Miami October 24, 2011

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Fuel Buyers Conference. Outlook for Fuel Oil Forward prices and derivatives. Patrick Melia. Miami October 24, 2011. Koch Industries - Overview. Koch Industries is among the world's largest private companies. Founded in 1940, it is owned and managed by Charles and David Koch
Fuel Buyers ConferenceOutlook for Fuel OilForward prices and derivativesPatrick MeliaMiamiOctober 24, 2011Koch Industries - Overview
  • Koch Industries is among the world's largest private companies. Founded in 1940, it is owned and managed by Charles and David Koch
  • Koch has interests spanning involvement in commodities (metals, petroleum, minerals etc.) and securities trading through to owning and operating refining and manufacturing facilities
  • As evidence of its financial strength Koch Resources, LLC maintains a long-term S&P A+ and Moody’s Aa3 credit rating
  • Trading operations located in London, Geneva, Singapore, Houston, New York, Wichita, Kansas (Corporate Headquarters), Rotterdam and Mumbai
  • Information:
  • Gulf Coast C12 vs C14 Spread Diff2011 highlights
  • Major flat price volatility. 8 days of $5+/bbl intraday moves YTD 2011. 4 year standard deviation of intraday move $3.75/bbl. Market is headline trading.
  • Event Risk. Middle East unrest, Libya, Fukushima, Riots, Prospect of double dip recession and Eurozone meltdown
  • Regime Change. WTI Brent dislocation due to growing North American / Canadian crude production + Cushing pipeline/inventory glut with no outlet to sea
  • Energy markets backwardated (except WTI)…WTI, the “broken benchmark”…LLS below Brent following release of 30m bbls of SPR crude, thereby closing “transatlantic arb”WTI-Brent
  • Forward spread / arb narrowing towards 2013 when Keystone XL scheduled completion
  • Wild cards: rail, truck and barge transportation, but questionable economics
  • Pipeline reversals (Longhorn pipeline, Seaway?)
  • Fuel oil has had a strong year…
  • Strong Singapore Bunker demand
  • Coker margins (convert low quality residuals into lighter disillates)
  • Utility demand – Fuel switching post Fukushima (HiLos >$70/mt in March 11 versus$20/mt in Feb). Oil-index buying vs Natural Gas in Europe
  • Russian export tax increase to 66% for Fuel effective oct11 (incentivise investment in cleaner refining)
  • Lacklustre performance in distillate markets
  • Strongest correlation in the oil complex to GDP growth / industrial production
  • Transportation, Heating, Industrial demand
  • Market bid during peak of Middle East unrest and Shell Pulau Bukom refinery fire more recently
  • Distillate complex hasn’t done the work refiners were hoping for...
  • Consumers
  • Hedging brent , Heating oil, ULSD and Jet instead of WTI.
  • Further exacerbates WTI-Brent weakness.
  • Buying into dips. Key entry targets around $100-105/bbl Brent.
  • Benefit from backwardation
  • Upside price protection relatively cheaper than downside (Put skew).
  • Refiners seek to optimise in a challenging margin environmentHedge individual product cracks
  • Reduce volatility in refining margins
  • Reduce volatility in inventory values
  • Consumers seek fixed off-take agreements
  • Enhance returns in times of low margin
  • Plan/budget for refinery investment
  • Compete in export orientated market
  • Naphtha: 25%(Sell 250 bbls)Crude 100%Buy 1000 bblsJet Fuel: 20%( Sell 200 bbls)Whole margin hedgeGasoil: 30%(Sell 300 bbls)HSFO 25%(Sell 250 bbls)Refinery hedging
  • Mid-continent refiners access to “cheap” WTI
  • NY Harbour refiners pulling seaborne “brent-benchmarked” crude from West Africa
  • Conoco Philips announced plans to sells its 185bbls/day Trainer refinery in Pennsylvania
  • Challenging margin environment globally
  • How do forward markets develop?
  • Some spot markets for commodities develop into forward markets
  • Crude oil
  • Natural gas
  • Refined products
  • NGLs
  • Others do not, but why?
  • Physical buyers and sellers not exposed to prices if they can pass them along
  • Some markets have too much variability in quality to function as single index
  • Conditions for forward market development
  • Buyers and sellers must have exposure and want to lessen that exposure
  • Liquid spot market necessary, but not sufficient, condition
  • Need to have multitude of buyers and sellers; relatively limited concentration
  • Gulf Coast has the most developed forward market for fuel oil
  • NYH somewhat less so
  • Rotterdam and Singapore as international markers
  • Fixed-price physical vs. derivatives
  • The simplest approach to minimizing market risk is to fix prices in physical contracts
  • Not all sellers set up to do so
  • They may not want to take on the fixed price themselves and may not know how to hedge their way out of it
  • Among those that will sell on fixed-price basis, pricing may not be very competitive
  • Physical contracts’ unique characteristics hamper easy comparison
  • Alternative is to keep the physical contract on floating-price basis and trade a financial derivative to fix the cost
  • Involves some accounting issues and may have impact on liquidity if MTM causes need to post margin
  • Derivative market participants
  • Commercial risk managers – seeking to shed exposure
  • Oil and gas producers, biofuel producers
  • Refiners, processors, storage operators, and transporters
  • Consumers and distributors
  • Petrochemical and other manufacturing companies
  • Transportation companies and transit systems
  • Retailers
  • Non-commercials (investors) – seeking to absorb exposure
  • Hedge funds, commodity trading advisors, index investors
  • Market-makers (banks and trading companies) – liquidity providers
  • Market-makers (banks and trading companies) – liquidity providers
  • Example: the first energy derivative - 1986
  • Bank offered airline customer a fixed fuel price for subsequent few years
  • Bank’s alternatives for hedging were:
  • Nymex heating oil futures, subject to basis risk and limited liquidity
  • Over-the-counter swap with a single counterparty (Koch). The swap index was closer to the airline’s actual exposure, thus limiting risk for the bank
  • Subsequently, energy derivatives markets have grown into the $ trillions (notionally), yet still relatively small market vs. interest rates and currencies
  • Fuel Oil derivatives markets growing
  • Fuel derivatives markets have developed far beyond the listed futures contract
  • Growth has been almost entirely in the OTC market, where monthly-average pricing and customized volumes can be executed easily.
  • Liquidity improving as buyers and sellers increasingly active amid higher volatility
  • Volumes still developing behind previous growth of crude, NG, and refined products forward markets
  • Options markets also developing, primarily used by producers to hedge floor price
  • Futures vs. financially-settled swaps
  • Propane futures contract existed since 1990s but was largely ignored until the development of OTC derivatives markets overtook forward trading
  • Physical settlement mechanism has merits but not necessary for standard corporate hedging
  • Calendar-average pricing more in line with exposures of producers and consumers
  • Options trade as calendar-average (Asian) as well
  • Forward markets developed largely from bilateral, financially-settled agreements
  • Now largely intermediated by exchange contracts
  • Convergence of exchanges and OTC
  • Futures exchanges (NYMEX and IPE/ICE) offer clearing of formerly OTC contracts
  • Fulfills necessary role of credit intermediation
  • Credit risk borne by clearing members
  • Enables price risk managers to hedge risks customized to their needs while not taking on counterparty credit risk
  • “Cost” is upfront margin, which may not be necessary in bilateral OTC contracts
  • … Demand for fuel derivatives rising with global markets and demand
  • Competitiveness of U.S. petrochemicals industry enhanced by low cost of light ends
  • Buyers often looking for long-dated pricing on feedstocks (e.g. olefins)
  • Hedging a short position, not unlike a fuel consumer (e.g. airline)
  • Despite higher prices, heavier NGLs in demand for blending into fuels, high-viscosity crude oil streams
  • Buyers typically seek to lock in the relative cost of c5 vs. crude oil
  • Some enterprises looking to hedge several years forward
  • May be tied to long-term Cap Ex budget
  • Volatility: the cost of options
  • Of the components of option prices, the only real variable is implied volatility
  • The other components are relatively fixed, or external
  • Exercise price
  • Time to expiration
  • Underlying price
  • Discount rate
  • If the market expectation for volatility is high, option prices will be high
  • Two additional dimensions
  • Term structure of volatility
  • Skew
  • 24Options and other structures: Worth paying for?
  • New structures marketed as offering greater value than existing products
  • There is no free lunch
  • Any structure can be offered more cheaply if the buyer is willing to maintain or increase exposure
  • A derivatives dealer can develop risk-management tools for any specific exposures via existing or novel structures
  • Need to establish client objectives
  • Relative importance of net cash cost
  • Predictability vs. buying low
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