In-the-money A call option whose strike price is lower than the stock or future’s price, or a put option whose strike price is higher than the underlying stock or future’s price. For example, when a commodity price is $500, a call option with a strike price of $400 is considered in-the-money.

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Income dividends Payments to mutual fund shareholders consisting of dividends, interest and short-term capital gains earned on the fund’s portfolio securities after deduction of operating expenses. Independent Introducing Broker A firm or individual that solicits and accepts commodity futures orders from customers but does not accept money, securities or property from the customer. Unlike a Guaranteed Introducing Broker, an Independent Introducing Broker is subject to minimum capital requirements and can introduce accounts to any registered Futures Commission Merchant. Independent power producer A corporation, person, agency, authority or other legal entity or instrumentality which is a wholesale electricity producer that operates within the franchised service territory of a host electric utility and is usually authorised to sell at market-based rates. Unlike traditional electric utilities, independent power producers do not possess transmission facilities, unless authorised by law, nor do they sell electricity in the retail market. Independent power producers are considered to be nonutility power producers. See also Electric utility and Nonutility power producer. Index fund A mutual fund that replicates the behaviour of a given index. Indicated recoverable reserves, coal See Probable (indicated) reserves, coal Indicated reserves See Probable energy reserves Inductive logic The progress from statements describing particular events to a general statement. Inefficient markets Behavioural finance. Driven by frame dependence and heuristic bias, when market prices stray from fundamental values. Infilling wells Infilling wells are wells drilled in a producing area in order to improve the recovery of hydrocarbons from the field and to maintain and/or increase production levels. Initial balance The first or first two half-hour trading periods in the CBOT Market Profile during which prices tend to converge; the initial auction of the trading day. Initial margin The amount a futures market participant must deposit into his margin account at the time he places an order to buy or sell a futures contract. Also referred to as original margin. Initial public offering When a stock is officially available for the public to buy. Inside day A day in which the daily price range is completely within the previous day’s daily price range. Intercommodity spread The purchase of a given delivery month of one futures market and the simultaneous sale of the same delivery month of a different, but related, futures market. Interdelivery spread The purchase of one delivery month of a given futures contract and simultaneous sale of another delivery month of the same commodity on the same exchange. Also referred to as an intramarket or calendar spread. Interest rate swaps An arrangement that requires both sides of the transaction to make payments to each other based on two different interest rates. The most

GLOSSARY OF TERMS

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commonly traded requires one side to pay a fixed rate and the other to pay a floating rate. Intergovernmental Panel on Climate Change (IPCC) A panel established jointly in 1988 by the World Meteorological Organisation and the United Nations Environment Program to assess the scientific information relating to climate change and to formulate realistic response strategies. Intermarket analysis Observing the price movement of one market for the purpose of evaluating a different market. Intermarket spread The sale of a given delivery month of a futures contract on one exchange and the simultaneous purchase of the same delivery month and futures contract on another exchange. Internal combustion electric power plant A plant in which the prime mover is an internal combustion engine. An internal combustion engine has one or more cylinders in which the process of combustion takes place, converting energy released from the rapid burning of a fuel–air mixture into mechanical energy. Diesel or gas-fired engines are the principal types used in electric plants. The plant is usually operated during periods of high demand for electricity. International bunker fuels See Bunker fuels International Energy Agency (IEA) Current members are: Australia, Austria, Belgium, Canada, Czech Republic, Denmark Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom, and USA. Note: Data for Guam, the former Hawaiian Trade Zone, Puerto Rico, and the US Virgin Islands (usually listed here as Virgin Islands, US) are included in the IEA-related data. Intrinsic value The portion of an option’s premium that is represented when the cash market price is greater than the exercise price; a known constant equal to the difference between the strike price and underlying market price. Introducing Broker (IB) A person or organisation that solicits or accepts orders to buy or sell futures contracts or commodity options but does not accept money or other assets from customers to support such orders. Inverted market A futures market in which the relationship between two delivery months of the same commodity is abnormal. Invisible supply Uncounted stocks of a commodity in the hands of wholesalers, manufacturers, and producers that cannot be identified accurately; stocks outside commercial channels but theoretically available to the market. IOC Indian Oil Corp. IPE International Petroleum Exchange IRA Individual Retirement Account. An employer’s retirement plan that, as specified by tax law, allows employees to elect to have their federal taxable income be deducted and set aside for retirement. Irregular flat A type of Elliott wave correction that has a 3–3–5 wave pattern, where the B wave terminates beyond the start of wave A. A ‘flat’ is in progress, implying that a larger pattern is developing. It will contain waves of one higher degree than the A–B–C waves just completed. Island Electronic communications network.

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Isomerate A gasoline blendstock made in an isomerisation unit Isopentane A saturated branched-chain hydrocarbon (C5H12) obtained by fractionation of natural gasoline or isomerisation of normal pentane.

J Jet fuel A refined petroleum product used in jet aircraft engines. It includes kerosene-type jet fuel and naphtha-type jet fuel. Joule The metre–kilogram–second unit of work or energy, equal to the work done by a force of one newton when its point of application moves through a distance of one metre in the direction of the force; equivalent to 107 ergs and one watt second.

K Kerogen The solid, bituminous mineraloid substance in oil shales which yields oil when the shales undergo destructive distillation Kerosene A light petroleum distillate that is used in space heaters, cook stoves, and water heaters and is suitable for use as a light source when burned in wick-fed lamps. Kerosene has a maximum distillation temperature of 400 °F at the 10% recovery point, a final boiling point of 572 °F, and a minimum flash point of 100 °F. Included are No. 1-K and No. 2-K, the two grades recognised by ASTM Specification D 3699 as well as all other grades of kerosene called range or stove oil, which have properties similar to those of No. 1 fuel oil. See also Kerosene-type jet fuel. Kerosene-type jet fuel A kerosene-based product having a maximum distillation temperature of 400 °F at the 10% recovery point and a final maximum boiling point of 572 °F and meeting ASTM Specification D 1655 and Military Specifications MIL-T-5624P and MIL-T-8133D (Grades JP-5 and JP-8). It is used for commercial and military turbojet and turboprop aircraft engines. Kilowatt (kW) One thousand (103) watts. See also Watt. Kilowatt hour (kWh) One thousand (103) watt hours. See also Watt hour. Knowledge base In artificial intelligence, a given inventory of knowledge specific to a set of rules. Kondratieff, Nikolai Developer of a wave theory. Kurtosis Descriptive measure of how flat or pointed a distribution is. kW See Kilowatt (kW) kWh See Kilowatt hour (kWh) Kyoto Protocol The result of negotiations at the third Conference of the Parties (COP-3) in Kyoto, Japan, in December 1997. The Kyoto Protocol sets binding greenhouse gas emissions targets for countries that sign and ratify the agreement. The gases covered under the Protocol include carbon dioxide, methane, nitrous oxide, hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride.

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L Lag The number of data points by which a filter, such as a moving average, follows or trails the input price data. Lagging indicators Market indicators showing the general direction of the economy and confirming or denying the trend implied by the leading indicators. Also referred to as concurrent indicators. Landed cost (crude oil) See Crude oil landed cost Last trading day The last day on which trading may occur in a given futures or option. Latest quarterly earnings The percentage change from the latest earnings reported compared with the same quarter a year earlier. Law of series A succession of random events, such as flipping a coin. Lead The number of data points by which a filter, much as a moving average, precedes the input price data. Leading indicators Market indicators that signal the state of the economy for the coming months. Some of the leading indicators include average manufacturing work week, initial claims for unemployment insurance, orders for consumer goods and material, percentage of companies reporting slower deliveries, change in manufacturers’ unfilled orders for durable goods, plant and equipment orders, new building permits, index of consumer expectations, change in material prices, prices of stocks, change in money supply. LEAPS Acronym for long-term equity anticipation securities, which are long-term listed options with maturities that can be as long as two and a half years. Lease condensate A mixture consisting primarily of pentanes and heavier hydrocarbons which is recovered as a liquid from natural gas in lease separation facilities. This category excludes natural gas plant liquids, such as butane and propane, which are recovered at downstream natural gas processing plants or facilities. Lease separation facility (lease separator) A facility installed at the surface for the purpose of (a) separating gases from produced crude oil and water at the temperature and pressure conditions set by the separator and/or (b) separating gases from that portion of the produced natural gas stream that liquefies at the temperature and pressure conditions set by the separator. Least squares method A technique of fitting a curve close to some given points that minimises the sum of the squares of the deviations of the given points from the curve. Leg One side of a spread. Leg out In rolling forward in futures, a method that would result in liquidating a position. Leverage The ability to control large dollar amounts of a commodity with a comparatively small amount of capital. Lifting Tankers and barges loading petroleum at a terminal or transfer point. Light crude oil Has an API gravity higher than 33 degrees. The higher the API gravity, the lighter the crude oil. Light gasoils Light petroleum distillates heavier than naphtha, with an approximate boiling range of 401 °F to 650 °F.

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Light products, light ends The group of petroleum products with lower boiling temperatures including gasolines and distillate fuels. Lignite The lowest rank of coal, often referred to as brown coal, used almost exclusively as fuel for steam-electric power generation. It is brownish-black and has a high inherent moisture content, sometimes as high as 45%. The heat content of lignite ranges from 9 to 17 million Btu per ton on a moist, mineralmatter-free basis. The heat content of lignite consumed in the USA averages 13 million Btu per ton, on the as-received basis (i.e. containing both inherent moisture and mineral matter). Lignite briquets See Coal briquets Limit move A change in price that exceeds the limits set by the exchange on which the contract is traded. Limit order An order to buy or sell when a price is fixed. Limit up, limit down Commodity exchange restrictions on the maximum upward or downward movements permitted in the price for a commodity during any trading session day. Limits The maximum number of speculative futures contracts one can hold as determined by the Commodity Futures Trading Commission and/or the exchange upon which the contract is traded. Also referred to as trading limit. The maximum advance or decline from the previous day’s settlement permitted for a contract in one trading session by the rules of the exchange. According to the Chicago Board of Trade rules, an expanded allowable price range set during volatile markets. See also Position limit; Price limit; Variable limit. Linkage The ability to buy (sell) contracts on one exchange and later sell (buy) them on another exchange. Liquefied natural gas (LNG) Natural gas (primarily methane) that has been liquefied by reducing its temperature to –260 °F at atmospheric pressure. (The volume of the LNG is 1/600 that of the gas in its vapour state.) Liquefied petroleum gases (LPG) A group of hydrogen-based gases derived from crude oil refining or natural gas fractionation. They include ethane, ethylene, propane, propylene, normal butane, butylene, isobutane and isobutylene. For convenience of transportation, these gases are liquefied through pressurisation. Liquefied refinery gases (LRG) Liquefied petroleum gases fractionated from refinery or still gases. Through compression and/or refrigeration, they are retained in the liquid state. The reported categories are ethane/ethylene, propane/propylene, normal butane/butylene and isobutane. Excludes still gas used for chemical or rubber manufacture, which is reported as petrochemical feedstock, and also excludes liquefied petroleum gases intended for blending into gasoline, which are reported as gasoline blending components. Liquid A characteristic of a security or commodity market with enough units outstanding to allow large transactions without a substantial change in price. Institutional investors are inclined to seek out liquid investments so that their trading activity will not influence the market price.

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Liquid collector A medium-temperature solar thermal collector, employed predominately in water heating, which uses pumped liquid as the heat transfer mechanism. See also Solar thermal collector, medium-temperature. Liquidate Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract. Taking a second futures or options position opposite to the initial or opening position. Also referred to as offset. Liquidity (liquid market) A characteristic of a security or commodity market with enough units outstanding to allow large transactions without a substantial change in price. Liquidity data bank A computerised profile of CBOT market activity, used by technical traders to analyse price trends and develop trading strategies. There is a specialised display of daily volume data and time distribution of prices for every commodity traded on the Chicago Board of Trade. LISP A programming language based on predicate logic; the one most commonly used in artificial intelligence applications. Ljung–Box statistic A chi-square test of significance of higher order correlation existence. The marginal significance level is the probability that no more higher order correlation exists. LLS Light Louisiana Sweet LNG See Liquefied natural gas (LNG) Load (electric) The amount of electric power delivered or required at any specific point or points on an electric system. The requirement originates at the energyconsuming equipment of the consumers. Loan program A federal program in which the government lends money at preannounced rates to farmers and allows them to use the crops they plant for the upcoming crop year as collateral. Default on these loans is the primary method by which the government acquires stock of agricultural commodities. Loan rate The amount lent per unit of a commodity to farmers. Local The trader in a pit of a commodity exchange who buys and sells for his or her account. Locked limit A market that, if not restricted, would seek price equilibrium outside the limit but, instead, moves to the limit and ceases to trade. Long Establishing ownership of the responsibilities of a buyer of a tradable; holding securities in anticipation of a price increase in that security. Long hedge Buyer futures contracts to protect against a possible price increase of cash commodities that will be purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. Also referred to as a buying hedge. Lookback interval The number of periods of historical data used for observation and calculation. Low The lowest price of the day for a particular futures contract. Low pass frequency filter A data smoother or filter that lets pass low-frequency trend sinusoids and rejects high frequency noise (see SMA).

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Low Sulfur No. 2 Diesel Fuel No. 2 diesel fuel that has a sulphur level no higher than 0.05% by weight. It is used primarily in motor vehicle diesel engines for on-highway use. Low-temperature collector See Solar thermal collector, low-temperature Low-ticking To sell at the bid price. LPG See Liquefied petroleum gases LRG See Liquefied refinery gases Lubricants Substances used to reduce friction between bearing surfaces, or incorporated into other materials used as processing aids in the manufacture of other products, or used as carriers of other materials. Petroleum lubricants may be produced either from distillates or residues. Lubricants include all grades of lubricating oils, from spindle oil to cylinder oil to those used in greases.

M MACD See Moving average convergence/divergence Macro A computer method commonly used in spreadsheets to automate repetitive steps by recording the necessary keystrokes. The macro can then be run and the keystrokes implemented. Maintenance A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account. Maintenance margin A set minimum margin (per outstanding futures contract) that a customer must maintain in his margin account to retain the futures position. See also Margin. Major auction The overall trend of the market such as might be observed on a bar chart. Managed account Financial safeguards to ensure that clearing members (usually companies or corporations) perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfilling of contract obligations. FCMs are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance-bond margin. Managed Funds Association (MFA) The trade association for the managed funds industry. Managed futures A fund that uses the futures market as its primary asset. Mandelbrot set Complex but structured pattern produced by an equation in which the result is fed back into the equation repeatedly; self-similarity. Manufactured gas A gas obtained by destructive distillation of coal, or by thermal decomposition of oil, or by the reaction of steam passing through a bed of heated coal or coke. Examples are coal gases, coke oven gases, producer gas, blast furnace gas, blue (water) gas, and carburetted water gas Mapping A function, or relation between values.

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Margin An amount of money deposited by both buyers and sellers of futures contracts and by sellers of options contracts to ensure performance of the terms of the contract (the making or taking delivery of the commodity or the cancellation of the position by a subsequent offsetting trade). Margin in commodities is not a down payment, as in securities, but rather a performance bond. See also Initial margin; Maintenance margin; Variation margin. Margin call A call from a clearing house to a clearing member, or from a brokerage firm to a customer, to bring margin deposits up to a required minimum level. Marginal significance level of test statistics The probability distribution used to test the hypothesis that the beta coefficient does not equal zero. A T-statistic of approximately 1.65 reflects a 0.90 or 90% confidence and the marginal significance is 1 – 0.90 = 0.1 or 10%. Marked-to-market At the end of each business day the open positions carried in an account held at a brokerage firm are credited or debited funds based on the settlement price of the open positions that day. Market-based pricing Prices of electric power or other forms of energy determined in an open market system of supply and demand under which prices are set solely by agreements as to what buyers will pay and sellers will accept. Such prices could recover less or more than full costs, depending upon what the buyer and seller see as their relevant opportunities and risks. Market breadth The shares of a particular stock traded during a specific period. Usually refers to the overall strength and trading volume of the market. Market if touched Resting order with the floor broker that becomes a market order to be executed if the trigger price is traded. Market Information Data Inquiry System (MIDIS) Historical Chicago Board of Trade price, volume, open interest data and other market information accessible by computers within the Chicago Board of Trade building. Market maker A broker or bank continually prepared to make a two-way price to purchase or sell for a security or currency. Market on close An order specification that requires the broker to get the best price available on the close of trading, usually during the last five minutes of trading. Market order Instructions to the broker to immediately sell to the best available bid or to buy from the best available offer. Market reporter A person employed by the exchange and located in or near the trading pit who records prices as they occur during trading. Market risk The uncertainty of returns attributable to fluctuation of the entire market. Market sentiment Crowd psychology, typically a measurement of bullish or bearish attitudes among investors and traders. Market timing Using analytical tools to devise entry and exit methods. Market value Company value determined by investors, obtained by multiplying the current price of company stock by the common shares outstanding. Marketed production, natural gas Gross withdrawals of natural gas from reservoirs less gas used for reinjection into reservoirs for repressuring, gas that is vented and flared, and nonhydrocarbon gases removed in treating or processing operations.

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Marking-to-Market See Marked-to-market MATIF The Marche A Terme Des Instruments Financiers exchange in Paris. Maxima The highest or maximum value. Maximax Optimistic decision-making that identifies the decision alternative with the best possible outcomes. Maximin Pessimistic decision-making that identifies the decision alternative with the worst possible outcomes. Maximum adverse excursion A historical measurement of the closed losing trades versus the closed profitable trades of a trading system. Used to determine the stop-loss level that can be used that will allow winning trades to remain; the extreme unfavorable price level reached for both profitable and unprofitable trades. Maximum entropy method More flexible than Fourier analysis, the maximum entropy method is both a tool for spectrum analysis and a method of adaptive filtering and trend forecasting. As a tool for spectrum analysis, the MEM system can provide high resolution spectra for identifying the dominant data cycles within relatively short time series, such as open, high, low, close, volume and open interest, or study results, such as RSI, TRIX, and so on. (Fourier analysis, in contrast, gives best results when applied to time series of six months or longer.) As a forecasting tool, MEM is used in conjunction with moving averages to forecast lower and upper trend channels in the data. Maximum price fluctuation See Price limit Maximum entropy spectrum analysis See Maximum entropy method Mean The sum of the values divided by the number of observations. Mean deviation The average absolute value of the difference between the population of numbers and the mean. Mean P/L The average profitability of a trader’s account, as measured over a given period. Mean return The average monthly total return of a stock. The total return is price change added to dividends. Mean reverting The term adopted in academic literature for one possible state of a price series: that state when price is oscillating randomly about some (unknown) mean value. That is, it is not trending. Measured recoverable reserves, coal See Proved (measured) reserves, coal and Proved recoverable reserves, coal Measured reserves See Proved energy reserves Median line The line that is drawn from an extreme that bisects a line drawn through the next corrective phase after the pivot point. See also Andrews method. Medium-temperature collector See Solar thermal collector, medium-temperature. Mediation A voluntary process in which the parties to a futures-related dispute work with a neutral third party to find a mutually acceptable solution. Megawatt (MW) One million (106) watts of electricity. See also Watt. Megawatt hour (MWh) One million (106) watt hours. See also Watt hour Mental stop-loss A stop-loss order kept in your head instead of instructing your broker. Metallurgical coal Coking coal and pulverized coal consumed in making steel.

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Metallurgical coke A strong, hard coke produced mainly for use in the iron and steel industry, where it serves as a chemical agent and source of energy. It is used mainly in blast furnaces to absorb the oxygen contained in iron oxides and provide energy for smelting. A portion of its potential energy is captured in the gases generated in the smelting process, then recycled in the form of blast furnace gas to provide additional energy inside or outside the smelting process. Metallurgical coke is also used to some extent as a domestic fuel and as a raw material for the manufacture of gas. See also Coke (coal). Methane (CH4) A hydrocarbon gas that is the principal constituent of natural gas. Methane has a 100-year Global Warming Potential of 21. Methanol A light alcohol that can be used for motor gasoline blending. See also Oxygenates. Methyl tertiary butyl ether (MTBE) A colourless, flammable, liquid oxygenated hydrocarbon containing 18.15% oxygen. See also Oxygenates. Metric ton A unit of weight equal to 2,204.6 pounds. Midgrade gasoline Gasoline having an antiknock index, i.e. octane rating, greater than or equal to 88 and less than or equal to 90. Note: Octane requirements may vary by altitude. See also Gasoline grades. Midgrade unleaded Unleaded gasoline with a 89 (R + M)/2 octane rating. Milling of uranium The processing of uranium from ore mined by conventional methods, such as underground or open pit, to separate the uranium from the undesired material in the ore. Million Btu One million (106) British thermal units (Btu). See also British thermal unit (Btu) Mineral-matter-free basis Mineral matter in coal is the parent material in coal from which ash is derived. It comes from minerals present in the original plant materials that formed the coal or from extraneous sources such as sediments and precipitates from mineralised water. Mineral matter in coal cannot be analytically determined and is commonly calculated using data on ash and ashforming constituents. Coal analyses are calculated to the mineral-matter-free basis by adjusting formulas used in calculations in order to deduct the weight of mineral matter from the total coal. Mineral potential (‘potentially recoverable hydrocarbon volumes’) Estimated recoverable volumes which cannot be defined as reserves due to a number of reasons, such as the temporary lack of viable markets, a possible commercial recovery dependent on the development of new technologies, or for their location in accumulations yet to be developed or where evaluation of known accumulations is still at an early stage. Mineral storage Volumes required for allowing optimal operation of natural gas fields in Italy for technical and economic reasons. Minima The lowest or minimum values. Minimum price fluctuation The smallest allowable increment of price movement for a contract. Minor auction The latest trend of the market, i.e. what it is doing now. Mode The most frequently occurring value. Model Equation.

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Modern portfolio theory Investing theory in which portfolio managers estimate and manage risk and return. Modified endowment contract Life insurance in which funds such as policy loans, assignments, pledges, and partial surrenders are considered gross income and subject to income tax. Modulation storage Volumes required for meeting hourly, daily and seasonal swings of demand. Moist (coal) basis ‘Moist’ coal contains its natural inherent or bed moisture, but does not include water adhering to the surface. Coal analyses expressed on a moist basis are performed or adjusted so as to describe the data when the coal contains only that moisture which exists in the bed in its natural state of deposition, and when the coal has not lost any moisture due to drying. Momentum A time series representing change of today’s price from some fixed number of days back in history. Momentum filter A measure of change, derivative or slope of the underlying trend in a time series. Implemented by first applying a low pass filter to the data and then applying a differencing operation to the results. Momentum indicator A market indicator utilising price and volume statistics for predicting the strength or weakness of a current market and any overbought or oversold conditions, and to note turning points within the market. Money flow A number of technical indicators that incorporate volume and price action to measure buying or selling pressure. Money market The market in which dealers trade riskless, short-term securities such as certificates of deposit and Treasury bills. Money market fund A mutual fund made up of money market instruments that are short term in nature. Money stop A fixed amount of money that a market participant would lose if a stop were hit. Money supply The amount of money in the economy, consisting primarily of currency in circulation plus deposits in banks. M-1 – US money supply consisting of currency held by the public, travellers’ checks, checking account funds, NOW and super-NOW accounts, automatic transfer service accounts, and balances in credit unions. M-2 – US money supply consisting of M-1 plus savings and small time deposits (less than $100,000) at depository institutions, overnight repurchase agreements at commercial banks, and money market mutual fund accounts. M-3 – US money supply consisting of M-2 plus large time deposits ($100,000 or more) at depository institutions, repurchase agreements with maturities longer than one day at commercial banks, and institutional money market accounts. Monowave In Elliott wave theory, a single wave within a range of waves. Morning star A bottom reversal pattern; according to Steve Nison, a signal that the bulls have seized control. Motor gasoline blending Mechanical mixing of motor gasoline blending components, and oxygenates when required, to produce finished motor gasoline. Finished motor gasoline may be further mixed with other motor gasoline blending components or oxygenates, resulting in increased volumes of finished motor gasoline and/or changes in the formulation of finished motor

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gasoline (e.g. conventional motor gasoline mixed with MTBE to produce oxygenated motor gasoline). Motor gasoline blending components Naphthas (e.g. straight-run gasoline, alkylate, reformate, benzene, toluene, xylene) used for blending or compounding into finished motor gasoline. These components include reformulated gasoline blendstock for oxygenate blending (RBOB), but exclude oxygenates (alcohols, ethers), butane and pentanes plus. Note: oxygenates are reported as individual components and are included in the total for other hydrocarbons, hydrogen and oxygenates. Motor gasoline, conventional See Conventional gasoline Motor gasoline (finished) A complex mixture of relatively volatile hydrocarbons with or without small quantities of additives, blended to form a fuel suitable for use in spark-ignition engines. Motor gasoline, as defined in ASTM Specification D 4814 or Federal Specification VV-G-1690C, is characterised as having a boiling range of 122 °F to 158 °F at the 10% recovery point to 365 °F to 374 °F at the 90% recovery point. ‘Motor gasoline’ includes conventional gasoline; all types of oxygenated gasoline, including gasohol; and reformulated gasoline, but excludes aviation gasoline. Note: volumetric data on blending components, such as oxygenates, are not counted in data on finished motor gasoline until the blending components are blended into the gasoline. 1. Conventional gasoline: finished motor gasoline not included in the oxygenated or reformulated gasoline categories. Note: this category excludes reformulated gasoline blendstock for oxygenate blending (RBOB) as well as other blendstock. 2. Oxygenated gasoline: finished motor gasoline, other than reformulated gasoline, having an oxygen content of 2.7% or higher by weight and required by the US Environmental Protection Agency (EPA) to be sold in areas designated by EPA as carbon monoxide (CO) nonattainment areas. See also Nonattainment area. Note: oxygenated gasoline excludes oxygenated fuels program reformulated gasoline (OPRG) and reformulated gasoline blendstock for oxygenate blending (RBOB). Data on gasohol that has at least 2.7% oxygen, by weight, and is intended for sale inside CO nonattainment areas are included in data on oxygenated gasoline. Other data on gasohol are included in data on conventional gasoline. 3. Reformulated gasoline: finished motor gasoline formulated for use in motor vehicles, the composition and properties of which meet the requirements of the reformulated gasoline regulations promulgated by the US Environmental Protection Agency under Section 211(k) of the Clean Air Act. Note: This category includes oxygenated fuels program reformulated gasoline (OPRG) but excludes reformulated gasoline blendstock for oxygenate blending (RBOB). Motor gasoline grades See Gasoline grades Motor gasoline, oxygenated See Oxygenated gasoline Motor gasoline, reformulated See Reformulated gasoline Moving average A mathematical procedure to smooth or eliminate the fluctuations in data and to assist in determining when to buy and sell. Moving averages emphasise the direction of a trend, confirm trend reversals and smooth out price and volume fluctuations or ‘noise’ that can confuse interpretation of

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the market; the sum of a value plus a selected number of previous values divided by the total number of values. Moving average charts A statistical price analysis method of recognising different price trends. A moving average is calculated by adding the prices for a predetermined number of days and then dividing by the number of days. Moving average crossovers The point where the various moving average lines intersect each other or the price line on a moving average price bar chart. Technicians use crossovers to signal price-based buy and sell opportunities. Moving average convergence/divergence (MACD) The crossing of two exponentially smoothed moving averages that are plotted above and below a zero line. The crossover, movement through the zero line and divergences generate buy and sell signals. Moving window Snapshot of a portion of a time series at an instant in time. The window is moved along the time series at a constant rate. MTBE See Methyl tertiary butyl ether Multicollinearity Two variables that have a correlation of greater than 0.70 or less than –0.70 in a regression model. The final result is the two variables explaining the same portion of variation where either variable would be sufficient. Multiple linear regression More than one independent variable is used to account for the variability in one dependent variable. Municipal bonds Debt securities issued by state and local governments, and special districts and counties. Municipal solid waste Residential solid waste and some nonhazardous commercial, institutional, and industrial wastes. MW See Megawatt (MW) MWh See Megawatt hour (MWh)

N Naked option See Uncovered option Naked put The writer of a put option contract who is not short the underlying security. Naphtha A generic term applied to a petroleum fraction with an approximate boiling range between 122 °F and 400 °F. Naphthas Refined or partly refined light distillates with an approximate boiling point range of 27 °C to 221 °C. Blended further or mixed with other materials, they make high-grade motor gasoline or jet fuel. Also used as solvents, petrochemical feedstocks, or raw materials for the production of town gas. Naphtha-type jet fuel A fuel in the heavy naphtha boiling range having an average gravity of 52.8 degrees API, 20–90% distillation temperatures of 290 °F to 470 °F, and meeting Military Specification MIL-T-5624L (Grade JP-4). It is used primarily for military turbojet and turboprop aircraft engines because it has a lower freeze point than other aviation fuels and meets engine requirements at high altitudes and speeds.

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Naphthenic naphtha Usually favored as reformer feedstock. Narrow range day A trading day with a smaller price range relative to the previous day’s price range. National Association of Investors Corporation Also known as the National Association of Investment Clubs. National Futures Association (NFA) An industry-wide, industry-supported, self-regulatory organisation for futures and options markets. The primary responsibilities of the NFA are to enforce ethical standards and customer protection rules, screen futures professional for membership, audit and monitor professionals for financial and general compliance rules and provide for arbitration of futures-related disputes. Natural gas A gaseous mixture of hydrocarbon compounds, the primary one being methane. Note: the Energy Information Administration measures wet natural gas and its two sources of production, associated-dissolved natural gas and nonassociated natural gas, and dry natural gas, which is produced from wet natural gas. 1. Wet natural gas: a mixture of hydrocarbon compounds and small quantities of various nonhydrocarbons existing in the gaseous phase or in solution with crude oil in porous rock formations at reservoir conditions. The principal hydrocarbons normally contained in the mixture are methane, ethane, propane, butane and pentane. Typical nonhydrocarbon gases that may be present in reservoir natural gas are water vapour, carbon dioxide, hydrogen sulphide, nitrogen and trace amounts of helium. Under reservoir conditions, natural gas and its associated liquefiable portions occur either in a single gaseous phase in the reservoir or in solution with crude oil and are not distinguishable at the time as separate substances. Note: The Securities and Exchange Commission and the Financial Accounting Standards Board refer to this product as natural gas. See also Natural gas. (a) Associated/dissolved natural gas: natural gas that occurs in crude oil reservoirs either as free gas (associated) or as a gas in solution with crude oil (dissolved gas). (b) Nonassociated natural gas: natural gas that is not in contact with significant quantities of crude oil in the reservoir. 2. Dry natural gas: natural gas which remains after: (1) the liquefiable hydrocarbon portion has been removed from the gas stream (i.e. gas after lease, field and/or plant separation); and (2) any volumes of nonhydrocarbon gases have been removed where they occur in sufficient quantity to render the gas unmarketable. Note: dry natural gas is also known as consumergrade natural gas. The parameters for measurement are cubic feet at 60 °F and 14.73 pounds per square inch absolute. See Natural gas. Natural gas, ‘dry’ See Dry natural gas Natural gas, dry production See Dry natural gas Natural gas dry production Gross withdrawals of natural gas from reservoirs less gas used for reinjection into reservoirs for repressuring, gas that is flared or vented, gas lost in transmission, and shrinkage. Derived by subtracting shrinkage or extraction loss from marketed production. It represents the amount of natural gas that can be marketed and consumed as a gas.

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Natural gas gross production See Gross withdrawals, natural gas Natural gas gross withdrawals See Gross withdrawals, natural gas. Natural gas hydrates Solid, crystalline, wax-like substances composed of water, methane and usually a small amount of other gases, with the gases being trapped in the interstices of a water-ice lattice. They form beneath permafrost and on the ocean floor under conditions of moderately high pressure and at temperatures near the freezing point of water. Natural gas liquids (NGL) A general term for all liquid products separated from natural gas in gas processing or cycling plants. They include natural gas plant liquids and lease condensate. Natural gas marketed production See Marketed production, natural gas Natural gasoline A term used in the gas processing industry to refer to a mixture of liquid hydrocarbons (mostly pentanes and heavier hydrocarbons) extracted from natural gas. It includes isopentane. Natural gas, pipeline quality See Pipeline quality natural gas Natural gas plant liquids (NGPL) Those hydrocarbons in natural gas that are separated as liquids at downstream natural gas processing plants or at fractionating and cycling plants. Data on lease condensate are excluded. Products obtained include liquefied petroleum gases and pentanes plus. Natural gas processing plants Facilities designed to recover natural gas liquids from a stream of natural gas that may or may not have passed through lease separators and/or field separation facilities. These facilities also control the quality of natural gas to be marketed. Cycling plants are classified as natural gas processing plants. Natural gas production See Dry natural gas production Natural gas storage Use of a depleted formation (or well) near a market to store gas bought in from another field or location Natural gas, wet See Wet natural gas Nearby (delivery) month The futures contract month closest to expiration. Also referred to as spot month. Near-month contract/far-month contract Contract whose expiration is near/far. Near-the-money An option with a strike price close to the current price of the underlying tradable. Neckline A trendline drawn along the support or resistance points of various reversal and consolidation pattern (i.e. head and shoulder, double and triple top/bottom formations). Negative amortisation This means that a payment of the stated size is insufficient to repay even the interest on the debt, meaning that the total debt actually increases each month instead of falling. Negative divergence When two or more averages, indices or indicators fail to show confirming trends. Negative yield curve A chart in which the yield level is plot on the vertical axis and the term to maturity of debt instruments of similar creditworthiness is plotted on the horizontal axis. The yield curve is positive when long-term rates are higher than short-term rates. However, yield curve is negative or inverted.

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NETA New Electricity Trading Arrangements in England and Wales. Net asset value The total market value of all securities contained in a mutual fund; also known as price per share. Net electricity consumption Consumption of electricity computed as generation, plus imports, minus exports, minus transmission and distribution losses. Net electricity generation See Net generation Net electric power generation See Net generation. Net generation The amount of gross generation less the electrical energy consumed at the generating station(s) for station service or auxiliaries. Note: electricity required for pumping at pumped storage plants is regarded as electricity for station service and is deducted from gross generation. Net heat content of a quantity of fuel See Heat content of a quantity of fuel, net Net performance An increase or decrease in net asset value exclusive of additions, withdrawals and redemptions. Network code A code containing norms and regulations for access to, management of and operation of natural gas pipelines. Neural network An artificial intelligence program that is capable of learning through a training process of trial and error. NGL See Natural gas liquids NGPL See Natural gas plant liquids Nitrogen oxides (NOx) Compounds of nitrogen and oxygen produced by the combustion of fossil fuels. Nitrous oxide (N2O) A colourless gas, naturally occurring in the atmosphere. Nitrous oxide has a 100-year Global Warming Potential of 310. No-Action Letter The Federal Reserve, the Securities and Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC) agrees to take no action to block a proposal by an exchange or company in conducting some aspect of the securities business. The aspect could be for almost anything, but the most common is a new contract listing (USA). No. 1 Diesel Fuel A light distillate fuel oil that has distillation temperatures of 550 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 975. It is used in high-speed diesel engines generally operated under frequent speed and load changes, such as those in city buses and similar vehicles. See also No. 1 Distillate. No. 2 Diesel Fuel A fuel that has distillation temperatures of 500 °F at the 10% recovery point and 640 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 975. It is used in high-speed diesel engines that are generally operated under uniform speed and load conditions, such as those in railroad locomotives, trucks, and automobiles. See also No. 2 Distillate. No. 4 Diesel Fuel See No. 4 Fuel No. 1 Distillate A light petroleum distillate that can be used as either a diesel fuel (see No. 1 Diesel Fuel) or a fuel oil (see No. 1 Fuel Oil). No. 2 Distillate A petroleum distillate that can be used either as a diesel fuel (see No. 2 Diesel Fuel) or a fuel oil (see No. 2 Fuel Oil).

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No. 4 Fuel A distillate fuel oil made by blending distillate fuel oil and residual fuel oil stocks. It conforms to ASTM Specification D 396 or Federal Specification VV-F-815C and is used extensively in industrial plants and in commercial burner installations that are not equipped with preheating facilities. It also includes No. 4 diesel fuel used for low- and medium-speed diesel engines and conforms to ASTM Specification D 975. No. 1 Fuel Oil A light distillate fuel oil that has distillation temperatures of 400 °F at the 10% recovery point and 550 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 396. It is used primarily as fuel for portable outdoor stoves and portable outdoor heaters. See also No. 1 Distillate. No. 2 Fuel Oil (Heating Oil) A distillate fuel oil that has distillation temperatures of 400 °F at the 10% recovery point and 640 °F at the 90% recovery point and meets the specifications defined in ASTM Specification D 396. It is used in atomising-type burners for domestic heating or for moderate capacity commercial/industrial burner units. See also No. 2 Distillate. No. 4 Fuel Oil See No. 4 Fuel No-load Without any sales charge. For mutual funds, shares sold at net asset value. Noise Price and volume fluctuations that can confuse interpretation of market direction. Noisy signal A signal in which the effects of random influences cannot be dismissed. Nonassociated natural gas Natural gas that is not in contact with significant quantities of crude oil in the reservoir. See also Natural gas. Nonattainment area Any area that does not meet the national primary or secondary ambient air quality standard established by the US Environmental Protection Agency for designated pollutants, such as carbon monoxide and ozone. Nonconventional plant (uranium) A facility engineered and built principally for processing of uraniferous solutions that are produced during in situ leach mining, from heap leaching, or in the manufacture of other commodities, and the recovery, by chemical treatment in the plant’s circuits, of uranium from the processed solutions. Nonhydrocarbon gases Typical nonhydrocarbon gases that may be present in reservoir natural gas such as water vapour, carbon dioxide, hydrogen sulphide, nitrogen and trace amounts of helium. Nonlinear dynamics analysis Analysis of relationships that start from welldefined outcomes to complex and chaotic results. Nonlinear statistics Statistics theory that attempts to define probability distribution from disorder to either a more orderly state or a sharp trend reversal, such as stock market fluctuations. Non-seasonal autocorrelation Autocorrelation that shows up other than at 12month lag intervals. Non-trend day A narrow range day lacking any discernible movement in either direction. Nonutility See Nonutility power producer

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Nonutility power producer A corporation, person, agency, authority or other legal entity or instrumentality that owns or operates facilities for electric generation and is not an electric utility. Nonutility power producers include qualifying cogenerators, qualifying small power producers and other nonutility generators (including independent power producers). Nonutility power producers are without a designated franchised service area and do not file forms listed in the Code of Federal Regulations, Title 18, Part 141. See also Electric utility. Normal butane See Butane Normal distribution For the purposes of statistical testing, the simulated net returns are assumed to be drawn from a particular distribution. If net returns are drawn from a normal distribution, low and high returns are equally likely, and the most likely net return in a quarter is the average net return. Normalisation Adjusting a time series so that the series lies in a prescribed normal, standard range. Notice day The day that a notice of intent to deliver is issued to a futures contract holder. NOx See Nitrogen oxides Nuclear electric power (nuclear power) Electricity generated by the use of the thermal energy released from the fission of nuclear fuel in a reactor. Nuclear fuel Fissionable materials that have been enriched to such a composition that, when placed in a nuclear reactor, they will support a self-sustaining fission chain reaction, producing heat in a controlled manner for process use. Nuclear power See Nuclear electric power Nuclear power generation See Nuclear electric power Nuclear power plant A single-unit or multi-unit facility in which heat produced in one or more reactors by the fissioning of nuclear fuel is used to drive one or more steam turbines. Nuclear reactor An apparatus in which a nuclear fission chain reaction can be initiated, controlled, and sustained at a specific rate. A reactor includes fuel (fissionable material), moderating material to control the rate of fission, a heavy-walled pressure vessel to house reactor components, shielding to protect personnel, a system to conduct heat away from the reactor, and instrumentation for monitoring and controlling the reactor’s systems. Null hypothesis The hypothesis that there is no validity to the specific claim that two variations (treatments) of the same thing can be distinguished by a specific procedure. NYMEX New York Mercantile Exchange

O Observer A concept used in radar research, applicable to trading, in how often and what manner detection or radar contact is achieved. OBV See On-balance volume Octane A flammable liquid hydrocarbon found in petroleum. Used as a standard to measure the antiknock properties of motor fuel.

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Octane rating A number used to indicate gasoline’s antiknock performance in motor vehicle engines. The two recognised laboratory engine test methods for determining the antiknock rating, i.e. octane rating, of gasolines are the Research method and the Motor method. In the USA, to provide a single number as guidance to the consumer, the antiknock index (R + M)/2, which is the average of the Research and Motor octane numbers, was developed. Odd lot An order to buy/sell fewer than 100 shares of stock. OECD See Organisation for Economic Cooperation and Development (OECD) OECD Europe See Organisation for Economic Cooperation and Development, Europe (OECD Europe) Off farm The amount of stocks held by nonproducers, including supplies held at mills, elevators, terminals and processors. Off peak Period of relatively low system demand. These periods often occur in daily, weekly and seasonal patterns Offer An expression indicating one’s desire to sell a commodity at a given price; opposite of bid. Offset Taking a second futures or options position opposite to the initial or opening position. Selling (or purchasing) futures contracts of the same delivery month purchased (or sold) during an earlier transaction or making (or taking) delivery of the cash commodity represented by the futures contract. Offshore/onshore The term offshore indicates a portion of open sea and, by induction, the activities carried out in such area, while onshore refers to land operations. Ohm The unit of measurement of electrical resistance. The resistance of a circuit in which a potential difference of 1 volt produces a current of 1 ampere. Oil See Crude oil Oil reservoir An underground pool of liquid consisting of hydrocarbons, sulphur, oxygen, and nitrogen trapped within a geological formation and protected from evaporation by the overlying mineral strata. Oil shale A sedimentary rock containing kerogen, a solid organic material. Oil well A well completed for the production of crude oil from one or more oil zones or reservoirs. Wells producing both crude oil and natural gas are classified as oil wells. Oil well (casinghead) gas Associated and dissolved gas produced along with crude oil from oil completions. Olefins A group of petrochemicals characterised by their straight or branched structure. Includes ethylene, the largest volume petrochemical, and propylene and butadiene. Omnibus account An account carried by one Futures Commission Merchant (FCM) with another FCM in which the transactions of two or more persons are combined and carried in the name of the originating FCM rather than of the individual customers; the opposite of Fully Disclosed. On farm The amount of stocks held by producers. On-balance volume Plotted as a line representing the cumulative total of volume. The volume from a day’s trading with a higher close when compared with the previous day is assigned a positive value, while volume on a lower close from the previous day is assigned a negative value. Traders look for a

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confirmation of a trend in OBV with the market or a divergence between the two as an indication of a potential reversal. One-tailed T-test A statistical test of significance for a distribution that changes its shape as N gets smaller; based on a variable t, equal to the difference between the mean of the sample and the mean of the population divided by a result obtained by dividing the standard deviation of the sample by the square root of the number of individuals in the sample. OPEC See Organisation of Petroleum Exporting Countries Opening print The first price of a stock that comes across the ticker for the session. Open The period at the beginning of the trading session officially designated by the exchange during which all transactions are considered made ‘at the open’. Open interest The total number of futures or options contracts of a given commodity that have not yet been offset by an opposite futures or option transaction nor fulfilled by delivery of the commodity or option exercise. Each open transaction has a buyer and a seller, but for calculation of open interest, only one side of the contract is counted. Open market operation The buying and selling of government securities Treasury bills, notes and bonds by the Federal Reserve. Open outcry Method of public auction for making verbal bids and offers in the trading pits or rings of futures exchanges. Open trade equity The unrealised gain or loss on open positions. Open trades Current trades that are still held active in the customer’s account. Opening call A period at the opening of a futures market in which the price for each contract is established by outcry. Opening range The range of prices that occur during the first 30 seconds to five minutes of trading, depending on the preference of the individual analyst. Operable nuclear unit (foreign) A nuclear generating unit outside the USA that generates electricity for a grid. Operable nuclear unit (US) A US nuclear generating unit that has completed low-power testing and is in possession of a full-power operating license issued by the Nuclear Regulatory Commission. Operable unit (electric) A unit available to provide electric power to the grid. Opportunity costs Income foregone by the commitment of resources to another use. Optimisation A method by which a system is developed with rules tailored to fit the data in question precisely. Option A contract that provides the right but not the obligation to buy or sell a specified amount of a security within a specified time period. Option buyer The purchaser of either a call or put option. Option buyers receive the right, but not the obligation, to assume a futures position. Also referred to as the holder. Option contract A contract which gives the buyer the right, but not the obligation, to buy or sell a specified quantity of a commodity or a futures contract at a specific price within a specified period of time. The seller of the option has the obligation

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to sell the commodity or futures contract or buy it from the option buyer at the exercise price if the option is exercised. See also Call option and Put option. Option premium The price of an option the sum of money that the option buyer pays and the option seller receives for the rights granted by the option. Option seller The person who sells an option in return for a premium and is obligated to perform when the holder exercises his right under the option contract. Also referred to as the writer. See also Grantor. Option spread The simultaneous purchase and sale of one or more options contracts, futures, and/or cash positions. Option writer The person who sells an option in return for a premium and is obligated to perform when the holder exercises his right under the option contract.Also referred to as the Option Seller. Optional cash purchase Buying additional shares made through the dividend reinvestment account. Organisation for Economic Cooperation and Development (OECD) Current members are Australia, Austria, Belgium, Canada, Czech Republic, Denmark Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia, South Korea (usually listed here as Korea, South), Spain, Sweden, Switzerland, Turkey, United Kingdom and United States. Note: data for Guam, the former Hawaiian Trade Zone, Puerto Rico and the US Virgin Islands (usually listed here as Virgin Islands, US) are included in the OECD-related data. Organisation for Economic Cooperation and Development, Europe (OECD Europe) Includes Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovakia, Spain, Sweden, Switzerland, Turkey, and United Kingdom. Organisation of Petroleum Exporting Countries (OPEC) The Organisation of Petroleum Exporting Countries; emerged as the major petroleum pricing power in 1973, when the ownership of oil production in the Middle East transferred from the operating companies to the governments of the producing countries or to their national oil companies. The original members were Algeria, Ecuador, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. (Ecuador withdrew from OPEC on 31 December 1992 and Gabon withdrew on 31 December 1994.) Original margin The amount a futures market participant must deposit into his margin account at the time he places an order to buy or sell a futures contract. Also referred to as initial margin. Order The number of days of past price history used to predict the following day’s price. Oscillator Technical indicator used to identify overbought and oversold price regions. An indicator that detrends data, such as price. Other hydrocarbons (petroleum) Materials received by a re-finery and consumed as raw materials. Includes hydrogen, coal tar derivatives, Gilsonite,

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and natural gas received by the refinery for reforming into hydrogen. Natural gas to be used as fuel is excluded. Out data The result (singular) stemming from a statistical test. Out-of-sample An item within the range of a sample that does not conform to the mean of the sample. Out-of-the-money A call option whose exercise price is above the current market price of the underlying security or futures contract. For example, if a commodity price is $500, then a call option purchased for a strike price of $550 is considered out-of-the-money. Out-turn Quantity of oil unloaded from vessel at discharge point. Out trade A mismatched trade between two traders in the pit, and which is settled the next day. Outlier A value removed from the other values to such an extreme that its presence cannot be attributed to the random combination of chance causes. Outside reversal month A month in which the recent monthly trading range exceeds the previous month’s range and closes opposite (reverses) the previous month’s close. Overbought Market prices that have risen too steeply and too fast. Overbought/oversold indicator An indicator that attempts to define when prices have moved too far and too fast in either direction and thus are vulnerable to a reaction. Overfitting 1. The parameters of a trading system are selected to return the highest profit over the historical data. 2. A model developed with rules tailored to fit the historical data precisely. Over/under lifting Agreements stipulated between partners regulate the right of each to its share in the production of a set period of time. Amounts different from the agreed ones determine temporary over/under lifting situations. Overshoot To pass beyond or over a specific targeted level. Oversold Market prices that have declined too steeply and too fast. Over-the-counter market A market where products such as stocks, foreign currencies, and other cash items are bought and sold by telephone and other means of communications. Oxidise To chemically transform a substance by combining it with oxygen. Oxygenate Oxygen-containing blend stocks favored for their octane and their clean burning quality. Includes MTBE and ethanol. Oxygenated gasoline Finished motor gasoline, other than reformulated gasoline, having an oxygen content of 2.7% or higher by weight and required by the US Environmental Protection Agency (EPA) to be sold in areas designated by EPA as carbon monoxide (CO) nonattainment areas. See Nonattainment area. Note: oxygenated gasoline excludes oxygenated fuels program reformulated gasoline (OPRG) and reformulated gasoline blendstock for oxygenate blending (RBOB). Data on gasohol that has at least 2.7% oxygen, by weight, and is intended for sale inside CO nonattainment areas are included in data on oxygenated gasoline. Other data on gasohol are included in data on conventional gasoline. See also Motor gasoline (finished).

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Oxygenates Substances which, when added to gasoline, increase the amount of oxygen in that gasoline blend. Ethanol, methyl tertiary butyl ether (MTBE), ethyl tertiary butyl ether (ETBE) and methanol are common oxygenates.

P PADD Petroleum Allocation for Defense District. A group of five geographic areas in the USA used in reference to petroleum distribution. Par The face value of a security. For example, a bond selling at par is worth the same dollar amount it was issued for or at which it will be redeemed at maturity. Parabolic Of, having the form of, or relating to a parabola. Paraffin (oil) A light-coloured, wax-free oil obtained by pressing paraffin distillate. Paraffin (wax) The wax removed from paraffin distillates by chilling and pressing. When separating from solutions, it is a colourless, more or less translucent, crystalline mass, without odour and taste, slightly greasy to touch, and consisting of a mixture of solid hydrocarbons in which the paraffin series predominates. Paraffin base stock The crude oils that come out of the ground are put into three categories. The naphthenic and paraffin crudes are used to produce engine oils. Paraffin oils have a naturally higher viscosity index and produce the best engine oils. Paraffinic A high paraffins content. Paraffinic naphtha Usually favoured quality of naphtha for ethylene plant feedstock. Parameter A variable, set of data, or rule that establishes a precise format for a model. Pareto’s law A law that states that 80% of results come from 20% of the effort. PASCAL Block-structured programming language developed originally as an aid to instruction, now widely used for applications development. Passive solar heating A solar heating system that uses no external mechanical power, such as pumps or blowers, to move the collected solar heat. Payment-in-kind program A government program in which farmers who comply with a voluntary acreage-control program and set aside an additional percentage of acreage specified by the government receive certificates that can be redeemed for government-owned stocks of grain. Peak load The maximum load during a specified period of time. Pennants A short compact wedge accompanied by receding volume. Pentanes plus A mixture of hydrocarbons, mostly pentanes and heavier, extracted from natural gas. Includes isopentane, natural gasoline and plant condensate. Percentile A value on a scale of one hundred that indicates the percentage of a distribution that is equal to or below it.

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Perceptron A pattern-recognition machine, based on an analogy with the human nervous system, capable of learning by means of a feedback system that reinforces correct answers and discourages wrong ones. Perfluorocarbons (PFCs) A group of artificially made chemicals composed of one or two carbon atoms and four to six fluorine atoms, containing no chlorine. PFCs have no commercial uses and are emitted as a byproduct of aluminium smelting and semiconductor manufacturing. PFCs have very high 100-year Global Warming Potentials and are very long-lived in the atmosphere. Performance bond margin The amount of money deposited by both buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Within the futures industry, financial guarantees are required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfilling of contract obligations. FCMs are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Financial safeguards ensure that clearing members (usually companies or corporations) perform on their customers’ open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Pessimistic rate of return A statistic that adjusts the usual wins/losses statistic to estimate the worst return from trading results. It reduces the number of wins by the square root of the actual number and increases the number of losses by the square root of the actual number of losses. The resulting numbers of wins or losses are multiplied by the average win or loss and the sum of the resulting wins/losses is divided by the required investment. Petrochemical feedstock Feedstock derived from petroleum, used principally for the manufacture of chemicals, synthetic rubber and a variety of plastics. The categories reported are naphthas (endpoint less than 401 °F) and other oils (endpoint equal to or greater than 401 °F). Petrochemicals Chemicals derived from petroleum; feedstocks for the manufacture of plastics and synthetic rubber. Petrochemicals include benzene, toluene, xylene, styrene and methanol. Petroleum A broadly defined class of liquid hydrocarbon mixtures. Included are crude oil, lease condensate, unfinished oils, refined products obtained from the processing of crude oil, and natural gas plant liquids. Note: volumes of finished petroleum products include nonhydrocarbon compounds, such as additives and detergents, after they have been blended into the products. Petroleum coke See Coke (petroleum) Petroleum consumption See Apparent consumption (petroleum) Petroleum jelly A semi-solid oily product produced from de-waxing lubricating oil basestocks. Petroleum products Products obtained from the processing of crude oil (including lease condensate), natural gas and other hydrocarbon com-pounds. Petroleum products include unfinished oils, liquefied petroleum gases, pentanes plus, aviation gasoline, motor gasoline, naphtha-type jet fuel, kerosene-type jet fuel, kerosene, distillate fuel oil, residual fuel oil, petrochemical

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feedstocks, special naphthas, lubricants, waxes, petroleum coke, asphalt, road oil, still gas and other miscellaneous products. Petroleum stocks Primary stocks of crude oil and petroleum products held in storage at (or in) leases, refineries, natural gas processing plants, pipelines, tankfarms and bulk terminals that can store at least 50,000 barrels of petroleum products or that can receive petroleum products by tanker, barge, or pipe-line. Crude oil that is in-transit by water from Alaska or that is stored on Federal leases or in the Strategic Petroleum Reserve is included. Primary stocks exclude stocks of foreign origin that are held in bonded warehouse storage. PFCs See Perfluorocarbons Phase delay The time lag that a filter falls behind the pre-filtered data. Phasor Used to describe the frequency, amplitude and phase of all frequency components of the signal. Photovoltaic cell An electronic device consisting of layers of semiconductor materials fabricated to form a junction (adjacent layers of materials with different electronic characteristics) and electrical contacts and being capable of converting incident light directly into electricity (direct current). Photovoltaic energy Direct current electricity generated from sunlight through solid state semiconductor devices that have no moving parts. Photovoltaic module An integrated assembly of interconnected photovoltaic cells designed to deliver a selected level of working voltage and current at its output terminals, packaged for protection against environmental degradation, and suited for incorporation in photovoltaic power systems. The electricity produced is used primarily in applications requiring remote power, such as radio communication, cathodic protection and navigational aids. See also Photovoltaic cell. Pipeline quality natural gas A mixture of hydrocarbon compounds existing in the gaseous phase with sufficient energy content, generally above 900 British thermal units, and a small enough share of impurities for transport through commercial gas pipelines and sale to end-users. Pit The area on the trading floor where futures and options on futures contracts are bought and sold. Pits are usually raised octagonal platforms with steps descending on the inside that permit buyers and sellers of contracts to see each other. Pivot point In market activity, a price reversal point. Plant A term commonly used either as a synonym for an industrial establishment or a generation facility or to refer to a particular process within an establishment. Plant condensate One of the natural gas liquids, mostly pentanes and heavier hydrocarbons, recovered and separated as liquids at gas inlet separators or scrubbers in natural gas processing plants. Does not include lease condensate. Plant (electric) A facility at which are located prime movers, electric generators and auxiliary equipment for converting mechanical chemical or nuclear energy into electric energy. A plant may contain more than one type of prime mover. Play A play is a set of known or postulated oil and (or) gas accumulations sharing similar geologic, geographic and temporal properties, such as source rock, migration pathway, timing, trapping mechanism and hydrocarbon type

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Play area The two-dimensional plan extent over which a play concept is considered to be valid and within which all known accumulations and potential for undiscovered accumulations or other additions to reserves within the play exist Plug To stop the flow of oil from one stratum to another in connection with the abandoning of a well Point and figure chart A price-only chart that plots up prices as Xs and down prices as Os. The minimum price recorded is called the box size. Typically, a three-box reversal indicates a change in the direction of prices. Polymers Long chain molecules made from monomers. The most common include widely traded plastics like polyethylene, polypropylene and polystyrene. Pool See Commodity pool Position A market commitment. A buyer of a futures contract is said to have a long position and, conversely, a seller of futures contracts is said to have a short position. Position day According to the Chicago Board of Trade rules, the first day in the process of making or taking delivery of the actual commodity on a futures contract. The clearing firm representing the seller notifies the Board of Trade Clearing Corporation that its short customers want to deliver on a futures contract. Position limit The maximum number of speculative futures contracts one can hold as determined by the Commodity Futures Trading Commission and/or the exchange upon which the contract is traded. Also referred to as trading limit. Position management ratio The ratio of profits extracted on winning transactions versus losses suffered on trades that liquidate unprofitably. Position trader An approach to trading in which the trader either buys or sells contracts and holds them for an extended period of time. Possible reserves Amounts of hydrocarbons that have a lower degree of certainty than probable reserves and are estimated with lower certainty, for which it is not possible to foresee production. Posted price A statement of the price requested by a seller of crude oil or products. The ‘list price’. Pour point Lowest temperature at which oil will readily flow without disturbance when chilled. Power (electric) See Electric power Power exchanges Trading arenas in which electricity can be bought or sold normally up to two days ahead of real time, often via the Internet. Power loss The difference between electricity input and output as a result of an energy transfer between two points. PPM Parts per million. Prearranged trading Trading between brokers in accordance with an expressed or implied agreement or understanding. Prearranged trading is a violation of the Commodity Exchange Act. Premium Refers to (1) the amount a price would be increased to purchase a better quality commodity; (2) a futures delivery month selling at a higher price than

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another; (3) cash prices that are above the futures price; (4) the price paid by the buyer of an option; or (5) the price received by the seller of an option. Premium gasoline Gasoline having an antiknock index, i.e. octane rating, greater than 90. Note: octane requirements may vary by altitude. See also Gasoline grades. Preparation plant A mining facility at which coal is crushed, screened and mechanically cleaned. Preprocessing Altering data to some extent to be more accurately analysed; smoothing, reducing unwanted data, removing trend. Processing data is mathematically transforming the data from one form into another with the goal of amplifying the pertinent information for traders. Prewhitening Removing the bulk of first-, second- and possibly third-order autocorrelations using non-linear regression. Price discovery The generation of information about ‘future’ cash market prices through the futures markets. Price/earnings ratio Stock price divided by annual earnings per share. Price limit The maximum advance or decline from the previous day’s settlement permitted for a contract in one trading session by the rules of the exchange. According to the Chicago Board of Trade rules, an expanded allowable price range set during volatile markets. Price limit order A customer order that specifies the price at which a trade can be executed. Price to sales ratio The price of a stock divided by sales-per-share of the company in the most recent fiscal year. Primary coal All coal milled and, when necessary, washed and sorted. Primary dealer A designation given by the Federal Reserve System to commercial banks or broker/dealers who meet specific criteria. Among the criteria are capital requirements and meaningful participation in the Treasury auctions. Primary market Market of new issues of securities. Prime mover The engine, turbine, water wheel or similar machine that drives an electric generator; or, for reporting purposes, a device that converts energy to electricity directly (e.g. photovoltaic solar and fuel cell(s)). Prime rate Interest rate charged by major banks to their most creditworthy customers. Probability density function A graph showing the probability of occurrence of a particular data point (price). Probable energy reserves Estimated quantities of energy sources that, on the basis of geologic evidence that supports projections from proved reserves, can reasonably be expected to exist and be recoverable under existing economic and operating conditions. Site information is insufficient to establish with confidence the location, quality and grades of the energy source. Note: this term is equivalent to ‘Indicated Reserves’ as defined in the resource/reserve classification contained in the US Geological Survey Circular 831, 1980. Measured and indicated reserves, when combined, constitute demonstrated reserves. See also Energy reserves.

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Probable (indicated) reserves, coal Reserves or resources for which tonnage and grade are computed partly from specific measurements, samples, or production data and partly from projection for a reasonable distance on the basis of geological evidence. The sites available are too widely or otherwise inappropriately spaced to permit the mineral bodies to be outlined completely or the grade established throughout. See also Probable energy reserves. Processing gain See Refinery processing gain (petroleum) Processing loss See Refinery processing loss (petroleum) Processing of uranium The recovery of uranium from solutions produced by nonconventional mining methods, i.e. in situ leach mining (ISL), a byproduct of copper or phosphate mining, or heap leaching. Processing plant (natural gas) See Natural gas processing plant Producer Price Index (PPI) An index that shows the cost of resources needed to produce manufactured goods during the previous month. Production See production terms associated with specific energy types. Production Sharing Agreement Contract in use in African, Middle Eastern, Far Eastern and Latin American countries, regulating relationships between state and oil companies with regards to the exploration and production of hydrocarbons. The mining concession is assigned to the national oil company jointly with the foreign oil company that has the exclusive right to perform exploration, development and production activities and can enter agreements with other local or international entities. In this type of contract the national oil company assigns to the international contractor the task of performing exploration and production with the contractor’s equipment and financial resources. Exploration risks are borne by the contractor and production is divided into two portions: ‘cost oil’ is used to recover costs borne by the contractor, and ‘profit oil’ is divided between contractor and national company according to variable schemes and represents the profit deriving from exploration and production. Further terms and conditions may vary from one country to the other. Profit margin expansion In long-term reference, a measure of a company’s net profit margin in the latest reported quarter divided by profit margin in the fiscal year previous. In short-term reference, a measure of a company’s net profit margin in the latest reported quarter divided by profit margin in the quarter immediately preceding. Profit taking Selling tradables that have appreciated since initial purchase in order to take advantage of the appreciation. Program trading Trades based on signals from computer programs, usually entered directly from the trader’s computer to the market’s computer system. Propane A normally gaseous straight-chain hydrocarbon (C3H8). It is a colourless paraffinic gas that boils at a temperature of –43.67 °F. It is extracted from natural gas or refinery gas streams. It includes all products covered by Gas Processors Association Specifications for commercial propane and HD-5 propane and ASTM Specification D 1835. Propylene An olefinic hydrocarbon (C3H6) recovered from refinery and petrochemical processes.

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Prospectus Report published by the company that operates a mutual fund. It describes the fund’s investment objectives; its managers and their experience; the fees and charges associated with the fund; and policies and restrictions. Proved energy reserves Estimated quantities of energy sources that analysis of geologic and engineering data demonstrates with reasonable certainty are recoverable under existing economic and operating conditions. The location, quantity and grade of the energy source are usually considered to be well established in such reserves. Note: this term is equivalent to ‘Measured Reserves’ as defined in the resource/reserve classification contained in the US Geological Survey Circular 831, 1980. Measured and indicated reserves, when combined, constitute demonstrated reserves. See also Energy reserves. Proved (measured) reserves, coal Reserves or resources for which tonnage is computed from dimensions revealed in outcrops, trenches, workings and drill holes and for which the grade is computed from the results of detailed sampling. The sites for inspection, sampling, and measurement are spaced so closely and the geologic character is so well defined that size, shape, and mineral content are well established. The computed tonnage and grade are judged to be accurate within limits that are stated, and no such limit is judged to be different from the computed tonnage or grade by more than 20%. See also Proved energy reserves. Proved recoverable reserves, coal Defined by the World Energy Council as the tonnage within the Proved Amount in Place that can be recovered (extracted from the earth in raw form) under present and expected local economic conditions with existing available technology. It approximates the US term proved (measured) reserves, coal. See also Proved (measured) reserves, coal. Proved reserves, crude oil The estimated quantities of all liquids defined as crude oil that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved reserves, natural gas The estimated quantities of natural gas that analysis of geological and engineering data demonstrates with reasonable certainty to be recoverable in future years from known oil and gas reservoirs under existing economic and operating conditions. Public Utility Regulatory Policies Act of 1978 See PURPA Pulpit A raised structure adjacent to, or in the centre of, the pit or ring at a futures exchange where market reporters, employed by the exchange, record price changes as they occur in the trading pit. Pulpwood Roundwood, whole-tree chips or wood residues. Pumped storage See Hydroelectric pumped storage. Pumped storage hydroelectric power plant A plant that usually generates electric energy during peak-load periods by using water previously pumped into an elevated storage reservoir during off-peak periods when excess generating capacity is available to do so. When additional generating capacity is needed, the water can be released from the reservoir through a conduit to turbine generators located in a power plant at a lower level. See also Pure pumpedstorage hydroelectric power plant and Combined pumped-storage electric power plant.

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Purchase and sell statement A statement sent by a commission house to a customer when its futures or options on futures position has changed, showing the number of contracts bought or sold, the prices at which the contracts were bought or sold, the gross profit or loss, the commission charges, and the net profit or loss on the transaction. Purchasing hedge or long hedge Buyer futures contracts to protect against a possible price increase of cash commodities that will e purchased in the future. At the time the cash commodities are bought, the open futures position is closed by selling an equal number and type of futures contracts as those that were initially purchased. Also referred to as a buying hedge. The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes. Pure pumped-storage hydroelectric power plant A plant that produces power only from water that has previously been pumped to an upper reservoir. PURPA The Public Utility Regulatory Policies Act of 1978, passed by the US Congress. This statute requires States to implement utility conservation programs and create special markets for cogenerators and small producers who meet certain standards, including the requirement that States set the prices and quantities of power the utilities must buy from such facilities. Put option A contract to sell a specified amount of a stock or commodity at an agreed time at the stated exercise price. Pyramid To increase holdings that an investor has by using the most buying power available in a margin account with paper and real profits. Pyramiding The use of unrealised profits on existing futures positions as margin to increase the size of the position, normally in successively smaller increments. Pyrolysis gasoline A naphtha-range product with a high aromatics content used either for gasoline blending or as a feedstock for a BTX extraction unit. Pygas is produced in an ethylene plant that processes butane, naphtha or gasoil.

Q Quadrillion Btu One quadrillion (1015) British thermal units (Btu). See also British thermal unit (Btu). Quarterly earnings change (%) Historical earnings change between the earnings most recently reported and the quarter preceding. Quarterly net profit margin (%) Net operating earnings after taxes for the latest quarter divided by revenues for the quarter. Quick ratio Indicates a company’s financial strength; a company’s cash and equivalent divided by current liabilities. Quotation The actual price or the bid or ask price of either cash commodities or futures or options contracts at a particular time. Quotron A proprietary financial data service.

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R R-squared The percentage of variation in the dependent variable that is explained by the regression equation. A relative measure of fit. Rack pricing Selling to petroleum jobbers or other resellers FOB at the refinery, with the customer picking up transportation charges. The price of petroleum products at the refinery loading rack; cash and carry at the refinery’s loading dock. Radiative forcing A change in average net radiation at the top of the troposphere (known as the tropopause) because of a change in either incoming solar or exiting infrared radiation. A positive radiative forcing tends on average to warm the Earth’s surface; a negative radiative forcing on average tends to cool the Earth’s surface. Greenhouse gases, when emitted into the atmosphere, trap infrared energy radiated from the Earth’s surface and therefore tend to produce positive radiative forcing. See also Greenhouse gases. Radiatively active gases Gases that absorb incoming solar radiation or outgoing infrared radiation, affecting the vertical temperature profile of the atmosphere. See also Radiative Forcing. Rally tops A price level that concludes a short-term rally in an ongoing trend. A bull market will be made up of a series of rally tops. Random shock The unexplained component of an equation that models a time series (i.e. forecast errors). Random walk A theory that says there is no sequential correlation between prices from one day to the next, that prices will act unpredictably as they seek a level in response to supply and demand. Range The difference between the high and low price during a given period. Range extension In the CBOT Market Profile, a price movement beyond the range set by the initial auction. Rate of change In which today’s closing price is divided by the closing price n days ago. Then multiply by 100 and subtract 100 from this value: ((Ctoday/Cn) × 100) – 100. Ratio The relation that one quantity bears to another of the same kind, with respect to magnitude or numerical value. RBAR-squared The R-squared value adjusted for the number of degrees of freedom. Reaction A short-term decline in price. Realised/unrealised profit and loss The difference between trading revenues that are generated on positions that have been offset and closed versus those associated with the marking of open positions to current market prices. Reciprocal of European Terms One method of quoting exchange rates which measures the US dollar value of one foreign currency unit, i.e. US dollars per foreign units. See also European Terms. Reciprocity This term refers to the new obligations introduced by the European Directive on natural gas. At the international level, the concept of reciprocity entails the adoption of measures on the part of any country regarding foreign operators to be reciprocated by analogous measures in the home country of the foreign operator to which such measures apply. According to Legislative Decree 164/00, Italian companies are allowed to sell natural gas to eligible

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customers from other EU member countries only if such customers are defined eligible in Italy too. This constraint is applied reciprocally to companies from other European countries or companies located in Italy but controlled by companies from other European countries. Recoverable coal See Proved recoverable reserves, coal and Proved (measured) reserves, coal. Recoverable reserves of coal See Proved recoverable reserves, coal and Proved (measured) reserves, coal. Rectangle A trading area bounded by horizontal, or near horizontal, lines. It can be either a reversal or a continuation pattern, depending on the breakout. Recursive A process that is repetitive and usually dependent upon the results of the previous repetition. Refiner acquisition cost of crude oil The cost of crude oil, including transportation and other fees, paid by the refiner. The composite cost is the weighted average of domestic and imported crude oil costs. See also US refiner acquisition cost of imported crude oil. Note: the refiner acquisition cost does not include the cost of crude oil purchased for the Strategic Petroleum Reserve (SPR). Refinery fuel Crude oil and petroleum products consumed at the refinery for all purposes. Refinery gain (petroleum) See Refinery losses and gains Refinery gas See Still gas (refinery gas) Refinery input (petroleum) The raw materials and intermediate materials processed at refineries to produce finished petroleum products. They include crude oil, products of natural gas processing plants, unfinished oils, other hydrocarbons and alcohol, motor gasoline and aviation blending components, and finished petroleum products. Refinery loss (petroleum) See Refinery losses and gains (petroleum) Refinery losses and gains (petroleum) Refinery processing gains and refinery processing losses that take place during the refining process itself. Excludes losses that do not take place during the refining process, e.g. spills, fire losses, and contamination during blending, transportation, or storage. Refinery output (petroleum) The total amount of petroleum products produced at a refinery. Includes petroleum consumed by the refinery. Refinery (petroleum) An installation that manufactures finished petroleum products from crude oil, unfinished oils, natural gas plant liquids, other hydrocarbons and alcohol. Refinery processing gain (petroleum) The amount by which the total volume of refinery output is greater than the total volume of refinery input for a given period of time. The processing gain arises when crude oil and other hydrocarbons are processed into petroleum products that are, on average, less dense than the input. Refinery processing loss (petroleum) The amount by which the total volume of refinery output is less than the total volume of refinery input for a given period of time. The processing loss arises when crude oil and other hydrocarbons are processed into petroleum products that are, on average, more dense than the input.

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Reforestation Replanting of forests on lands that have recently been harvested or otherwise cleared of trees. Reformate A high-aromatics, high-octane product made in a reformer and used to blend motor gasoline or aviation gasoline. Reforming, catalytic See Catalytic reforming Reformulated gasoline Finished motor gasoline formulated for use in motor vehicles, the composition and properties of which meet requirements of the reformulated gasoline regulations promulgated by the US Environmental Protection Agency under Section 211(k) of the Clean Air Act. Note: this category includes oxygenated fuels program reformulated gasoline (OPRG), but excludes reformulated gasoline blendstock for oxygenate blending (RBOB). See also Motor gasoline (finished). Regression (simple) A mathematical way of stating the statistical linear relationship between one independent and one dependent variable. Regular gasoline Gasoline having an antiknock index, i.e. octane rating, greater than or equal to 85 and less than 88. Note: octane requirements may vary by altitude. See also Gasoline grades. Regulations (CFTC) The regulations adopted and enforced by the CFTC in order to administer the Commodity Exchange Act. Reinjected (natural gas) The forcing of gas under pressure into an oil reservoir in an attempt to increase recovery. Relative return The annualised return on an investment in excess of the average three-month US Treasury bill yield during the same period as the investment. This statistic measures the return on an investment relative to what would have otherwise been earned on a risk-free investment. Relative return standard deviation Measures the amount of variability of the relative return. A large relative return standard deviation indicates that the relative return experienced during the holding period fluctuated dramatically and, if the holding period were different, a significantly different relative return would have been achieved. A small relative return standard deviation indicates the opposite. Relative strength A comparison of the price performance of a stock to a market index such as Standard & Poor’s 500 stock index. Relative Strength Index An indicator invented by J. Welles Wilder and used to ascertain overbought/oversold and divergent situations. Renewable energy resources Energy resources that are naturally replenishing but flow-limited. They are virtually inexhaustible in duration but limited in the amount of energy that is available per unit of time. Renewable energy resources include: biomass, hydro, geothermal, solar, wind, ocean thermal, wave action and tidal action. Renko A kind of candlestick chart that does not take time into account for constructing the chart. Reparations The term is used in conjunction with the CFTC’s customer claims procedure to recover civil damages. Reportable positions The number of open contracts specified by the CFTC when a firm or individual must begin reporting total positions by delivery month to the authorised exchange and/or the CFTC.

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Repressuring The injection of a pressurized fluid (such as air, gas or water) into oil or gas reservoir formations to effect greater ultimate recovery. Representativeness Behavioural finance. Judgment by stereotype. Repurchase agreements (repo) An agreement between a seller and a buyer, usually in US government securities, in which the seller agrees to buy back the security at a later date. Reserve requirements The minimum amount of cash and liquid assets as a percentage of demand deposits and time deposits that member banks of the Federal Reserve are required to maintain. Reserves, coal Quantities of unextracted coal that comprise the demonstrated base for future production, including both proved and probable reserves. See also Proved energy reserves; Probable energy reserves; Energy reserves; Proved (measured) reserves, coal; and Probable (indicated) reserves, coal. Reservoir A porous and permeable underground formation containing an individual and separate natural accumulation of producible hydrocarbons (crude oil and/or natural gas) which is confined by impermeable rock or water barriers and is characterised by a single natural pressure system. Residual fuel oil A general classification for the heavier oils, known as No. 5 and No. 6 fuel oils, that remain after the distillate fuel oils and lighter hydrocarbons are distilled away in refinery operations. It conforms to ASTM Specifications D 396 and D 975 and Federal Specification VV-F-815C. No. 5, a residual fuel oil of medium viscosity, is also known as Navy Special and is defined in Military Specification MIL-F-859E, including Amendment 2 (NATO Symbol F-770). It is used in steam-powered vessels in government service and inshore power plants. No. 6 fuel oil includes Bunker C fuel oil and is used for the production of electric power, space heating, vessel bunkering, and various industrial purposes. Residual value The standard deviation of the unexplained portion of the monthly return. Residuum Residue from crude oil after distilling off all but the heaviest components, with a boiling range greater than 1,000 °F. Resistance A price level at which rising prices have stopped rising and either moved sideways or reversed direction; usually seen as a price chart pattern. Resistance line On a chart, a line drawn indicating the price level at which rising prices have stopped rising and have moved sideways or reversed direction. Response The change in value of the average in response to the impulse. Resting order An order placed with a condition or qualifier but not yet executed. Resumption The reopening the following day of specific futures and options markets that also trade during the evening session at the Chicago Board of Trade. Retention rate Percentage of a firm’s after-tax profits that can be put to those earnings retained. Retracement A price movement in the opposite direction of the previous trend. Return on assets (%ROA) The net earnings of a company divided by its assets. Return on equity (%ROE) The net earnings of a company divided by its equity.

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Reverse crush spread The sale of soybean futures and the simultaneous purchase of soybean oil and meal futures. The purchase of soybean futures and the simultaneous sale of soybean oil and meal futures. Reverse exponential moving average An exponential moving average computed working backward through the time series, rather than forward, as is the case with a standard EMA. A REMA is used so the target would reflect only future price behaviour, not past action that would induce spurious correlation. Reward–risk rank Stocks ranked in descending order by reward-risk ratio. Reward–risk ratio Monthly excess return to risk comparison, calculated by dividing alpha by standard deviation. (A ratio better than 0.4 is excellent.) Reversal gap A chart formation where the low of the last day is completely above the previous day’s range with the close above midrange and above the open. Reversal stop A stop that, when hit, is a signal to reverse the current trading position, i.e. from long to short. Also known as stop and reverse. Rich Price higher than expected. Risk (implied) In which the formula produces the percentage overbought/oversold for a contract using the price, a moving average and the option’s implied volatility. Risk-adjusted return on capital (RAROC) Another measure of risk-adjusted profitability, derived as the ratio between profit and loss and value at risk. Road oil Any heavy petroleum oil, including residual asphaltic oil, used as a dust palliative and surface treatment on roads and highways. It is generally produced in six grades, from 0, the most liquid, to 5, the most viscous. Roll Substituting a far option for a near option on the same underlying instrument at the same strike price; also to roll forward or roll over. Root mean square percentage error (RMSPE) Square root of the average sum of squared errors expressed as a percentage. Rotary rig A machine used for drilling wells that employs a rotating tube attached to a bit for boring holes through rock. Rotation Moving funds from one sector to another sector of the stock market as the business cycle unfolds. Round turn A completed futures transaction involving both a purchase and a liquidating sale, or a sale followed by a covering purchase. Roundwood Logs, bolts and other round timber generated from the harvesting of trees. Rules (NFA) The standards and requirements to which participants who are required to be Members of the National Futures Association must subscribe and conform. Runners Messengers who rush orders received by phone clerks to brokers for execution in the pit. Running market A market wherein prices are changing rapidly in one direction with very few or no price changes in the opposite direction. Running total Each day’s value is added to yesterday’s total or subtracted if the value is negative.

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S Sales growth The growth in sales in a company. Sales load A service charge of a mutual fund that is added to the costs of owning a stake in the fund. Saucer base Similar to a cup and handle formation, but the saucer base is shallower and rounder in shape. Savings and Loan Investment Contracts (SLICs) A negotiated-term deposit issued by a savings and loan. Scallop Chart formation in which the price dips momentarily, forming a cup, before resuming its upward course. Scalp In commodities, purchasing and selling in equal amounts so there is no net position at the end of the trading day; a speculative attempt to make a quick profit by buying at the initial offering price in the hope the issue will increase and can be sold. Scalper A trader who trades for small, short-term profits during the course of a trading session, rarely carrying a position overnight. Schwarz-a-tron A dedicated computer system for options calculations and simulations. Seasonal autocorrelation Autocorrelation that shows up at 12-, 24-, 36- and 48month lag intervals or at 4, 8, 12 and 16 quarterly lags. Seasonality A consistent and predictable change in market activity that occurs from consistent and predictable events. Seasonal trend A consistent but short-lived rise or drop in market activity that occurs due to predictable changes in climate or calendar. Secondary coal Solid fuels manufactured from primary coal, including coke (coal) or metallurgical coke and coal briquets. Secondary market Market where previously issued securities are bought and sold. Sector fund A mutual fund that concentrates on trading a range of securities within a broad industry group, such as technology, energy or financial services. Sector rotation When a block of investment professionals cash out of one industry sector to invest in another. Secular trend Pertaining to a long indefinite period of time. Security Common or preferred stock; a bond of a corporation, government or quasi-government body. Security selection ratio The percentage of trades in a given account that liquidate profitably. Seed The first value used to start a calculation. For example, an exponentially smoothed moving average (EMA) uses the previous day’s EMA for the calculation. On the first day’s calculation of the EMA, you could use a simple moving average as the seed for the EMA. Segregated account A special account used to hold and separate customers’ assets from those of the broker or firm. Seismogram A record produced by a seismographic survey

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Seismograph Apparatus used to measure and record vibrations in the Earth. It is used to detect possible oil-bearing structures. Seismographic survey Geophysical information on subsurface rock formations gathered by means of a seismograph. The investigation of underground strata by recording and analysing shock waves artificially produced and reflected from subsurface bodies of rock. Seismometer A device for receiving and recording shock waves set off by an explosion and reflected by underground rock formations. SelectNet A Nasdaq execution technology. Self-affine transformation A rescaling procedure used in fractal geometry and performed on a two-variable system. For example, in a system utilising an xaxis and y-axis representing time and price, the x-axis could be rescaled by one ratio and/or procedure while the y-axis is rescaled by a different ratio and/or procedure. Self-regulatory organisation (SRO) Self-regulatory organisations (i.e. the futures exchanges and National Futures Association) enforce minimum financial and sales practice requirements for their members. See also Designated selfregulatory organisation. Selling hedge or short hedge Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold. The practice of offsetting the price risk inherent in any cash market position by taking an equal but opposite position in the futures market. Hedgers use the futures markets to protect their business from adverse price changes. Selling short Selling a security and then borrowing the security for delivery with the intent of replacing the security at a lower price. In futures trading, selling short is to assume the responsibility of the seller vs. the buyer in the establishment of the futures contract between parties. Semilog Scaling method. With semilog, the distance between each point of a chart is exponential. Semilog scaling is used to compare relative price changes rather than physical point changes. Sensitivity The rate of change of the moving average in response to the movement of the underlying data. The most sensitive period is that in which the rate of change of the moving average is fastest in response to changes in the sine wave. Separative Work Units (SWU) The standard measure of uranium enrichment services. Serial correlation The systematic relationship between successive observation of a time series. Serially independent A number that is unrelated to the previous number in a given series in any way. Settle The last price paid for a commodity on any trading day. The exchange clearing house determines a firm’s net gains or losses, margin requirements, and the next day’s price limits, based on each futures and options contract settlement price. If there is a closing range of prices, the settlement price is

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determined by averaging those prices. Also referred to as settlement price or closing price. Settlement The price at which all outstanding positions in a stock or commodity are marked to market. Typically, the closing price. Settlement price The last price paid for a commodity on any trading day. The exchange clearing house determines a firm’s net gains or losses, margin requirements and the next day’s price limits, based on each futures and options contract settlement price. If there is a closing range of prices, the settlement price is determined by averaging those prices. Also referred to as settle or closing price. Sequestration See Carbon sequestration Shapiro–Wilkes test A statistical test indicating the likelihood that the sample of simulated net returns was drawn from a normal distribution. A small value of this statistic leads to nonacceptance of the null hypothesis that the sample is drawn from a normal distribution. Shareholder of record Share owner of company stock as registered in company files. Shaved candlestick In candlestick charting, when the shadows of a candle which mark the area between the real body and the extremes and which give the appearance of being wicks are absent. Ship-or-pay Clause included in natural gas transportation contracts according to which the customer for which the transportation is carried out is bound to pay for the transportation of the gas also in case the gas is not transported. Short (1) One who has sold futures contracts or plans to purchase a cash commodity. (2) Selling futures contracts or initiating a cash forward contract sale without offsetting a particular market position. Short hedge Selling futures contracts to protect against possible declining prices of commodities that will be sold in the future. At the time the cash commodities are sold, the open futures position is closed by purchasing an equal number and type of futures contracts as those that were initially sold. Short interest Shares that have been sold short but not yet repurchased. Short interest ratio A ratio that indicates the number of trading days required to repurchase all of the shares that have been sold short. A short interest ratio of 2. 50 would tell us that based on the current volume of trading, it will take two and a half days’ volume to cover all shorts. Short ton (coal) A unit of weight equal to 2,000 pounds. Signal In the context of stock or commodity time series historical data, this is usually daily or weekly prices. Signal line In artificial intelligence, a numeric variable that is prevalued in the knowledge base. In moving average jargon, the first moving average is smoothed by a second moving average. The second moving average is the signal line. Signature Medallion Guaranty Program used by banks and other institutions to verify a signature. Significance The probability of rejection on the basis of a statistical test and a hypothesis that there is no validity to the specific claim that two variations of the same thing can be distinguished by a specific procedure.

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SIMEX Singapore Monetary Exchange (now called SGX). Simple moving average The arithmetic mean or average of a series of prices over a period of time. The longer the period of time studied (that is, the larger the denominator of the average), the less impact an individual data point has on the average. Simple regression A mathematical way of stating the statistical linear relationship between one independent and one dependent variable. Simulation analysis of financial exposure A sophisticated computer risk analysis program that monitors the risk of clearing member and large-volume traders at the Chicago Board of Trade. It calculates the risk of change in market prices or volatility to a firm carrying open positions. Sine wave A wave whose amplitude varies as the sine of a linear function of time. Shrinkage (natural gas) The volume of natural gas that is transformed into liquid products during processing, primarily at natural gas processing plants. Skew A descriptive measure of lopsidedness in a distribution. Slippage The difference between estimated transaction costs and actual transaction costs. Sludge A dense, slushy, liquid-to-semifluid product that accumulates as an end result of an industrial or technological process designed to purify a substance. Industrial sludges are produced from the processing of energy-related raw materials, chemical products, water, mined ores, sewage, and other natural and artificial products. Sludges can also form from natural processes, such as the runoff produced by rainfall, and accumulate on the bottom of bogs, streams, lakes and tidelands. SMA See simple moving average Small Order Execution System (SOES) Computerised system developed by Nasdaq for immediate electronic execution of up to 1,000 shares of stock. Small Power Producer (SPP) Under the Public Utility Regulatory Policies Act (PURPA), a small power production facility (or small power producer) generates electricity using renewable energy (wood, waste, conventional hydroelectric, wind, solar and geothermal) as a primary energy source. Fossil fuels can be used, but renewable resources must provide at least 75% of the total energy input. See Nonutility power producer. Smoothing Simply, a mathematical technique that removes excess data variability while maintaining a correct appraisal of the underlying trend. SO2 See Sulphur dioxide Socialist Federal Republic of Yugoslavia Country that dissolved into five separate countries – Bosnia and Herzegovina; Croatia; Former Yugoslav Republic of Macedonia; Slovenia; and the Federal Republic of Yugoslavia (formerly listed as Serbia and Montenegro) – beginning on 25 June 1991. Solar collector See Solar thermal collector Solar energy The radiant energy of the Sun that can be converted into other forms of energy, such as heat or electricity. Electricity produced from solar energy heats a medium that powers an electricity-generating device. Solar thermal collector A device designed to receive solar radiation and convert it to thermal energy. Normally, a solar thermal collector includes a frame,

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glazing and an absorber, together with appropriate insulation. The heat collected by the solar thermal collector may be used immediately or stored for later use. Solar thermal collectors are used for space heating; domestic hot water heating; and heating swimming pools, hot tubs or spas. Solar thermal collector, high-temperature A solar thermal collector designed to operate at a temperature of 180 °F or higher. Solar thermal collector, low-temperature Metallic or nonmetallic solar thermal collectors that generally operate at temperatures below 110 °F and use pumped liquid or air as the heat transfer medium. They usually contain no glazing and no insulation, and they are often made of plastic or rubber, although some are made of metal. Solar thermal collector, medium-temperature Solar thermal collectors designed to operate in the temperature range of 140 °F to 180 °F, but which can also operate at a temperature as low as 110 °F. The collector typically consists of a metal frame, metal absorption panels with integral flow channels (attached tubing for liquid collectors or integral ducting for air collectors), and glazing and insulation on the sides and back. Solar thermal collector, special An evacuated tube collector or a concentrating (focusing) collector. Special collectors operate in the temperature range from just above ambient temperature (low concentration for pool heating) to several hundred degrees Fahrenheit (high concentration for air conditioning and specialised industrial processes). Solar thermal energy See Solar energy Solution, gas in Natural energy derived from the expansion of natural gas in solution in oil Sour/sweet crude Definitions which describes the degree of a given crude’s sulphur content. Sour refers to high sulphur and sweet to low sulphur. Special naphthas All finished products within the naphtha range that are used as paint thinners, cleaners or solvents. These products are refined to a specified flash point. Special naphthas include all commercial hexane and cleaning solvents conforming to ASTM Specifications D 1836 and D 484, respectively. Naphthas to be blended or marketed as motor gasoline or aviation gasoline, or that are to be used as petrochemical and synthetic natural gas (SNG) feedstocks are excluded. Special solar thermal collector See Solar thermal collector, special Specific gravity In the case of liquids, the ratio between the weight of equal volumes of water and another substance measured at standard temperature, where the weight of the water is assigned the value 1. Specify To set the parameters and variables of a given model. Speculator A market participant who tries to profit from buying and selling futures and options contracts by anticipating future price movements. Speculators assume market price risk and add liquidity and capital to the futures markets. Spectrum The frequency decomposition of time series data. This is used to detect periodic fluctuations or cycles in historical price data. Spent liquor The liquid residue left after an industrial process; can be a component of waste materials used as fuel.

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Spike A sharp rise in price in a single day or two; may be as great as 15–30%, indicating the time for an immediate sale. Spline The linear interpolation between two adjacent points on a curve. Spot Usually refers to a cash market price for a physical commodity that is available for immediate delivery. Spot market price See Spot price Spot month In trading, the current contract month. Also known as the front month. See also Nearby delivery month. Spot price The price for a one-time open market transaction for immediate delivery of a specific quantity of product at a specific location where the commodity is purchased ‘on the spot’ at current market rates. SPR See Strategic Petroleum Reserve (SPR). Spread A trade in which two related contracts/stocks/bonds/options are traded to exploit the relative differences in price change between the two. Spreading The simultaneous buying and selling of two related markets in the expectation that a profit will be made when the position is offset. Examples include buying one futures contract and selling another futures contract of the same commodity but different delivery month; buying and selling the same delivery month of the same commodity on different futures exchanges; and buying a given delivery month of one futures market and selling the same delivery month of a different, but related, futures market. Spread rolls Using a spread order to bridge the closing of one position and the establishment of a new one. Spring (1) A two-day pattern in which on the first day, the market declines below a support point, while the next day sees the market move strongly back up into the congestion area. (2) Another term for upthrust; occurs when price moves above a pivot top and a widespread reversal ensues as follows: (a) two previous closes are reversed, (b) close is below pivot top, (c) close is below opening and mid-range, (d) daily price range is greater than the previous day’s range. Stair-stepping In which market activity is characterised by a trend, then sideways movements, followed by another trend and further sideways movement. Standard deviation The positive square root of the expected value of the square of the difference between a random variable and its mean. A measure of the fluctuation in a stock’s monthly return over the preceding year. Standard error of the estimate (SEE) A measure of absolute fit. One can use this measure to compare the last portion of this model with another portion of the same dependent variable. Standardised unanticipated earnings (SUE) A company’s average earnings surprise is compared with analyst earnings estimates dispersion, which can be used to estimate the likelihood of earnings surprises. Stationarity A distribution of a quantity that does not change over time. Stationary time series Implies that no trend is observed in the time series. Identified when the time series has a constant mean and variance. Steam coal All nonmetallurgical coal. Steam cracker (ethylene plant) A petrochemical plant that produces olefins, particularly ethylene, and, in some cases, aromatics.

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Steam-electric power plant (conventional) A plant in which the prime mover is a steam turbine. The steam used to drive the turbine is produced in a boiler where fossil fuels are burned. Step function A function defined on an interval so that the interval can be partitioned into a finite number of subintervals on each of which the function is a constant. Also known as a simple function. Stepwise regression A mathematical technique to choose the independent variables that best describe the behaviour of the dependent, in order of improving description. Still gas (refinery gas) Any form or mixture of gases produced in refineries by distillation, cracking, reforming and other processes. The principal constituents are methane, ethane, ethylene, normal butane, butylene, propane and propylene. Still gas is primarily used as a refinery fuel and as a petrochemical feedstock. Stochastic Literally means random. Stochastics oscillator An overbought/oversold indicator that compares today’s price to a preset window of high and low prices. These data are then transformed into a range between zero and 100 and then smoothed. Stock change The difference between stocks at the beginning of the reporting period and stocks at the end of the reporting period. Stock index futures A futures contract traded that uses a market index as the underlying instrument. Typically, the value of the contract is $500 times the underlying index. The delivery mechanism is usually cash settlement. Stocks Inventories of fuel stored for future use. See also Coal stocks and Petroleum stocks. Stop and reverse (SAR) A stop that, when hit, is a signal to reverse the current trading position, i.e. from long to short. Also known as reversal stop. Stop-limit order A variation of a stop order in which a trade must be executed at the exact price or better. If the order cannot be executed, it is held until the stated price or better is reached again. Stop loss The risk management technique in which the trade is liquidated to halt any further decline in value. Stop order An order to buy or sell when the market reaches a specified point. A stop order to buy becomes a market order when the futures contract trades (or is bid) at or above the stop price. A stop order to sell becomes a market order when the futures contract trades (or is offered) at or below the stop price. Stop-running After a trend, the market will enter into a trading range and have a tendency to trade to levels where stop-loss orders have been placed. Stops Buy stops are orders that are placed at a predetermined price over the current price of the market. The order becomes a ‘buy at the market’ order if the market is at or above to the price of the stop order. Sell stops are orders that are placed with a predetermined price below the current price. Sell stop orders become ‘Sell at the market’ orders if the market trades at or below the price of the stop order. Straddle The purchase or sale of an equivalent number of puts and calls on an underlying stock with the same exercise price and expiration date.

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Straight-run Material which has come straight from an atmospheric distillation unit and has not been cracked or reformed, and which is usually used as a feedstock or as a utility fuel. Strange attractor A balance point between a set of conflicting forces. Strangle The purchase or sale of an equivalent number of puts and calls on an underlying stock with the same expiration date but a different exercise price. Usually, the put has a low strike price and the call has a higher strike price. Strategic Petroleum Reserve (SPR) Petroleum stocks maintained by the US Federal government for use during periods of major supply interruption. Strategic storage Volumes required for covering lack or reduction of supplies from extra-European sources or crises in the natural gas system. Street name Stock ownership in which shares are registered to a brokerage or other financial institution and held. Strike price The price per unit at which the holder of an option may receive or deliver the underlying unit; also known as the exercise price. Stripper well (natural gas) A well that produces 60 thousand cubic feet per day or less of gas-well gas for a period of three consecutive months, while producing at its maximum flow rate. Stripper well property (petroleum) A property whose average daily production of crude oil per well (excluding condensate recovered in natural gas production) did not exceed an average of 10 barrels per day during any preceding consecutive 12-month period beginning after 31 December 1972. Strips An option strategy in which an investor buys one call and two puts on the same underlying security with the same exercise price and expiration date. Struck The price at which an exercised option delivers the underlying securities. Student The pseudonym of Irish chemist W. S. Gosset, who published ‘The Probable Error at a Mean’ under that name in 1908. Sub-bituminous coal A coal whose properties range from those of lignite to those of bituminous coal and used primarily as fuel for steam-electric power generation. It may be dull, dark brown to black, soft and crumbly at the lower end of the range, to bright, jet black, hard and relatively strong at the upper end. Sub-bituminous coal contains 20–30% inherent moisture by weight. The heat content of sub-bituminous coal ranges from 17 to 24 million Btu per ton on a moist, mineral-matter-free basis. The heat content of sub-bituminous coal consumed in the USA averages 17–18 million Btu per ton, on the as-received basis (i.e. containing both inherent moisture and mineral matter). Sulphur A yellowish nonmetallic element, sometimes known as ‘brimstone’. It is present at various levels of concentration in many fossil fuels whose combustion releases sulphur compounds that are considered harmful to the environment. Some of the most commonly used fossil fuels are categorised according their sulphur content, with lower sulphur fuels usually selling at a higher price. Note: No. 2 distillate is currently reported as having either a 0.05% or lower sulphur level for on-highway vehicle use or a greater than 0.05% sulphur level for off-highway use, home heating oil, and commercial and industrial uses. Residual fuel oil, regardless of use, is classified as having either no more than 1% sulphur or greater than 1% sulphur. Coal is also classified as being low-

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sulphur at concentrations of 1% or less or high-sulphur at concentrations greater than 1%. Sulphur dioxide (SO2) A toxic, irritating, colourless gas, soluble in water, alcohol and ether. Used as a chemical intermediate in paper pulping and ore refining, and as a solvent Sulphur hexafluoride (SF6) A colourless gas soluble in alcohol and ether, and slightly less soluble in water. It is used as a dielectric in electronics. It possesses the highest 100-year Global Warming Potential of any gas (23,900). Sulphur oxides (SOx) Compounds containing sulphur and oxygen, such as sulphur dioxide (SO2) and sulphur trioxide (SO3). Sum of squared residuals (SSR) Measure related to the R-squared value; the smaller the number, the higher will be R-squared, and the better the regression. Supply See Energy supply Supply, law of The relationship between product supply and its price. Support The place on a chart where the buying of futures contracts is sufficient to halt a price decline. Support A historical price level at which falling prices have stopped falling and either moved sideways or reversed direction; usually seen as a price chart pattern. Support line On a chart, a line drawn indicating the price level at which falling prices have stopped falling and have moved sideways or reversed direction. Surface mine (coal) A coal-producing mine that is usually within a few hundred feet of the surface. Earth and rock above or around the coal (overburden) is removed to expose the coal bed, which is then mined with surface excavation equipment such as draglines, power shovels, bulldozers, loaders and augers. It may also be known as an area, contour, open pit, strip or auger mine. Suspension The end of the evening session for specific futures and options markets traded at the Chicago Board of Trade. Swing chart A chart that has a straight line drawn from each price extreme to the next price extreme based on a set criteria such as percentages or number of days. For example, percentage price changes of less than 5% will not be measured in the swing chart. Swings The measurement of movement of the price of a tradable between extreme highs and lows. Synergistic market analysis Also known as synergistic analysis. An analytical method that merges technical and fundamental analysis with an emphasis on intermarket analysis. Synthetic natural gas (SNG) A manufactured product chemically similar in most respects to natural gas, resulting from the conversion or reforming of petroleum hydrocarbons or from coal gasification. It may easily be substituted for, or interchanged with, pipeline quality natural gas. Synthetic securities Security created by buying and writing a combination of options that imitate the risk and profit profile of a security. System (electric) See Electric system SWU See Separative units

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T T-statistics The probability distribution used to test the hypothesis that a random sample of n observations comes from a normal population with a given mean. T-test A statistical test of significance for a distribution that changes its shape as N gets smaller; based on a variable t equal to the difference between the mean of the sample and the mean of the population divided by a result obtained by dividing the standard deviation of the sample by the square root of the number of individuals in the sample. Take-or-pay Clause included in natural gas transportation contracts according to which the purchaser is bound to pay the contractual price or a fraction of such price for a minimum quantity of the gas set in the contract also in case it is not collected by the customer. The customer has the option of collecting the gas paid and not delivered at a price equal to the residual fraction of the price set in the contract in subsequent contract years. Tall oil The oily mixture of rosin acids, fatty acids and other materials obtained by acid treatment of the alkaline liquors from the digesting (pulping) of pine wood. Tangibles Cash equivalents of the futures contracts Tanker and barge Vessels that transport crude oil or petroleum products. Tar sands Naturally occurring bitumen-impregnated sands that yield mixtures of liquid hydrocarbon and that require further processing other than mechanical blending before becoming finished petroleum products. Tax-deferred In which an investment allows an investor to postpone paying taxes on money put into the investment until the investor literally takes possession of the money invested. Technical analysis A form of market analysis that studies demand and supply for securities and commodities based on trading volume and price studies. Using charts and modelling techniques, technicians attempt to identify price trends in a market. Telegrapher’s equation A variation of the diffusion equation that describes minor differences in the drunkard’s walk, in which the random decision controls the change in direction rather than the direction itself. Term structure Also known as yield curve. The slope of the term structure is the yield on long-term government bonds minus the yield on short-term instruments such as Treasury bills. Therm One hundred thousand (105) British thermal units. Thermal cracking A refining process in which heat and pressure are used to break down, rearrange, or combine hydrocarbon molecules. Thermal cracking includes gasoil visbreaking, fluid coking, delayed coking and other thermal cracking processes (e.g. flexicoking). Theta The measurement of the time decay of a position. Third party access to natural gas networks Legislative Decree 164/00, introducing the European Union Directive on natural gas into Italian legislation, decreed that companies active in natural gas transmission and dispatching are to allow access to their network to third parties requesting such access,

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provided that they have sufficient capacity for it and that linking works are technically feasible, based on criteria published by the Authority on Electricity and Gas. The Authority is also responsible for defining tariffs for transmission and dispatching services, obligations of operators and criteria ensuring access to all network users at equal conditions, impartiality and neutrality. Thrust A comparison between the price difference of successively lower pivot bottoms or higher pivot tops. For example, a reduction in the difference between pivot bottoms shows loss of momentum; an increase in the difference shows increased momentum. Tick The minimum fluctuation of a tradable. For example, bonds trade in 32nds, while most stocks trade in eighths. Tick indicator The number of stocks whose last trade was an uptick or a downtick. Time and sales ticker Part of the Chicago Board of Trade Market Profile. system consisting of an on-line graphic service that transmits price and time information throughout the day. Time domain Variation of a time series is accounted for by an autocorrelation function and other time series. Time limit order A customer order that designates the time during which it can be executed. Time series A collection of observations made sequentially in time and indexed by time. Time-stamped Part of the order-routing process in which the time of day is stamped on an order. An order is time-stamped when it is (1) received on the trading floor, and (2) completed. Time value The amount of money options buyers are willing to pay for an option in anticipation that over time a change in the underlying futures price will cause the option to increase in value. In general, an option premium is the sum of time value and intrinsic value. Any amount by which an option premium exceeds the option’s intrinsic value can be considered time value. Also referred to as extrinsic value. Topping process A basic refining process. It is simply a distillation process in which the crude petroleum is heated in a heater then run through a fractionating tower in which different fractions are separated and drawn off at different levels at varying controlled temperatures TPO Time–price opportunity; a price that occurs during designated half-hour periods of trading; a price–time relationship developed for the Chicago Board of Trade’s Market Profile and Liquidity Data Bank reports. Tradable Trading instrument. Trade facilitation Liquidity. Trade balance The difference between a nation’s imports and exports of merchandise. Trading bands Lines plotted in and around the price structure to form an envelope, answering whether prices are high or low on a relative basis and forewarning whether to buy or sell by using indicators to confirm price action. Trading limit The maximum number of speculative futures contracts one can hold as determined by the Commodity Futures Trading Commission and/or

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the exchange upon which the contract is traded. Also referred to as position limit. Trading range The difference between the high and low prices traded during a period of time; in commodities, the high/low price limit established by the exchange for a specific commodity for any one day’s trading. Trailing stop A stop-loss order that follows the prevailing price trend. Transfer agent Financial institution that manages ownership records of company stock. Transfer function The mathematical relationship between the output of a control system and its input for a linear system, it is the Laplace transform of the output divided by the Laplace transform of the input under conditions of zero initial energy. Transfer response Refers to the shape of the wave coming out of a filter in comparison to the shape going into it. Transform A process to change or convert. For example, a simple moving average is a filter to reduce noise; the moving average is the transform function. Transmission The movement or transfer of electric energy over an interconnected group of lines and associated equipment between points of supply and points at which it is transformed for delivery to consumers, or is delivered to other electric systems. Transmission is considered to end when the energy is transformed for distribution to the consumer. Transmission and distribution loss Electrical energy lost due to the transmission and distribution of electricity. Much of the loss is thermal in nature. See also Power loss. Transmission system (electric) An interconnected group of electric transmission lines and associated equipment for moving or transferring electric energy in bulk between points of supply and points at which it is transformed for delivery over the distribution system lines to consumers, or is delivered to other electric systems. Trap The occurrence of those structures, pinch-outs, permeability changes and similar features necessary for the entrapment of oil and (or) gas in at least one accumulation of the minimum size. Included in this attribute are existence of seals sufficient for entrapping hydrocarbons and capable of holding oil and gas accumulations during appropriate ranges of geologic time Treasury bill A Treasury bill is a short-term US government obligation with an original maturity of one year or less. Unlike a bond or note, a bill does not pay a semi-annual, fixed rate coupon. A bill is typically issued at a price below its par value and is therefore a discounted instrument. The level of the discount depends on the level of prevailing interest rates. In general, the higher shortterm interest rates are, the greater the discount. The return to an investor in bills is simply the difference between the issue price and par value. Treasury bond Government-debt security with a coupon and original maturity of more than 10 years. Interest is paid semi-annually. Treasury note Government-debt security with a coupon and original maturity of 1–10 years. Trend The general drift, tendency or bent of a set of statistical data as related to time.

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Trend channel A parallel probable price range centered about the most likely price line. Historically, this term has been used to denote the area between the base trendline and the reaction trendline defined by price moves against the prevailing trend. Trend day A day in which the price of a futures contract moves consistently away from the opening range and does not return to the opening range prior to the close. Trend-following Moving in the direction of the prevailing price movement. Trending market Price moves in a single direction, generally closing at an extreme for the day. Trendless Price movement that vacillates to the degree that a clear trend cannot be identified. Trendline A line drawn that connects either a series of highs or lows in a trend. The trendline can represent either support as in an uptrend line or resistance as in a downtrend line. Consolidations are marked by horizontal trendlines. Triangle A pattern that exhibits a series of narrower price fluctuations over time; top and bottom boundaries need not be of equal length. Triangular moving average A moving average in which each day’s data are multiplied by a weight that increases in value at steady increments to a peak value and then declines to zero at equivalent increments. The sum of the weighted daily data is divided by the number of variables. TRIN See Arms index Trix The one-period difference of the triple exponential smoothing operating on the log of price. Troposphere The inner layer of the atmosphere below about 15 kilometres, within which there is normally a steady decrease of temperature with increasing altitude. Nearly all clouds form and weather conditions manifest themselves within this region. Its thermal structure is caused primarily by the heating of the Earth’s surface by solar radiation, followed by heat transfer through turbulent mixing and convection. True range The largest of the following: today’s high minus today’s low, today’s high minus yesterday’s close, today’s low minus yesterday’s close. Tulip sector A sector that is the intense focus of speculators at the moment. Turbine A machine for generating rotary mechanical power from the energy of a stream of fluid (such as water, steam, or hot gas). Turbines convert the kinetic energy of fluids to mechanical energy through the principles of impulse and reaction, or a mixture of the two. Turning point The approximate time at which there is a change in trend. Tweezers bottoms and tops Candlestick formations. Both candles must have identical highs and lows. Significant when found at contract highs or lows, and can indicate a breakout.

U UKPX (UK Power Exchange) A trading arena in which electricity can be bought or sold normally up to two days ahead of real time, often via the Internet.

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Unconventional accumulation A broad class of hydrocarbon deposits of a type (such as gas in ‘tight’ sandstones, gas shales and coal bed gas) that historically has not been produced using traditional development practices. Such accumulations include most continuous-type deposits Uncovered option The buying or selling of an option without a position in the underlying futures contract; also known as a naked option. Underground mine (coal) A mine where coal is produced by tunnelling into the Earth to the coal bed, which is then mined with underground mining equipment such as cutting machines and continuous, longwall and shortwall mining machines. Underground mines are classified according to the type of opening used to reach the coal, i.e. drift (level tunnel), slope (inclined tunnel) or shaft (vertical tunnel). Underlying futures contract The specific futures contract that the option conveys the right to buy (in case of a call) or sell (in the case of a put). Underlying instrument A trading instrument subject to purchase upon exercise. Underlying security In options, a stock subject to purchase upon exercise of the option. Unfinished oils All oils requiring further processing, except those requiring only mechanical blending. Unfinished oils are produced by partial refining of crude oil and include naphthas and lighter oils, kerosene and light gasoils, heavy gasoils and residuum. Uniform Gifts to Minors Acts A law that allows minors to own property without the use of a trust. United States of America (USA) Unless otherwise noted, United States of America in this publication means the 50 States and the District of Columbia. Note: the USA has varying degrees of jurisdiction over a number of territories and other political entities outside the 50 States and the District of Columbia, including Puerto Rico, the US Virgin Islands (usually listed as Virgin Islands, US), Guam, American Samoa, Johnston Atoll, Midway Islands, Wake Island and the Northern Mariana Islands. EIA data programs may include data from some or all of these areas in US totals. For these programs, data products will contain notes explaining the extent of geographic coverage included under the term ‘United States of America’. See also Exports (US) and Imports (US). Univariate Involving only one variable. Upthrust Occurs when price moves above a pivot top and a widespread reversal ensues as follows: (a) two previous closes are reversed, (b) close is below pivot top, (c) close is below opening and mid-range, (d) daily price range is greater than the previous day’s range. Upstream/downstream The term upstream refers to all hydrocarbon exploration and production activities. The term downstream includes all activities inherent to the oil sector that are downstream of exploration and production activities. Uranium A heavy, naturally radioactive, metallic element (atomic number 92). Its two principally occurring isotopes are uranium-235 (235U) and uranium-238 (238U). The isotope 235U is indispensable to the nuclear industry because it is the only isotope existing in nature to any appreciable extent that is fissionable by thermal neutrons. The isotope 238U is also important because it absorbs neutrons to produce a radioactive isotope that subsequently decays to

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plutonium-239 (239Pu), an isotope of plutonium that is also fissionable by thermal neutrons. Uranium concentrate A yellow or brown powder obtained by the milling of uranium ore, processing of in situ leach mining solutions, or as a byproduct of phosphoric acid production. See also In situ leach mining (ISL). Uranium milling See Milling of uranium Uranium ore Rock containing uranium mineralisation in concentrations (typically 1 to 4 pounds of U3O8 per ton or 0.05 to 0.20% U3O8) that can be mined economically. Uranium oxide Uranium concentrate or yellowcake. Abbreviated as U3O8. See also Yellowcake. US refiner acquisition cost of imported crude oil The average price paid by US refiners for imported, that is, non-US, crude oil booked into their refineries in accordance with accounting procedures generally accepted and consistently and historically applied by the refiners concerned. The refiner acquisition cost of imported crude oil includes transportation and other fees paid by the refiner. See Refiner acquisition cost of crude oil and imports (US). US Treasury bill A short-term US government debt instrument with an original maturity of one year or less. Bills are sold at a discount from par with the interest earned being the difference between the face value received at maturity and the price paid. US Treasury bond Government-debt security with a coupon and original maturity of more than 10 years. Interest is paid semi-annually. US Treasury note Government-debt security with a coupon and original maturity of 1–10 years. USSR The Union of Soviet Socialist Republics (or Soviet Union) consisted of 15 constituent republics: Armenia, Azerbaijan, Belarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova, Russia, Tajikistan, Ukraine and Uzbekistan. As a political entity, the USSR disbanded on 26 December 1991. Underlying futures contract The specific futures contract that is bought or sold by exercising an option. Utility See Electric utility

V Value area The price range on the CBOT Market Profile in which approximately 70% of the day’s trades occur. Value at risk (VAR) A measure of exposure within a given portfolio, which attempts to estimate how much the portfolio would be expected to lose, given the recent behaviour of the securities contained therein. Value averaging In which the average is taken of a series of values. Value-weighted index A market average such as Standard & Poor’s 500 Index that takes into account the market value of each security rather than calculating a straight price average.

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Vanadium Metal present in certain types of fuel Variable-length moving average A moving average where the number of periods selected for smoothing is based on a volatility measurement of price. Typically, the standard deviation of price is used to measure price volatility. The more volatile the price, the shorter the number of periods used for smoothing. Variable limit According to the Chicago Board of Trade rules, an expanded allowable price range set during volatile markets. Variation margin During periods of great market volatility or in the case of highrisk accounts, additional margin deposited by a clearing member firm to an exchange. Vega The amount by which the price of an option changes when the volatility changes. Vented Gas released into the air on the production site or at processing plants. Vented, flared (natural gas) Gas that is disposed of by releasing (venting) or burning (flaring). Vented natural gas See Vented. Versus cash A transaction generally used by two hedgers who want to exchange futures for cash positions. Also referred to as ‘against actuals’ or ‘exchange for physicals.’ Vertical spread An option spread based on simultaneous purchase and sale of options on the same underlying stock with the same expiration months but different strike prices. Vesting The rights that an employee gains for working at a firm for a specific length of time. Vessel A ship used to transport crude oil, petroleum products, or natural gas products. Vessel categories are as follows: Ultra Large Crude Carrier (ULCC), Very Large Crude Carrier (VLCC), Other Tanker, and Specialty Ship (LPG/ LNG). See also Tanker and barge. Vessel bunkering (US) Includes sales for the fuelling of commercial or private boats, such as pleasure craft, fishing boats, tugboats, and ocean-going vessels, including vessels operated by oil companies. Excluded are volumes sold to the US Armed Forces. Visbreaking A thermal cracking process in which heavy atmospheric or vacuumstill bottoms are cracked at moderate temperatures to increase production of distillate products and reduce viscosity of the distillation residues. Viscosity One of the physical properties of a liquid, namely its ability to flow. It is expressed inversely, i.e. the less viscous the fluid, the greater its mobility. The viscosity of oil in a reservoir affects the rate and amount of recovery. While viscosity is related to specific gravity, it is also affected by the amount of gas in solution in the oil. Greater recoveries can be obtained where the solution gas is not allowed to escape prior to the time the oil is removed from the reservoir. Volatile matter (coal) Those products, exclusive of moisture, given off by a material as gas or vapour. Volatile matter is determined by heating the coal to 950 °C under carefully controlled conditions and measuring the weight loss, excluding weight of moisture driven off at 105 °C.

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Volatility A measure of a stock’s tendency to move up and down in price, based on its daily price history over the latest 12 months. Volume The number of purchases and sales of futures contracts made during a specified period of time, often the total transactions for one trading day. Volume price trend (VPT) In which a running sum is maintained when a day’s total volume is added if the market closes positive or the day’s total volume is subtracted if the market closes lower. See also On-balance volume.

W W formation A double-bottom formation. Warehouse receipt Document guaranteeing the existence and availability of a given quantity and quality of a commodity in storage; commonly used as the instrument of transfer of ownership in both cash and futures transactions. Warrant A company-issued certificate that represents an option to buy stock shares at a given time. Waste Municipal solid waste, landfill gas, methane, digester gas, liquid acetonitrile waste, tall oil, waste alcohol, medical waste, paper pellets, sludge waste, solid byproducts, tires, agricultural byproducts, closed loop biomass, fish oil and straw. Waste energy Municipal solid waste, landfill gas, methane, digester gas, liquid acetonitrile waste, tall oil, waste alcohol, medical waste, paper pellets, sludge waste, solid byproducts, tires, agricultural byproducts, closed loop biomass, fish oil, and straw used as fuel. Water vapour Water in a vaporous form, especially when below boiling temperature and diffused (e.g. in the atmosphere). Wasting A term depicting how an option’s value decreases over time; as each day after acquisition passes a portion of the option’s time value is lost or wasted. Watt (W) The unit of electrical power, equal to one ampere under a pressure of one volt. A watt is equal to 1/746 horsepower. Watt hour (Wh) The electrical energy unit of measure equal to one watt of power supplied to, or taken from, an electric circuit steadily for one hour. Wave In Elliott wave theory, a sustained move by a market’s price in one direction as determined by the reversal points that initiated and terminated it. Wave cycle An impulse wave followed by a correction wave, the impulse wave being made up of five smaller, numbered waves of alternating direction designated 1, 2, 3, 4 and 5, and the correction wave being composed of three smaller alternating waves designated a, b, and c. Waxes Solid or semi-solid materials derived from petroleum distillates or residues by such treatments as chilling, precipitating with a solvent, or de-oiling. Waxes are light-coloured, more-or-less translucent crystalline masses, slightly greasy to the touch, consisting of a mixture of solid hydrocarbons in which the paraffin series predominates. Included are all marketable waxes, whether crude scale or fully refined. The three grades included are microcrystalline, crystalline-fully refined, and crystalline-other. Waxes are used primarily as industrial coatings for surface protection.

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Wedge A pattern in which two converging lines connect a group of price peaks and troughs. Weighted average purchase price Multiply each purchase order bought by the associated purchase price, add them together and divide the total by the number of blocks. The result is the weighted average purchase price. Weighted industry index An index where the importance of each stock is related to its market capitalisation. Weighted moving average (WMA) A moving average that puts more weight on recent prices. A three-day weighted moving average would add a multiple of 1 to the first date, 2 to the second date and 3 to the third date. Well A hole drilled in the Earth for the purpose of (1) finding or producing crude oil or natural gas; or (2) producing services related to the production of crude oil or natural gas. See also Completion; Development well; Dry hole; Exploratory well; Gas well; and Oil well. Wellhead The top of, or a structure built over, a well. Wet natural gas A mixture of hydrocarbon compounds and small quantities of various nonhydrocarbons existing in the gaseous phase or in solution with crude oil in porous rock formations at reservoir conditions. The principal hydrocarbons normally contained in the mixture are methane, ethane, propane, butane, and pentane. Typical nonhydrocarbon gases that may be present in reservoir natural gas are water vapour, carbon dioxide, hydrogen sulphide, nitrogen and trace amounts of helium. Under reservoir conditions, natural gas and its associated liquefiable portions occur either in a single gaseous phase in the reservoir or in solution with crude oil and are not distinguishable at the time as separate substances. Note: the Securities and Exchange Commission and the Financial Accounting Standards Board refer to this product as natural gas. Whiplash Alternating buy and sell signals that result in losses. Whipsaw Losing money on both sides of a price swing. White spirit A highly refined distillate with a boil-ing point range of about 150–200 °C. It is used as a paint solvent and for dry-cleaning purposes. Wholesale sales All domestic oil sales activities, excluding distribution through the service stations network, marine bunkering and sales of goods non subject to excise tax, to wholesalers and distributors (particularly gasoil), to large customers (e.g. Enel – gasoil, airlines – jet fuel), to the public administration and to industries. Wildcards Characters in a quote symbol or DOS filename that indicates an undefined, but categorised, value. Williams’ %R Overbought and oversold indicator that is used to determine market entry and exit points. Wind energy The kinetic energy of wind converted into mechanical energy by wind turbines (i.e. blades rotating from the hub) that drive generators to produce electricity. Window Set period of time, such as a lookback period for market indicator in question. Wire house An individual or organisation that solicits or accepts orders to buy or sell futures contracts or options on futures and accepts money or other assets

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from customers to support such orders. Also referred to as ‘commission house’ or Futures Commission Merchant (FCM). Wizard A preprogrammed step-by-step procedure to aid the user in accomplishing a specific task. Writer The person who sells an option in return for a premium and is obligated to perform when the holder exercises his right under the option contract. Also referred to as the option seller. WTI West Texas Intermediate. The WTI spot price of crude is reported from Cushing, Oklahoma. WTS West Texas Sour

Y Yates’s correction When a small amount of data is available for testing, the chisquare formula is adjusted to account for the small sample base. Yield A measure of the annual return on an investment. Yield curve A chart in which the yield level is plot on the vertical axis and the term to maturity of debt instruments of similar creditworthiness is plotted on the horizontal axis. The yield curve is positive when long-term rates are higher than short-term rates. However, yield curve is negative or inverted. Yield to maturity The rate of return an investor receives if a fixed-income security is held to maturity.

Z Zero-coupon government bonds Government bonds that are purchased at a deep discount and pay no cash dividend, unlike regular bonds. Zeta The percentage change in an options price per 1% change in implied volatility. Zigzag In a bull market, an Elliott three-wave pattern that subdivides into a 5–3–5 pattern with the top of wave B noticeably lower than the start of wave A. In a bear market, this pattern will be inverted.

APPENDIX 1

Example of a Risk Management Review of a Company Using Derivatives to Hedge Oil Requirement

Here is an example of a risk management procedure review made by an external consultant for ABCXYZ Ltd Trading company which is using derivatives for hedging (risk management) purposes.

CRITERIA AND EXAMPLE RESULTS PRIVATE & CONFIDENTIAL OPERATIONAL RISK MANAGEMENT REVIEW Report based on interviews and observations made through September 1999 ABC-XYZ TRADING LTD 12345 Canary Wharf, London, E14 United Kingdom Review Conducted by: London – United Kingdom Tel: 44 12345 Fax: 44 12346 Email: [email protected] Review conducted during September 2002 Published 10 October 2002

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PRIVATE AND CONFIDENTIAL The Management ABC-XYZ TRADING LTD 12345 Canary Wharf, London, E14 United Kingdom

10 October 2002

Dear Sir/Madam, RISK MANAGEMENT REVIEW In accordance with my engagement as a consultant to review the risk management processes of ABC-XYZ, I am pleased to deliver my Risk Management Review report covering the processes and infrastructure that supports the Risk Management Policy and trading activities of ABCXYZ. USE OF REVIEW This review is addressed to you as management of ABC-XYZ, although I understand that you may wish to make the report available to other companies within your group, and I consent to the review being provided to them on the basis that the review as a whole is provided to them. At your request I can issue copies of this report directly to overseas offices of your company in order to satisfy any due diligence reporting requirements. SCOPE OF WORK Note that the information in this review is based on observations made, documentation reviewed and verbal representations received, and has not been subjected to further verification or testing. My review comprised interviewing ABC-XYZ personnel and site visits to ABC-XYZ office. LIMITATIONS IN SCOPE The findings of my review apply to a point in time. I cannot guarantee that the information given regarding the processes and infrastructure in place will remain valid. I trust that you will find the contents of this report satisfactory for your purposes. If you would like to discuss any elements of this review please do not hesitate to contact me at +44 12345. You can also email me at: [email protected].

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In closing, I thank you for the opportunity to work with you on this important effort and hope that I may be of further assistance to you in the near future. Your sincerely Independent Risk Management Consultant

THE RISK ENVELOPE Areas of risk management A_01

Funding Credit and settlement

Market

Legal

Tax

Operations

IT

Compliance

Physical and crime

Liability

Overview of risk management practice in AIST I am pleased to report that for a company which would in Price Risk Management terms be described as an ‘end user’ of the derivatives market, the risk management infrastructure and controls already in place within ABC-XYZ Ltd have impressed me. (An ‘end user’ in this context being a company with underlying price risk exposure in the physical commodity markets, whose primary aim in the use of derivatives contracts (futures, options, swaps) is to control/reduce this Price Risk.) I have completed a risk management review and attached are the key results of this review and my recommendations for consideration. Whether you apply any or all of these recommendations will depend on your judgement as ABC-XYZ management on the relevance of my suggestions to your business. My recommendations are based on my experience of ‘standard practice guidelines’ for users of derivatives markets. Review of risk management/trading policies I noted that ABC-XYZ is bound by the parent company ZYX’s treasury risk management policy and also ABC-XYZ board of directors policy and that staff and management are aware of these policies. It was also noted in addition to this that in the near future a specific commodity risk management policy for ZYX is to be compiled.

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I noted from interviews with ABC-XYZ personnel that it is already current practice for ABC-XYZ to hold a Risk Management Committee (RMC) meeting at least once a week. I was informed that this Committee reviews current ABC-XYZ open positions in the markets traded, reviews the current market trends, ABC-XYZ market exposure and discusses trading/ hedging recommendations for the weeks ahead and creates a trading strategy for the traders to follow. Also Trading Policies including but not limited to Trading position limits are set. All RMC meeting minutes are filed for the record. This is good management practice and in line with standard risk management controls in a company using Futures contracts on organised exchanges and Over-the-counter swaps markets (derivatives). I noted that there are rules on position limits in existence and these cover how far forward in the future a derivatives position can be opened... e.g. 12 months in the future, or 6 months in the future etc. Trading policies such as these are crucial for any operation utilising derivatives for trading or hedging and it is good to see that these are in operation at ABC-XYZ. I noted that management monitors a hedging limit of 75% of budgeted physical requirement in the future. This is very prudent risk management control as forward budgeted physical requirement are just that: estimates. Recommendation on trading policy for a company hedging As it is my understanding that ABC-XYZ is primarily involved in hedging the cost of forecast physical requirements of ABC-XYZ’s parent company’s manufacturing business, ABC-XYZ does not have a policy on loss limits to close out derivatives positions if they were to hold large unrealised losses. (Loss limits are more associated with speculative trading rather than hedging). In companies where this is implemented, trading limits in the actual futures market utilised for hedging are based on assessments of open interest and volatility. Basically this is an assessment of the liquidation risk, i.e. the risk of losing money due to having to pay an extreme price to close out a futures position due to lack of liquidity in that market. As we are on the topic of trading policy, I believe it is worth mentioning a flexibility that is normally granted to traders in ‘end user’ companies. The flexibility I am referring to is where traders are granted a %, normally in the region of 10–20% of total hedging volume for ‘opportunistic hedging’. I would recommend that ABC-XYZ start looking into offering this flexibility to its traders in order to permit them to take advantage of sudden, perhaps short-lived, beneficial price moves. A separate set of controls would need to be put together to cover this ‘opportunistic hedging’. In

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this situation, brokers would have to be advised of the authority of the trader to trade ‘x’ volume at short notice without having pre-authorised the precise details of the trade (the trader’s limit already pre-authorised) through a fax authority signed by ABC-XYZ and ZYX. The trader would normally be required to inform the broker that this was a ‘special’ execution. On receiving this order or when the trade was executed, the broker would generate a manual recap fax to ZYX and ABC-XYZ immediately informing them of the ‘special’ trade. ZYX and ABC-XYZ would then fax back to the broker a signed copy of their manual recap to authenticate the transaction. Also, ABC-XYZ may wish to consider (even if its physical requirements and derivatives position match volume for volume) to create loss limit alerts within its back office system or management reporting system, in order to avoid a cash flow crisis where losing forward derivatives positions put a large strain on the company. From discussion with ABC-XYZ staff I believe it is worth noting that even with OTC Swaps, ABC-XYZ will have a credit limit with its Swaps counterparties (usually not disclosed), ABC-XYZ must keep in mind that it may, should forward swaps positions be valued at a large loss, be requested to place cash or guarantees with its counterparts. The potential for unrealised losses in forward positions is something that the Risk Management Committee should regularly review. I will raise a point related to this later on when I discuss the scope of reports generated for management. I was informed that all over-the-counter (OTC) swaps deals are executed on the basis of an ISDA Master Swaps Agreement between ABC-XYZ and its counterparts. The use of ISDA agreements is also good risk management practice. ISDA contracts are used widely in the Swaps trading industry worldwide and it is a tested and proven basis for legally binding swaps agreements. As ISDA wording for swaps agreements has become the standard in many financial markets many law firms have expertise in the handling of disputes on contracts covered by an ISDA master swaps agreement. Segregation of roles & responsibilities in the risk management and trading environment In line with international standard practices for derivatives trading operations I observed that ABC-XYZ have staff independent of any trading functions to operate their back office reconciliation of trades executed and the creation of management reports on derivatives trades. Back office staff report directly to the Finance Manager of ABC-XYZ so the management of the back office staff is also independent of any manager responsible for the

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execution of day-to-day trades in the derivatives markets. It is worth mentioning that I was glad to hear about the planned changes in the IT infrastructure of the back office, i.e. the introduction of the 123ABC system, this should further tighten the IT Segregation of Trading Front Office and Back Office systems. Order/transaction flow I noted good controls already in place for the internal approval of trading orders. It is my understanding that Orders at ABC-XYZ in Singapore are submitted by the trader(s) for signing by: 1. The General Manager of ABC-XYZ London or ZYX Head Office Procurement manager It is then faxed to ZYX Head office for signing by 2. Treasury Management in ZYX Head Office And then it is faxed back to ABC-XYZ London. As another prudent audit trail check... 3. When the broker has received the fax copy of the order instruction from ABC-XYZ London, the broker has to fax a time-stamped and signed copy of this order instruction back to ABC-XYZ. I was made aware that in the future authorisation of trades could be permitted by two non-trading-related managers based at ABC-XYZ signing off on the proposed order, subject to a copy being sent for reference to ZYX Head Office. It would still have to be two non-trading-related authorised signatures from the two lists of signatures (A) and (B) (Please refer to notes on signature lists). This will still be within normal standard practice for risk management given the fact that XYZ Head Office has a general trading policy in place for ABC-XYZ. Once received, the order is considered live and can be submitted to brokers or forwarded to counterparties in the case of OTC Derivatives Swaps, for execution. When the order is placed it is done over the telephone, and then sometimes the broker/dealer will receive the fax confirmation of the authorised order immediately from my understanding; e.g. in the case of the NYMEX futures markets (due to diligence on the part of ABC-XYZ traders) I noted that the futures brokers may only get to see the order and its full volume by fax once some of the order has been completed after initially relying on a verbal instruction. The broker though will expect to receive a copy of the signed order instruction (signed by ABC-XYZ and ZYX Head Office treasury management) within 48 hours, as this is the policy of ABC-XYZ.

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This process of order entry is good but the security of the transaction and audit trail could be improved for ABC-XYZ, and I have noted some recommendations on the next few pages. Best execution – OTC swaps trading ABC-XYZ trading staff and back office staff are receiving market price information for marked-to-market valuations of positions from at least two different sources. This is good, as it is important given the non-transparent nature of over-the-counter markets to have several sources for price valuation data. Platts Forward Curve (PFC; http://www.platts. com/) is now a reliable third party data source for forward curve value information on all key over-the-counter oil-related swaps. Recommendations – order/transaction flow In order to avoid the situation of a broker denying receipt of an order via the telephone or denying making an error in the best execution of a transaction and to assist ABC-XYZ support its case surrounding the execution of an order and the timing of an order either to counterparties/brokers, or for the benefit of Internal Auditors, I make the following recommendations: 1. All telephone lines of traders placing orders are taped and that, in order to be enforceable in evidence, all brokers and OTC swaps counterparties are informed in writing (and asked to confirm their understanding and receipt of such a note) that ABC-XYZ may tape conversations between traders and brokers/OTC Swaps dealers. 2. Traders at ABC-XYZ are issued with a time stamp machine, ideally a modern digital time stamp which automatically keeps time from radio signals, or at least a manual time stamp, the key to which is kept by back office or other non-trading management. If it is a manual time stamp, the key holder should be given the responsibility to ensure that the time is always correct at the beginning of each trading day and then again at some stage during the trading day. 3. ABC-XYZ risk managers/traders should be issued with deal tickets (one per order). This is in addition to the current signed-off order by ABCXYZ and ZYX Head Office treasury staff. ABC-XYZ Traders write down orders as they place them with brokers over the phone. One copy of this deal ticket can remain with the trader for his/her end of day checking with brokers and one copy can be picked up by ABC-XYZ back office staff and recorded in the back office system as a new trade for that day. This is then reconciled against information sent to the back office by Brokers. Recommendations – order/transaction flow 4. Traders should time stamp their deal ticket or order book, once on entering the order with the broker or OTC Swaps counterpart, then again on any alteration to the order or partial execution, and finally on

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5.

6.

7.

8.

449

completion of the order. This will allow easier checking if a futures broker is accused of not giving ‘best execution’ service, since a trader could refer back to the time on the deal ticket and check times and sales with the relevant exchange to see what price traded and how much traded at that time. Traders should sign deal tickets with at least their initials so that the audit trail of the order can also show which trader placed and handled the order. The back office administration staff should check broker reports against the deal tickets/hedging book of ABC-XYZ traders at the end of the trading day or as soon as reasonably possible as part of their reconciliation. They can note the broker contract reference (or in the case of OTC contracts the counterpart reference number) on their copy of the deal ticket for ease of cross-reference if necessary later on. Back office copies of the deal tickets should be kept on site for at least 1 month in case of any delayed disputes that may arise. Ideally, copies of deal tickets should be kept until after the financial year-end audits have been cleared in case auditors ever need ABC-XYZ records of deals done. (It is worth noting that Financial Institutions are often required to store deal ticket information for 5 years or more in some jurisdictions.) Many companies do not allow their traders to trade from outside the office but in consideration of the small size of the risk management team at ABC-XYZ and the fact that some of the derivatives markets used by ABC-XYZ for hedging/risk management purposes are in a different time zone to ABC-XYZ’s office, this is probably not a practical control to enforce. However, traders should endeavour to record phone calls placed to brokers when outside the office. (Some mobile phones offer this facility.) A suggestion is that traders work shifts and one trader stays in the office to place orders with counterparts and brokers.

Confirmation process of trade execution Once a deal has been executed, the first information regarding this is received via the phone which places even more importance on the recommendation for trader’s phones to be taped for security of transactions. I noted from discussions with ABC-XYZ Staff that all broker recaps of deals done are sent to ABC-XYZ London, but are also directly copied by ABC-XYZ designated brokers to ZYX Head Office Treasury Department. This gives a good split of reporting controls in line with good Risk Management practice. I noted that OTC Swaps confirmation reports are sent to ABC-XYZ London and separately by fax to ZYX Head Office treasury department. This also gives a good division of reporting controls in line with a good

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Risk Management practice. I was informed that posted contract notes are signed first by ABC-XYZ London by the General Manager and then all copies are sent to the Head Office for signing, with a copy sent back to ABC-XYZ London and an original sent to the Counterparty. Recommendation – OTC swaps recapping and execution It is a current requirement for ABC-XYZ Ltd London and ZYX Head Office signatures to be on OTC Swaps contract notes. Prudent control practices are being enforced here and are in line with standard risk management practice. Signature lists After going through the order submission process including the requirement for signatures from ABC-XYZ London management and ZYX Head Office treasury Department, I asked ABC-XYZ London staff about how the signature list was updated and distributed to brokers and counterparties. ABC-XYZ Staff informed me that through quarterly board meetings of ABC-XYZ London the signature list is reviewed and updated if necessary. The signature lists comprise a List (A) and a List (B). For authorisation of trades one signature from List (A) and one signature from List (B) is required. ABC-XYZ staff were able to confirm that the signatures of ZYX Head Office treasury management were sent directly by ZYX Head Office to brokers and counterparties. Prudent control practices are being enforced here and are in line with standard risk management practice. New counterparty controls Any new broker or Swaps counterparty is vetted by the Head Office and then authority is given to the subsidiary ABC-XYZ in London to enter into some agreement with the broker or swaps counterparty. ABC-XYZ Board of Directors approve someone in ABC-XYZ (usually the general manager/ Managing Director of ABC-XYZ) to sign the new broker account agreement or Swaps trading agreement. The document is signed and then sent to the Head Office for countersigning. After this, the original is sent directly to the new broker or counterparty and a copy is sent back to ABCXYZ London for their records. All board meetings are minuted and copies of the minutes or board resolutions are sent to the broker or counterparty to prove that ABC-XYZ London board of directors had approved the agreement. This is good risk management practice, reducing the risk of a trader opening up an unauthorised brokerage account in the name of ABC-XYZ

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or conducting unauthorised OTC Swaps trades with a new or potentially non-existent counterparty. Order capture Collateral management system

Market risk management system

Credit risk management system

Settlement system General ledger

Confirmation delivery and payment

Internal report generation – market risk management INTEGRITY OF TRADED/FAIR VALUE PRICE DATA – RECOMMENDATION

I noted that market valuations for Over-the-counter (OTC) swaps are not created in-house but taken from price reports generated and supplied by ABC-XYZ London’s main OTC Swap counterparties. Having more than one source of valuation data (as is the case now for ABC-XYZ) does give a greater assurance as to the accuracy of the ‘fair value’ being represented to AIST for the forward price curve. A recommendation is to utilise existing data sources alongside Platts Forward Curve (PFC) data now available (http://www.platts.com/) to further enhance the ability to ‘marked to market’ the derivative portfolio at a ‘fair value’. This is very important for day-to-day management reporting and controls and for internationally accepted accounting practices of ‘fair value’ reporting of derivatives. With ABC-XYZ London holding OTC Swaps positions sometimes as far forward as 27 months it is critical that ABC-XYZ continues to have a group of suppliers of ‘fair value’ data, which eventually is responsible for generating management reports on forward unrealised profits/losses on derivatives positions. THE QUALITY AND RELEVANCE OF THE REPORTS THAT MANAGEMENT GET OUT OF THEIR SYSTEM DEPEND ON THE QUALITY OF THE DATA GOING IN .

DAILY INTERNAL MARKET POSITION REPORTS GENERATED ■ ■ ■ ■ ■ ■

Reconciliation Report Daily Marked to Market Report Open Futures Report Futures Options Position Report Swaps Positions Report Realised Position Report

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Generally my review had found that these are good reports in line with standard risk management practice, although I have a few recommendations to improve on them still further. WEEKLY COMPLIANCE REPORT

I noted that this report looks at upcoming physical Oil pricing, and resultant realisation of derivatives hedges in Oil, Gas and currencies. The report also covers such events as derivatives contract expiries, upcoming option expiries and upcoming likely trading requirements.The trader and back office staff present this report to the General Manager and Finance Manager during the weekly ‘derivatives compliance meeting’. This is also a minuted meeting. This is a good risk management reporting/control procedure. MONTHLY EXPOSURE REPORT

Covers all exposure (up to the two year limited as per Head Office trading policy) in Oil and Gas (derivatives and physical). Included in this report according to ABC-XYZ staff are actual volumes, hedge/cover price and potential price which incorporates market price for uncovered volumes against budgeted prices. I noted that this report also contains forecasted physical volume requirements, which for the purposes of risk management can be used as a guide for management to detect over-hedging. This is good risk management reporting practice. Internal market position reports – recommendations ■ Reconciliation Report – OK ■ Open Futures Report ● Should include the Broker Contract/Deal Number ● If adopted, it should include the AIST Deal Ticket Number (side by side with the brokers one for easier audit trail) ● The Trader ID, which trader in AIST had executed the order with the broker ■ Futures Options Position Report ● Add time to expiry of the option so plain to see how long left before it is exercised and becomes a futures contract ■ Selling Options Report ● For management to fully appreciate the exposure that AIST is taking onboard via a selling (short) options position, the management positions reports should note whether this option is covered by an opposite futures or physical position which offsets the potential unlimited liability of selling options without this opposite position cover. ■ Swaps Positions Report ● Add a column for counterparty. At the moment, even if a deal is executed directly with a counterparty, the counterparty name is still shown in a column marked broker. This is incorrect and may be

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confusing to auditors. The introduction of INFINITY should actually resolve this problem. Realised Position Report – OK

RECOMMENDATIONS OTC SWAPS POSITION REPORTING – RECOMMENDATION

One thing that I believe would be useful to have included in Management Reports on OTC Swaps positions (Oil/Gas) is some analysis of forward cash flow risk. Forward cash flow risk can come about when a sudden and unexpected change in the price structure of the market occurs, e.g. a drastic change from a backwardated market to a contango market or vice versa, and/or individual forward derivatives contracts suddenly dropping or increasing in price, producing large unrealised losses. These losses may need to be financed. ABC-XYZ Management would look to create some market structure change scenarios and regularly check their current open position against these scenarios. Under small market movements ABC-XYZ London may never hear the word ‘Margin Call ‘ or ‘Collateral Request’, but even banks who offer to trade swaps have an internal credit limit for your company (they do not normally disclose this limit to you) and if a severe adverse move in swaps prices occurred, ABC-XYZ London could find itself in a cash crunch where it has to finance forward position unrealised losses. Having these disaster scenarios calculated and included in management reports on a daily basis will at least allow management to think ahead as to what action would be necessary if it were ever to happen. VALUE AT RISK

ABC-XYZ may wish to take a look at adopting Value at Risk calculations for positions in order to give US$ values on the risk being taken on their various positions in Oil, Gas, and Forex. EXCEPTION REPORTS

Exception Reports to be generated by ABC-XYZ London back office and distributed to ABC-XYZ London and the Head Office management. ■

■ ■

Reports should be added for any breaking of trading limits as per the trading policy which is set by the Risk Management Committee at ABCXYZ London and copied to the Head Office. Reports should be generated for any break of loss limits by any trader(s). Reports should be generated for any deals executed for which no broker recap has been received or which does not show as an open position when it should in broker statements.

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In the event of this happening it is advisable to request the broker in question to fax a letter explaining when the trades will be properly recapped and/or added to the ABC-XYZ London account or what remedy is being offered. This letter should be kept on record and presented with the Management Reports that day and then filed with deal tickets/reports of the trading day in question in case it is required at a later date by auditors. OPERATIONAL RISK

Key persons – I observed that due to the small size of the team in ABC-XYZ London there is a clear operational risk present in the organisation. With only two people looking after the back office operations, if they were both away then a trader or someone without the proper training/experience would have to take over, potentially creating a breakdown in the splitting of roles and responsibilities that currently exists in line with standard risk management control practice. Creating an internal Risk Management Handbook, which would allow even temporary staff to be able to execute word for word risk management guidelines, could cover for this situation (see below). On the trading side ABC-XYZ London has one key trader, but I have noted that the Managing Director of ABC-XYZ London can act as a backup as he has had experience in hedging Oil & Gas and he knows all the futures brokers, OTC Swaps brokers and swaps trading counterparts. RISK MANAGEMENT POLICY HANDBOOK

When confronted with a situation it can sometimes be overwhelming at times, especially if combined with high price volatility in the market place. For the comfort of ABC-XYZ London, might I suggest that management put together a Risk Management guideline handbook. Back office staff, traders and other support staff can refer to this handbook In order to get a better idea of their role and what they should do if certain ‘exceptions’ come about, e.g. a trade does not turn up in broker open positions, or what course of action should be taken. By creating this handbook ABC-XYZ London could bring in temporary staff to cover others in the safe knowledge that day-to-day operation guidelines were spelt out clearly in black and white. Also a management action plan like this in case of disaster scenarios might bring added comfort to overseas management at Headquarters. This brings me on to another important area of OPERATIONAL RISK. Operational risk – disaster recovery plan Through discussions with ABC-XYZ London I understand that no Disaster Recovery Plan currently exists. If it does then staff need to be

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given information on it. If it does not exist, I strongly recommend that one is set up and staff are advised of it. A disaster recovery plan would basically cover what would happen if, for example, ABC-XYZ’s London office burnt down or was unusable for any reason. The World Trade Center disaster comes to mind. How would you keep your business running? Where would you open up a backup office? Where could you go to get copies of backup data from the ABC-XYZ Local Area network showing you all trader hedging position records? At this stage I would mention that backing up data is very important at the end of every business day. I was informed that ABC-XYZ London does back up all key computer files at the end of every day. These files are kept on site at ABC-XYZ’s office though. I would recommend the use of a secure offsite data warehouse service. They can collect each day a backup tape of your data and store this offsite, or you can upload it securely to offsite servers. Should anything happen to your office, this means that your data is still safe. IT infrastructure USE OF LOTUS IN BACK OFFICE AND ACCOUNTING – RECOMMENDATION

Back office running on Lotus currently – preventive measures against macro viruses should be taken. Check documents for macros that might contain viruses A macro virus is a type of computer virus that is stored in the macros within a document or template. When you open such a document, the macro virus is activated, transmitted to your computer, and stored in your Normal template. From that point on, every document you save is automatically ‘infected’ with the macro virus and if other users open such infected documents, the macro virus is transmitted to their computers as well. Microsoft Word and Excel cannot scan your floppy disk, hard disk, or network drive to find and remove macro viruses. (If you want this kind of protection, you need to purchase and install specialised antivirus software.) However, Word can display a warning message whenever you open a document that contains macros that might contain a virus. You can then choose to open the document with or without its macros: If you expect the document to contain useful macros (for example, an order form used in your company), you may want to open the document with its macros.

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Network security As mentioned under segregation of duties, access to the back office network should be better restricted. ISSUE: Integrity of Back Office Data I have been informed that the computers trader(s) use are on the same office intranet as the back office administration staff. The potential ability for traders to modify files on back office staff computers is a concern. Even if files are password protected for read access, they could still be erased or replaced. Recommendation Create a separate network drive on the office Intranet which the back office utilises for storing its files and data. Trader computers should not be assigned access to this network drive. Traders still require read access to position information, as the back office can have access to its own network drive and the traders’ network drive, and recaps of reports can easily be copied over by the back office to the traders’ network drives for traders to review. The issue of brokers and transaction security SECURITY OF FUNDS FOR ABC-XYZ WITH FUTURES BROKERS

I noted that futures accounts with ABC-XYZ designated brokers are segregated accounts, i.e. ABC-XYZ’s monies are kept separate from Broker funds. This is good risk management practice and a standard practice these days, usually promoted by regulated brokers. I was even more impressed by the fact that it is actually corporate policy for ABC- XYZ to make sure that all of its futures accounts are segregated accounts. It is worth noting that all FSA regulated brokers of the United Kingdom tend to automatically open futures clearing accounts for their clients as ‘Segregated Account’. It will specify this in the account documentation. The advantage is that, if a broker’s business is adversely affected by the credit/performance failure of another of its clients, then any realised profits or deposits ABC-XYZ has with the broker are safe. As these funds are separate from the operating capital of the broker, if an account is nonsegregated which used to be the norm for most of the 1990s, a broker could co-mingle client funds with its own operating capital. Best Regards Independent Risk Management Consultant

APPENDIX 2

The Main Energy Sector and Transportation Names/Credits Traded in the CDS Market (September 2002)

El Paso Corp Endesa (Spain) Allegheny Energy Supply Vivendi Environnement Duke Energy Corp. RWE AG Electricité de France Enel SPA Suez Lyonnaise Des Eaux British Energy PLC SK Corporation Devon Energy Corp. Electricidade de Portugal SA Edison SPA Kansai Electric Power Co. Inc. TXU Corp. Eon AG National Grid PLC Weatherford International Inc. Reliant Energy Resources Corp. Oneok Inc. United Utilities PLC Vattenfall AB Sempra Energy

Duke Capital Corp. Union Electrica Fenosa SA Petroliam Nasional Berhad Italgas SPA Eni SPA Norsk Hydro ASA Birka Energi AB Gaznat SA Israel Electric Corp. Ltd Kelda Group PLC National Grid Group PLC United Utilities Water Ltd Yukong Endesa (Chile) Tokyo Electric Power Co. Inc. TotalFinaElf SA Xcel Energy Inc. Constellation Energy Group Inc. Halliburton Co. Phillips Petroleum Co. Pride International Inc. Valero Energy Corp. AEP Resources Inc. AES Corp.

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Alliant Energy Resources Inc. American Electric Power Australian Gas and Light Co. Avista Corp. Baker Hughes Inc. BG Transco Holdings PLC BG Transco PLC Boston Edison Co. BP Amoco PLC Burlington Resources Inc. Calenergy Co. Inc. Calpine Corp. Caltex Australia Limited Canadian Natural Resources Ltd Chevron Corp. China Light and Power Co. Chubu Electric Power Co. Inc. Chugoku Electric Power Co. Cinergy Corp. CMS Energy Corp. Coastal Corp. Cogen PLC Columbia Energy Group Conoco Inc. Consolidated Edison Inc. CSW Energy Inc. Dominion Resources Inc. Dynegy Holdings Inc. Dynegy Inc. Eastern Electric Eastern Group PLC Edison International Edison Mission Energy Elf Enersis S.A. (Chile) Enron Corp. Exelon Corp. Forest Oil Corp. Gas Natural SDG SA Gener SA Global Marine Inc. Gulf Canada Resources Ltd Hokuriku Electric Power Co. Hyder PLC

Hydro-Quebec Illinois Power Co. International Power PLC Kepco Kerr-McGee Corp. Keyspan Energy Corp. Kinder Morgan Energy Partners LP Kinder Morgan Inc. Kyushu Electric Power Co. Inc. Lasmo PLC LG-Caltex Oil Corp. London Electricity PLC Midlands Electricity PLC Mirant Corp. Nabors Industries Inc. National Power Philippines National Power PLC National Rural Utilities Cooperative Finance Corporation Nipsco Capital Markets NRG Energy Inc. Nstar Nuevo Energy Co. Oil and Natural Gas Commission, India Ontario Hydro Pennzoil-Quaker State Co. Petroleos Mexicanos PG&E Corp. Potomac Capital Investment Corp. Powergen PLC Powergen UK PLC PPL Corporation Public Power Corp. Public Service Electric and Gas Co. Reliant Energy Inc. Reliant Resources Inc. Republic Services Inc. Rio Tinto Ltd Scottish Power PLC

APPENDIX 2

Scottish Power UK PLC Seacor Smit Inc. Shikoku Electric Power Co. Inc. Showa Shell Sekiyu KK Singapore Power Ltd Southern California Edison Co. Southern Co, the Talisman Energy Inc. Teco Energy Inc. Tenaga Nasional Berhad Texas Utilities Electric Co. Texas–New Mexico Power Co. Tohoku Electric Power Co. Inc. Total SA Transocean TXU Europe Group PLC TXU Europe Ltd Union Pacific Resources Group Inc. Utilicorp United Inc. Veba Vintage Petroleum Inc. Western Mining Corp. Williams Companies Inc. Yorkshire Electricity PLC Air Canada Air France Northwest Airlines Corp Japan Airlines Co. Ltd American Airlines Inc. British Airways PLC Qantas Airways Ltd UAL Corp. Delta Airlines Inc. Cathay Pacific Airways Ltd All Nippon Airways Co. Ltd Deutsche Lufthansa AG KLM AMR Corp. Ansett Airlines Swiss Air Air New Zealand Ltd PSA Corp. Ltd Southwest Airlines Co. CNF Inc.

459

Cosco Scandinavian Airlines System AB Continental Airlines Inc. United Parcel Service Inc. AES New Energy Inc. AIG International Inc. Allegheny Energy Supply Company Alliant Energy Corp Services Inc. Amerada Hess Corporation American Electric Power Services Bank of America Bank of Montreal Bank of Nova Scotia Banque Paribas Barclays Bank PLC Barclays Capital (UK) BHP Australia British Petroleum Burlington Resources Trading Inc. BP Amoco Corporation Caltex Trading Canadian Imperial Bank of Commerce Cargill Inc. Chase Manhattan Bank Citibank N.A. Conoco Cosmo Oil Co. Ltd Crédit Agricole Indosuez Crédit Lyonnais s.a. Deutsche Bank AG Deutsche Lufthansa AG DTE Energy Trading Inc. Macquarie Bank Ltd Marathon Oil Company Marubeni Corporation Mitsubishi Corporation Mitsui Chemicals Mitsui & Co Ltd Tokyo Morgan Stanley Capital National Australia Bank Norsk Hydro ASA

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Northwest Airlines Inc. Petronas Sdn Bhd PTT Petroleum Authority of Thailand Royal Bank of Scotland Samsung Corporation

SK Corporation Sumitomo Chemical Co. Ltd Statoil Texaco Inc. United Airlines Western Resources Inc.

Sources: GFI Holdings +44 207 422 1120 or +1 212 968 4199 and Credit Trade (http://www.credittrade.com/)

APPENDIX 3

The ISDA Master Agreement

This appendix contains a copy of the ISDA Master Agreement and the Schedule to the Master Agreement.

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Example Derivatives Trade Confirmation Under ISDA

SHORT FORM SWAPS TRADE CONFIRMATION – BASED AROUND AN EXECUTED ISDA MASTER AGREEMENT & SCHEDULE CONFIRMATION – Commodity SWAP – Cash settled From:

XYZ BANK LTD (XYZ)

To:

ABC Small Trader Ltd 16 December 2002

Our SWAP Reference: (counterparts will have agreed at the time of execution a reference code or number for the deal) Dear Sir/Madam, The purpose of this Letter Agreement is to confirm the terms and conditions of the Transaction entered into between us on the Trade Date specified below (the ‘Transaction’). This Letter Agreement constitutes a ‘Confirmation’ as referred to in the ISDA Master Agreement specified below. The definitions and provisions contained in the 1993 ISDA Definitions (as published by the International Swaps and Derivatives Association Inc.) are incorporated into this Confirmation. In the event of any inconsistency between those definitions and provisions and this Confirmation, this Confirmation will govern. 1) This Confirmation supplements, forms part of, and is subject to, the ISDA Master Agreement dated as of 15th December 2002, as amended and supplemented from time to time (the ‘Agreement’), between you and us.

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All provisions contained in the Agreement govern this Confirmation except as expressly modified below. 2) The terms of the particular Transaction to which this Confirmation relates are as follows: Trade Date: 16 December 2002 Commodity: Singapore Gasoil 0.5% as reported by Platts Effective date:

1 January 2003 (the beginning of the Swap pricing period) Termination date: 31 January 2003 (the last possible day of the Swap pricing period) Currency: US Dollars Calculation Period(s): Start Date End Date Notional Quantity Fixed Price 01/01/2002 31/01/2002 50,000.00 barrels 25.55 Payment dates: The Tenth Business Day following the last Date of each Calculation Period Fixed amount details: Fixed Price Payer: ABC Small Trader Ltd (the company that Bought fixed price) Floating amount details: Floating Price Payer: XYZ Bank Ltd (the company that sold fixed price) Commodity Reference Price: Singapore Gasoil 0.5% Specified Price: The means of the high/low reference price as published by Platts Method of averaging:The arithmetic unweighted mean of the Specified Price rounded to the nearest 3rd decimal (with 0.0005 being rounded up to 0.001). Financial centers for the purposes of establishing business days in relation to: Floating price: Payments:

Singapore New York

Calculation Agent: XYZ Bank Ltd 3) Account Details: Payment to XYZ Bank Ltd ____________________ Payments to ABC Small Trader Ltd: ____________________

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4) Offices XYZ Bank Ltd ABC Small Trader Ltd London Canary Wharf EC2V 4JU London Attention: Swaps Desk Tel: +44 207 550 2207 Fax: +44 207 550 2381 Please confirm that the foregoing correctly sets forth the terms of our agreement by executing the copy of this confirmation enclosed for that purpose and returning it to us by sending to us a letter or telex substantially similar to this letter, which letter or telex sets forth material terms of the Transaction to which this Confirmation relates and indicates agreement to those terms. XYZ Bank Ltd is very pleased to have concluded this Transaction with you. XYZ BANK LIMITED By Name Title

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ISDA SCHEDULE EXAMPLE (Without Notes) SCHEDULE TO THE ISDA MASTER AGREEMENT AGREEMENT DATED AS OF 15 DECEMBER 2002 BETWEEN ABC SMALL TRADER LIMITED Party A AND XYZ BANK LIMITED Party B PART 1 TERMINATION In this Agreement: 1. ‘Specified Entity’ means in relation to Party A for the purpose of: Section 5(a)(v): [Default under specified transactions] Section 5(a)(vi): [Cross Default] Section 5(a)(vii): [Bankruptcy] Section 5(b)(iv): [Termination event – credit event upon merger] ‘Specified Entity’ means in relation to Party B for the purpose of: Section 5(a)(v): Section 5(a)(vi): Section 5(a)(vii): Section 5(b)(iv):

Not applicable Not applicable Not applicable Not applicable

2. ‘Specified Transaction’ will have the meaning specified in Section 14 of this Agreement. 3. ‘Cross Default’: The provisions of Section 5(a)(vi) will apply to Party A and Party B. ‘Specified Indebtedness’ will have the meaning specified in Section 14 of this Agreement except that (i) such term shall not include obligations in respect of deposits received in the ordinary course of a party’s banking business and (ii) there shall be added at the end thereof ‘or any money otherwise raised whether by means of issue of notes, bonds, commercial paper, certificates of deposit or other debt instruments, under financial leases, deferred purchase schemes or under any currency or interest rate swap or exchange agreement of any kind whatsoever or otherwise.’ ‘Threshold Amount’ means with respect to Party A an amount of US$10,000,000 or the US Dollar equivalent of any obligations stated in any other currency, currency unit or combination thereof, with respect to Party B, an amount equal to 5% of stockholders equity as of the end of its most recently completed fiscal year (or its equivalent in any currency).

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4. ‘Credit Event Upon Merger’: The provisions of Section 5(b)(iv) will apply to Party A and Party B as amended as follows: Whether, for the purposes of Section 5(b)(iv) of this Agreement, the resulting, surviving or transferee entity (hereinafter ‘Y’) is ‘materially weaker’ shall be a matter to be determined in the reasonable discretion of the other party. Notwithstanding the foregoing, the creditworthiness of Y shall not be determined to be materially weaker if Y agrees to and does within two local Business Days of demand provide Eligible Credit Support (as defined in the Credit Support Annex) in an amount equal to or in excess of the Delivery Amount (as defined in the Credit Support Annex) on the basis that the Threshold for Y shall be zero notwithstanding anything to the contrary in the Credit Support Annex and thereafter maintains such Eligible Credit Support in accordance with the Credit Support Annex as amended by this provision. A Credit Event shall also occur if: (a) any person or entity acquires directly or indirectly the beneficial ownership of equity securities having the power to elect a majority of the board of directors of X, any Credit Support Provider of X or any applicable Specified Entity of X or otherwise acquires directly or indirectly the power to control their policy making decisions; or (b) X, any Credit Support Provider of X or any applicable Specified Entity of X enters into any agreement providing for any of the Credit Events specified in Section 5(b)(iv) of the Agreement or in clause (a) above. 5. The ‘Automatic Early Termination’ provision of Section 6(a) will apply to Party A and Party B. 6. Payments on Early Termination. For the purpose of Section 6(e) of this Agreement: (i) The Loss Method will apply. (ii) The Second Method will apply. 7. ‘Termination Currency’ means the currency selected by the party which is not the Defaulting Party or the Affected Party, as the case may be, or where there is more than one Affected Party the currency agreed by Party A and Party B. However, the Termination Currency shall be one of the currencies in which payments are required to be made in respect of Transactions. If the currency selected is not freely available, or where there are two Affected Parties and they cannot agree on a Termination Currency, the Termination Currency shall be United States Dollars. 8. ‘Additional Termination Event’ shall apply as follows:

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If a party (the ‘First Party’) determines, in its sole and reasonable discretion that there has been a material adverse change in the business, financial position or creditworthiness of the other party (the ‘Affected Party’) the First Party shall be entitled to demand that Eligible Credit Support in an amount equal to or in excess of the Delivery Amount is provided by the Affected Party in accordance with the Credit Support Annex hereto, on the basis that the Threshold for the Affected Party shall be zero, notwithstanding anything to the contrary in the Credit Support Annex, and thereafter maintains such Eligible Credit Support in accordance with the Credit Support Annex as amended by this provision. For the purpose of this provision any Eligible Credit Support shall either be paid or returned on demand in round sums of US$100,000. If the Affected Party shall fail to deposit Eligible Credit Support with the First Party within two Local Business Days of the First Party’s written request therefor this failure shall constitute an Additional Termination Event. PART 2 TAX REPRESENTATIONS Payer Tax Representations 1. For the purpose of Section 3(e) of this Agreement, both parties make the following representation: It is not required by any applicable law, as modified by the practice of any relevant governmental revenue authority, of any Relevant Jurisdiction to make any deduction or withholding for or on account of any Tax from any payment (other than interest under Section 2(e), 6(d)(ii) or 6(e) of this Agreement) to be made by it to the other party under this Agreement. In making this representation, it may rely on:(i) the accuracy of any representation made by the other party pursuant to Section 3(f) of this Agreement; and (ii) the satisfaction of the agreement of the other party contained in Section 4(a)(i) or 4(a)(iii) and the accuracy and effectiveness of any document provided by the other party pursuant to Section 4(a)(i) or 4(a)(iii) of this Agreement; and (iii) the satisfaction of the agreement of the other party contained in Section 4(d). Provided that it shall not be a breach of this representation where reliance is placed on Clause (ii) and the other party does not deliver a form or document under Section 4(a)(iii) by reason of material prejudice to its legal or commercial position.

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Payee Tax Representations 2. For the purpose of Section 3(f), both parties make the following representation: Each payment received or to be received by it in connection with this Agreement relates to the regular business operations of the party (and not to an investment of the party). OTHER REPRESENTATIONS 1. Each party represents and warrants to the other (which shall be deemed to be repeated by each party on each date on which a Transaction is entered into) that: (a) There has been no material adverse change in its financial condition since the last day of the period covered by its most recently prepared audited financial statement and that ‘Accuracy of Specified Information’ as provided for in Section 3(d) will apply to the financial information which a party is required to deliver to the other party under this Schedule. (b) It is entering into this Agreement and each Transaction as principal (and not as agent or in any other capacity, fiduciary or otherwise). 2. Each party will be deemed to represent to the other party on the date on which it enters into a Transaction that (absent a written agreement between the parties that expressly imposes affirmative obligations to the contrary for that Transaction): (a) Non-Reliance. It is acting for its own account, and it has made its own independent decisions to enter into that Transaction and as to whether that Transaction is appropriate or proper for it based upon its own judgment and upon advice from such advisers as it has deemed necessary. It is not relying on any communication (written or oral) of the other party as investment advice or as a recommendation to enter into that Transaction; it being understood that the information and explanations related to the terms and conditions of the Transaction shall not be considered investment advice or a recommendation to enter into that Transaction. No communication (written or oral) received from the other party shall be deemed to be an assurance or guarantee as to the expected results of that Transaction. (b) Assessment and Understanding. It is capable of assessing the merits of and understanding (on its own behalf or through independent professional advice), and understands and accepts, the terms, conditions and risks of that Transaction. It is also capable of assuming, and assumes, the risks of that Transaction.

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(c) Status of Parties. The other party is not acting as a fiduciary for or an adviser to it in respect of that Transaction. 3. Absence of Litigation. Section 3(c) of the Agreement is hereby amended by limiting the definition of ‘Affiliate’ for the purposes of this representation to such Affiliates, if any, as may be a Specified Entity for purposes of Section 5(a)(v). PART 3 DOCUMENTS TO BE DELIVERED For the purpose of Section 4(a)(i) and (ii) of this Agreement each party agrees to delivery of the following documents, as applicable: Party required Form/Document/Certificate to deliver Document

Date by which Covered by to be delivered Section 3(d) Representation

Party A

A certified copy of a board resolution authorising the execution, delivery and performance of this Agreement and each Confirmation executed hereunder together with the names, titles and specimen signatures of the persons entitled to execute this Agreement and each Confirmation executed hereunder.

On or before execution hereof and if any change in authority has occurred prior thereto, on or before the execution of each Confirmation.

Party A

In respect of each transaction an accepted Confirmation signed by an authorised signatory.

Within 24 Yes hours of receipt of the relevant Confirmation from Party B.

Party A

A capacity certificate in the form attached to this Agreement as Appendix A.

On or before execution hereof.

PART 4 MISCELLANEOUS 1. Address for Notices. For the purpose of Section 12(a): Address for notices or communications to Party A: Address: Attention: Telex No: Answerback: Facsimile No: Telephone No:

Yes

Yes

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Address for notices or communications to Party B: Address: Attention: Telex No: Facsimile No: 2. Process Agent. For the purpose of Section 13(c): Party A appoints as its Process Agent: Party B appoints as its Process Agent:

Not applicable

3. Offices. The provision of Section 10 (a) will not apply. 4. Multibranch Party. For the purpose of Section 10(c): Party A is not a Multibranch Party. Party B is not a Multibranch Party. 5. Calculation Agent. The Calculation Agent is Party B, unless otherwise specified in a Confirmation in relation to the relevant Transaction. 6. Credit Support Document. Details of any Credit Support Document: In respect of Party A: In respect of Party B: Not applicable 7. Credit Support Provider Credit Support Provider means in relation to Party A: Credit Support Provider means in relation to Party B: Not applicable 8. Governing Law. This Agreement will be governed by and construed in accordance with the laws of England. 9. Netting of Payments. Subparagraph (ii) of Section 2(c) of the Agreement will not apply to all Transactions under this Agreement starting from the date of this Agreement. PART 5 OTHER PROVISIONS The following changes are made to this Agreement: 1.

Definitions. This Agreement incorporates, and is subject to and governed by, unless otherwise specified in a Confirmation, the 2000 ISDA Definitions published by the International Swaps and Derivatives Association, Inc. (the ‘2000 Definitions’) and the 1993 ISDA Commodity Derivatives Definitions (‘1993 Definitions’). In the event of any inconsistency between the provisions of this Agreement and the 2000 Definitions and/or the 1993 Definitions, this Agreement will prevail. In the event of any inconsistency between the provisions of

APPENDIX 4

2.

3.

495

the 2000 Definitions and the 1993 Definitions, the 1993 Definitions will prevail. In the event of any inconsistency between the provisions of any Confirmation and this Agreement or the 2000 Definitions or the 1993 Definitions, such Confirmation will prevail for the purpose of the relevant Transaction. In the event of any inconsistency between the provisions of this Schedule and the Agreement this Schedule shall prevail. Change of Account. At the end of Section 2(b) add the following words: ‘provided that, if any new account of the notifying party is not in the same jurisdiction as the original account, the other party shall not be obliged to pay any greater amount and shall not receive any lesser amount as a result of such change than would have been the case if such change had not taken place.’ Pari Passu. Party A hereby agrees that it will ensure that its payment and delivery obligations under this Agreement rank at all times at least pari passu in all respects with all of its other unsecured and unsubordinated obligations (except for those which are mandatorily preferred by operation of law.

4.

Confirmations. Each confirmation shall be in the standard form used by Party B from time to time or in such other form as the parties may agree. With respect to each Transaction, Party B shall on, or promptly after the Trade Date, send Party A a Confirmation. Party A shall promptly sign and return a copy of the Confirmation or advise any discrepancy between the Confirmation and Party A’s own records whereupon the parties will promptly agree on the text of a replacement Confirmation for signature by Party A.

5.

Event of Default. There shall be incorporated into the Agreement a new Section 5(a)(iii)(4) as follows: ‘(4) The Credit Support Provider amends or modifies the terms of any Credit Support Document.’

6.

Automatic Early Termination. If Automatic Early Termination is specified as applying to a party in Part 1 paragraph 5 above, that Party shall upon the occurrence of an Event of Default notify it immediately to the other Party and provided further that Automatic Early Termination shall not apply to either party if the Event of Default concerned is the presentation of a winding up petition which is withdrawn without advertisement. In the event of absence of such notice on the day of the occurrence of the Event of Default, the Defaulting Party shall fully indemnify the Non-defaulting Party on demand against all expense, loss, damage or liability that the Non-defaulting Party may incur in respect of this Agreement and each Transaction as a consequence of

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movements in interest, currency, exchange or other relevant rates or prices between the Early Termination Date and the local Business Day on which the Non-defaulting Party first becomes aware that the Early Termination Date has occurred under Section 6 (a). The Nondefaulting Party may for this purpose convert any expense, loss, damage or liability to the Termination Currency. 7.

Early Termination. At the end of Section 6 add the following Sections 6(f) and (g): ‘(f) Conditions of Certain Payments. Notwithstanding the provisions of Section 6(e), the Non-defaulting Party shall have no obligation to make any payment on Early Termination to the Defaulting Party unless and until the Non-defaulting Party shall have received confirmation satisfactory to it in its sole discretion (which may include an unqualified opinion of its counsel) that (i) in accordance with Section 6(c)(ii) of the Agreement, no further payments or deliveries under Section 2(a)(i) or 2(e) in respect of Terminated Transactions will be required to be made and (ii) each Specified Transaction shall have terminated pursuant to its specified termination date or through the exercise by a party of a right to terminate and all obligations owing under each such Specified Transaction shall have been fully and finally performed; and (g) (i) Without affecting the provisions of this Agreement requiring the calculation of certain net payment amounts, all payments under this Agreement will be made without set-off or counterclaim; provided, however that any amount (the ‘Early Termination Amount’) payable to one party (the Payee) by the other party (the Payer) under Section 6 (e) in circumstances where there is a Defaulting Party or one Affected Party in the case where a Termination Event under Section 5 (b) (i) to (v) inclusive has occurred, will, at the option of the party (‘X’) other than the Defaulting Party or the Affected Party (and without prior notice to the Defaulting Party or Affected Party), be reduced by its set-off against any amount(s) (the ‘Other Agreement Amount’) payable (whether at such time or in the future or upon occurrence of a contingency) by the Payee to the Payer (irrespective of the currency, place of payment or booking office of the obligation) under any other agreement(s) between the Payee and the Payer or instrument(s) or undertaking(s) issued or extended by one party to, or in favour of, the other party (and the Other Agreement Amount will be discharged promptly and in all respects to the extent it is so set-off). X will give notice to the other party of any set-off effected under this Section.

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(ii) For this purpose, either the Early Termination Amount or the Other Agreement Amount (or the relevant portion of such amounts) may be converted by X into the currency in which the other is denominated at the rate of exchange at which X would be able, acting in a reasonable manner and in good faith, to purchase the relevant amount of such currency. (iii) If an obligation is unascertained, X may in good faith estimate that obligation and set-off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained. (iv) Nothing in this Section 6(g) shall be effective to create a charge or other security interest. This Section 6(g) shall be without prejudice and in addition to any right of set-off, combination of accounts, lien or other right to which any party is at any time otherwise entitled (whether by operation of law, contract or otherwise).’ 8.

Transfer. Rights and obligations under this Agreement or any Transaction may not be transferred, in whole or in part, except upon the prior written consent of both parties and any such transfer made without such consent shall be void.

9.

Default Rate. The Default Rate shall mean 1% over LIBOR compounded on a daily basis where ‘LIBOR’ on any day shall mean the one-month London Interbank Offered Rate as reported in The Financial Times or if the Financial Times ceases publication temporarily or permanently, such other newspaper published in London as Party B may determine.

10. Indemnifiable Tax. The definition of Indemnifiable Tax shall be amended to include the following in line 9 at the end thereof: ‘Indemnifiable Tax shall also mean any Tax imposed in respect of a payment under this Agreement by reason of Change in Tax Law by a government or taxing authority of a Relevant Jurisdiction of the party making such payment, unless the other party is incorporated, organised, managed and controlled, or considered to have its seat in such jurisdiction or acting for the purposes of this Agreement through a branch or office located in such jurisdiction.’ 11. Physical Delivery. Unless specifically stated to the contrary in a signed Confirmation, no physical delivery by either party shall take place under the terms of this Agreement and Transactions entered into hereunder shall be settled in cash only. 12. Telephone Recording. Each party to this Agreement acknowledges and agrees to the electronic recording of telephone conversations

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between the parties (including any director, officer, employee, agent or representative thereof) and whether by one or other or both of the parties and that any such recording may be submitted in evidence to any court or in any proceedings for the purpose of establishing any matters pertinent to any Transaction. 13. Designated Account Details for US Dollar Payments. (a) In the case of Party A: As specified by Party A when returning the Confirmation from Party B. (b) In the case of Party B: Name of Bank: Account Number: Account Name: 14. ‘Market Disruption Event’ means the occurrence of any of the following events in the reasonable determination of the Calculation Agent: (a) (b) (c) (d) (e) (f)

Price Source Disruption; Trading Suspension; Disappearance of Commodity Reference Price; Material Change in Formula; Material Change in Content; Trading Limitation.

15. Disruption Fallbacks relating to Commodity Transactions: The following Disruption Fallbacks (as defined in the 1993 Commodity Definitions) shall be applicable in each case in the order in which they appear: (i) in respect of any Transaction having a Calculation Period or Calculation Periods which are greater than or equal to one calendar month: (a) Average Daily Price Disruption, with Maximum Days of Disruption equal to five; (b) Fallback Reference Price; (c) Negotiated Fallback; (d) The Parties shall appoint a single independent expert to determine an alternative pricing method. If the parties fail to agree on the appointment of an expert, the Chairman for the time being of the Institute of Petroleum in the United Kingdom shall be requested by either party to make such appointment within 2 days of request. An expert, if appointed, shall be deemed not be an arbitrator but shall render his decision as an expert and his determination shall be final and binding upon both parties save in the event of manifest error or fraud; and

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(e) No Fault Termination. (ii) in respect of any Transaction having a Calculation Period or Calculation Periods which are less than one calendar month: (a) Average Daily Price Disruption, provided that the Maximum Days of Disruption shall be zero where the Calculation Period is less than or equal to two Commodity Business Days; one, where the Calculation Period is between three and five Commodity Business Days inclusive; two where the Calculation Period is between six and ten Commodity Business Days inclusive; three, where the Calculation Period is between eleven and fifteen Commodity Business Days inclusive; and four, where the Calculation Period is greater than sixteen Commodity Business Days inclusive; (b) Fallback Reference Price; (c) Negotiated Fallback; (d) The Parties shall appoint a single independent expert to determine an alternative pricing method. If the parties fail to agree on the appointment of an expert, the Chairman for the time being of the Institute of Petroleum in the United Kingdom shall be requested by either party to make such appointment within 2 days of request. An expert, if appointed, shall be deemed not be an arbitrator but shall render his decision as an expert and his determination shall be final and binding upon both parties save in the event of manifest error or fraud; and (e) No Fault Termination. All determinations and calculations hereunder by the Calculation Agent shall be made in good faith, in the exercise of its commercially reasonable judgement and only after consultation with the other party. 16. Commencement Date. This Agreement is deemed to have come into effect on _________________________ 2001 ABC LIMITED By: Name: Title:

XYZ BANK LTD By: Name: Title:

By: Name: Title:

By: Name: Title:

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CREDIT SUPPORT ANNEX EXAMPLE Where counterparts outline acceptable types of Credit Support against derivatives transactions they perform with one another and other terms associated with these. CREDIT SUPPORT ANNEX to the Schedule to the ISDA Master Agreement dated as of................. between ABC SMALL TRADER LTD (‘Party A’) and XYZ BANK LTD (‘Party B’) This Annex supplements, forms part of, and is subject to, the ISDA Master Agreement referred to above and is part of its Schedule. For the purposes of this Agreement, including, without limitation, Sections 1(c), 2(a), 5 and 6, the credit support arrangements set out in this Annex constitute a Transaction (for which this Annex constitutes the Confirmation). [[Notwithstanding any other provision of this Annex, only][Party A][and Party B] from the date hereof shall provide Eligible Credit Support to the other party in accordance with the terms of this Annex. Party B may at any time in its absolute discretion by notice in writing vary Party A’s Threshold and/or the Minimum Transfer Amount.]Eligible Credit Support shall be provided by both parties if, as and when required by Section 5(b) of the Agreement (as amended by its Schedule) in accordance with the terms of this Annex. Notwithstanding the foregoing Party B may at any time in its absolute discretion require Party A to provide Eligible Credit Support in accordance with the terms of this Annex and for such purpose Party B shall from time to time advise Party A of the applicable Threshold and the Minimum Transfer Amount. Paragraph 1. Interpretation Capitalised terms not otherwise defined in this Annex or elsewhere in this Agreement have the meanings specified pursuant to Paragraph 10, and all references in this Annex to Paragraphs are to Paragraphs of this Annex. In the event of any inconsistency between this Annex and the other provisions of this Schedule, this Annex will prevail. For the avoidance of doubt, references to ‘transfer’ in this Annex mean, in relation to cash, payment and, in relation to other assets, delivery. Paragraph 2. Credit Support Obligations (a) Delivery Amount. Subject to Paragraphs 3 and 4, upon a demand made by the Transferee on or promptly following a Valuation Date, if the Delivery Amount for that Valuation Date equals or exceeds the

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Transferor’s Minimum Transfer Amount, then the Transferor will transfer to the Transferee Eligible Credit Support having a Value as of the date of transfer at least equal to the applicable Delivery Amount (rounded up to the nearest integral multiple of U.S. $100,000). The ‘Delivery Amount’ applicable to the Transferor for any Valuation Date will equal the amount by which: (i) the Credit Support Amount exceeds (ii) the Value as of that Valuation Date of the Transferor’s Credit Support Balance (adjusted to include any prior Delivery Amount and to exclude any prior Return Amount, the transfer of which, in either case, has not yet been completed and for which the relevant Settlement Day falls on or after such Valuation Date). (b) Return Amount. Subject to Paragraphs 3 and 4, upon a demand made by the Transferor on or promptly following a Valuation Date, if the Return Amount for that Valuation Date equals or exceeds the Transferee’s Minimum Transfer Amount, then the Transferee will transfer to the Transferor Equivalent Credit Support specified by the Transferor in that demand having a Value as of the date of transfer as close as practicable to the applicable Return Amount (rounded down to the nearest integral multiple of U.S. $100,000) and the Credit Support Balance will, upon such transfer, be reduced accordingly. The ‘Return Amount’ applicable to the Transferee for any Valuation Date will equal the amount by which: (i) the Value as of that Valuation Date of the Transferor’s Credit Support Balance (adjusted to include any prior Delivery Amount and to exclude any prior Return Amount, the transfer of which, in either case, has not yet been completed and for which the relevant Settlement Day falls on or after such Valuation Date) exceeds (ii) the Credit Support Amount. Paragraph 3. Transfers, Calculations and Exchanges (a) Transfers. All transfers under this Annex of any Eligible Credit Support, Equivalent Credit Support, Interest Amount or Equivalent Distributions shall be made in accordance with the instructions of the Transferee or Transferor, as applicable, and shall be made: (i) in the case of cash, by transfer into one or more bank accounts specified by the recipient; (ii) in the case of certificated securities which cannot or which the parties have agreed will not be delivered by book-entry, by

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delivery in appropriate physical form to the recipient or its account accompanied by any duly executed instruments of transfer, transfer tax stamps and any other documents necessary to constitute a legally valid transfer of the transferring party’s legal and beneficial title to the recipient; and (iii) in the case of securities which the parties have agreed will be delivered by book-entry, by the giving of written instructions (including, for the avoidance of doubt, instructions given by telex, facsimile transmission or electronic messaging system) to the relevant depository institution or other entity specified by the recipient, together with a written copy of the instructions to the recipient, sufficient, if complied with, to result in a legally effective transfer of the transferring party’s legal and beneficial title to the recipient. Subject to Paragraph 4 and unless otherwise specified, if a demand for the transfer of Eligible Credit Support or Equivalent Credit Support is received by the Notification Time, then the relevant transfer will be made not later than the close of business on the Settlement Day relating to the day after the date such demand is received; if a demand is received after the Notification Time, then the relevant transfer will be made not later than the close of business on the Settlement Day relating to the day after the date such demand is received. (b) Calculations. All calculations of Value and Exposure for purposes of Paragraphs 2 and 4(a) will be made by the relevant Valuation Agent as of the relevant Valuation Time. The Valuation Agent will notify each party (or the other party, if the Valuation Agent is a party) of its calculations not later than the Notification Time on the Local Business Day following the applicable Valuation Date (or, in the case of Paragraph 4(a), following the date of calculation). (c) Exchanges. (i) The Transferor may on any Local Business Day by notice inform the Transferee that it wishes to transfer to the Transferee Eligible Credit Support specified in that notice (the ‘New Credit Support’) in exchange for certain Eligible Credit Support (the ‘Original Credit Support’) specified in that notice comprised in the Transferor’s Credit Support Balance. (ii) If the Transferee notifies the Transferor that it has consented to the proposed exchange, (A) the Transferor will be obliged to transfer the New Credit Support to the Transferee on the first Settlement Day following the date on which it receives notice (which may be oral telephonic notice) from the Transferee of its consent and (B) the Transferee will be obliged to transfer to the

APPENDIX 4

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Transferor Equivalent Credit Support in respect of the Original Credit Support not later than the Settlement Day following the date on which the Transferee receives the New Credit Support (the ‘Exchange Date’); provided that the Transferee will only be obliged to transfer Equivalent Credit Support with a Value as of the date of transfer as close as practicable to, but in any event not more than, the Value of the New Credit Support as of that date. Paragraph 4. Dispute Resolution (a) Disputed Calculations or Valuations. If a party (a ‘Disputing Party’) reasonably disputes (I) the Valuation Agent’s calculation of a Delivery Amount or a Return Amount or (II) the Value of any transfer of Eligible Credit Support or Equivalent Credit Support, then: (1)

the Disputing Party will notify the other party and the Valuation Agent (if the Valuation Agent is not the other party) not later than the close of business on the Local Business Day following, in the case of (I) above, the date that the demand is received under Paragraph 2 or, in the case of (II) above, the date of transfer;

(2)

in the case of (I) above, the appropriate party will transfer the undisputed amount to the other party not later than the close of business on the Settlement Day following the date that the demand is received under Paragraph 2;

(3)

the parties will consult with each other in an attempt to resolve the dispute; and

(4)

if they fail to resolve the dispute by the Resolution Time, then: (i)

in the case of a dispute involving a Delivery Amount or Return Amount, the Valuation Agent will recalculate the Exposure and the Value as of the Recalculation Date by: (A) utilising any calculations of that part of the Exposure attributable to the Transactions that the parties have agreed are not in dispute; (B) calculating that part of the Exposure attributable to the Transactions in dispute by seeking four actual quotations at mid-market from Reference Market-makers for purposes of calculating Market Quotation, and taking the arithmetic average of those obtained; provided that if four quotations are not available for a particular Transaction, then fewer than four quotations may be used for that Transaction, and if no quotations are available for a particular Transaction, then the Valuation Agent’s original calculations will be used for the Transaction; and

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APPENDIX 4

(ii)

in the case of a dispute involving the Value of any transfer of Eligible Credit Support or Equivalent Credit Support, the Valuation Agent will recalculate the Value as of the date of Transfer.

Following a recalculation pursuant to this Paragraph, the Valuation Agent will notify each party (or the other party, if the Valuation Agent is a party) as soon as possible but in any event not later than the Notification Time on the Local Business Day following the Resolution Time. The appropriate party will, upon demand following such notice given by the Valuation Agent or a resolution pursuant to (3) above and subject to Paragraph 3(a), make the appropriate transfer. (b) No Event of Default. The failure by a party to make a transfer of any amount which is the subject of a dispute to which Paragraph 4(a) applies will not constitute an Event of Default for as long as the procedures set out in this Paragraph 4 are being carried out. For the avoidance of doubt, upon completion of those procedures, Section 5(a)(i) of this Agreement will apply to any failure by a party to make a transfer required under the final sentence of Paragraph 4(a) on the relevant due date. Paragraph 5. Transfer of Title, No Security Interest, Distributions and Interest Amount (a) Transfer of Title. Each party agrees that all right, title and interest in and to any Eligible Credit Support, Equivalent Credit Support, Equivalent Distributions or Interest Amount which it transfers to the other party under the terms of this Annex shall vest in the recipient free and clear of any liens, claims, charges or encumbrances or any other interest of the transferring party or of any third person (other than a lien routinely imposed on all securities in a relevant clearance system). (b) No Security Interest. Nothing in this Annex is intended to create or does create in favour of either party any mortgage, charge, lien, pledge, encumbrance or other security interest in any cash or other property transferred by one party to the other party under the terms of this Annex. (c) Distributions and Interest Amount. (i) Distributions. The Transferee will transfer to the Transferor not later than the Settlement Day following each Distributions Date cash, securities or other property of the same type, nominal value, description and amount as the relevant Distributions (‘Equivalent Distributions’) to the extent that a Delivery Amount would not be created or increased by the transfer, as calculated by the Valuation Agent (and the date of calculation will be deemed a Valuation Date for this purpose).

APPENDIX 4

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(ii) Interest Amount. In lieu of any interests, dividends or other amounts paid or deemed to have been paid with respect to Eligible Credit Support transferred to or received by the Transferee under this Annex in the form of Cash (all of which may be retained by the Transferee), the Transferee will transfer to the Transferor on the last Local Business Day of each calendar month and on any Local Business Day an amount is transferred to the Transferor pursuant to Paragraph 2(b) the Interest Amount to the extent that a Delivery Amount would not be created or increased by the transfer, as calculated by the Valuation Agent (and the date of calculation will be deemed to be the Valuation Date for this purpose). Paragraph 6. Default If an Early Termination Date is designated or deemed to occur as a result of an Event of Default in relation to a party, an amount equal to the Value of the Credit Support Balance, determined as though the Early Termination Date were a Valuation Date, will be deemed to be an Unpaid Amount due to the Transferor (which may or may not be the Defaulting Party) for purposes of Section 6(e). For the avoidance of doubt, if Market Quotation is the applicable payment measure for the purposes of Section 6(e), then the Market Quotation determined under Section 6(e) in relation to the Transaction constituted by this Annex will be deemed to be zero, and, if Loss is the applicable payment measure for purposes of Section 6(e), then the Loss determined under Section 6(e) in relation to the Transaction will be limited to Unpaid Amount representing the Value of the Credit Support Balance. Paragraph 7. Representation Each party represents to the other party (which representation will be deemed to be repeated as of each date on which it transfers Eligible Credit Support, Equivalent Credit Support or Equivalent Distributions) that it is the sole owner of or otherwise has the right to transfer all Eligible Credit Support, Equivalent Credit Support or Equivalent Distributions it transfers to the other party under this Annex, free and clear of any security interest, lien, encumbrance or other restriction (other than a lien routinely imposed on all securities in a relevant clearance system). Paragraph 8. Expenses Each party will pay its own costs and expenses (including any stamp, transfer or similar transaction tax or duty payable on any transfer it is required to make under this Annex) in connection with performing its obligations under this Annex, and neither party will be liable for any such costs and expenses incurred by the other party. Paragraph 9. Miscellaneous (a) Default Interest. Other than in the case of an amount which is the subject of a dispute under Paragraph 4(a), if a Transferee fails to make,

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APPENDIX 4

when due, any transfer of Equivalent Credit Support, Equivalent Distributions or the Interest Amount, it will be obliged to pay the Transferor (to the extent permitted under applicable law) an amount equal to interest at the Default Rate multiplied by the Value on the relevant Valuation Date of the items of property that were required to be transferred, from (and including) the date of transfer of the Equivalent Credit Support, Equivalent Distributions or Interest Amount were required to be transferred to (but excluding) the date of transfer of the Equivalent Credit Support, Equivalent Distribution or Interest Amount. This interest will be calculated on the basis of daily compounding and the actual number of days elapsed. (b) Good Faith and Commercially Reasonable Manner. Performance of all obligations under this Annex, including, but not limited to, all calculations, valuations and determinations made by either party, will be made in good faith and in a commercially reasonable manner. (c) Demands and Notices. All the demands and notices given by a party under this Annex will be given as specified in the Notices Section of this Agreement. Paragraph 10. Definitions As used in this Annex: ‘Base Currency’ means United States Dollars. ‘Base Currency Equivalent ‘ means, with respect to an amount on a Valuation Date, in the case of an amount denominated in the Base Currency, such Base Currency amount and in the case of an amount denominated in a currency other than the Base Currency (the ‘Other Currency’), the amount of Base Currency required to purchase such amount of the Other Currency at the spot exchange rate determined by the Valuation Agent for value on such Valuation Date. ‘Credit Support Amount’ means, with respect to a Transferor on a Valuation Date, (i) the Transferee’s Exposure minus (ii) the Transferor’s Threshold; provided, however, that the Credit Support Amount will be deemed to be zero whenever the calculation of Credit Support Amount yields a number less than zero. ‘Credit Support Balance’ means, with respect to a Transferor on a Valuation Date, the aggregate of all Eligible Credit Support that has been transferred to or received by the Transferee under this Annex, together with any Distributions and all proceeds of any such Eligible Credit Support or Distributions, as reduced pursuant to Paragraph 2(b), 3(c)(ii) or 6. Any Equivalent Distributions or Interest Amount (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance.

APPENDIX 4

507

‘Delivery Amount’ has the meaning specified in Paragraph 2(a) ‘Disputing Party’ has the meaning specified in Paragraph 4 ‘Distributions’ means, with respect to any Eligible Credit Support comprised in the Credit Support Balance consisting of securities, all principal, interest and other payments and distributions of cash or other property to which a holder of securities of the same type, nominal value, description and amount as such Eligible Credit Support would be entitled from time to time. ‘Distributions Date’ means, with respect to any Eligible Credit Support comprised in the Credit Support Balance other than cash, each date on which a holder of such Eligible Credit Support is entitled to receive Distributions, or if that date is not a Local Business Day, the next following Local Business Day. ‘Eligible Credit Support’ means: Valuation Percentage 100% 99.25%

(A) Cash in an Eligible Currency (B) negotiable debt obligations issued by the US Treasury Department having on maturity at issuance of not more than one year (‘Treasury Bills’) 96.5% (C) negotiable debt obligations issued by the US Treasury Department having an original maturity at issuance of more than one year but not more than 10 years (‘Treasury Notes’) (D) negotiable debt obligations issued by the US 95.5% Treasury Department having an original maturity at issuance of more than 10 years (‘Treasury Bonds’)

and, in relation to any securities, the proceeds of any redemptions in whole or in part of such securities by the relevant issuer. ‘Eligible Currency’ means the Base Currency. ‘Equivalent Credit Support’ means, in relation to any Eligible Credit Support comprised in the Credit Support Balance, Eligible Credit Support of the same type, nominal value, description and amount as that Eligible Credit Support. ‘Equivalent Distributions’ has the meaning specified in Paragraph 5(c)(i). ‘Exchange Date’ has the meaning specified in Paragraph 3(c)(ii). ‘Exposure’ means, with respect to a party on a Valuation Date and subject to Paragraph 4 in the case of a dispute, the amount, if any, that would be

508

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payable to that party by the other party (expressed as a positive number) or by that party to the other party (expressed as a negative number) pursuant to Section 6(e)(ii)(l) of this Agreement if all Transactions (other than the Transaction constituted by this Annex) were being terminated as of the relevant Valuation Time, on the basis that (i) that party is not the Affected Party and (ii) the Base Currency is the Termination Currency; provided that Market Quotations will be determined by the Valuation Agent on behalf of that party using its estimates at mid-market of the amounts that would be paid for Replacement Transaction (as that term is defined in the definition of ‘Market Quotation’). ‘Interest Amount’ means, with respect to an Interest Period, the aggregate sum of the Base Currency Equivalents of the amounts of interest determined for each relevant currency and calculated for each day in that Interest Period on the principal amount of the portion of the Credit Support Balance comprised of cash in such currency, determined by the Valuation Agent for each such day as follow: (x) (y) (z)

the amount of cash in currency on that day; multiplied by the relevant Interest Rate in effect for that day; divided by 360 (or, in the case of pounds sterling, 365).

‘Interest Period’ means the period from (and including) the last Local Business Day on which an Interest Amount was transferred (or, if no Interest Amount has yet been transferred, the Local Business Day on which Eligible Credit Support or Equivalent Credit Support in the form of cash was transferred to or received by the Transferee) to (but excluding) the Local Business Day on which the current Interest Amount is transferred. ‘Interest Rate’ means, with respect to an Eligible Currency, the rate equal to the then current one month US Dollars London Interbank Offered Rate as published in the Financial Times or if the Financial Times ceases publication temporarily or permanently, such other newspaper published in London as Party B may determine, as such rate may change from time to time. ‘Local Business Day’, means: (i) in relation to a transfer of cash or other property (other than securities) under this Annex, a day on which commercial banks are open for business (including dealings in foreign exchange and foreign currency deposits) in the place where the relevant account is located and, if different, in the principal financial centre, if any, of the currency of such payment; (ii) in relation to a transfer of securities under this Annex, a day on which the clearance system agreed between the parties for delivery of the securities is open for the acceptance and

APPENDIX 4

509

execution of settlement instructions or, if delivery of the securities is contemplated by other means, a day on which commercial banks are open for business (including dealings in foreign exchange and foreign currency deposits) in the place(s) agreed between the parties for this purpose; (iii) in relation to a valuation under this Annex, a day on which commercial banks are open for business (including dealings in foreign exchange and foreign currency deposits) in the place of location of the Valuation Agent and in the place(s) agreed between the parties for this purpose; and (iv) in relation to any notice or other communication under this Annex, a day on which commercial banks are open for business (including dealings in foreign exchange and foreign currency deposits) in the place specified in the address for notice most recently provided by the recipient. ‘Minimum Transfer Amount’ means, with respect to a party, zero. ‘New Credit Support’ has the meaning specified in Paragraph 3(c)(i) ‘Notification Time’ means 1pm, London time, on a Local Business Day. ‘Recalculation Date’ means the Valuation Date that gives rise to the dispute under Paragraph 4; provided, however, that if a subsequent Valuation Date occurs under Paragraph 2 prior to the resolution of the dispute, then the ‘Recalculation Date’ means the most recent Valuation Date under Paragraph 2. ‘Resolution Time’ has the meaning 1pm on a Local Business Day following the date on which the notice is given that gives rise to a dispute under Paragraph 4. ‘Return Amount’ has the meaning specified in Paragraph 2(b). ‘Settlement Day’ means, in relation to a date, (i) with respect to a transfer of cash or other property (other than securities), the next Local Business Day and (ii) with respect to a transfer of securities, the first Local Business Day after such date on which settlement of a trade in the relevant securities, if effected on such date, would have been settled in accordance with customary practice when settling through the clearance system agreed between the parties for delivery of such securities or, otherwise, on the market in which such securities are principally traded (or, in either case, if there is no such customary practice, on the first Local Business Day after such date on which it is reasonably practicable to deliver such securities). ‘Threshold’ means, with respect to Party A, US$ 100,000, and with respect to Party B, US$ 100,000.

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APPENDIX 4

‘Transferee’ means, in relation to each Valuation Date, the party in respect of which Exposure is a positive number and, in relation to a Credit Support Balance, the party which, subject to this Annex, owes such Credit Support Balance or, as the case may be, the Value of such Credit Support Balance to the other party. ‘Transferor’ means, in relation to a Transferee, the other party. ‘Valuation Agent’ means Party B. ‘Valuation Date’ means each Local Business Day. ‘Valuation Percentage’ means, for any item of Eligible Credit Support the percentage specified in definition of Eligible Credit Support. ‘Valuation Time’ means the close of business on each Local Business Day or date of calculation as is applicable. ‘Value’ means, for any Valuation Date or other date for which Value is calculated, and subject to Paragraph 4 in the case of a dispute, with respect to: (i) Eligible Credit Support comprised in a Credit Support Balance that is: (A) an amount of cash, the Base Currency Equivalent of such amount multiplied by the applicable Valuation Percentage, if any and (B) a security, the Base Currency Equivalent of the bid price obtained by the Valuation Agent multiplied by the applicable Valuation Percentage, if any; and (ii) items that are comprised in a Credit Support Balance and are not Eligible Credit Support, zero.

PROPER EXECUTION OF ISDA AGREEMENTS Most of the time Banks who enter in to an ISDA Agreement with a corporate will require a full board resolution showing that the company is permitted to and that the board has approved the company to enter in to Derivative instruments. In addition to this most banks will require a Capacity Certificate. Example Capacity Certificate I am a senior executive officer of [Name of Company] (the ‘Company’) not being involved directly in the trading activities of the Company which is duly organised and validly existing under the laws of [insert place of

APPENDIX 4

511

incorporation] and having its principal place of business at [insert address] and as such am generally familiar with its affairs and I hereby certify that 1. The Company has the power to enter into contracts for differences (swaps), over-the-counter options or a combination thereof based on energy and/or other commodities and/or bullion. Entry into such transactions does not violate or conflict with any law applicable to the Company, any provision of its constitutional documents, any order or judgement of any court or other agency of government applicable to it or any of its assets, or any contractual restriction binding on or affecting the Company. 2. All governmental and other consents that are required to be obtained have been obtained and are in full force and effect and it has complied with all conditions of any such consents. 3. The obligations of the Company under any transactions entered into constitute legal, valid and binding obligations, enforceable in accordance with their respective terms subject as to enforceability to applicable bankruptcy, reorganisation, insolvency, moratorium or similar laws affecting creditors’ rights generally, and to equitable principles of general application (regardless of whether enforcement is sought in a proceeding in equity or at law). 4. The Company has the power to execute and deliver master agreements governing the terms of any transactions and written confirmations evidencing such contracts and transactions as necessary. Yours faithfully For and on behalf of [Name of Company] ________________________ ________________________ Name: Date: Title:

EXAMPLE BOARD RESOLUTION It is worth checking the legal incorporation details of the counterpart you are establishing an ISDA with. For example their Memorandum & Articles of Association to ensure that there is nothing explicit in them prohibiting the other party from entering in to derivatives transactions.

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APPENDIX 4

In addition though it is worth getting a copy of a Board Resolution showing the boards acceptance of entering in to the ISDA agreement with you. Banks will often insist on a Board Resolution prior to trading with a corporate. ABC TRADER LTD (the ‘Company’) Minutes of a meeting of the Board of Directors of ABC TRADER LTD held at its head office on 15 December 2002. Present:

Mr R Leighton Mr A Rose Mr A Gooch Mr D Oxley In Attendance: Mr M Spencer Company Secretary It was resolved: 1. that it is in the best interests of and to the advantage and further benefit of the Company to enter into the agreement detailed hereunder; and 2. that the Company should further enter into an ISDA Master Agreement dated as of 15th December 2002 with XYZ Bank Ltd in the form annexed hereto and that Mr R Leighton and Mr M Spencer are authorised to sign the same on behalf of the Company. CHAIRMAN’S SIGNATURE

Certified as a true copy of the original SECRETARY’S SIGNATURE

Date:

Index

5% confidence 378 1993 ISDA Commodity Derivatives Definitions 288 2000 ISDA Definitions and Annex 289 2000 Supplement to the 1993 ISDA Commodity Derivatives Definitions 288 abandon 26, 337 ABC 337 accounting 144, 159, 169 accounting standards consolidation and clarification 319 effectiveness of 331 international 317 accrued interest 337 accumulation 337 accumulation/distribution line 337 acidising 337 activity 337 actuals 338 adaptive filter 338 Additional Termination Event 298 add-on method 338 adjusted futures price 338 ADP 39 heating oil 55 light, sweet crude oil 51 natural gas 60 unleaded gasoline 57 ADR see American Depository Receipts adsorption 338 AFRA 338 against actuals 338 aggregation 338 AGO see Gasoil, atmospheric

air draft 338 airlines bonds and loans 278 hedging with bonds 277 AKA 338 aliphatic 338 alkylate 338 alkylation unit 338 Allen & Overy 286 Alternative Delivery Procedure see ADP American Depository Receipts 338 American options 22, 25, 109 American Petroleum Institute 340 American Society for Testing and Materials see ASTM amortisation 338 Amsterdam power market 82 analysis of variance 338 anaume 339 anchoring-and-adjustment 339 Andersen Accounting 162 Andrews method 339 angle of deflection 339 aniline point 339 annealing simulated 339 annual earnings change 339 annual net profit margin 339 annual sales change 339 annualised 339 annular space 339 anthracite 339 briquets 339 anthropogenic 340 antiknock index 340 antithetic forecasts 340 API degrees 340 513

514

INDEX

API gravity 340 APi indices 90 apparent consumption coal 340 natural gas 340 petroleum 340 refined petroleum products 340 appraisal well 340 aquifer 340 AR 340 arbitrage 26, 340 conversion 360 arbitration 315, 340 ARIMA 342 aromatics 340 artificial intelligence 341 artificial lift 341 ash 341 Asia 78 key products 78 tenures versus liquidity 78 Asian options 22, 25, 109, 117, 126 pricing 128 asphalt 341 asphalt cement 341 asphaltenes 341 assay 341 assets ownership 273 rented 273 assign 341 assignment 246 futures 26 swaps 26 Associate Membership 341 Associated Person 342 ASTM 342 ATM see options, at-the-money atmos 342 atmospheric distillation 342 atmospheric residue 342 attenuation 342 at-the-money 25, 109 audit and compliance 158 auditing 149, 158 external 159 Austrian power market 82 autocorrelation 342 seasonal 423 automated knowledge acquisition see AKA autoregressive 342

availability 342 Average Directional Movement Index 342 Average Freight Rate Assessments see AFRA average price contract 26 average rate options 25 average reserve life index 342 average true range 343 avgas 343 aviation gasoline 343 blending components 343 finished 343 aviation turbine fuel 343 %b 343 B/D 345 back month 343 back office 26, 146, 154 derivative management 157 internal controls 157–8 back office systems 153, 155, 157 counterparty documentation 156 exception reports 156 input data 154–5 position records 156 risk manager 156–7 security 157 transaction records 156 backhaul 343 backpropagation network 343 back-testing 343 backwardation 26, 52–3, 343 bad oil 343 baffles 343 balance of payment 344 Balance of the Month contracts see BOM balance sheet 318–19 ballast 344 Bank Investment Contracts 344 bar charts 212, 344 scale 212 barge 432 barge lots 344 Barings Bank 134, 145–7, 162 Barker, Tim 331 Barlow, Edward 335 Barone-Adesi and Whaley model 128 barrel 344 barrels of oil equivalent 344 barrels per calendar day 344

INDEX

barrels per stream day 344 barrier options 20, 117–18 base stock 344 basis 344 basis points 345 basis risk 3, 5–6, 36 causes of 3 components of 5 definition 3 hedging and 166 locational 5 mixed 5 time 5 tripartite financing 279 basket trades 345 batch 345 Bayes decision rule 345 bbl 345 bcf 345 bcm 345 beam 345 beam well 345 bean 345 bear 345 bear flags 238 bear market 345 bear spread 345 benchmark 26 benzene 345 beta coefficient 345 bias 345 bid 345 bid and ask 345 bilateral energy trading 345 bill of lading 346 bimodal distribution 346 biodiesel 346 biofuels 346 biogas 346 biomass 346 biosphere 346 bit 346 bitumen 346 bituminous coal 346 black box 346 black liquor 346 Black, Fischer 125 Black–Scholes model 125, 128, 346 blender 346 blendstock 346 block 346

515

block trades 347 blow-down 347 blow-off top 347 blow-out preventers 347 BLPD 345 Board of Trade Clearing Corporation 347 boiler 347 boiling range 347 BOM 49 bonds 347 energy indexed 277 book 26 book entry securities 347 Boolean 347 BOPD 345 bottoms 347 Box–Jenkins method 347 bozu 348 BP 328 BPD 345 bracketing 348 breakaway gap 348 breakout 348 Brent Crude futures contract specification 44 Brent Crude Oil Futures 6, 12 Brent Crude options contract specification 44–6 Brent–Forties–Osenberg futures 12 brine 348 briquetting plant 348 British Thermal Unit see Btu broker 348 brokerage fee 348 brokerage house 348 bromine number 348 Btu 348 BTX 348 extraction 348 bull 348 bull flags 237 bull market 348 bull spread 348 bulls and bears 214 Bunker C 348 bunker fuels 348 business continuity plans 272 business ethics training 161 business risk reducing 278 butadiene 349

516

INDEX

butane 349 butterfly strategy 120, 349 butylene 349 buy and hold 349 buy/sell 349 buyer 263 buying hedge 349 BWPD 345 Calculation Agent 303 calendar spread options 52–3, 349 call backspread strategy 122 calls 21, 26, 110 buying 113 minimum value 125–6 Calmar ratio 349 cancelling order 349 candlestick charts 219, 350 capital at risk 275 capital losses 350 capital reserves 274 caps 21, 26, 110, 113 buying 113 coal 91 selling 114 carbon budget 350 carbon cycle 350 carbon dioxide 350 carbon dioxide equivalent 350 carbon intensity 350 carbon output rate 350 carbon residue 350 carbon sequestration 350 carbon sink 350 carry cost 26 carrying broker 351 carrying charge 351 carryover 351 cash commodity 351 cash contract 351 cash flow differential swap 17 option premium 23 plain vanilla swap 16 cash flow crunch 202 cash flow risk 3–4 cash market 351 cash settlement 263, 351 cash-settled contract 27 Castelli, Charles 125 cat gasoline 351 cat naphtha 352

catalytic cracking 351 catalytic reforming 351 catfeed 351 CBOT see Chicago Board of Trade CDS 253–5 compared with TRS 260 credit paradox 256 development of market 258–9 Enron and 258 most active geographic regions 260 names 254 pricing and valuation mechanics 257 seller 256 size of market 260 uses of 254 centigrade 352 centistoke 352 Central Appalachian coal futures 69–71 Central Limit Theorem 352 Certificate of Deposit 352 cetane 352 index 352 number 352 CFPP 356 CFTC 331, 357 Chaikin oscillator 352 chains 352 channel 352 chaos theory 352 Charlesworth, Tom 335 chart patterns 228–39 continuation patterns 229 defined 228 groups 229 reversal patterns 229 triangle formations 230 charter party 352 charterer 353 charting 353 charts 353 cheap 353 cheapest to deliver 353 cherry picking 291, 293 Chicago Board of Trade 347 chlorides 353 Christmas tree spread 353 C.I.F. 353 circuit 353 circuit breaker 353

INDEX

classifier systems 353 clean 353 clear 353 clearing corporation 353 clearing houses 14, 262, 354 clearing margin 353 clearing member 354 climate 354 climate change 354 clips 75 closed trades 354 closing price 354 closing range 354 cloud point 354 clustering 354 CME 354 CNR 354 COA 354 coal 17, 192, 354 Antwerp–Rotterdam–Amsterdam 89 briquets 355 China 89 environmental impact 69 European swaps 88 exports 68 market 88 market volume 90 metallurgical 396 producers 68 reserves 421 sea-borne 88 secondary 423 South Africa 89 steam 428 sub-bituminous 430 trading and hedging opportunities 91 transportation 68 coal futures 68 coal production 355 coal rank 355 coal stocks 355 coal swaps OTC 89 pricing references 89–90 trading patterns 91 coalbed 355 coalbed methane 355 coefficient 355 of determination 355 cogeneration 355

517

cogenerator 355 coiled 355 coincidence 355 coke 355 metallurgical 396 petroleum 355 coke oven gas 355 coke plant 356 coker 356 delayed 365 coking coal 356 cold blender 356 cold filter plugging point 356 collars, zero cost zero cost collars 117 collateral financial instruments as 250 requirements 250 collateralisation 244, 249, 279 Colonial grade 356 Colonial pipeline 356 colour 356 COM membership 357 combination carriers 356 combined cycle 356 combined cycle unit 357 combined forecast 357 combined pumped storage electric power plant 357 combustion 357 commercial field 357 commission fee 357 commission house 357 commodity 357 Commodity Credit Corp. 357 Commodity Exchange Act 357 Commodity Futures Trading Commission see CFTC commodity pool 357 Commodity Pool Operator 357 Commodity Trading Adviser 357 comparative relative strength 357 comparator 358 compatibility 358 completion 358 component 358 compounding 358 computer security 159 concession contracts 358 concurrent indicators 358 condensate 358 Conference of the Parties 358

518

INDEX

confidence factor 358 confidence level 133, 358 Confirmation Statement 358 confirmations 358 electronic 306 congestion area or pattern 359 consolidation 359 Consumer Price Index 359 consumption 359 contango 27, 53, 359 continuation chart 359 continuous-type deposit 359 contract 359 Contract For Differences 352 contract grades 359 contract market 359 contract month 359 controlled account 359 conventional accumulation 360 conventional gasoline 360 conventional mill (uranium) 360 conventional thermal electricity generation 360 convergence 360 conversion 360 conversion factor 360 cooling degree days 93 Coppock curve 361 co-products 360 correction 361 correction wave 361 correlogram 361 cost basis 361 Cost of Carry 360 countermove 361 counterparts approving 266 counterparty risk 27 ISDA Master Agreement transfer 292 coupon 361 covariance 361 cover 361 covered option 361 covered write 361 COW 361 crack options 118, 199–200 crack spread options 53, 361 cracked component 361 cracked cutters 362 cracked fuel 362 cracked naphtha 362

cracked stock 362 cracker 362 cracking 361–2 credit 362 investment grade 269 credit control establishing framework 266–7 Credit Default Swap see CDS credit derivatives 27, 245 documentation 257 Credit Event Upon Merger 296 credit events 253, 263, 297 credit insurance 245, 252 credit limits establishing 266 credit lines 263 approving 266 management 254–5 credit paradox 256 credit quality average assessment for energy sector 269 higher quality 270 credit rating 241 factors affecting 268, 270 credit rating agencies 268–9 examination of risk management operations 270 credit risk 2, 133, 146, 206, 241 accounting and 317 aggregating 209 counterparty 256 creditworthiness of counterparts 209 current exposure 208 daily position report 270 establishing controls 267 FRS 13 328 identifying 266 management 209, 271 managing exposure 244–5 measuring 208, 267 mitigation via clearing houses 262–3, 265 OTC derivatives 9 potential exposure 208 pre-payment financing 281 reducing 206, 278 reducing via ISDA schedule 246–7 reduction 272 rented assets 273 credit risk environment

INDEX

establishing 266 credit spread 362 credit status 268–75 credit support documents 249, 304 Credit Support Provider 304 credits tradeable 257 crop (marketing) year 362 crop reports 362 cross correlations 362 Cross Default 295 cross-hedging 362 cross-product netting 305 crude oil 362 heavy 385 light 391 production 363 crude oil landed cost 363 crude oil less lease condensate 363 crush spread 363 cSt 363 CTI2 363 cubic foot 364 cull wood 364 cup and handle 364 currency risk FRS 13 328 current ratio 364 current yield 364 current, electric 364 direct 368 curve 364 curve-fitting 364 Cushing Cushion 6 customer margin 364 customer segregated funds 364 cut 364 cutoff frequency 364 cutter 364 cycle 364 cycle oil 364 cycling 364 %D 365 daily range 365 daily trading limit 365 dark spreads 17, 91 data historical 386 preprocessing 365 day contracts 49 day order 365

day trade 27 day traders 365 dead cat bounce 365 deadweight tonnage 365 deal capture 27 debit spread 365 deductive logic 365 deep waters 365 deep-in-the-money 365 default 365 deferred (delivery) month 365 definitions see ISDA, definitions deforestation 365 degree days 93 degrees API gravity 365 degrees of freedom 365 delay 365 delayed coking 365 delayed start date options 119 deliverable grades 366 deliverable obligation 263 delivery 27, 37, 366 day 366 heating oil 55 light, sweet crude oil 51 month 366 natural gas 60 of physical energy 15 points 366 unleaded gasoline 57 delivery risk pre-payment financing 281 delta 25, 27, 112–13, 366 delta hedged 366 delta neutral portfolio 120 delta neutral spread 122, 366 delta position 366 demand law of 366 demand index 366 demurrage 366 density 366 density function 366 dependence 367 DERD 367 derivative contract 27 derivatives 367 accounting 148 accounting for 144 advantages 107 choosing 142 credit insurance 252

519

520

INDEX

disclosures 327 financial statements 209 financing with 276 growth of markets 331 losses during 1990s 331 managing 143 new markets 210 purpose of 148 reporting on balance sheet 318 selection table 177 trend towards complex structures 332 types of 8 derivatives forward curve assessments 97, 99, 101, 103, 105 derivatives portfolios valuing 206 derivatives positions valuation of 271 derivatives trade confirmation under ISDA 486 derivatives, OTC see OTC derivatives derrick 367 derrick hand 367 Designated Self-Regulatory Organisation 367 Determining Party 312–14 deterministic 367 deterministic system 367 detrend 367 development 367 development well 367 diesel index 367 dif 17 difference-in-means test 367 differencing 367 differential swaps 17 differentials 367 diffusion equation 368 diffusion index 368 Directional Movement Index 368 disclosure document 368 discount 368 discount method 368 discount rate 368 discretionary account 368 disputes 315 resolving 315–16 disruption fallbacks 309 distillate fuel oil 368 distillation curve 369 distillation unit (atmospheric) 369

distiller 369 distribution 369 distribution system 369 distributors 369 divergence 369 diversity 273 dividend 369 dividend reinvestment plan 369 doctor test 369 documentation ISDA 290 documentation risk 293 ISDA Master Agreement 292 doji 370 dollar cost averaging 370 domestic inland consumption (petroleum) 370 double bottoms 238, 370 double tops 238, 370 double up swaps 18 double-smoothed 370 Dow Theory 213 Dow, Charles 213 downstream 370, 436 DPK 370 draft 370 drawdown 370 dry (coal) basis 370 dry hole 371 dry natural gas production 371 dual fired unit 371 dual trading 371 Durbin–Watson statistic 371 Dynamic Data Exchange 371 Dynamic Linked Library 371 Dynegy 243, 333 E-4 371 early entry 371 early exercise 27 early termination calculating payments 297 earnings estimates 372 eavesdropper 372 econometrics 372 economic capital 263 EEX 265 EFET 27, 286 efficient market theory 372 EFPs 37, 39, 374 coal 71 delivery 43

INDEX

heating oil 55 initiating a position 41 light, sweet crude oil 51 liquidating a position 42 margining 43 market 41 matching quantity of futures contracts 40 nominal price 41 transaction mechanics 41 elasticity 372 electric power 372 electric power plant 372 electric system 372 electric utility 372 electricity 372 electricity capacity 372 electricity demand 372 electricity generation 372 electronic communications network 372 Electronic Energy Trading System see ETSII electronic order 372 electronic trading systems 373 Elliott wave theory 224, 337, 373, 376 Elliott, R. N. 224 embedded options 27 emissions 373 coefficient 373 end user 27 energy 373 renewable sources 92 energy consumption 373 energy demand 373 energy futures 8 energy futures contracts 33 energy indexed bonds 277 energy indexed loans 276–7 energy prices factors affecting 1 energy producer bonds 277 energy reserves 373 energy sector and transportation names 457 energy source 373 energy supply 373 energy swaps 8 energy trading growth of 333 Engler 374 enhanced recovery 374

521

enriched uranium 374 Enron 160–3 bandwidth trading 161 CDS and 258 collapse of 241, 243 corporate culture 161 credit crunch 2 credit events 297 credit rating 241 expansion 161 increasing revenues 162 lack of external controls 162 lessons from 162 management culture 160 regulatory reaction 333 risk assessment 161 shareholders 162 timetable of collapse 241 entry 374 envelope 374 equilibrium market 374 equilibrium price 374 equity 374 equity holders 374 estimated EPS change 374 ethane 374 ether 374 Ethyl Tertiary Butyl Ether 374 ethylene 374 ETSII 48 Euler Group 285 Eurodollar 374 Europe 78 energy hubs 81 key products 79 markets 78 products 78 tenures vs. liquidity 79 European coal swaps 88 European Energy Exchange see EEX European Federation of Electricity Traders see EFET European gas markets 85, 87 European options 22, 25, 109 European Union 374 evening star pattern 374 events 28 exception reports 203 exchange 28 exchange of futures for physicals see EFP exchange-traded funds 375

522

INDEX

ex-dividend date 375 exercise 28, 375 exercise price 375 exit 375 exotic contracts 28 exotic options 28 expanded trading hours 375 expert systems 375 expiration 28, 375 expiration date 375 exploration 375 Exponential Moving Average 375 exponential smoothing 375 exports, US 375 extraction loss 376 extreme 375 extrinsic value 28, 376 fabricated fuel 376 face value 376 fade 376 Fahrenheit 376 failure 376 failure swings 376 failure to pay 263 fair value 25, 109, 321 fair values 376 evidence of 327 far-month contract 402 FAS 133 317, 319 fair value 320 summary 333 volatility of reported earnings 323 F.A.S. value 376 FASB 319, 331 fast Fourier transform 376 fast market 376 Fastow, Andrew 160 Federal Deposit Insurance Corporation 376 federal funds 376 Federal Funds Rate 376 Federal Housing Administration 377 Federal Open Market Committee 377 Federal Reserve Bank 377 Federal Reserve System 377 feedforward computation 377 feedstock 377 Feinstein, Dianne 333 Fibonacci ratio 377 Fibonacci retracement levels 224–5

identifying 225 Fibonacci series 337, 377 field 377 field separation facility 377 fill 377 fill order 377 fill-or-kill 377 filter 377 filter point 377 finance 268 Financial Accounting Standards Board see FASB Financial Analysis Auditing Compliance Tracking System 377 financial guarantee 245 financial instrument 377 defined by IAS 32 323 Financial Reporting Standard 13 see FRS 13 First Notice Day 378 fit criterion 378 fixed carbon 378 fixed price payer 189 flag formations 237 flaglike 378 flared 378 flash fill 378 flash point 378 flexicoking 378 float 378 floor broker 378 floor trader 378 floors 20–1 buying 114 coal 91 selling 114 fluid coking 378 flyers 378 F.O.B. 378 FOD 378 forecast origin 378 foreign exchange market 379 forex risk 207 FORTIES 379 forward (cash) contract 379 forward curves mismarking 336 Forward Rate Agreements 379 fossil fuel 379 fossil fuel electric generation 379 fossil fueled steam-electric power plant 379

INDEX

fractal dimension 379 fractals 379 fractionation 379 Framework Convention on Climate Change 379 framing 379 freight 96 freight rate swaps 96 frequency 379 component 379 distribution 379 domain 380 response 380 front month 380 front office 28, 146 front-loaded 380 front-running 380 FRS 13 327 components 328 purpose of 328 F-statistics 380 fuel 380 fuel cells 380 fuel ethanol 380 Fuel Oil Futures 12 full carrying charge market 380 Full Membership (CBOT) 380 fully disclosed 380 fundamental analysis 380 fundamentals 380 futures 3, 10–11, 13, 28 compared with options 36 convergence with OTC 14 defined 8 energy 8, 33 expiry 177 gas 40 history of 10, 33 margins 13 vs. OTC 13 oil 39 physical delivery 107 power 41 settlement on expiry 14 Futures Commission Merchant 380 futures contract specifications for gasoline 66–8 futures contracts 380 components 34 delivery cycle 34 delivery location 35 expiration date 34

523

expiry 34 features 33 grade 35 marked-to-market 34 settlement 34 settlement mechanism 35 size 34 standardised 34 termination 34 futures exchange 380 futures exchanges 34 Futures Industry Association 381 futures market 381 futures markets 33 liquidity 33, 43 futures options 35 fuzzy systems 381 GAAP 320 gamma 112, 381 relationship with theta 113 Gann lines 224 Gann theory 381 Gann, W. D. 224 gap 381 gas electric 381 still 429 gas condensate well 381 gas conversions 31 gas indexed loan 276 gas to liquids 382 gas turbine electric power plant 382 gas well 382 gasohol 381 Gasoil 381 atmospheric 342 EFPs 42 futures 193 heavy 385 light 391 Gasoil future contract specification 46–7 Gasoil options contract specification 47–8 gasoline 66–8 natural 402 premium 413 pyrolysis 417 reformulated 420 regular 420 gasoline grades 381

524

INDEX

Generally Accepted Accounting Principles 320 generating facility 382 generating unit 382 generator 382 generator capacity 382 genetic algorithms 382 genetic programming 382 geothermal 382 geothermal electric power generation 382 geothermal energy 382 geothermal plant 382 gigawatt (GW) 383 gigawatt hour (GWh) 383 Gilsonite 383 GIM Membership 383 give-up 383 Global Coal’s RB index 90 global power markets 82 global warming 383 potential 383 GLOBEX 383 Golden Mean 383 Golden Ratio see Golden Mean Golden Section 383 good faith deposit 262 Governing Law 304 grain terminal 383 grantor 383 Greeks 111, 383 greenhouse effect 383 greenhouse gases 383 Greenspan, Alan 335 grid 384 Grid Trading Master Agreement see GTMA Gross Domestic Product 384 gross generation 384 gross input to atmospheric crude oil distillation units 384 Gross National Product 384 gross processing margin 384 GTMA 28, 87, 193, 286 Gulf War volatility in oil markets 2 haircuts 249–50 Hanover power market 82 harami 384 head and shoulders 384

head and shoulders patterns 235–7 neckline 236 heap leach solutions 384 heat content gross 384 net 385 heating degree days 93 heating oil 53–6 hedge accounting FAS 133 321 qualifying hedges 325 hedge fund 385 hedger 385 hedges 28 defined by IAS 39 325 effective 326 effectiveness 322, 325 long 393 proxy 138, 166 purchasing 416 selling 424 short 425 hedging 137, 164, 385 airlines 178, 189 amount of 176 cash flow risk 177 charter airlines 176 choice of market 143 coal futures 69, 193 collar structure 189 compared with speculation 165 crude oil 194, 196 crude oil producer 196 defined 176 demand sensitivity 95 electricity producers 192 end users 208 energy indexed loans 276 energy price exposure 110 examples 178–99 expense of 166 fixed price swap 178 floors with a knock-out 197 futures 36 long-term 205 management controls 164 metal producer 194 misunderstandings about 164 profits and losses 164–5 purpose of 36 quantity 141–2 refineries 198–200

INDEX

risk management policy and 165 short-term 189 strategies 110 timing of 165 Herrick Payoff Index 385 heuristic bias 385 heuristic method 385 heuristics 386 hidden node 386 hierarchical neural network 386 high 386 high pass frequency filter 386 High Sulfur No. 2 Diesel Fuel 386 high-ticking 386 Hines ratio 386 holder 386 hook day 386 horizontal spread 386 human error 168 hydrocarbons 386 other 408 hydroelectric power generation 386 hydroelectric pumped storage 387 hydrofluorocarbons 387 hydrogen 387 hydropower generator 94 IAS 323, 325 IAS 32 320 disclosure and presentation 323 excluded derivatives 324 proposed amendments 324 IAS 39 317–20 fair value 325 hedge effectiveness 327 implementing 325 recognition and measurement 325 summary 333 IASC 319 ICE 264 implied volatility 28, 124 imports (US) 387 improved recovery 387 impulse 387 impulse wave 387 in play 387 in situ leach mining 387 income dividends 387 Independent Introducing Broker 388 independent power producer 388 index fund 388 Indian Oil Corp. 389

525

Individual Retirement Account 389 inductive logic 388 inefficient markets 388 initial balance 388 initial margins 28, 35, 264, 388 initial public offering 388 inside day 388 intercommodity spread 388 Intercontinental Exchange 306 interdelivery spread 388 interest accrued 337 interest rate swaps 388 Intergovernmental Panel on Climate Change 388 intermarket analysis 389 intermarket spread 389 internal combustion electric power plant 389 Internal Control Framework 147 International Accounting Standards Committee see IASC International Energy Agency 389 International Petroleum Exchange see IPE International Petroleum Exchange of London see IPE International Swaps Dealers Association see ISDA in-the-money 25, 109, 387 intrinsic value 25, 109, 389 Introducing Broker 389 inventory financing 278 uses of 279 inverted head and shoulders pattern 235 inverted market 389 invisible supply 389 IOC see Indian Oil Corp. IPE 6, 12, 29, 389 IRA see Individual Retirement Account irregular flat 389 Irrevocable Standby Letters of Credit 247, 249 as collateral 249 ISDA 6, 28, 155, 286 achievements of 286 automatic early termination 297 Automatic Early Termination 306 change of account 305 Confirmations 306

526

INDEX

default 312 definitions 305 disruption fallbacks 309 documentation processing 290–1 early termination 307 Early Termination Amount 307 Master Agreements 286 netting 311 Operational Benchmarking Survey 286 pari passu 306 payments on early termination 297 physical delivery 308 proposed changes 311, 313 publications 288 telephone recording 308 trading before signature 246, 293 Transfer 308 withholding tax 311 ISDA agreements components 287 Credit Support Annex 287 Master Swaps Agreement Multicurrency Cross-border 287 time to negotiate 289 ISDA Master Agreement 287, 461 default 292 enforceability 247 jurisdiction 292, 299 risk associated with 291 sections of 287 transfer 292 ISDA Master Agreement Schedule 247, 287, 293 collateral/credit support 247 components 294 step by step explanation 294 island 389 isomerate 389 isopentane 389 Italian power market 83 IV see volatility, implied jet fuel 390 joule 390 kerogen 390 kerosene 63–5, 390 burning 349 kerosene-type jet fuel kilowatt 390

390

kilowatt hour 390 knock-ins 20 knock-outs 20, 118 knowledge base 390 Kondratieff, Nikolai 390 Korean Airlines 3 kurtosis 390 Kyoto Protocol 390 lag 390 lagging indicators 391 last trading day 391 latest quarterly earnings 391 law of series 391 Lay Kenneth 160 lead 391 leading indicators 391 LEAPS 391 lease condensate 391 lease separation facility 391 least squares method 391 Leeson, Nick 134, 145–7 leg 391 leg out 391 legal risk 6 ISDA Master Agreement 291 OTC derivatives 9 Leipzig power market 82 Letters of Credit 250 leverage 391 Libor 257, 308 lifting 391 Light Louisiana Sweet 393 light products, light ends 391 light, sweet crude oil 49–53 lignite 391 limit move 392 limit order 392 limit up, limit down 392 limits 392 linkage 392 liquefied petroleum gases 392 liquefied refinery gases 392 liquid 392 liquid collector 392 liquidate 392 liquidity 29, 143, 393 capital 274 liquidity data bank 393 liquidity risk 2, 4 FRS 13 328

INDEX

LISP 393 Ljung–Box statistic 393 LLS see Light Louisiana Sweet load (electric) 393 loan program 393 loan rate 393 loans embedded option structures 283 local 393 locked limit 393 London Clearing House 75, 264 long 29, 34–5, 42, 393 long-form confirmations 289 lookback interval 393 LOOP see Louisiana Offshore Offloading Point Loss Method 297 Louisiana Offshore Offloading Point 6 low 393 low pass frequency filter 393 Low Sulfur No. 2 Diesel Fuel 393 low-ticking 393 lubricants 394 M&As 290 MACD 394 macro 394 Madrid power market 83 maintenance 394 maintenance margin 394 major auction 394 managed account 394 Managed Funds Association 394 managed futures 394 management track record 274 management controls 145 breakdown 148 management failure 145 management information systems 204, 206 credit risk 267 Mandelbrot set 394 manufactured gas 394 mapping 394 margin 394 margin calls 395 margin options 22 margin swaps 19 marginal significance level of test statistics 395

527

margins 13, 23 EFPs 43 Gasoil options 47 initial 13, 28, 35 variation 13, 24 marked-to-market 29, 335, 395 accounting and 318 evidence of fair value 327 market breadth 395 Market Disruption Event 303, 309 market if touched 395 Market Information Data Inquiry System 395 market maker 395 market on close 395 market order 395 Market Quotation Method 297 market reporter 395 market risk 271, 395 avoiding with EFPs 42 ISDA Master Agreement 292 management 208 measuring 207 see also price risk market sentiment 395 market standing 273 market timing 395 market value 395 market-based pricing 395 marketed production, natural gas 395 markets choosing 143 cyclical 213 master netting 244 Master Netting Agreements 249 MATIF 395 maturity 29 maxima 395 maximax 395 maximin 396 maximum adverse excursion 396 maximum entropy method 396 mean 396 mean deviation 396 mean P/L 396 mean return 396 mean reverting 396 measured reserves 396 median line 396 mediation 396 megawatt 396

528

INDEX

megawatt hour 396 MEM see maximum entropy method memorandum and articles of association see M&As mental stop-loss 396 Metallgesellschaft AG 4 methane 397 methanol 397 methyl tertiary butyl ether 397 metric ton 397 MGRM see Metallgesellschaft AG midgrade gasoline 397 midgrade unleaded 397 mineral potential 397 mineral storage 397 mineral-matter-free basis 397 minima 397 minimum price fluctuation 397 minor auction 397 MNA see Master Netting Agreements Mod R 263 mode 397 model 397 modern portfolio theory 397 modified endowment contract 397 modulation storage 398 moist (coal) basis 398 momentum 398 momentum filter 398 momentum indicator 398 money flow 398 money market 398 money market fund 398 money stop 398 money supply 398 monowave 398 Monte Carlo simulation 128 month contracts 49 morning star 398 motor gasoline (finished) 399 motor gasoline blending 398 moving average charts 399 moving average convergence/ divergence 400 moving average crossovers 400 moving averages 228, 399 13 day 228 39 week 228 interpretation 228 market cycles and 228 simple 228 types of 228

moving window 400 MTM see marked-to-market Multibranch Party 303 multicollinearity 400 multiple linear regression 400 multiple transaction netting 305 municipal bonds 400 municipal solid waste 400 naked options 21 naked put 400 naphtha 400 naphthenic 400 paraffinic 410 special 427 naphthas 400 naphtha-type jet fuel 400 narrow range day 400 National Association of Investors Corporation 400 National Balancing Point see NBP National Futures Association 401 natural gas 58–60, 401 associated/dissolved 341 dry 371 futures 86 gross withdrawals 384 liquefied 392 nonassociated 404 pipeline quality 412 storage 402 wet 440 natural gas dry production 401 natural gas futures contract specification 48–9 natural gas hydrates 401 natural gas liquids 402 natural gas markets Europe 85 natural gas plant liquids 402 natural gas processing plants 402 NBP 85 nearby (delivery) month 402 near-month contract 402 near-the-money 402 NECH 265 neckline 402 negative amortisation 402 negative divergence 402 negative yield curve 402 net asset value 402 net electricity consumption 402

INDEX

net generation 403 net performance 403 NETA 402 netting agreements 209 netting arrangements 272 Netting of Payments 304 network code 403 neural network 403 New York Mercantile Exchange see NYMEX nitrogen oxides 403 nitrous oxide 403 No. 1 Diesel Fuel 403 No. 1 Distillate 403 No. 1 Fuel Oil 404 No. 2 Diesel Fuel 403 No. 2 Distillate 403 No. 2 Fuel Oil (Heating Oil 404 No. 4 Fuel 403 No-Action Letter 403 noise 404 noisy signal 404 no-load 404 nonattainment area 404 nonconventional plant (uranium) 404 nonhydrocarbon gases 404 nonlinear dynamics analysis 404 nonlinear statistics 404 non-seasonal autocorrelation 404 non-trend day 404 nonutility power producer 404 Nord Pool 83 normal distribution 405 normalisation 405 notice day 405 notional 29 nuclear electric power 405 nuclear fuel 405 nuclear power plant 405 nuclear reactor 405 null hypothesis 405 NYMEX 4, 11, 29, 266, 405 coal 192 EFP documentation 43 electronic confirmations 306 founding 33 NYMEX ACCESS trading platform 50, 54, 56, 58 NYMEX Coal Futures 69 NYMEX heating oil futures 53–6 NYMEX Henry Hub natural gas futures 69

529

NYMEX Henry Hub natural gas futures and options 58–60 NYMEX New York Harbor unleaded gasoline futures and options 56–8 NYMEX WTI light, sweet crude oil futures 49–52 observer 405 OCI 322 octane 405 octane rating 405 odd lot 406 off farm 406 off peak 406 off-balance sheet items 9 offer 406 offset 36, 406 offshore 406 ohm 406 oil consumption 72 importers 72 oil conversion factors 30 oil index notes 284–5 oil reservoir 406 oil shale 406 oil well 406 oil well (casinghead) gas 406 Old R 263 olefins 406 omnibus account 406 on farm 406 on-balance volume 406 one world energy derivatives market 74 one-tailed T-test 406 ’On-exchange’ derivatives see futures onshore 406 open 407 open interest 221, 407 open market operation 407 open outcry 407 open position 29 open trade equity 407 open trades 407 opening call 407 opening print 407 opening range 407 operable nuclear unit 407 operable unit 407 operational risk 6, 158, 167, 275 assessing 169, 171

530

INDEX

components of 167 containment 174 control 173 control measures 171 controlling 169, 171 core operational capability 167 gathering information 172–3 human risk 168 identifying 169 monitoring 171 OTC derivatives 9 owned assets 273 reconciliation and accounting 169 reduction 173 straight through processing 174 transaction processing systems 168 transfer 174 opportunity costs 407 optimisation 407 option buyer 407 option contract 407 option premium 407 option seller 408 option spread 408 option values rules for 125 option writer 408 optional cash purchase 408 options 8, 407 American 22, 25, 125 Asian 22, 25, 117 at-the-money 342 average rate 25 call 36, 349 compared with futures 36 cost of 22 crack 118 defined 8 delayed start date 119 embedded 27 European 22, 25, 126 exercising 36 exotic 28 expiry 15 flexibility 111 floor 20 futures 35 as insurance policies 107 in-the-money 16 knock-in 20 knock-out 20 margin 22

naked 21 OTC 16 path-dependent 22, 109 popular structures 115, 117 premium 22 put 20, 36, 417 retrospective 22 spread 118 strategies 113 strike price 9 styles of 22 types of 36, 110, 125 uncovered 435 options barrier 20 options models types of 127 order 408 Organisation for Economic Cooperation and Development 408 original margin 408 oscillator 408 OTC 9 advantages of 10 convergence with futures 14 counterparts 14 liquidity of 10 see also OTC derivatives OTC derivatives 9 OTC energy derivative markets 72 OTC energy derivatives clearing 246 OTC energy markets 72 OTC market effectiveness 72 OTC oil derivatives key markets 75 market 73, 75, 77 OTC oil markets trading volume data 75 OTC swaps gas 78–9 oil 78–9 pricing 73 OTC swaps and options 3, 9 Other Comprehensive Income see OCI out data 408 out trade 409 outlier 409 out-of-sample 409 out-of-the-money 25, 109, 409 outside reversal month 409 out-turn 409

INDEX

over lifting 409 overbought 409 indicator 409 overfitting 409 over-hedging 166, 176 overshoot 409 oversold 409 indicator 409 over-the-counter see OTC swaps and options over-the-counter market 409 oxidise 409 oxygenated gasoline 409 oxygenates 409 PADD see Petroleum Allocation for Defense District paper contract 29 par 410 parabolic 410 paraffin (oil) 410 paraffin (wax) 410 paraffin base stock 410 paraffinic 410 parameter 410 parental guarantees 249 Pareto’s law 410 pari passu 306 Paris power market 82 participation swaps 18 Partnoy, Frank 336 PASCAL 410 passive solar heating 410 Payee Tax Representations 300 Payer Tax 300 Payer Tax Representations 299 payment due dates 15, 177 payment-in-kind program 410 peak load 410 pennants 238, 410 pentanes plus 410 percentile 410 perceptron 410 perfluorocarbons 410 performance bond margin 411 personnel 209 pessimistic rate of return 411 petrochemical feedstock 411 petrochemicals 411 petroleum 411 Petroleum Allocation for Defense District 410

531

petroleum jelly 411 petroleum products 411 petroleum stocks 411 PFC see Platts Forward Curve service phase delay 412 phasor 412 photovoltaic cell 412 photovoltaic energy 412 photovoltaic module 412 physical delivery 263 pit 412 pivot point 412 plain vanilla derivatives 147 plain vanilla swaps 16 plant 412 electric 412 plant condensate 412 Platts 73, 96, 98 Platts Forward Curve service 98–9 Asia series 99 European series 98 play 412 play area 412 plug 412 point and figure chart 413 political unrest 261 polymers 413 position 413 position day 413 position limits 35, 203, 413 breached 204 types of 204 position management ratio 413 position trader 413 positions closing out 36 posted price 413 pour point 413 power exchanges 413 power loss 413 power markets global 82 Powernext 82 PPM 413 prearranged trading 413 pre-confirmations 289 premium 22–3, 25, 109, 413 preparation plant 414 pre-payment financing 280, 282 advantages 281 disadvantages 281 long term 281

532

INDEX

medium term 280 Special Purposes Vehicle 282 preprocessing 414 prewhitening 414 price discovery 29, 414 price gaps 222 bearish trend 224 bullish trend 223 price limit 414 order 414 price risk 2, 275 light, sweet crude oil 52 price targets 222 price to sales ratio 414 price/earnings ratio 414 prices extreme 141–2 transparency 143 primary coal 414 primary dealer 414 primary market 414 prime mover 414 prime rate 414 probability density function 414 probable energy reserves 414 probable reserves, coal 414 Process Agent 302 Producer Price Index 415 Production Sharing Agreement 415 profit margin expansion 415 profit taking 415 program trading 415 propane 415 propylene 415 prospectus 415 proved energy reserves 415 proved recoverable reserves, coal 416 proved reserves coal 416 crude oil 416 natural gas 416 proxy hedge see hedges, proxy pulpit 416 pulpwood 416 pumped storage 416 pumped storage hydroelectric power plant 416 purchase and sell statement 416 pure pumped-storage hydroelectric power plant 417 PURPA 417

put backspread strategy put options 20 puts 21, 110 buying 114 maximum value 126 minimum value 126 pyramid 417 pyramiding 417

122–3

quarterly earnings change 417 quarterly net profit margin 417 quick ratio 417 quotation 417 quote sheet 75 Quotron 417 rack pricing 417 radiative forcing 418 radiatively active gases 418 rainfall 94 rally tops 418 random shock 418 random walk 418 range 418 range extension 418 rate of change 418 ratio 418 ratio backspreads 122 ratio call backspread 122 ratio put backspread 122 RBAR-squared 418 reaction 418 realised profit and loss 418 reciprocal of European Terms 418 reciprocity 418 rectangle 419 recursive 419 reference credit 263 reference obligation 263 refiner acquisition cost of crude oil 419 refinery (petroleum) 419 refinery fuel 419 refinery input (petroleum) 419 refinery losses and gains (petroleum) 419 refinery output (petroleum) 419 refinery processing gain (petroleum) 419 refinery processing loss (petroleum) 419 reforestation 419

INDEX

reformate 419 regression (simple) 420 regulation 331 regulations (CFTC) 420 regulatory capital 263 reinjected (natural gas) 420 relative return 420 relative return standard deviation 420 relative strength 420 Relative Strength Index 226, 420 3 day 227 14 day 227 calculation method example 226 relevant jurisdiction 299 renewable energy resources 420 renko 420 reparations 420 replacement value 312–14 independent sources 315 reportable positions 420 reporting 205 failure of 149 representativeness 420 repressuring 420 repurchase agreements 421 reserve requirements 421 reserves coal 421 possible 413 probable 414 reservoir 421 residual fuel oil 421 residual value 421 residuum 421 resistance 421 resistance line 421 response 421 resting order 421 restructuring 263 resumption 421 retention rate 421 retracement 421 return on assets 421 return on equity 421 reversal gap 422 reversal stop 422 reverse crush spread 421 reverse exponential moving average 421 reward–risk rank 422 reward–risk ratio 422

533

rich 422 risk accepting 171 avoiding 171 implied 422 recording 202 reducing 171 transferring 171 types of 1 risk assessment failure of 148 risk limit policies 207 risk management 1, 29 computer systems 272 end-users 208 futures 37 increasing use of 335 key questions 141 risk management committee 271 risk management control systems 272 risk management policy Board level approval 149, 206 control and supervision 150 creating 149, 151 credit procedures 151 guidelines 205, 207, 209 legal and documentary issues 151 organisation, roles and responsibility 150 policies and procedures 150 policy document 153 policy document 152–3 review of 271 risk management process components 201 risk management review 159 example 442 risk management scenario 130–1 risk managers independent 207 risk matrix 1 risk measurement add-on approaches 132 risk measurement methods 131 risk reduction CDS 254 risk tolerance 271 risk-adjusted return on capital 422 road oil 422 roll 422 root mean square percentage error 422

534

INDEX

rotary rig 422 rotation 422 round turn 422 roundwood 422 RSI see Relative Strength Index R-squared 417 rules (NFA) 422 runners 422 running market 422 running total 422 sales growth 422 sales load 422 saucer base 423 Savings and Loan Investment Contracts 423 scallop 423 scalp 423 scalper 423 Scandinavian power market 83 Scholes, Myron 125 Schwarz-a-tron 423 season contracts 49 seasonal trend 423 seasonality 423 SEC 331 Second Method 297 secondary market 423 sector fund 423 sector rotation 423 secular trend 423 securities synthetic 431 Securities Exchange Commission see SEC security 423 security selection ratio 423 seed 423 segregated account 423 segregation of duties 146, 149, 168, 205–6, 274 Enron 162 seismogram 423 seismograph 423 seismographic survey 423 seismometer 424 SelectNet 424 self-affine transformation 424 self-hedging 95 self-regulatory organisation 424 seller 263 selling short 424

semilog 424 sensitivity 424 Separative Work Units 424 serial correlation 424 serially independent 424 settle 424 settlement 424 settlement operational risk 168 settlement price 29, 424 settlement risk 168 ISDA Master Agreement 293 Shapiro–Wilkes test 425 shareholder of record 425 shaved candlestick 425 ship-or-pay 425 shipping companies bonds and loans 278 short 30, 34–5, 42, 425 short interest 425 short interest ratio 425 short ton (coal) 425 shrinkage (natural gas) 426 signal 425 signal line 425 Signature Medallion Guaranty 425 significance 425 silent guarantee 245 SIMEX 12, 134, 145, 425 simple moving average 425 simple regression 426 simulation analysis of financial exposure 426 sine wave 426 Singapore power market 84–5 Single Transaction Netting 304 size of company 273 skew 426 Skilling, Jeffrey 160 resignation 258 slippage 426 sludge 426 Small Order Execution System 426 Small Power Producer 426 smoothing 426 solar energy 426 solar thermal collector 426 high-temperature 426 low-temperature 427 medium-temperature 427 special 427 solution, gas in 427 soot spreads see dark spreads

INDEX

sour crude 427 spark spreads 17, 69, 87, 119, 191 UK 87–8, 193 Special Purposes Vehicle 282 specific gravity 427 specifications actual 337 Specified Entities 201, 247, 295 Specified Indebtedness 295 Specified Transaction 295 specify 427 spectrum 427 speculation 24 speculator 427 spent liquor 427 spike 427 spline 427 spot 427 spot month 428 spot price 428 spread 428 spread options 118 spread rolls 428 spreading 428 spring 428 SPV see Special Purposes Vehicle stair-stepping 428 Standard & Poor’s press releases 242 standard deviation 428 standard error of the estimate 428 standardised unanticipated earnings 428 stationarity 428 stationary time series 428 steam cracker 428 steam-electric power plant 428 step function 428 stepwise regression 429 still gas 429 stochastic 429 stochastic simulation 134 stochastics oscillator 429 stock change 429 stock index futures 429 stocks 429 stop and reverse 429 stop loss 429 stop order 429 stop-limit order 429 stop-running 429 stops 429

535

STP see straight through processing straddle 429 straddles 120 straight through processing 155–6, 174 straight-run 429 strange attractor 429 strangle 429 strangles 120 Strategic Petroleum Reserve 430 strategic storage 430 street name 430 stress testing 131, 133, 138–9, 202–3, 206–7 historical scenarios 139 hypothetical scenarios 139–40 limitations 140 methodologies 139 strike price 9, 21, 25, 109, 430 heating oil futures 54 light, sweet crude oil 51 natural gas 59 unleaded gasoline 57 stripper well (natural gas) 430 stripper well property (petroleum) 430 strips 430 struck 430 structured notes 283 advantages 284 oil-linked 283–4 Student 430 sulphur 430 sulphur dioxide 430 sulphur hexafluoride 430 sulphur oxides 431 sum of squared residuals 431 supply law of 431 support 431 support line 431 surface mine (coal) 431 suspension 431 SwapNet 306 swaps defined 8 differential 17 double up 18 energy 8 half month contracts 177 margin 19 participation 18

536

INDEX

regrade 17 settlement 177 settlement on expiry 15 types of 16 see also plain vanilla swaps swaptions 9, 29 expiry 16 sweet crude 427 swing chart 431 swings 431 Swiss power market 83 synergistic market analysis 431 synthetic natural gas 431 take-or-pay 432 tall oil 432 tangibles 432 tanker 432 tanker freight swaps 96 tar sands 432 tax representations 299 tax risk 7 tax-deferred 432 technical analysis 211, 432 defined 212 history 213–14 human emotions and 213 influence of 212 market fundamentals 213 mathematical indicators 225, 227 principles 213 techno-fundamental analysis 211 telegrapher’s equation 432 telephone recording 308 temperature risk 91 tenures choosing 142 term structure 432 Terminated Transactions 312–14 Termination Currency 298 TFS indices 90 The Intercontinental Exchange 84 therm 432 thermal cracking 432 theta 112, 432 relationship with gamma 113 third party access to natural gas networks 432 Threshold Amount 295–6 thrust 432 tick 29, 433 tick indicator 433

time and sales ticker 433 time domain 433 time limit order 433 time series 433 time to expiry American options 126 time value 25, 109, 433 time–price opportunity 433 time-stamped 433 TOCOM 12, 63, 73 TOCOM futures contract specifications for kerosene 63–5 TOCOM Middle East crude contract forex hybrid 73 TOCOM Tokyo Commodity Exchange Middle East crude oil futures contract 60–3 Tokyo Commodity Exchange see TOCOM topping process 433 Total Return Swaps see TRS Totem Market Valuations 331 Totem Risk 98 valuations 99 TPO see time–price opportunity tradable 433 trade balance 433 trade facilitation 433 trade receivables financing 285 traders 274 trading bands 433 trading limit 433 trading range 433 trading volume data 75 Singapore 75 trailing stop 433 transfer agent 434 transfer function 434 transfer response 434 transform 434 transmission 434 transmission and distribution loss 434 transmission system (electric) 434 trap 434 treasury bill 434 treasury bond 434 treasury note 434 trend 434 trend channel 434 trend day 434

INDEX

trend-following 435 trending market 435 trendless 435 trendlines 215, 435 breakout 218 resistance 218 steepness 215 support 218 volume and 218 trends 213 bear 214 bull 214 defined 215 downtrend 216 end of trend signal 222 uptrend 216 triangle formations 230, 435 ascending 231 descending 233 falling wedge 233–4 rising wedge 234 symmetrical 230 triangular moving average 435 tripartite financing 279 trix 435 troposphere 435 TRS 260 compared with CDS 260 country risk application 261 disadvantages 262 true range 435 T-statistics 431 T-test 431 tulip sector 435 turbine 435 turning point 435 tweezers bottoms and tops 435 UK Accounting Standards Board 327 UK Power Exchange see UKPX UK power market 83 UKPX 83, 264, 266, 435 unconventional accumulation 435 under lifting 409 underground mine (coal) 436 underlying futures contract 436–7 underlying instrument 34, 436 underlying security 436 unfinished oils 436 Uniform Gifts to Minors Acts 436 univariate 436 unleaded gasoline 56–8

537

unrealised profit and loss 418 up-and-out barrier 118 up-and-out floor 20, 118 upstream 436 upthrust 436 uranium 436 concentrate 436 milling 397 ore 437 oxide 437 processing 415 US Federal Reserve 335 US power market 84 US refiner acquisition cost of imported crude oil 437 US Treasury bill 437 US Treasury bond 437 US Treasury note 437 USA 80 value area 437 Value At Risk see VAR value averaging 437 value date 25, 109 value-weighted index 437 vanadium 437 VAR 30, 130–1, 437 credit risk 133 hedge effectiveness and 137–8 historical simulation 134–6 history of 131 mathematical models 133 Monte Carlo simulation 134, 136–7, 271 purpose 133 types of 133 variance/covariance 134 variable limit 438 variable-length moving average 437 variation 30 variation margin 264, 438 vega 113, 438 vented 438 versus cash 438 vertical spread 438 Very Large Crude Carriers see VLCC vessel 438 vessel bunkering 438 vesting 438 VIP relationship 220–1 visbreaking 438 viscosity 438

538

INDEX

absolute 337 VLCC 43 volatile matter 438 volatility 25, 108–9, 113, 119–23, 323, 438 future 380 historic 28, 386 historical 28, 108 implied 25, 28, 108, 113, 387 strategies 120 volatility trading 119, 121, 123 volume 218, 221, 438 decreasing 222 high 219 increasing 218, 222 low 218 volume price trend 438 warehouse receipt 439 warrant 439 Warsaw power market 82 waste 439 waste energy 439 wasting 439 water vapour 439 watt 439 watt hour 439 wave 439 wave cycle 439 waxes 439 weather derivatives 91, 93, 95 growth of 91–3, 96 weather hedging 93 weather risk 91 Weather Risk Management Association see WRMA weather swaps hydroelectricity 278 wedge 439 weighted average purchase price

weighted industry index 439 weighted moving average 440 wellhead 440 wells 440 exploratory 375 infilling 388 West Texas Intermediate see WTI West Texas Sour 441 W formation 439 whiplash 440 whipsaw 440 white spirit 440 wholesale sales 440 wildcards 440 Wilder, J. Welles 226 Williams’ %R 440 wind energy 440 window 440 wire house 440 withholding tax 299, 311 wizard 440 working capital 201 worst case analysis 203 writer 440 WRMA 92 WTI 6, 12, 441 WTI light, sweet crude oil calendar spread options 52–3 Yates’s correction yield 441 yield curve 441

441

zero cost collar 117, 190 zero cost collar spark spread option 119 zero-coupon government bonds 441 zeta 441 zigzag 441 439