stability in energy markets 1st International Meeting on Enterprise Risk Management November 4, 2002 Presenters: Konstantin Babourine Georges Tijbosch
Agenda 1. BP Risk Management Team who we are 2. Oil Markets Overview 3. Introduction to Energy Risk Management 4. Risk Management Program Design 5. Bpriskmanager.com
BP Risk Management Chicago London Singapore BP has global 24hrs trading Coverage, employing about 150 energy traders Provision of Risk Management solutions for external and internal client
Market Overview
Oil Markets Current Status 1. Main drivers: Demand, OPEC and non OPEC Supply 2. Gulf War I and II 3. Recent events 4. Movements in Product Prices 5. Forward Prices 6. Longer Term View
Market Drivers! Major trends: " Severity of global economic downturn " OPEC restraint Saudi, Kuwait, Iran " Non-OPEC production Russian barrels " Bush agenda re Iraq! Onset of winter in US & Europe! Changing markets: " Trending market - speculative Fund activity " Inventory levels cashflow / volatility " Companies hedge programmes catching up
Global Oil Demand 80.00 78.00 76.00 74.00 72.00 70.00 Demand World (mb/d pa) RHS Demand World (mb/d) LHS 3.00 2.50 2.00 1.50 1.00 0.50 0.00-0.50 68.00 97 98 99 00 01 02 03-1.00 Weak demand in 2002 but pick-up in 2003
Non-OPEC Supply 50.00 49.00 48.00 47.00 46.00 45.00 44.00 43.00 42.00 Supply Non-OPEC Total (mb/d pa) RHS Supply Non-OPEC Total (mb/d) LHS 2.50 2.00 1.50 1.00 0.50 0.00-0.50 41.00-1.00 97 98 99 00 01 02 03 Burst of non-opec supply in 2002 and further
OPEC Oil Supply (incl. Iraq) 30.00 29.00 28.00 27.00 26.00 25.00 24.00 23.00 22.00 Supply OPEC Crude (mb/d pa) RHS Supply OPEC Crude (mb/d) LHS 4.00 3.00 2.00 1.00 0.00-1.00-2.00-3.00 21.00-4.00 97 98 99 00 01 02 03 Increased output in 2000 but OPEC has cut since then
OPEC Quota 28000 OPEC Production (kb/d) 27000 26000 25000 24000 23000 22000 21000 Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 OPEC-10 Production OPEC-10 Quota Non-compliance (HRS) Since Jan-01, tighter quotas have led to increased non-compliance 3000 2500 2000 1500 1000 500 0
Conclusion Call on OPEC 35.00 Call on OPEC Crude + Stock ch. (mb/d pa) RHS Call on OPEC Crude + Stock ch. (mb/d) LHS 4.00 30.00 3.00 25.00 2.00 20.00 1.00 15.00 0.00 10.00-1.00 5.00-2.00 0.00 97 98 99 00 01 02 03-3.00 Call is unchanged for 2003 Any increased OPEC output would weaken prices
Gulf War what happened 70 $/bbl 60 50 40 30 20 10 Brent IPE 1M Jet/Kerosene Gasoil 0 May-90 Jul-90 Sep-90 Nov-90 Jan-91 Mar-91 May-91! Flat Prices " Significant flat price gains, most markedly for jet. " Price peak sometime before air war begins " Price falls at start of air war and by ceasefire is back to normal.! Cracks " Product cracks remained within historical patterns )other than for jet. " Fuel oil lagged crude move, pressurising straight run margins. " Start of air war pushed jet crack back to late-1990 levels
Gulf War II what s different (1/2) Issue Gulf War I Gulf War II Effects Production Spare Capacity Immediate impact on production and capacity once Iraqi invasion took place Immediate loss of output recently averaging 4.15mb/d (from Kuwait and Iraq) Spare capacity largely eliminated following Saudis matching the 4.5mb/d removal of Iraqi and Kuwati capacity. GDP Prior to invasion, global GDP of 2.5% No loss of capacity in the build-up to US intervention Loss of current Iraqi output of 2.0mb/d Currently substantial spare capacity (5.5mb/d). As before most (60%) is in Saudi. Currently global economy is growning more slowly at 1% GDP. Jet fuel demand has been impacted by 9/11. Oil Balance Inventories Demand for Inventory Balances tightened and stocks drew substantially in 2H90, but less than expected due to higher oil prices and weak demand (4Q90-1.5m/b yoy) OECD stocks at 4Q90 at 64.0 days, larger than a year earlier. (Were high and declining) Increased demand for inventory even though inventory was high caused soaring prices. Balances are tightening and stock declining but industry sees adequate re-supply. 4Q02 OECD stocks at 52-53 days (Stocks are balanced but declining). Demand to build as expectation of war builds. But prices to be moderated by experience of SPR/IEA actions in 1991. But relatively low inventories provides major upside to prices if war escalates. Greater market uncertainty in in 1990/91
Gulf War II what s different (2/2) Issue Gulf War I Gulf War II Prices Immediate skyrocketing from supply and capacity loss. Prices collapse once war risks go demand weakens and SPR/IEA actions. Price rises to be moderated by spare capacity, knoweledge of SPR/IEA. Also prices will dampen weak global economy, setting scene for price collapse. Knowledge Initially huge uncertainty of outcome Experience from 1991 re Forces/ IEA/ SPR/ demand effects. War Precise in timescale and area of action Imprecise in timescale and area of action. Destruction Destruction of Kuwati capacity by Iraq of Capacity Destruction of Iraqi capacity not a US war aim. USA More reliant on Arabian Gulf Oil in US oil import mix Less reliant on Arabian Gulf Oil in US import mix Middle East Oil Western markets remained particularly important. Proportionately far more moving East. Destruction of of capacity assumed not to to be be war aim
Recent Prices Spot Crude Prices ($/bbl) 32 31 Brent Dated WTI Cushing 1mth (Adj) Dubai 1mth (Adj) 30 29 28 27 26 25 24 23 7/29 8/12 8/26 9/9 9/23 10/7 10/21 10 3-2-1 Crack Spread ($/bbl) 9 8 7 6 5 4 3 2 7/29 8/12 8/26 9/9 9/23 10/7 10/21 Rotterdam Mediterranean NY Harbour Singapore Better margins as crude falls more than product prices
Market Outlook Products (1) 80000 OECD Total Gasoil Inventories (k.tonnes) 75000 70000 65000 60000 55000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1996-2000 2000 2001 2002 1850 1800 OECD Gasoil Demand (kt/d) 1750 1700 1650 1600 1550 1500 1450 1400 1350 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1996-2000 2000 2001 2002! In absence of late summer gasoline spike, refiners now looking to winter distillate demand for margin relief. Atlantic Basin distillate stocks now slightly below the previous 5-year average.! Stronger demand, but adequate stocks, except in the USA! Relative strength in nat gas prices and forecast of colder than normal winter is supportive for heating oil.! Refining capacity still recovering from recent tropical storms in the Gulf of Mexico.
Market Outlook Products (2) 650 OECD Jet/Kerosene Demand (kt/d) 600 550 500 450 400 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1996-2000 2000 2001 2002 20000 19000 OECD Total Jet/Kerosne Inventories (k.tonnes) 18000 17000 16000 15000 14000 13000 12000 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1996-2000 2000 2001 2002! Recovery in jet fuel demand taking longer than expected and may be permanently impacted by potential structural shift from flying to driving particularly for short business trips.! Transition to lower sulfur fuels in Europe has potential to divert low sulfur products from the US, thus creating possibility of some supply tightness.! Gasoline remains well supplied in both the US and Europe.! Relatively heavy turnaround schedule on the Gulf Coast into the first half of 2003 will be supportive to product prices.
Forward Prices 30.00 IPE Brent Forw ard Price Curve ($/bbl) 29.00 28.00 27.00 26.00 25.00 24.00 23.00 22.00 8-Oct-02 15-Oct-02 22-Oct-02 29-Oct-02 M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 Front Months weakening by more than Outer Months, backwardation remains but is more shallow.
The longer-term outlook 100 90 80 70 60 50 40 30 20 10 0 mb/d 98 99 00 01 02 03 04 05 06 07 08 09 10 Demand OPEC Supply Non-OPEC Supply mb/d 2000 2010 mb/d % Demand 76.0 89.9 13.9 18.2% OPEC Supply 30.9 36.3 5.5 17.7% Non-OPEC Supply 46.0 53.5 7.6 16.4% OPEC Supply (% of Total) 40.6% 40.4% 39.5% Adjusted DOE forecast indicates OPEC share not recovering to 2000 levels.
Introduction to Energy Risk Management
Risk Management Overview! Historically low involvement in risk management "Misinterpretation of risk management goals "Lack of liquidity in some regional markets "Narrow spectrum of risk management products available "Derivatives debacles! The level of sophistication in the market has grown exponentially! Strong competitive pressure to better manage costs! Physical suppliers created greater forward price transparency in some regional markets! Specialized risk management teams offer customized tailor-made programs unique to customer s exposure
Energy Price Risk! Margin Risk Mismatch in revenue and cost sides of the business! Budget Risk Risk of exceeding a preset budgetary targets! Cash Flow Risk Fuel price volatility generates uncertainty in future cash flow! Performance Risk Unexpected market events (caused by military tensions, etc.) can create cost prohibitive environment for business! It all depends on how a customer measures Performance
Risk Management Process Map! Identify Exposure! Risk Profile! Forecasting and Market View! Authority Levels! Buy-in by management and investors! Design the program! Disciplined execution! Close Monitoring! Settlement
Know your exposure! Energy producers "face fixed costs and high investment levels "look for certainty of revenues! Energy users "airlines, shipping companies, factories etc "fuel can be a large percentage of total costs "look to protect margins, budgets! Oil refiners "exposed to crude price and to product selling prices "look to protect refining margins! Speculators "use derivatives as a speculative trading tool
Risk Management Myths and Reality! Term Structure "Myth: Forward prices decline should I hedge? "Reality: Term structure is NOT prediction, i.e. backwardation does not mean bearish and contango does not mean bullish! Hedge + Physical = 0 "Myth: My hedge made $5M dollars last year "Reality 1: Paper P/L offsets physical "Reality 2: Basis risk
Basis Risk Liquidity Market Efficiency NYMEX Crude Nymex Products Platts Oilgram Basis Risk Paper Physical (Wet) Fixed Price Physical NO Basis Risk BP can help you study your basis risk
Risk Management Options! Do nothing! Hedge by yourself through NYMEX "Operationally expensive "Hedge monitoring "Initial margin and margin calls "Risk of accidental obligation to deliver or take delivery! Using professional over-the-counter (OTC) RM providers "Basis risk management "Efficient execution "Strong market/industry presence " Wet Barrel risk management Physical players are able to offer wet barrel risk management Price managed product is physically delivered
Risk Management Program Design
Hedging Strategy! Tactical Hedging " Couple of months-1yr " Flat price " Changing strategies depending on markets " Variable results! Strategic Hedging " Importance of cash flow and profit stability " Long term ( 1-4 yrs ) " Use of Cracks/Diffs " Long term markets " Targets/strategy depend on financials " Sometimes trade in/out
Case 1: Refining Margin Hedging! A refiner is looking to protect its margin for Q4 03! Currently, Q4 03 3-2-1 USGC Crack (2/3 USGC Unleaded Platts Mean plus 1/3 USGC HO#2 Platts Mean minus Nymex WTI front line) is $4.00! Market news: " Late and mild winter " High heating oil stock levels " Refinery utilization forecasts are high " Currently, and generally, heat crack forward curve is in contango! To create certainty around its future cash flow refiner decides to fix its future margin by selling swap on a crack
Swaps! Contractual agreement between two parties who agree to make regular payments to each other.! Fixes the price of future oil at a level agreed today.! No initial outlay.! Need to agree: " which fuel and floating price index " volume " time period " fixed price
Refiner Margin Swap or Crack! Short physical crude oil.! Long physical fuel products.! Difference between the two prices = refining margin.! OTC derivatives allow the refiner to swap or fix the margin.! Hedges position by selling margin swap " pays floating and receives fixed
the swap Refiner sells a crack swap Refiner BP USGC Crack Oct-Dec2003 100kb per month $4/bbl Average of Platts USGC Mean 5 days after pricing mth Platts USGC Mean 6 5 4 3 2 1 BP pays you You pay BP Nov02 Dec02
Refining Margin Hedge Crude Supplier Average Nymex WTI price (floating price) Refiner Average Platts USGC price for product (floating price) Customer $4 per barrel (fixed price) Difference between: Platts USGC and WTI Swap Counterparty
Case 2: Production Hedging! A producer is looking to protect its revenue for Q4 03! While majority of the costs is fixed all the revenue is subject to oil price volatility! Currently, forward price for Cal 03 Maya crude is $19/bbl.! Producer is not willing to fix the price as there is a good chance that the crude price will bounce back up, but needs to place some protection in case if the market keeps falling! To create its future margin protection producer decides to place a floor on its future sales price by purchasing a crude oil option
Options! Give the right but not the obligation to buy or sell oil! Upfront premium => Price insurance! Need to agree " fuel and index " volume " time period " strike price i.e. floor or ceiling " premium to be paid
Floors (or Puts)! Purchaser has the right but not the obligation to sell oil at a certain price during a certain period of time.! If the price of oil falls below the strike price then the floor seller pays the average difference to the buyer.! If the price remains above the strike price then the buyer does not exercise his option.! Remember that the buyer has paid a premium.
The floor (put option) Avg = 21 $/bbl Producer Does not exercise option Actual price = (21-1) = 20 $/bbl Option Premium = $1/bbl Floor Level = $19/bbl Avg = 16 $/bbl Producer receives 3 $/bbl back Actual cost = (16+3-1) = 18 $/bbl it is a min sales price
Collars! Don t want to pay premium? get a cap! Producer can buy a floor and sell a cap " smaller premium " or zero-cost! If average prices exceed the floor, the producer benefits, however there is an opportunity loss if prices exceed the cap
Case 3: Airline Hedging! An airline is looking to manage its costs for Q1 according to its budget requirements! Up to 30% airline s operating costs are fuel related; a portion of revenue is often fixed (airline tickets sold in advance)! An airline wants to determine its maximum jet price, whilst benefiting from some decrease in prices
Three-Way Option! Airline agrees to a maximum price (call option) and a minimum price (put option 1), similar to a collar. Furthermore, it agrees a 3 rd price level (put option 2), below which Airline will start to benefit from falling prices. The three-way is agreed at a premium or at zero cost! Protection against rising market! Some participation in a falling market! Significantly reduces credit exposure
Three-way option
and many more! Extendibles! Participation! Bullet swaps! Basket options! Knock-ins; Knock-outs! Pre-pay structures
About BP! Leading supplier of Physical & Paper Risk management! Specialist in tailor-made Risk Management solutions! World Class Trading Organization Physical & Paper! 24h trading Organization - Execution of your strategy! Service that meets all compliance rules and regulations! BP offers anything from straight paper swaps to complex structured products! Outsourcing middle and back office
www..com! You can track the markets on our website! Includes a risk management game! Explanation about swaps, options,! Enhancements based on customer feedback! Coming soon: Daily Refiner Update