Section 1: Explain and discuss the various oil and gas price drivers and make a clear recommendation of the trend you believe prices will follow and why.
Economic cycles of boom and recession have a major impact on oil and gas prices. Demand for oil is significantly affected by the two economic cycles. The Department of Energy and Climate Change (2012) observed that studies have shown that there is a very close link between global GDP growth and oil demand. This link has been identified in various business cycles that have been identified as having a significant impact on economic growth. Business cycles can affect oil and gas prices in both the upward and downward directions. A boom in the global economy often leads to rises in prices of oil and gas (Darby, 1982).
Economic growth experienced during such periods usually results in increases in the purchasing power of consumers. When this trend affects major world economies or the global economy, then the demand for oil and gas increases considerably. Normally, suppliers are not able to respond to such a significant surge in demand for oil and gas to offset the increase as soon as it appears. Consequently, the resultant market forces drive up the prices of the commodities in question, notably, oil and gas.
The recent trend in oil and gas prices in the period after the recession that wrecked the global economy in the later part of the past decade can be explained by the global economic growth experienced across the globe; this began in late 2009 as depicted in figure. A report issued by the Islamic Development Bank (2009) found that the recent rise in global oil prices can be attributed to the modest growth in the global economy since the later part of 2009. During the recession, prices of oil and gas dropped significantly as will be seen in the next paragraph, but they have picked up in the post-recession era thanks to an increase in demand.
Similarly, a recession can have an adverse effect on the global economy. Recessions depress global demand for oil and gas. As real incomes fall, consumers’ purchasing power is negatively affected and the demand for oil and gas drops (Brown & Yucel, 2008). The slow-down in economic activity as evidenced by the recent economic downtown serves as a perfect example for this case. Oil prices were adversely affected during this period. Prior to the recession, the Islamic Development Bank (2009) observed that initially, this price peaked $147 per barrel in the month of July 2008. The recession saw the price plummet to $42 per barrel in the global market. Figure 1 below indicates that the deterioration of global economic growth led to a negative growth in oil demand. Although the recession also constrained production, it is evident that the fall in demand was more significant, leading to a considerable fall in the price of oil.
Figure 1: Oil demand: incremental oil demand versus economic growth
The observations above imply that demand is a very important driver of oil and gas prices. The uncertainty surrounding the oil and gas business environment as regards demand is a major concern to investors as well as consumers of these commodities. This driver imposes a significant and sometimes adverse effect on the stability of oil and gas prices as witnessed in the most recent recession explored above (Panagiotidis & Rutledge, 2007). The importance of this driver is underscored by the fact that many authorities, governments and bodies operating within the industry such as OPEC invest considerable resources to predict possible future demand trends such as that depicted in figure 1 above and take necessary precautionary measures.
Crude oil inventories also constitute another driver of the product prices. Oil and gas prices are significantly impacted by the balance between supply and demand for these commodities. This effect is based on speculation. According to Yang et al (2002), accurate estimates are known after three to four months in some case as may be given. Investors, however, are more interested with real time figures as a basis for investment decisions and therefore tend to closely follow these figures to identify any possible trends. Analysts present investors with a good opportunity to monitor price changes in the industry. These analysts use past trends in prices of the two commodities to determine expectations as far as prices are concerned. Information derived from such analyses is used by investors to gauge the market based on expectations and make decisions. If for some reasons inventories rise, then supply exceeds demand while a fall in the same indicates that demand exceeds supply for the period under scrutiny. Such discrepancy between demand and supply for oil and gas increases their prices.
There are multiple other drivers of oil and gas prices. Increasing costs of exploration, development, production and refining marks a new but important trend that affects oil and gas prices. Companies pay hefty fees in exploratory activities in some locations as may be required by the governments. In a bid to offset these costs, the industry prices are also adjusted accordingly to resonate with the increasing costs. This trend, although recent, is a crucial factor relating to the intrinsic value for oil and gas (Standing, 2013).
Other factors include, interest rates, actions of dominant bodies in the industry such as OPEC, prices of other energy commodities like coal, geopolitical events and even prospects for and new discoveries. The level of interest rates or at least the trend of this variable is widely used by producers and other dealers as far as oil production and supply is concerned. Producers tend to withhold production by retaining oil reserves in the ground when they interest rates are deemed unfavourable. Similarly, other dealers may withhold oil reserves for the similar or other reasons. These practices often affect the supply available in the market at a given time. When the supply available does not meet the demand for oil and gas, then the shortage pushes prices of these commodities high. This factor or practice is conventionally referred to as arbitration (Dorsman et al., 2011).
Similarly, OPEC may undertake initiatives that attempt to maintain prices at certain levels. The prices of substitutes to oil and gas can also impact on the price of the commodities. Even so, the demand factor remains the overarching driver for oil and gas prices.
The possible future oil prices in the next one, five and fifteen years are 65 pence per litre, 60 pence per litre and 57 pence per litre respectively. Gas prices for the same periods will be priced at 64 pence per them, 66 pence per therm and 58 pence per therm respectively. After one year, oil and gas prices will remain relatively stable but will exhibit a slight increase in line with the modestly increasing demand (Department of Energy and Climate Change, 2012). The available reserves held by various governments and bodies across the globe will offset this demand to maintain stable prices in the coming year. After five years however, prices will be quite lower as the growth in demand experienced in China will begin levelling off. New drilling technology such as shale gas will lead to increased production from countries such as the U.S (U.S Department of Energy, 2011). Although production from conventional drilling technology is expected to be on the decline after about five years, new technology coupled with green practices will have a greater impact on oil prices after fifteen years, lowering them.
References
Brown, P. S., & Yucel, K. M. 2008. What Drives Natural Gas Prices? The Energy Journal, [E-journal] 29 (2).
Darby, R. M. 1982. The price of Oil and World Inflation and Recession. [E-journal] 72 (4), Available through http://www.jstor.org/stable/1810014 [Accessed 9 April 2013]
Dorsman, B. A., Vesterman, W., Karan, B. M. & Arslan, O. 2011. Financial Aspects in Energy: A European Perspective. London: Springer Heidelberg Dordrecht
Islamic Development Bank, 2009. Impact of Global Economic Recession on Oil Market and Implication for OIC Member Countries. Istanbul: COMCEC.
Standing, T. 2008. Oil Price Drivers- a Look at the Fundamentals. Association for the Study of Peak Oil and Gas USA. Available through <"http://aspousa.org/2008/06/oil-price-drivers-a-look-at-the-fundamentals/" http://aspousa.org/2008/06/oil-price-drivers-a-look-at-the-fundamentals/ > [Accessed 7 April, 2013]
U.S Depart of Energy. 2011. Shale Gas: Applying Technology to Solve America’s Energy Challenges. Available through
Yang, C. W., Hwang, J. M. & Huang, N. B. 2002. An Analysis of Factors Affecting Price Volatility of the US Oil Market
Panagiotidis, T. & Rutledge, E. 2007. Oil and Gas Markets in the UK, Evidence from a Cointegrating Approach. Available through http://www.sciencedirect.com/science/article/pii/S0140988306001307 [Accessed on 9 April 2013]
Section 2: A commodity trader is hedging British Airways exposure to Jet Fuel Oil for the next 10 years. Explain and discuss the various ways in which the trader could source the product and minimise risks.
The trader has various alternatives available in an attempt to hedge British Airways’ exposure to Jet Fuel Oil for the stated period of ten years. These include hedging in the futures market, the stop market, use of swaps and options. These strategies are discussed below. It is worth noting that each of the hedging strategies has its pros and cons. These strategies are grouped in two main categories: over-the-counter and exchange-traded hedging (Morrell, & Swan, 2006).
Swaps
A swap is an agreement whereby a floating or market price is exchanged for a fixed price over a specified time period. This type of hedging is done over-the-counter. Swaps have the advantage that they are more customizable than exchange traded futures (Windcliff, Forsyth & Vetzal, 2006). Being an over-the-counter strategy, the use of swaps can be quite straightforward and convenient for customization. However, two disadvantages that are often associated with this strategy include the counterparty risk that results from the direct trading between airlines and investment banks and illiquidity.
Options market
Options are of two types: a call option and a put option. Whereas call options give the buyer a non-obligatory right to buy the underlying commodity at a predetermined strike price within a specific time period, a put option gives the buyer a non-obligatory right to sell the underlying commodity at a stated strike price within a given time period (Defence Business Board, 2004). The fluctuations in price increase the potential for a profit or loss. Generally, options are more expensive when volatility of price is high for the case of buyers like British Airways. To sellers, the risk and reward are magnified during periods of volatility and therefore premiums are high. Consequently, options may be preferably bought during specific periods of price stability, and sold during times of volatility. Like swaps, options are less liquid and have counter-party risk.
Stop market
A stop market is used by investors to protect themselves from great losses in the event that an investment does not go as predicted or expected. Similarly, this strategy can be used to protect portions of profits in cases where there had been some positive outcome (Labuszewski, Nyhoff & Peterson, 2010). This market allows the investors to take advantage of opportunities with a reduced risk. A stop market agreement can help shield the trader against the risk of losing all that may have been earned or the entire profits.
Futures market
Futures are exchange-traded derivatives and their market is essential to jet fuel hedging though. This strategy is more liquid and eliminates counter-party risk. Both producers and manufacturers of jet fuel use this strategy to reduce the price risk associated with this commodity when they will want to purchase or sell it. Since it is unlikely to come across futures contracts traded on jet fuel, substitutes, notably heating oil futures contracts are used. This introduces the problem of basis risk to the trader. Basis risk represents the difference between the price of jet fuel and the price of heating oil futures at the date when the jet fuel is purchased (Garner & Brittain, 2009). The two approaches used in this strategy are long hedge and short hedge. On one hand, Mahul (2001) defined a long hedge as an arrangement in the futures market that businesses use to lock in the price of jet fuel which they may want to purchase at some point in future. The trader, however, should be more interested in a short hedge which, on the other hand, is used to lock in a selling price for jet fuel that is to be sold in the future. Although hedging in the futures market is less expensive than in over-the-counter strategies, its major disadvantage relates to basis risk.
Evidently, no single hedging strategy is perfect. All of the strategies discussed above present both benefits and mishaps to not only the trader, but also British Airways. As a result, the trader faces serious challenges as far as minimizing the associated risks is concerned. Although there is no perfect hedging strategy for jet fuel, a fairer approach should incorporate the strengths of strategies that use both over-the-counter derivatives like options and swaps, and exchange-trade derivatives like futures. This would also dilute the weaknesses that are associated with individual strategies. The recommendation, therefore, is that the trader should employ dynamic hedging strategy which will employ a mix of the above strategies in order to achieve the best results (Cobbs and Wolf, 2004). Nascimento and Powell (2008) noted that this mix should be dependent on a number of contingencies discussed in this work including aspects such as liquidity, volatility and simplicity among others. Such a diversified approach would aid the trader to in satisfying British Airways’ demands, and minimizing the risks related to the trade.
References
Cobbs, R. & Wolf, A. 2004. Jet Fuel Hedging Strategies: Options Available for Airlines and Survey of Industry Practices. Available through
Defence Business Board. 2004. Fuel Hedging Task Group Report. Available at < http://www.defenselink.mil/dbb/pdf/FuelHedging-03-2004.pdf > [Accessed 9 April 2013]
Garner, C. & Brittain, P. 2009. Commodity Options: Trading and Hedging Volatility in the World’s Most Lucrative Market. Harlow: FT Press.
Morrell, P. & Swan, W. 2006. Airline Jet Fuel Hedging: Theory and Practice. Department of Air Transport. Transport Reviews, [E-journal] 26 (6)
Labuszewski, J. W., Nyhoff, J. E., R. & Peterson, P. E. 2010. Hedging with Options. The CME Group Risk Management Handbook: Products and Applications, John Wiley & Sons, Inc., Hoboken, NJ, USA. Available through
Mahul, O. 2001. Hedging in Futures and Options Markets with Basis Risk. Journal of futures Markets. 22 (1): 59-72. Available through < http://onlinelibrary.wiley.com/doi/10.1002/fut.2207/pdf> [Accessed on 10 April 2013]
Nascimento, M. J. & Powell, B. W. 2008. An Optimal Solution to a General Dynamic Jet Fuel Hedging Problem. Princeton University. Available through < http://www.castlelab.princeton.edu/Papers/NascimentoPowell-JetFuelHedging.pdf> [Accessed on 9 April 2013]
Windcliff, H., Forsyth, A. P. & Vetzal, R. K. 2006. Pricing Methods and Hedging Strategies. Journal of Banking & Finance, 30 (2). [E-journal] Available through
Section 3: Explain and discuss the various forward curve behaviours and how arbitrage can be used to make a profit.
With respect to energy, a forward curve represents a schedule of the current price of energy based on different future dates. It therefore refers to projections of market spot prices over time. This curve is very important to investors and exhibits certain behaviours as a result of a presence of different factors. These behaviours affect the nature of the curve, which gives rise to the concepts of backwardation, contango and seasonality. These are further explained in the ensuing paragraphs.
Backwardation and contango are opposite but important behaviours of the forward curve. Generally, markets are characterised by fluctuations in prices. The two concepts are influenced by the differences in the futures price and the spot price for a given market. Factors that may lead to this discrepancy in the above prices include expectations, interest rates, storage and transportation costs and logistic limitations on physical transport (CME Group, N.d). However, the futures price will always converge to the spot price at expiration. Backwardation is a situation where the forward price of a futures contract is less than the expected future spot price (Folger, 2013). According to the concept of convergence, the futures price must converge towards the spot price until the two become equal at maturity. Hence, the futures price must rise over time. The backwardation curve is shown in figure 2 below. Conversely, contango refers to a situation whereby the forward price of is above the expected future spot price. The prices have to converge at maturity, therefore the shape of the forward curve as shown in figure 2 below. The crude oil forward curve has been in contango for some time since the onset of the recent economic downturn of 2008-09 (Dorsman et al, 2011). Similarly, if a disruption occurs in major producer and/or refinery of oil such as the Gulf Coast, then near term contracts may be priced higher.
Figure 2
Certain prices follow a seasonal trend. This is characterised by the rise and fall in prices due to changes in the short-run conditions affecting price. These seasonal price effects in natural gas for instance may involve a rise in prices in winter and a decline in summer months. Consequently, these seasonality patterns give rise to short-term contango and backwardation segments (Mitchell & Pulvino, 2001).
Arbitrage
Arbitrage has become a mainstay practice in many industries. Arora and Tyers (2011) defined this term as the earning of riskless profit by taking advantage of differentiated pricing for the same physical asset or security in different markets. In the context of energy, this concept may refer to the ability to purchase low-cost off-peak energy and resell it during on-peak periods when prices are higher, or otherwise use it when the cost is more beneficial. An ideal example is a scenario whereby when the yield on financial assets declines, producing countries find it attractive to retain oil reserves rather than sell at existing prices. Similarly, dealers may undertake energy storage initiatives on the basis of taking advantage of current technological costs and associated energy prices
Arbitration may lead to increased prices of commodities. Studies have found that there exists an inverse relationship between oil prices and interest rates (Shleifer & Vishny, 1997). In response to low interest rates, producers can constrain production by retaining oil in the grounds. This practice has been found to be prevalent in Saudi Arabia and is consistent with Hotelling theory that changes in interest rates will alter oil prices through producer extraction decisions (Arora, 2011 p. 4).
Another disadvantage of this practice is that the pursuit of such risk-free returns can be costly. This is due to the fact that in reality, there may be certain underlying risks to the opportunity. A fairly recent failure that resulted from such an approach to profit-making involved Long Term Capital Management (LTCM). According to Bryan (2007), LTCM operated as a hedge fund and made overwhelming profits through a complex bond price arbitrage. A default by Russia left investors opting out of Europe and Japan into the U.S. bond market. Consequently, LTCM lost 3.5 billion U.S dollars bailout and was closed.
References
Arora, V. 2011. Arbitrage and the Price of Oil. Working Papers in Economics & Econometrics, Working Paper No 535. ISBN: 0 868315354.
Arora, V. & Tyers, R. 2011. Arbitrage and the Price of Oil. Economic Modelling 2011.
Bryan, K. 2007. Arbitrage. Region Focus, 11 (2). [E-journal] Available through http://search.proquest.com.proxyau.wrlc.org/docview/201457403 [Accessed on 11 April 2013]
CME Group. N.d. Seasonality and Storage in Natural Gas. Available through < http://www.cmegroup.com/trading/energy/files/PM203-Seasonality-and-Storage.pdf> [Accessed on 10 April 2013]
Dorsman, B. A., Vesterman, W., Karan, B. M. & Arslan, O. 2011. Financial Aspects in Energy: A European Perspective. London: Springer Heidelberg Dordrecht.
Folger, J. 2013. How to Leverage Market Contango and Backwardation. Futures, 42 (1) p28-31. Available through Proquest Central (www.proquest.com). [Accessed 11 April 2013]
Mitchell, M. & Pulvino, T. 2001, Characteristics of Risk and Return in Risk Arbitrage. The Journal of Finance, 56: 2135–2175. [E-journal] Available through
Shleifer, A. & Vishny, W. R. 1997. The Limits of Arbitrage. The Journal of Finance, 53 (1) [E-journal] Available through www.jstor.org/stable/2329555. [Accessed 12 April 2013]
