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
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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: www.kochind.comwww.ksandt.comwww.kochmetals.com
  • 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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