Konstantin Babourine seminar presentation on Oil trading, Hedging and Price Risk Management.

1. Trading Fundamentals and Trading Terminology

2. Oil Markets Drivers
• As any physical commodity oil prices are determined by availability of raw
material, processing capacity and ability to deliver the final goods to the market
• Consumer demand sets the trend for oil prices balanced by the supply at hands
• Major misalignment of supply and demand causes significant price moves in the
market

3. Oil Markets Drivers
Seasonality
“Technicals” Economic Growth
Military Unrest PRICE Speculators
Infrastructure
Weather
New Projects
Politics

4. Oil Markets Drivers
Processing
• Crude oil markets operate between the producer and the refiner
• Benchmarks are set for various crudes but the ultimate price is determined by what
value each specific refinery sees in each type of crude
• It is important to not only have high quality crude available but also have access to the
market that values it the most
• Product markets operate between the refiner and the blender or wholesaler
• Very localized markets and depend on:
• Local demand for each product (i.e. some country are more gasoline oriented than
diesel)
• Configuration of local refineries
• Regional product quality requirements
• One needs to be careful about refinery utilization as it varies by region (some regions
may produce poor product specs and run at lower rate despite high demand for product
in general)

5. Oil Markets Drivers
Storage
• Stock control is crucial in any demand driven market to avoid disruption of the
product flow
• In a normal course of business oil companies try to keep stocks to a minimum and
avoid costly storage rental fees
• Generally storage is used as an insurance instrument to protect from unforeseen
supply disruptions but is also often used for speculative purposes if term structure
permits

6. Oil Markets Drivers
Transportation
• Waterborne crude and products shipping
• Crude oil is normally sold close to point of production and can be traded as
transferred into the ship or/and already on the water
• Refined products are traded closer to the market on various terms based on
delivery arrangements and parcel sizes
• Pipeline trading is mostly traded on a ratable basis and is sold free-in-pipeline at
designated locations
• Rail

7. Reasons for Open Arbitrage
30
% 25
% 22
17 %
%
31
%
30
%
7%
10
%
12
9% %
5%
3%
% of World Consumption
% of World Production

8. Oil Supply Drivers
• OPEC
• Significantly increased influence from non-OPEC producing countries
• New infrastructure project development
• Political tensions in oil rich regions
• Stocks
• Forward Cover = Available stock / Consumption over the period
• Strategic reserves (about 10%)
• Minimum operating stocks of the companies (about 30% are in pipelines,
tankers, tank bottoms and in refineries)
• The rest is oil in transit

9. Cost of Production by Region
Source: CERA

10. Oil Demand Drivers
• The state of global economy especially in the industrialized countries
• Seasonal consumption
• Driving season
• US Northeast heating season
• Hurricane season
• Construction season
• Political tensions
• Taxation (compare US vs. UK vs. low tax developing countries)

11. Introduction to Financial Markets and
Derivatives Trading

12. What makes a Market
• Materiality
• Lack of state interference
• Widespread ownership
• Tax regime
• Geographical locality
• Quality and consistency of quality
• Operating considerations

13. Energy Markets Participants
Day Traders
Investors Brokers
Consumers Energy Producers
Market
Market Makers Arbitrageurs
Refiners

14. The Market: Users
• Producers – long reserves, strategic hedging, ROI management
• Refiners – refining margin management
• Aviation – jet fuel budget management
• Commercial transport – operating cost coverage
• Shipping – bunker fuel and freight management
• Chemicals – feedstock price management
• Second tier (lending) banks

15. Key Market Players
Speculator:
– Frequent in & out of the market looking for potential gain opportunities
– View driven
– Take a bet on the future direction of a market
– Want price volatility to increase
– Will enter into deals and set limits on when to exit

16. Key Market Players
Hedger:
– In & out of the market only when there is a (strategic) business
– Reduce/eliminate the risk faced from potential future price movements
– Business objective driven
– Reduce/eliminate exposure to volatility of the business
– Want certainty at the cost of sacrificing away potential upside
– No surprise approach

17. Key Market Players
Arbitrageur
– Take offsetting positions in two or more instruments/markets to lock in profit
– Exploit inefficiency in different markets/locations
– Take advantage of mis-pricing of certain financial instruments
– “Riskless” profit (from a price perspective)

18. Basic Trading Terminology
• Position: Long/Short
• Spot Vs Forward Curve
• Bid / Offer Spread
• Liquidity
• Market Direction: Bullish/Bearish
• Exposure
• Market Structure
• Spreads and Cracks
• Arbitrage

19. Position: Long/Short
LONG
To net own a commodity in a market. A LONG position is taken in the expectation that
prices will RISE. Think of something you own e.g. Your house. You are LONG one house
and would prefer its value to increase
SHORT
To net owe a commodity in a market. You have an obligation to supply a commodity not
currently owned to someone else. A SHORT position is taken in the expectation that prices
will FALL
In the oil industry, you may agree to supply a service station with gasoline at a certain price
for an entire year. This makes you SHORT gasoline
QUESTION 1: If you buy a car, is your position long or short?

20. Spot Price vs. Forward Price
SPOT PRICE
The spot price is the price for immediate payment and delivery
FORWARD PRICE
The forward price is established by a contract in which you set the price now, but
delivery and payment occur at a future date
FORWARD CURVE
A graph of forward prices over different forward time periods

21. Forward Curve Explained
Typical Forward Curve Shapes (Indexed At Spot)
Contango vs. Backwardation
• Due to the physical
nature of oil and oil Price
Contango
products, the shapes of Backwardation
these forward curves
cannot be explained
alone by the time value
of money
• Forward curve shapes 100% Price of the swap
for a given month
are primarily driven by
in the future
supply and demand
expectations in the
market
Spot 3 6 9 12 15 18 21 24
Question 2: Which commodity forward curve is most likely to
be in contango ?

22. Bid-Offer Spread
BID PRICE
The price at which you can sell
OFFER PRICE
The price at which you can buy
BID-OFFER SPREAD
The difference between the selling price and the purchase price
QUESTION: Which price is normally higher? Always?

23. Liquidity
• The ease with which something can be bought or sold (converted to cash) in
the marketplace.
• A large number of buyers and sellers and a high volume of trading activity are
important components of liquidity.
• Depth, or the ability of the market to absorb either a large buy or a large sell
order without a significant price change in the underlying commodity, is also
crucial to the liquidity of the market

24. Market Direction: Bullish/Bearish
BULLISH
Having the belief that prices will rise. A ‘Bull’ is someone who thinks market prices
are going up
A ‘Bull Market’ is when the price is rising
BEARISH
Having the belief that prices will fall. A ‘Bear’ is someone who thinks market prices
are going down
A ‘Bear Market’ is when the price is falling

25. Exposure
PHYSICAL EXPOSURE
You have bought a cargo of Crude, pricing on the average of next weeks Platts quotes. You
are contracted to lift the cargo and hence have physical exposure, but the cargo will not
price until next week, so you do not yet have a priced exposure
PRICED EXPOSURE
You have bought a cargo of Crude at $90/bbl. You have both physical exposure and price
exposure (You are LONG 1 cargo). Similarly if you buy a cargo of crude oil which is pricing
around loading date and will then take 45 days to arrive at your disport, you are carrying a
priced exposure all the time the vessel is on the water (You are LONG 1 cargo). You may
wish to hedge under these circumstances to give protection against adverse price
movements

26. Types of trading
Trading activity in energy markets may be grouped under the following broad headings:
1. Asset, commercial or industrial optimization: trading activity intended to balance real
time needs in the operation of physical assets, commercial or industrial processes, buying
additional supply or selling excess production when demand and production levels require,
and making optimal choice of feedstocks to service the operations.
2. Hedging: trading activity intended to reduce the riskiness of a portfolio.
3. Arbitrage: trading activity resulting in a riskless profit, usually arising from participants
exploiting inefficiencies in a market. The forces of supply and demand usually ensure
these price mismatches subsequently disappear as a result of the trade being executed.
4. Speculation: taking risky positions in a market with the intention of exploiting market price
movements.
5. Investment: investing cash through positions in energy markets, with the intention of
earning returns on these positions.

27. Trading Strategies
• Flat Price trading
• Making a call on the commodity price in the future
• Product Spread Trading
• Making a call on relative price behavior between two markets
• Geographical Spread Trading and/or Arbitrage
• Crack Spread Trading
• Calendar Spread Trading
• Volatility Trading
• Making a call on how volatile the market will be in the future