Managing Oil Price RiskManaging Oil Price Riskwith Derivativeswith Derivatives

Ivan ZelenkoHead of Structured Finance and DerivativesThe World Bank Treasury

Stabilizing Oil Fiscal Revenues over the Short to Medium Term

Oil and Gas Seminar April 27-30

Libreville, Gabon

04/11/23 2

Managing Oil Price RiskManaging Oil Price Risk AgendaAgenda

Definition of a Stabilization Policy

Risk Management with Derivatives

Implementation

Case Study: European Airlines

04/11/23 3

Managing Oil Price Risk Managing Oil Price Risk

Definition of a Stabilization PolicyDefinition of a Stabilization Policy

Oil price risk challenges fiscal policy

Oil exporting countries may derive a large share of their fiscal revenues from oil sales

Exposure to oil price challenges fiscal policy:

shelving of planned projects, higher savings and lower investments, wasteful use of oil ‘windfall’

increased vulnerability of governments balance sheet

Exporting countries have set up policies to insulate budgetary revenues from oil price shocks

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The objective of an oil price stabilization policy is to reduce the vulnerability to oil price shocks and to smooth the fluctuations in oil fiscal revenues over the short to medium term:

at a minimum cost

and subject to:

tolerance to downside risk and concern with upside gains

Managing oil Price RiskManaging oil Price Risk Definition of a Stabilization PolicyDefinition of a Stabilization Policy

Stabilization Policy Objective

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Stabilization Funds have been set up to immunize budgets

Oil revenues above a certain reference price are saved in the Fund. The Fund pays to the budget to ensure stable oil fiscal revenues based on the reference price.

BudgetOil Price sensitive Fiscal Revenues

Managing Oil Price RiskManaging Oil Price Risk Definition of a Stabilization PolicyDefinition of a Stabilization Policy

Fluctuate

Stabilization

Fund

Stable

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Stabilization Funds have shortcomings

The initial capitalization of and the reference price should be properly set to avoid either exhaustion or over-accumulation

The reference price is difficult to determine as oil prices do not exhibit a natural long term average. It could, however, be defined as a moving average.

The accumulated savings may raise the question of their use.But the Fund may include a “Fund for the Future” tranche

Stabilization Funds require robust governance rules

Cost of carry if invested in short term liquid $ assets

Managing Oil Price RiskManaging Oil Price Risk Definition of a Stabilization PolicyDefinition of a Stabilization Policy

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Transfer Risk to Markets using Oil Derivatives

Oil Derivatives enable hedging or insurance RM strategies. They do not require immobilization of capital. They can be combined with the Stabilization Fund approach.

Managing Oil Price RiskManaging Oil Price Risk Defining a Stabilization PolicyDefining a Stabilization Policy

BudgetStabilization Fund

Oil Price sensitive Fiscal Revenues

Transfer of Risk

Fluctuate Derivatives

transaction

Stable

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Managing Oil Price RiskManaging Oil Price Risk Definition of a Stabilization PolicyDefinition of a Stabilization Policy

ObjectiveGovernanceApproachTime HorizonRisk ToleranceBudgetInstrumentsImplementation infrastructure

Formulation of a Risk Management Policy

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Managing Oil Price RiskManaging Oil Price Risk AgendaAgenda

Definition of a Stabilization Policy

Risk Management with Derivatives

Implementation

Lessons learned: Case Study of European Airlines

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Generic Strategies with Derivatives

Remove uncertainty. Fix future oil prices. Low cost (but implied costs of margin calls). Do not permit upside gains

An insurance strategy placing a floor on future oil prices. Purchase payments (premiums) for buying puts is the cost of insurance. Permit upside gains.

Managing Oil Price Risk Managing Oil Price Risk RM with DerivativesRM with Derivatives

Forward sales

Purchase of puts

Hedging

Insurance

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Managing Oil Price RiskManaging Oil Price Risk RM with DerivativesRM with Derivatives

Forward

Initial exposure

Forward Oil Price

Revenues

Forward Sale

Net exposure

Initial exposure

Forward Oil Price

Put

Net exposure

Revenues

Put

Floor future oil price at a costFix future oil price

Cost of insurance

Hedging Insurance

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Managing Oil Price Risk Managing Oil Price Risk RM with DerivativesRM with Derivatives

The purchase cost of puts can be mitigated

Forward Oil Price

Put

Net exposure

Revenues

But upside gains are capped

Forward Oil Price

Put

Net exposure

Revenues

Call

But protection is lessened

Buy Put + Sell Call Buy Put + Sell Put

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Oil Prices have increased markedly since 2003

Managing Oil Price Risk Managing Oil Price Risk RM with DerivativesRM with Derivatives

WTI Oil Prices (monthly)

0

10

20

30

40

50

60

70

80

90

100

1995 1997 1999 2001 2003 2005 2007 2009

US

D/B

BL

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Managing Oil Price RiskManaging Oil Price Risk RM with derivatives RM with derivatives

$0

$40

$80

$120

$160

$200

1980 1990 2000 2010 2020 2030

No

min

al D

olla

rs p

er

Bar

rel

ReferenceCase

$69

High Oil PriceCase

Low Oil Price Case

$113

$180

Source : Annual Energy Outlook 2008, EIA

$0

$40

$80

$120

$160

$200

1980 1990 2000 2010 2020 2030

No

min

al D

olla

rs p

er

Bar

rel

ReferenceCase

$69

High Oil PriceCase

Low Oil Price Case

$113

$180

Source : Annual Energy Outlook 2008, EIA

The US Energy Information Administration forecasts a decline in prices over the next 10 years

Production increases (OPEC, non OPEC), growth of other energy sources

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Managing Oil Price RiskManaging Oil Price Risk AgendaAgenda

Definition of a Stabilization Policy

Derivatives: instruments, strategies and markets

Implementation

Lessons learned: Case Study of European Airlines

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Hedging Board sets policies, ensures accountability and reviews results. Should “own” the Hedging policy

Hedging Committee selects and implements hedging strategies consistent with objectives and risk tolerance of the Board.

Hedging execution teams (traders, analysts)

Control teams, responsible for monitoring performance, review strategy based on commodity market changes

Good governance = clear separation of roles and accountabilities

Managing Oil Price RiskManaging Oil Price Risk ImplementationImplementation

Hedging Committee

Market analysis, hedging strategy, guidelines, eligible

instruments

Hedging Board

Hedging Policy, Risk Tolerance, Time Horizon

and Budget

Derivatives Traders

Execution, Market Knowledge

Risk & AnalyticsRisk ModelingForecasting

ControlCompliancePerformanceMonitoring

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Managing Oil Price RiskManaging Oil Price Risk AgendaAgenda

Definition of a Stabilization Policy

Derivatives: instruments, strategies and markets

Implementation

Case Study: European Airlines

04/11/23 18

Managing Oil Price Risk Managing Oil Price Risk

Case Study: European AirlinesCase Study: European Airlines

Minimize variability in jet fuel purchase costsTwo years8 million tons of crude/jet fuel p.a. Tighter “cap” on oil price, but reducing the costs by selling out-of-money puts

Options (buying calls and selling puts)Hedging committee reporting to the Board

6 staff in Trading, Analytics, Risk Management, M/O & B/O functions, Systems Software bought & customized (~ $1 Mio)

Net price of calls = 5% Jet Fuel purchase costs

Objective:

Time Horizon:Size:Risk Tolerance:

Instruments:Governance:ImplementationInfrastructure:

Budget:

Formulation of the Risk Management Policy

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Managing Oil Price RiskManaging Oil Price Risk Case Study: European Airlines Case Study: European Airlines

Generic Risk Management Strategy based on collars

Program: ~ 8 Mio tons purchase of Kerosene per year

Annual Cost: ~ $ 4 Bio

Budget: ~ 4% of purchase ~ $ 160 Mio ~ $3 / bbl

Upside Protection: ~ $ 2 / bbl above forward price

Downside OpportunityRisk: ~ - $ 10 $ / bbl

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Managing Oil Price RiskManaging Oil Price Risk Case Study: European Airlines Case Study: European Airlines

Airline Risk Management Strategy is more geared towards reducing uncertainty

20 40 8060

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Managing Oil Price RiskManaging Oil Price Risk Case Study: European Airlines Case Study: European Airlines

Trade off in Hedging Strategy

Cost of InsurancePremium

Insurance againstPrice increase (buy call)

Acceptance ofOpportunity loss (sell put)

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Managing Oil Price RiskManaging Oil Price Risk Case Study: European AirlinesCase Study: European Airlines

Implementation of Risk Management Policy

Mandatory/Automatic Trading

Computer-generated automatic trading program (works as a benchmark)Given budget and insurance parameter solves for the last value (strike of sold put)Price averaging approach

6 months 18 months (7th-24th)

90%

85% - 5%

Active Management•Can deviate from the mandatory hedging program to take advantage of market conditions •Provides flexibility to the hedging program•Within the pre-determined parameters such as stop-loss limits and tolerance range of the hedge ratio

6 months 18 months (7th-24th)

90%

85% - 5%

Deviation

+

04/11/23 23

Managing Oil Price RiskManaging Oil Price Risk Quote Quote

Quote on collar strategy as of April 29

Spot WTI: $116 / bbl

Horizon: 3 years (May 2009, 2010, 2011)

Budget: $3 / bbl

Downside Protection: $90 / bbl

UpsideOpportunityLimit : 2009 no limit

2010 $182 / bbl 2011 $ 167 / bbl