Commodity Risk Management

1. Commodity Risk Management

2. Physical Contracts • Volume Types Firm - seller or buyer has legal recourse if volume not delivered or taken Interruptible or Swing - seller nor buyer obligated • Key Terms of Contract buyer seller price quantity receipt/delivery point/title transfer point time terms and conditions

3. Energy components of floating prices or fixed prices • Index Reference Point such as NYMEX “Henry Hub” for Natural Gas WTI (West Texas Intermediate-Cushing) or Brent for Crude Oil plus • Basis or Location Differential from Index Pricing Point Any or all components can be fixed or floating.

4. Financial Market Terminology Derivative: A Trading Instrument: Value is determined from one or more physical commodities and/or financial securities underlying the derivative. Underlying Commodity or Security: The physical commodity or financial security from which a derivative obtains its value.

5. Leverage: The effect of magnifying the outcome of an investment through use of borrowed funds. Example: Price at Purchase = 100 Price at Sale Year Later = 120 Equity % Gain = 20% Unlevered Gain = 20% If borrowed 50% at 10% Interest Gain = 120 - 100 - 5 = 15 Original Equity Investment = 50 Equity Gain % = 30%

6. Hedging: In general, the term hedging is used when describing entering a transaction with the intent of offsetting risk from another related transaction. Examples: insurance for fire, business interruption In commodities and securities markets, a hedge is a transaction entered into for the purpose of protecting the value of a commodity or security from adverse price movement by entering an offsetting position in a related commodity or security.

7. Futures Contracts: • Standardized: Each contract represents the same quantity and quality of the underlying physical commodity, valued in the same pricing format to be delivered and received at the same delivery location. • The date of delivery and receipt is the same for all contracts traded. • Futures contract is a tradable document which entitles the buyer of the contract to claim physical delivery of the commodity from the seller at the contract delivery point at a specified date in the future, and entitles the seller to deliver the physical commodity to the buyer under the same conditions.

8. Value: Because a futures contract is a tradable, (can be bought and sold in the open market), its value changes as the supply and demand for the futures contract changes. The price of a futures contract is derived from the price of the underlying commodity which it represents and thus is a derivative.

9. Exchange: No cost swap of physical commodity from one physical location to another location without actually moving the commodity. Futures Liability: Unlimited upside or downside.

10. Financial Swaps: Fixed Price Buyer Seller Buyer trades fixed receives floating. Seller trades floating receives fixed. At the time of the trade, the two positions are considered to be of equal value. Used frequently for currencies, commodities and interest rates. Floating Price

11. Futures Swaps: Performs almost the same function as a futures contract with the exception that, after expiration of the futures contract, there is a financial settlement for futures swaps (exchange of payment), as opposed to a physical settlement (making or taking delivery if an open position is held through expiration) in the case of actual futures contracts.

12. Options American Option: Tradable contract between two parties giving the buyer of the option the right, but not the obligation, to purchase or sell a given commodity or security at a specified price at any time up to and including the expiration of the option contract. European Option: Identical to American except may only be exercised at expiration of contract.

13. Option Contracts: Two Types • Calls (American): Grants the buyer of the option the right, but not the obligation, to buy the underlying commodity or security from the seller of the call option at a specified price (called the strike price) at any time up to and including the expiration of the option. The seller of a call option is obligated to sell the underlying commodity or security to the buyer of the call option, at the strike price, at any time, up to and including the expiration date.

14. Put Option (American): Grants the buyer of the option the right, but not the obligation, to sell the underlying commodity or security to the seller of the put option at the strike price at any time up to and including the expiration of the option. The seller of the put option is obligated to buy the underlying commodity or security from the buyer of the put option, at the strike price, at any time, up to and including the expiration date.

15. Buying a Call Profit Strike Price Cost ofCall Price of Underlying Commodity or Security Buyer of Call Option Profits if Prices Rise

16. Selling a Put Profit PutPremiumReceived Strike Price Price of Underlying Commodity or Security Seller of Put Option Loses if Prices Fall

17. Costless Collars The simultaneous selling of a call option at an above market strike price and the buying of a put option at a below market strike price such that the premium received on the sale of the call option equals the price paid for the put option. Has the effect of locking in a range of prices with a floor and ceiling in which you are guaranteed to receive for your commodity or security at expiration.

18. Option Risk and Liability The buyer’s risk is limited to what it paid for the option (option premium), but the seller’s liability is theoretically unlimited for the duration of the option’s life.

19. Exercising an Option Process where the buyer of an option (either a put or a call) elects to execute its given right to either buy (call) or sell (put) the underlying commodity or security from or to the option seller at the strike price.

20. Option Valuation The price of an option is called its premium. Option Premium is paid by the buyer to seller at time option contract is written. Option Premium: Two Components • Intrinsic Value: Positive difference, if any, between the strike price of the option, and the price of the underlying commodity or security for which option is based on. • Time Value: Remaining Value other than intrinsic.

21. An option which has intrinsic value is called an in the money option. An option which has no intrinsic value is called an out of the money option.

22. Black Scholes Valuation Used to Value Options: Quantified probability that the strike price of the option will be in the money at expiration. Four Main Valuation Parameters: 1. relationship between the strike price of the option and the current price 2. time remaining until option contract expires 3. level of interest rates and dividend (if any) 4. estimated volatility of the underlying commodity or security

23. Volatility Price change movement measured as a percentage of stock price based upon the standard deviation of historical prices. If a commodity or security is extremely volatile, the probability is higher that an option with an out of the money strike price will expire with intrinsic value (in the money).