Derivatives and Commodity HedgingDerivatives and Commodity Hedging

The World BankTreasury1818 H Street, N.W.Washington, DC, 20433, USAtreasury.worldbank.org

OECD-MENA Senior Budget Officials Network

Randy Ewell, World Bank, Banking and Debt Management Department

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Commodity prices have fallen sharply, beginning in July 2008 with the sharpest falls over the past month

Falls have been most severe in oil and metals

Agricultural commodity prices have also fallen, but by less

Price falls have been both large and fast Many intermediaries in the commodity chain, who are naturally long, will have lost considerable money unless they were hedged and will may experience financing difficulties in the coming monthsUn-hedged northern hemisphere farmers may experience large losses since the price falls have come just as crops are brought to market Decreasing prices create an opportunity for importers (of food/oil) to lock in lower prices

The world has changed …The world has changed …

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Commodity prices rose steadily from 2003 until the summer of 2008

This is the longest and most general commodity boom since the 1920s

Not all prices shared in the boom, and some started to fall in 2007

IMF commodity price indices, normalized at 2000 = 100 deflated by US PPI. The 2008 figure is the January-July average

75

100

125

150

175

200

225

250

275

2000 2001 2002 2003 2004 2005 2006 2007 2008

FoodsBeveragesAgricultural raw materialsMetalsEnergy

The aggregate pictureThe aggregate picture

4

Most least developed countries are oil importers but a significant minority are major exporters

Crude oil prices rose more or less steadily from 2001 to early July 2008 reaching over $140/bl

They have now halved to $70/bl 0

10

20

30

40

50

60

70

80

90

($/b

l, 20

00 p

rices

)

Average, Brent and WTI first positions, deflated by US PPI. Source: IMF

Crude OilCrude Oil

5

Along with oil, metals prices have fallen furthest and fastest – particularly over the past month

Al, Ni & Zn are lower now than at the start of 2006

Cu, Pb & Sn are around the same level as Jan 2006 0

100

200

300

400

500

600

700

800

900

(Jan

200

3 =

100)

Al CuNi PbSn Zn

20-Oct-08

Source: LME

Non-Ferrous MetalsNon-Ferrous Metals

6

Chicago (CBOT) corn prices jumped sharply in 2006 to peak in June 2008 at $7/bl. They have now fallen to $4/bl.

South African (SAFEX) white maize prices also rose but this reflected local factors. Although they have now fallen sharply in dollar terms, this is almost all due to the downward fall of the Rand

CBOT first position and SAFEX spot prices (converted into dollars), deflated by US PPI. Sources: CBOT, SAFEX and IMF

0

50

100

150

200

250

300

350

400

$/to

n (2

006

valu

es)

JohannesburgChicago

MaizeMaize

7

Rice is the principal food of many poor people. An increase in the rice price has a negative impact on poverty levels worldwide

Bangkok rice export price.

Source: World Bank

320

330

340

350

360

370

380

$/to

n

India prohibits rice exports

RiceRice

8

Cotton prices have been very stable since 2005, albeit at a low level

They have dropped sharply over the past month to 60c/lb, lower in real terms than in 2004

This price fall will have caused serious problems for any unhedged ginner

0

10

20

30

40

50

60

70

80

(c/lb

, 200

0 pr

ices

)

0

200

400

600

800

1000

1200

1400

1600

(F.C

FA/k

g, 2

000

pric

es)

c/lbF.CFA/kg

Cotlook A Index deflated by US PPI, and converted into F.CFA/kg and deflated by Burkina Faso CPI. Source: ICAC and IMF.

CottonCotton

9

The food price crisis led many countries to revert to the food policies of the 1970s

Export bansCostly strategic grain reserves Reversal of diversification policiesPrice stabilization/subsidy programs

These policies carry risksCan be destructive to market / tradeTotal financing needed for these interventions are unknown / unpredictable

Policy ResponsesPolicy Responses

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Dealing with RiskDealing with Risk

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Governments need to.. Plan for & budget responsesRaise financing for responses & ensure rapid implementation Ensure that they are protected against future shocks

Donors & International community should..Maximize value & impact of assistanceEnsure resources are not diverted from longer term programs

Both have led to renewed interest in ex ante solutions Since ex post reactions are costly, inefficient, and difficult to finance & implement when countries are already in crisis

Increased Interest inIncreased Interest inRisk ManagementRisk Management

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No Shareholders – only VotersNot necessarily driven by returns on Capital or EquityRisk appetite virtually zeroUnfortunately, short term Horizons

Affected by PoliticsNot necessarily Commercial decisions, therefore the solution is not necessarily a commercially driven oneCannot ignore the ‘Power of One’ – the VETOAll solutions have to pass the ‘Monday Morning Quarterback’ test

Significant Factors for a NationSignificant Factors for a Nation

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Why Would a Nation Hedge ?Why Would a Nation Hedge ?

Reduce Volatility of the Budget in favor of stabilityStrengthen the probability of meeting the Budget

‘Targeted’ Hedging of Key Elements in BudgetEducationHealthInfrastructureInflation

Imports where there is inelastic demand and no substitution To address security of supply & security of energy and food

Investment of Government FundsCommodity Indices, Bonds, Notes where inversely Correlated to Budget

Event’ Hedging

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Hedging ProductsHedging Products

A commercial contract which limits the impact of adverse price movements which might take place between buying (or incurring production costs) and sellingWhy?

Traditional (unhedged) price stabilization programs can’t survive without high levels of subsidy / bailoutMarket intermediaries (co-ops, exporters) can’t survive repeated years of trading lossesBanks

A) Can’t survive repeated years of default when borrowers mismanage price exposures and have financial losses as a result

B) Will have to charge high interest rates to maintain lending in high risk agricultural sectors -the high cost of finance erodes margins for all

Oil Price Volatility HedgingOil Price Volatility HedgingIntroductionIntroduction

Why Hedge?

Oil prices are volatile and hard to predict

Exposure to oil price may harm fiscal policyUncertain fiscal revenues linked to oil exports may lead to shelving of planned projects or wasteful use of ‘windfall’ revenues

Hedging stabilizes cash flows Allows to lock in prices in advance or specify their rangeSubstantially reduces volatility of revenuesReduces the risk of sudden financial loss due to adverse market movements

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-10

-5

0

5

10

15

Market Oil Price (USD/BBL)

Prof

it/Lo

ssNo HedgeNo Hedge

Current Price Current Price USD/BBLUSD/BBL

Selling on a spot basis exposes producer to rising and falling commodity prices

Oil Price Volatility HedgingOil Price Volatility HedgingIntroductionIntroduction

There are two ways to pursue stabilization

Self Insurance: Oil revenues in excess of a predefined average level are saved. Savings are used to complement oil revenues when they fall below average.

Oil revenues can be fixed or floored for future dates using market instruments.

The second method is usually more efficient

Hedging with markets

Oil Price Volatility HedgingOil Price Volatility HedgingHedging with MarketsHedging with Markets

There are generic instruments

No cost. Lock in future price. Do not permit upside gains

Futures/ForwardsSwaps

Put options Upfront cost (to buy puts). Place a floor on future price. Permit upside gains.

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Derivatives are used for eitherHedging, orSpeculation

Growth in Derivatives Use

Hedging

Speculation

Hedgers use derivatives to manage risk and protect themselves against the possibility that the market might go “against them”

Speculators use derivatives to produce a returnThey “take a view”, i.e. bet on where the market is going and try to make a profit

Scope of the Presentation • For our purposes, the use of derivatives is a risk management tool

Derivatives IntroductionDerivatives Introduction

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End users: “SHORT” energy – concerned about rising pricesEg. Airline, Industrial, Shipper, Road Transport, Railway: all active hedgers

Producers: “LONG” energy – concerned about falling prices Eg. Energy Majors and Independents, State Oil Companies

Refiners and Power-Generators: MARGIN exposed – concerned about relative prices

Oil Refiner: Crude oil versus oil products (called “cracks”)Power-generator: Coal / Oil / Gas versus Electricity (“Dark / Spark spreads”)

Traders and Distributors: TIMING and / or BASIS RISK Mismatch between purchase price and sale price windowMismatch between purchase price INDEX sale price INDEX Eg. buy LNG on Brent Index, Selling on UK Gas NBP

Who Hedges and Why?Who Hedges and Why?

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An over-the-counter (OTC) contract determining the price of the underlying to be paid or received on an obligation beginning at a future start dateEssentially forwards contracts lock-in the price of the underlying

Forward Contract

OTC Contract

Forward contracts are not standardizedMaturity dates agreed by the partiesNominal amount can be adjustedNominal amounts in any currencyDay count convention applicable in the reference rate and currency chosen

Forward Contract vs

Futures

Instrument is similar to that of a futureThe payment under the contract is equivalent to a margin payment but…

…Payment at maturity only: Higher credit risk

Forward ContractForward Contract

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Futures: obligation to buy or sell an underlying instrument at a certain price and dateA futures is a method to lock in a price

Physical delivery of the underlying assetCash settlement: difference between the spot and the futures price

Exchange traded and standardized contract: specified quantity and quality of the instrument, price per unit, date and method of delivery (if any)

Futures

The role of clearing houses

Futures counterparties interact with the exchange’s clearinghouse (CH). Clients do not know whom they have traded withA futures trade is really two trades

The agreement will be honored by the CHTo protect itself the CH demands that

An initial collateral amount is deposited to cover future losses A futures account is marked to market daily. Daily margin increase to cover unrealized losses from daily market movements

No party will incur a big loss at maturity

Clearing houseParty A Party B

Credit Risk Mitigation

FuturesFutures

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A contract between two counterparties to exchange streams of cash flows

What is a Swap?

Characteristics of Swaps

Defined period of time and can be customizedContracts are traded over-the-counter (OTC)Cash flows are calculated over a notional principal amount

Interest Rate Swaps

Exchange payments linked to the price of a commodityUsed to reduce volatility in income/expenditures due to fluctuations

Currency Swaps

Commodity

Swaps

Exchange of fixed payments against floating interest paymentsMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter interest rate exposure and align asset and liabilities

Exchange payments in one currency for anotherMaturities vary by market; in major currencies, 3 months to 30 yearsUsed to alter the currency exposure of an asset or liability

SwapsSwaps

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Futures ForwardsExchange Exchange traded Over the counterCounterparty Clearinghouse Counterparty in the forward

agreementTransaction Timing

Marked-to-market every day Transact when purchased and on the settlement date

Customization Standardized: Amount, currency, dates are fixed

Non-standardized: Amount, currency, maturity dates can be adjusted

Credit Risk Minimal: essentially eliminated through margining process

Counterparty credit risk

Regulation Highly regulated Private, unregulated transactions

Liquidity Highly liquid IlliquidBid-Ask Spread Low High

Both futures and forwards represent agreements to buy or sell some underlying asset in the future

Both allow for physical or cash settlement depending on the underlying instruments (interest rates, commodities, etc)

Both entail market risk and can be used for hedging purposes

Similarities

Differences

Forward and Futures: A SummaryForward and Futures: A Summary

Endogenous Term-Structure of Futures Endogenous Term-Structure of Futures PricesPrices

For low oil prices the market is in contango, i.e. the term structure is upward-sloping.

For medium oil prices the term structure of futures prices can be slightly humped

For high oil prices the market is in backwardation.Backwardation occurs when the oil price expected for the expiration date declines with the maturity of the futures contracts.

Oil futures prices exhibit “mean-reversion,” i.e., prices in contracts for delivery many months in the future converge to the long-term expected price.

Hedging with Futures or Forward ContractsHedging with Futures or Forward Contracts

Firm commitment that provide for the futures sale/delivery of crude oil at a specified price

Gains or losses realized daily (Futures)

P/L from the agreed upon price vs. the actual market price on the delivery date is usually settled on the delivery date

Profit to seller

= initial futures price - ultimate market price

Profit to buyer

= ultimate market price - initial futures price

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-$30.00

-$20.00

-$10.00

$0.00

$10.00

$20.00

$30.00

$90 $95 $100 $105 $110 $115 $120 $125 $130 $135 $140

Price / Barrel

Prof

it / L

oss

Long Inventory

Short Futures

Final Payout

A country with a long position in commodities (i.e. an oil producer) loses out if the price of the commodity drops and gains if the commodity price rises.

To hedge that position, it can sell exchange-traded futures to lock in the price.Therefore, no matter if the price moves up or down, the producer is not exposed to the

volatility because the gain/loss on the futures contract will offset the gain/loss on the commodity.

Oil Futures

Using Futures for HedgingUsing Futures for Hedging

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$90

$95

$100

$105

$110

$115

$120

$125

$130

$135

$140

1 2 3 4 5 6 7 8 9 10 11 12

Month

$/B

arre

l

Market Price

Floor - Realized Price

Alternatively, if the producer wants to participate in the upside gains, it may choose to enter into a series of put options to create a price floor, which means that the producer is guaranteed a minimum price for its commodities.

However, an upfront premium must be paid to purchase this series of put options

Price Floors

Hedging through OTC Options - Price Floor Hedging through OTC Options - Price Floor (Insurance)(Insurance)

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Illustrative example

Indicative Levels - Jet Cargos CIF NWE

Aug 2008- Jul 2009Strike PremiumUSD 1500 / mt USD 85 /mt

Time

Price USD/mt The client receives the difference

between the floating and fixed price

No exchange

StrikeMarket Price

Potential gainsPotential costs

1500

Swap

ObjectiveTo cap forward price.

DescriptionIt is the right, but not the obligation, to buy specific volumes of diesel at a specified price (the strike price) during a specified period of time.In purchasing a call option, the party is effectively buying insurance against higher products prices.The buyer pays an upfront premium for protection from prices above the specified cap strike price.The average monthly settlement price is compared to the strike

• If settlement price is lower than the strike price, the client does not receive anything

• If settlement price is higher than the strike, the client receives the difference between the strike and the settlement price

Advantages Locks in a cap over a time period and is protected from any price appreciation above the strikePrice rises in the physical market are compensated by hedging gainsBenefit from potential upside, should diesel prices drop.

DisadvantagesThe buyer has to pay an upfront premium to buy a call option.

Key considerations

Consumer: Buying a Call Option – CapConsumer: Buying a Call Option – Cap

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Hedging Instruments Description Benefits Potential Costs

Fixed for Floating

Swap

Enables the party to eliminate their price exposure, protecting themselves from a fall in oil prices.

To do this the party sells a swap to bank and receive a fixed rate in return for paying the floating market rate.

No upfront premium

By receiving a fixed market price there is greater control over their revenue base.

Forgone benefit from rising oil prices

Floor

In purchasing a put option, The buyer is effectively buying insurance against lower prices.

The party pays an upfront premium for protection from prices below the specified floor strike price

Able to retain 100% of the upside if market prices rise (minus the premium paid for floor).

Must pay an upfront premium for upside protection.

Zero Cost Collar

Collars involve buying a put and offsetting the premium by selling a call option struck above the market.

The party receives the same protection as a put option provides, however, the group has sold away some of its upside in order to finance the purchase of the put.

No upfront premium is paid.

Floored on the downside, but is allowed to ride the market up to the call strike that it sells.

Party loses the benefit of rising prices above the cap option strike price.

The below table illustrates the tools available to hedge against a fall in commodity prices

Hedging Instruments - SummaryHedging Instruments - Summary

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Airline

Bank

Supplier

Airline pays supplier floating price for jet fuel

Airline receives jet fuel from supplier

Airline pays a fixed price to Bank

Airline receives the floating price from

Bank

Hedging Tools Description Benefits Potential Costs

Fixed for Floating

Swap

Enables the airline to eliminate their price exposure, protecting themselves from a rise in fuel prices.

To do this the airline would enter a swap and receive the floating market rate in return for paying a fixed price.

No upfront premium

By receiving the floating market price the client now has greater control over their cost base

Forgone benefit from falling prices

An airline is exposed increase in jet fuel prices and can choose a variety of tool to hedge depending on their risk philosophy. The most vanilla product that an airline could utilise is a swap. Here the airline would enter a swap and pay a fixed price in return for the floating price.

Case Study – Outright Exposure - AirlineCase Study – Outright Exposure - Airline

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An airline can also hedge their exposure using options.The below table outlines the different hedging options available:

Hedging Tools Description Benefits Potential Costs

Cap

In purchasing a call option, The airline is effectively buying insurance against higher prices.

The airline pays an upfront premium for protection from prices above the specified cap strike price.

The client is able to retain 100% of the downside if market prices decline (minus premium paid for cap)

The client must pay an upfront premium for upside protection.

Zero Cost Collar

Collars involve buying a call and offsetting the premium by selling a put option struck below the market.

The airline receives the same protection as a cap option provides, however, the group has sold away some of its downside in order to finance the purchase of the call.

No upfront premium is paid.

The client is capped on The upside, but is allowed to ride the market down to the put strike that it sells.

The client loses the benefit of falling prices below the floor option strike price.

Three waySimilar ides to a Zero Cost Coupon, yet the Airline would sell an additional call with a strike above the existing collar to fund a lower collar

No upfront premium is paid

Market levels are capped at a lower level than a Zero Cost Coupon

The client is exposed to prices above the upper call level and loses the benefit of price below the floor

Case Study – Outright Exposure - AirlineCase Study – Outright Exposure - Airline

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$90

$95

$100

$105

$110

$115

$120

$125

$130

$135

$140

1 2 3 4 5 6 7 8 9 10 11 12

Month

$/B

arre

l

Market Price

Sw ap - Realized Price

Swaps are basically a series of futures or forward contracts. Swaps can be used when a commodity producer wants to hedge at a several points in time.

In this case, the producer enters into a fixed price swap, which guarantees a set selling price no matter how much the commodity price moves in the future.

Fixed Price Swaps

Hedging through OTC Swaps Hedging through OTC Swaps (Fixed Price Swap)(Fixed Price Swap)

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Producer

Bank

Off taker

Producer receives floating price from off taker supplier

Producer delivers oil to off taker

Producer receives a fixed price

throughout the period

Producer pays the floating

price throughout period

Hedging through OTC Swaps Hedging through OTC Swaps (Fixed Price Swap)(Fixed Price Swap)

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Illustrative example

Indicative Levels – Jet Cargos CIF NWE

Aug 2008- Jul 2009Fixed Level USD 1325.00 / mt12

Time

Price USD/mt The client receives the difference

between the floating and fixed price

The client pays the difference between the fixed and floating price

HedgedMarket Price

Potential gainsPotential costs

1325

ObjectiveTo lock in forward price.

DescriptionThe buyer locks in the price for a fixed volume of diesel over a predetermined period by buying a fixed price swapThe average monthly settlement price is compared to the swap price

• If settlement price is lower than the swap price, the buyer pays the difference between the settlement price and the swap price

• If settlement price is higher than the swap price, the buyer receives the difference between the swap price and the settlement price

Advantages Locks in a fixed price over a time period and is protected from any price appreciation above the swap pricePrice rises in the physical market are compensated by hedging gainsNo upfront premium required

DisadvantagesLoose all the potential gain from downside price moves below the swap pricePrice decreases in the physical market are offset by hedging losses

Key considerations

Consumer: Buying a Fixed Price SwapConsumer: Buying a Fixed Price Swap

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-$30

-$20

-$10

$0

$10

$20

$30

$90 $95 $100 $105 $110 $115 $120 $125 $130 $135 $140

Price / Barrel

Prof

it / L

oss

Long Inventory

Long Put

Final Payout

Alternatively, the commodity producer may want to participate on the upside movement of the commodity price, which is not possible if futures contracts are used.

Buying put options allows the producer to gain when the price of the commodity drops, which offsets the loss in the commodity position. On the other hand, when the price of the commodity rises, the producer will gain from the commodity position, and at the same time do not face a marked-to-market loss in the hedging instrument as in the case of the future.

The cost is the price of the option, which can be very high in volatile markets

Oil Put Options

Using Put Options for HedgingUsing Put Options for Hedging

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$90

$95

$100

$105

$110

$115

$120

$125

$130

$135

$140

1 2 3 4 5 6 7 8 9 10 11 12

Month

$/B

arre

l

Market Price

Collar - Realized Price

Since buying options can be expensive, the producer may choose to forgo some upside by selling call options at a higher strike price and at the same time, lower its price protection by buying a put option at a lower striker price, which is basically a collar strategy.

Collars can be structured so that it costs the producer nothing, but a trade-off must be made with a lower floor when compare with a normal floor strategy.

Price Bands

Hedging through OTC Options - Zero Cost Hedging through OTC Options - Zero Cost Collars (Price Bands) Collars (Price Bands)

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ObjectiveTo hedge at zero cost whilst benefiting from the part of the downside

DescriptionThe party buys a call option and finances it by selling a put for the same time period and quantities at zero upfront cost.There are multiple possible combinations of call and put strikes so that the collar is zero-costA non-zero-cost collar can also obviously be envisaged (i.e. the client paying a reduced premium compared to the standalone call)The monthly average settlement price is compared to the strike levels of the monthly put and call

• If the settlement price is lower than put strike, the client pays the difference between the average and the put strike

• If the settlement price is higher than call strike, the client receives the difference between the call strike and the average

• If the monthly average is between the two strikes, nothing happens.

Advantages Hedging method against upward price moves while maintaining some downside participationZero-cost structure

DisadvantagesIf the market price drops below the put strike , the client will be buying at the put strike. The client has upward price exposure comparing the current swap level vs. the put strike

Key considerations Illustrative example

Indicative Levels - Jet Cargos CIF NWE

Aug 2008- Jul 2009The client buy Call StrikeUSD 1500 / mtThe client sell Put Strike USD 1200 / mt

Time

Price USD/mt

The client receives the difference between the call strike and fixed price

The client pays the difference between the put strike and floating price

1200

1500

SwapNo exchange

Strike - CallMarket Price

Potential gainsPotential costs

Strike - Put

Consumer: Zero Cost CollarConsumer: Zero Cost Collar

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Understand all aspects of ones current exposures and the contemplated Hedge

Strong procedures with checks and balances

Remember……..……..This is NOT speculation!

Create a regulatory environment for Industry to hedge in order to……Encourage InvestmentReduce Volatility of Earnings

Encourage Consumers to take ownership of HedgingRegulatory & Tax EnvironmentReward ‘Right Way Exposure’

Do NOT remove totally the fundamental price movementThis is needed in order that supply and demand can balance out

Rules for Sovereign HedgingRules for Sovereign Hedging

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In light of the recent financial crisis, to what extent are governments still concerned about commodity price volatility?

The recent fall in food/energy prices has created some relief for governments who are importing these commodity classes. Are they able to take advantage of the price decreases and lock in supplies/prices at these lower levels? If not, why not?

Should governments be involved in commodity risk management? If so, how?If not, why not?

Are there other examples of countries using macro level commodity risk management strategies?

What should the World Bank Group be doing to support governments in this area?

Questions to ConsiderQuestions to Consider

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©2008 The International Bank for Reconstruction and Development / The World Bank1818 H Street NW Washington DC 20433Telephone: 202-473-1000Internet: www.worldbank.org E-mail: feedback@worldbank.orgAll rights reservedThe findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. Rights and PermissionsThe material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 978-750-4470; Internet: www.copyright.com. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org.

Disclaimer

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