ENERGY HEDGING IN ASIA

ENERGY HEDGING IN ASIA

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Energy Hedging in Asia: Market Structure and Trading Opportunities PETER C. FUSARO AND TOM JAMES

Peter C. Fusaro and Tom James 2005 Softcover reprint of the hardcover 1st edition 2005 978-1-4039-3468-0 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 unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2005 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 978-1-349-51728-2 DOI 10.1057/9780230510968 ISBN 978-0-230-51096-8 (ebook) 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 catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 14 13 12 11 10 09 08 07 06 05

Contents List of Tables and Figures Preface Foreword vii ix xi 1 Megatrends of the Asia Pacific Energy Trading 1 2 The ABCs of Energy Hedging 5 3 Energy Futures Exchanges and OTC Trading 41 4 Setting up Your Energy Derivatives Policy 55 5 Energy Hedging with Derivatives Applications 60 6 Options in Hedging Applications 74 7 LNG Hedging 89 8 Energy Risk Management in Japan 99 9 Energy Developments in Southeast and South Asia 111 10 Electronic Energy Trading in Asia 136 11 ISDA 2002, The ISDA Master Agreement Ten Years On 157 12 Derivative Hedge Accounting 195 13 GreenTrading TM : Managing Financial Risk for the Environment in Asia 207 v

vi CONTENTS 14 What s on the Horizon for Asian Energy Markets 217 Appendix 1 ISDA A SURVEY 2004 221 Appendix 2 ISDA 2002 Chinese Version 231 Glossary 275 Index 375

List of Tables and Figures TABLES 2.1 Monthly Singapore paper market volumes (bbls) 22 2.2 Annualized price volatility for Singapore market (Cargo Lots) 25 2.3 Actively traded energy derivatives 37 6.1 Summary of exposures options vs swaps/futures 77 6.2 To hedge short energy positions with options 79 6.3 To hedge long underlying position with options 81 6.4 Options trade against market implied volatility 88 FIGURES 2.1 Electricity price volatility 34 5.1 Fixed price swap hedge by an airline 61 5.2 50,000 barrels per month of jet kero 62 5.3 Collar hedge structure 63 5.4 Zero-cost collar 64 5.5 Cash flow for collar hedge structure 64 5.6 Electricity producer risk profile 65 5.7 Metal producer risk profile 66 5.8 Knock-out optionality 70 5.9 Refinery margin hedge 71 vii

viii LIST OF TABLES AND FIGURES 6.1 Value of caps/floors 78 6.2 Seller of caps/floors 78 6.3 Barrier options caps/floors, knock in/knock out 82 6.4 Butterfly strategy 85 6.5 Call backspread option strategy 87 6.6 Put/floor backspread option strategy 88 7.1 Natural gas price forecast and cost of LNG ($/mmbtu) 91 12.1 The IAS 39 framework 197

Preface Asia is the second largest oil importing region in the world, second only to the United States of America and since the world s two most populous nations are located in Asia (China and India) it may not take much time before Asia becomes the largest oil importing region in the world. Risk avoidance rather than risk management has been the operative word in Asian oil markets. That is about to change due to the twin engines of deregulation and privatization driving competition. The business-as-usual approach no longer works as a sharp increase in oil dependence adds more price uncertainty and undoubtedly more future price volatility. The annualized volatility of oil, which ranges from 40 50% per year, is almost the highest of any commodity. Timing is everything. Now is the time for using energy risk management tools. Deregulation and globalization of energy markets are bringing with it the need for active management of market risks. The markets are becoming more price-sensitive with the rapid dissemination of price and market information. The need to use these financial tools exists. In 2004, we could see that this continued rapid rise in demand from Asia, finally brought an imbalance to the supply/demand of the global oil market. Global demand had finally outpaced the speed at which new oil reserves could be found and exploited, resulting in the highest prices of crude oil seen in the world since the oil crisis of the 1970s. The very crisis that spawned the birth of oil futures markets around the world allowed oil consumers to hedge (insure) themselves against high prices from another price crisis. High prices of crude oil are good for oil producers, but Asia is a huge net importer of oil, the very life blood of economies and as a result unhedged countries can experience sharp drops in GDP growth and inflation, and ix

x PREFACE energy dependent industries can face big bills or even face financial difficulty if they can not pass costs on to their customers. Headlines like these became every day news in 2004, Price Rise To Fuel India Inflation, Fiscal Gap, Global Oil Price Surge May Cost China Dearly, Japan Keeps Its Cool Despite High Crude Prices, and High Oil Prices Damp S. Korea s Economic Recovery. By 2005, Japan, South Korea, China, India, Taiwan, Thailand, and Singapore will all be importing oil at over 1 million bbl/d each. While some Atlantic Basin crude oil from West Africa and the North Sea may supply some of the older, less flexible Asian refineries that have an appetite for those sweet crudes, the key issue is the growing Asia Pacific dependency on Middle Eastern sources of crude. This increased dependency on oil foretells an era of continued price volatility and the growing need for more risk management instruments to be developed and utilized in the Asian markets. China already turned into a net oil importer during 1993 and its needs continue to grow. And Indonesia, an OPEC member and current oil exporter, seems to be slipping to the position of an importer of oil recently. With about half of world oil growth projected to continue to be in the Asia Pacific region, rising product demand and tightening fuel quality standards driven by rising environmental awareness, the need for managing energy price risk seems poised for explosive growth over the next several years. However, it has taken an inordinately long time to get started in the region compared to the North American and European experiences, particularly because of the more protectionist Asian economies. As Asian energy markets continue to be liberalized and open up to free market economy mechanics, the burden of protecting economies and industry to high prices of energy and also volatile energy prices is increasingly falling upon the oil consuming industries. Whether it is due to their size, the globalization of their products, or the nature of the close relationship of the raw materials and finished products, the energy markets are unique among the traded commodity markets. It is almost unthinkable to conduct a major energy transaction today without also taking a position in a corresponding derivatives market, either exchange-traded or over-the-counter. This book offers a comprehensive guide to the principles and tools of energy risk management. In 1978, energy market traditionalists at first likened using the futures derivatives market to speculating. Considering the volatility of energy pricing and the array of financial instruments that can be used from almost any market point of view to mitigate that volatility, it must be asked of those who do not hedge and manage their risk whether they are not in fact the true speculators. This book demystifies today s world of Risk Management and effectively explains to the reader the tried and tested price mitigation tools and strategies available in the market, new developments, and what the future may hold in the Asian energy hedging market.

Foreword In the late 70 s when a large conference met to consider the need for a petroleum exchange in London the Buying Director of a major world food group was invited to address the audience on his experience of managing price risk in cocoa and coffee using the existing futures markets of New York and London. To the embarrassment of those who had invited him the major oil companies in the audience treated him with scant respect. Oil is the business of multi-nationals and governments not as implied the corner shop market place of cocoa and coffee. There must have been some wry smiles around the AAA food group s board table as they watched the demise of Enron and others who failed to hedge prudently. Today, the management of Price Risks in Energy is at the heart of the business of many producers and consumers in Europe and North America. Recent commercial success stories such as low-cost airlines would not have worked with their modest original capital base without cost efficient means of managing their major variable cost jet fuel. A review of financial problems of Power Generators would closely correlate with whether or not they hedged. Prudent bankers in today s competitive financial markets are lending at margins with no cushion for bad debts, so, any long term project financing or medium term trade financing requires the removal of as many risks as possible. Integration of hedging into financial structures makes good projects cheaper to finance and marginal projects possible. Whilst these hedging markets are fairly mature and well understood in Europe and North America, the Asian markets have still a long way to go in meeting the needs of their industry in smoothing financial performance and attracting the investment capital needed to fuel Asia s impressive levels of economic growth. xi

xii FOREWORD We live in the period of a second industrial revolution with the transfer of major portions of global manufacturing capacity into Asia. With this comes an inevitable surge in the demand for all forms of energy. Most Asian markets now operate at around world prices for energy and therefore with a high level of volatility. For the Asian economic growth story to continue there is a need for a fast track learning process in the prudent use of modern risk management techniques in energy whether the user is a producer or consumer. The Asian market is more diverse than Europe or North America. Distances are greater and there are fewer pipelines with a greater need for sea freight and longer delivery times. Each of these elements contributes to higher risk not only the price risk of the underlying commodities but also the associated financing costs and freight prices. In this book you will find fact, flavour, and formulae. Each are key elements in running a successful hedging strategy but they must be integrated into the management ethos of the firm. Therefore, this is a book not just to be read in the trading departments, but, also in the boardroom; in the finance department and by shareholders in the enterprise. Whilst the media make much of derivatives scandals and corporate collapses, there are thousands of success stories for every disaster. Failure to hedge is to run risks and sooner or later these risks will come to bite. To hedge is to prosper. Roy Leighton U.K. Chairman, CALYON Bank Chairman, Futures & Options Association, UK