Energy trading scenario 2016

Rakesh Sharma, Executive Director & Head of Financial Engineering Team, Financial Algorithms
Energy Trading Scenario 2016
Slump in Crude Oil Prices – Modelling Prices & Volatilities
March, 2016

Financial Algorithms™
2Energy Trading Scenario 2016
Topics
1. Oil Prices – examining fundamentals as uncertainty continues
2. Modelling Oil Price, Volatility from Market Instruments
3. Correlation monitoring in energy derivatives

1
Oil Prices – examining
fundamentals as uncertainty
continues

World Oil Outlook 2015 – a subtext
» The OPEC published its World Oil Outlook 2015 (WOO) in late December 2015, which struck a much
more pessimistic note on the state of oil markets. On the one hand, OPEC does not see oil prices
returning to triple-digit territory within the next 25 years, a strikingly bearish conclusion.
» The group expects oil prices to rise by an average of about $5 per year over the course of this decade,
only reaching $80 per barrel in 2020. From there, it sees oil prices rising slowly, hitting $95 per barrel in
2040.
» Although this estimate carries an error, barring price modeling which involves an array of variables, and
modifications in certain assumptions – such as GDP projections or the pace of population growth – this
can lead to dramatically different conclusions. So the estimates should be taken only as a reference case
rather than a serious attempt at predicting crude prices in 25 years.
» In estimates, the world will consume an extra 6.1 million barrels of oil per day between now and 2020. But
demand growth slows thereafter: 3.5 mb/d between 2020 and 2025, 3.3 mb/d for 2025 to 2030; 3 mb/d for
2030 to 2035; and finally, 2.5 mb/d for 2035 to 2040. The reasons for this are multiple: slowing economic
growth, declining population rates, and crucially, efficiency and climate change efforts to slow
consumption.
» In fact, since 2014 WOO, OPEC lowered its 2040 oil demand projection by 1.3 mb/d because it sees
much more serious climate mitigation policies coming down the pike than it did last year. Such outcomes
yet to be seen but we are seeing some shifts in oil production levels (next slide)
OPEC released World Oil Outlook 2015
http://oilprice.com/Energy/Crude-Oil/10-Trillion-Investment-Needed-To-Avoid-Massive-Oil-Price-Spike-Says-OPEC.html

Crude Oil Production in OPEC region over the last few
years
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan 2013 Jan 2014 Jan 2015 Jan 2016
MillionBarrelsperday
Estimated Historical Unplanned OPEC
Crude Oil Production Outages
million barrels per day
Indonesia
Saudi Arabia
Kuwait
Iraq
Nigeria
Libya
Iran
Source: Short-Term Energy Outlook, March 2016.

Crude Oil Production in Non-OPEC region over the last
few years
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Jan 2013 Jan 2014 Jan 2015 Jan 2016
MillionBarrelsperday
Estimated Historical Unplanned Non-OPEC
Liquid Fuels Production Outages
million barrels per day
Other
United States
Mexico
Canada
Sudan / S. Sudan
Colombia
Brazil
North Sea
Yemen
China
Syria

What is next after Shell gas discovery : Energy security
scenario across regions affecting oil price levels
» There was a gap between business as-usual supply and business-as-usual demand of around 400
EJ/a – the size of the entire oil & natural gas industry in 2000. Though ,this has been reversed by
various factors over the last few years.
» As in focus on national energy security, immediate pressures drive decision makers, especially the
need to secure energy supply in the near future for themselves and their allies. National government
attention naturally falls on the supply-side levers readily to hand, including the negotiation of bilateral
agreements and incentives for local resource development. Growth in coal and biofuels becomes
particularly significant.
0.00 1.00 2.00 3.00
World Oil
Supply
World Oil
Demand
Million barrels per day
World Oil Demand-Supply growth for
first 3 quarters of 2015
Source: By OPEC Secretariat
» Despite increasing rhetoric, action to address climate
change and encourage energy efficiency is pushed into the
future, leading to largely sequential attention to supply,
demand and climate stresses.
» Clean energy sources such as nuclear energy rapidly
gaining support from energy thirsty economies.
» Demand-side policy is not pursued meaningfully until supply
limitations are acute. Likewise, environmental policy is not
seriously addressed until major climate events stimulate
political responses.
» Customized tool development such as DECC 2050 for major
economies is gaining popularity; but it has its limitations.

Oil Prices : OPEC investments in US economy, a driving
factor
A big risk is that the Saudi Kingdom is selling some of its treasury holdings, believed to be among the
largest in the world, to raise needed dollars. As a matter of policy, the US Treasury has never disclosed
the holdings of Saudi Arabia, long a key ally in the volatile Middle East, and instead groups it with 14
other mostly OPEC nations including Kuwait, the United Arab Emirates and Nigeria.
Source : http://ticdata.treasury.gov/Publish/mfh.txt
China,, 1237.9
Japan, 1123.5
Carib, 350.5
Oil Exporters,
293
Brazil, 255.7
Ireland, 252.2
Switzerland,
237.4
United
Kingdom,
223.2
Hong Kong,
201.6
Luxembourg,
200.1
Other, 862.3
US Treasury Holdings by Top 10 Countries - Jan
2016 in billion dollars» Earlier OPEC nations were
plowing cash into U.S.
Treasuries at a more than 50
percent faster rate than all other
foreign investors, during the time
when crude oil was trading
above $100 a barrel.
» Higher prices boosted their
currency reserves. While booking
super profits, OPEC countries
parked this profit in US
treasuries.

2 Modelling Oil Prices, Volatility
from Market Instruments

WTI : Probabilities projecting price levels
Using realized volatility (historical) – probabilities were calculated to project price levels for the range of WTI
contracts. These probabilities imply that WTI prices may trade between USD 30-45 in most likely scenario
for the entire year; though with limited upside chances.
0%
10%
20%
30%
40%
50%
Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17
Contract month
Probability of WTI spot price falling
below certain levels
Price < $25
Price < $30
Price < $35
0%
10%
20%
30%
40%
50%
Contract month
Probability of WTI spot price
exceeding certain levels
Price > $55
Price > $50
Price > $45
Source: EIA Short-Term Energy Outlook, March 2016, and CME Group (http://www.cmegroup.com)

Zomma (DGammaDVol) Sensitivity on WTI Futures using
Black’s Forward Model
WTI Price as of 27th March 2016 : $ 37.87 & OVI Index level : 52 week low 29; current 47.18, 52 week high :
109. Zomma is a useful sensitivity to monitor when maintaining a gamma-hedged portfolio as Zomma helps
the trader to anticipate changes to the effectiveness of the hedge as volatility changes.
37.50
35.55
33.60
31.65
29.70
27.75
25.80
23.85
21.90
19.95
18.00
-0.0050
-0.0040
-0.0030
-0.0020
-0.0010
0.0000
0.0010
0.0020
0.0030
0.10
0.36
0.63
0.89
WTI price
Zommalevels
Time to
maturity
Deep in the money Call - DGammaDvol for the
year 2016
62.50
59.25
56.00
52.75
49.50
46.25
43.00
39.75
36.50
33.25
30.00
-0.0030
-0.0025
-0.0020
-0.0015
-0.0010
-0.0005
0.0000
0.0005
0.0010
0.0015
0.10
0.36
0.63
0.89
WTI price
ZommaLevels
Time to
maturity
Deep in the money Put - DGammaDvol for the
year 2016

High volatility sensitivity : Zomma & Vanna (DDeltaDvol)
for Call using forward-forward model
OVI Level : 109 : Vanna is also a very useful sensitivity to monitor when maintaining a delta- or vega-
hedged portfolio as vanna will help the trader to anticipate changes to the effectiveness of a delta-hedge
as volatility changes or the effectiveness of a vega-hedge against change in the underlying spot price.
Here suggesting WTI price to hover between USD 30-45 zone for the year.
45.00
42.00
39.00
36.00
33.00
30.00
27.00
24.00
21.00
18.00
15.00
-0.0004
-0.0003
-0.0002
-0.0001
0.0000
0.0001
0.0002
0.0003
0.0004
0.10
0.36
0.63
0.89
WTI price
ZommaLevelsinhighvolatilityscenario
Time to
maturity
Deep in the money Call - DGammaDvol for the year
2016
45.00
42.00
39.00
36.00
33.00
30.00
27.00
24.00
21.00
18.00
15.00-0.0020
-0.0010
0.0000
0.0010
0.0020
0.0030
0.0040
0.0050
0.10
0.36
0.63
0.89
WTI price
VannaLevelsinhighvolatilityscenario
Time to
maturity
Deep in the money Call - DDeltaDvol for the year
2016

Gasoline Prices in US : RBOB in long term mean zone
» As shown in the figures below, the spread of gasoline and diesel is almost flat over the last few years
with respect to crude oil prices.
» Except for January 2015, the volatility levels were in a normal zone, suggesting mean reversion factor
acting up and maintaining the price levels at $1.9 – 2.3 for gas & $2-2.5 for diesel.
Forecast
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017
U.S. Gasoline and Crude Oil Prices
dollars per gallon
Price difference
Retail regular gasoline
Crude oil
Crude oil price is composite refiner acquisition cost. Retail prices include state
and federal taxes.
Forecast
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
5.00
Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017
U.S. Diesel Fuel and Crude Oil Prices
dollars per gallon
Price difference
Retail diesel fuel
Crude oil
Crude oil price is composite refiner acquisition cost. Retail prices include state
and federal taxes.

Speed Greek Sensitivity : mean level vs. high level vols
for calls & puts using forward-forward model
2.25
2.10
1.95
1.80
1.65
1.50
1.35
1.20
1.05
0.90
0.75
-1.0000
-0.5000
0.0000
0.5000
1.0000
1.5000
2.0000
0.10
0.36
0.63
0.89
Gasoline price
Time to
maturity
Speed sensitivity at high level vols for Gasoline
2.25
2.10
1.95
1.80
1.65
1.50
1.35
1.20
1.05
0.90
0.75
-15.0000
-10.0000
-5.0000
0.0000
5.0000
10.0000
15.0000
0.10
0.36
0.63
0.89
Gasoline price
Time to
maturity
Speed sensitivity at mean level vols for Gasoline
3.75
3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
-4.0000
-3.0000
-2.0000
-1.0000
0.0000
1.0000
2.0000
3.0000
4.0000
5.0000
0.10
0.36
0.63
0.89
Diesel price
Time to
maturity
Speed sensitivity at mean level vols for Diesel
3.75
3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25-0.4000
-0.3000
-0.2000
-0.1000
0.0000
0.1000
0.2000
0.3000
0.4000
0.5000
0.6000
0.7000
0.10
0.36
0.63
0.89
Diesel price
Time to
maturity
Speed sensitivity at high level vols for Diesel

NatGas Henry Hub : Probabilities projecting price levels
» In a highly correlated market, Natural Gas exhibiting range bound price levels. In a most likely
scenario, NatGas may move between US$ 3.00 to US$ 3.50, with a very limited upside price levels for
the entire years.
» During spring and summer time, seasonality holding down Henry Hub spot prices below US$ 2.00 but
supporting levels pushing up prices in a US$ 2.00-3.00 range.
0%
10%
20%
30%
40%
50%
Contract month
Probability of Henry Hub spot price
exceeding certain levels
Price > $4.00
Price > $3.50
Price > $3.00
0%
10%
20%
30%
40%
50%
Contract month
Probability of Henry Hub spot price
falling below certain levels
Price < $1.25
Price < $1.50
Price < $1.75
Source: EIA Short-Term Energy Outlook, March 2016, and CME Group (http://www.cmegroup.com)

Vanna & price adjusted Gamma sensitivity using forward
model for Henry Hub underlying
» Although, price levels suggesting US$ 2.00-3.50 range for NatGas, Vanna sensitivity suggesting high
volatility levels may stop rally in the NatGas & price may remain range bound i.e. US$ 1.50 – 2.75 for the
entire year.
» Price adjusted Gamma exhibiting skewness towards positive side suggesting price to hover between
US$ 2.00 – 3.25 in a most likely scenario.
3.75
3.38
3.00
2.63
2.25
1.88
1.50
-0.0080
-0.0060
-0.0040
-0.0020
0.0000
0.0020
0.0040
0.0060
0.0080
0.0100
0.0120
0.10
0.36
0.63
0.89
Henry Hub price
Time to
maturity
Henry Hub ITM Call - Vanna (DDeltaDvol) for the
year 2016
3.75
3.38
3.00
2.63
2.25
1.88
1.500.0000
0.0050
0.0100
0.0150
0.0200
0.0250
0.0300
0.0350
0.0400
0.0450
0.10
0.36
0.63
0.89
Henry Hub price
Time to
maturity
Henry Hub ITM Gamma-P Call for the year 2016

3 Correlation monitoring in energy
derivatives

Correlation factors : Eagle’s eye can slice good profits
OPEC & Non-OPEC Oil Production & Trading
Price Levels,
Spreads i.e.
Crack /
RBOB/Diesel
etc.
Currency
Reserves
Investments overseas
US treasuries
& Bonds i.e.
10Y/30Y
Investments
in other
regions
Impact on g-local economies
Price Levels determining
riskiness of asset
classes across regions
Economic growth & Core
inflationary levels
OPEC Production
forecasting using internal
models
World GDP growth &
energy demand per capita
projections

Climate Change Status
Planetary Boundaries Status
Climate Change (atmospheric CO2 concentration and change in
radiative forcing)
Boundary Exceeded
Rate of Biodiversity Loss Boundary Exceeded
Nitrogen Cycle -part of a boundary with the Phosphorus Cycle Cycle Boundary Exceeded
Phosphorus Cycle -part of a boundary with the Nitrogen Cycle Cycle Approaching Limit
Ocean acidification Approaching Limit
Global fresh water use Approaching Limit
Change in land use Approaching Limit
Stratospheric ozone depletion Not exceeded
Atmospheric aerosol loading Not yet quantified
Chemical pollution Not yet quantified
Source : Shell Scenarios 2050 signals sign posts
Research published by the Stockholm Resilience Centre in early 2009 proposes a framework based on
‘biophysical environmental 2 subsystems’. The Nine Planetary Boundaries collectively define a safe
operating space for humanity where social and economic development does not create lasting and
catastrophic environmental change. Political response to these metrics will affect the energy market
and shift in preferences of energy products.

Geo-political & Behavioral factors – next generation
variables
» The global economic crisis has coincided with a shift in geopolitical and economic power from west to
east. This decisive shift is transforming the global economic and political system. Middle east is
turbulent, US & Russian grappling with Eurasian political scenario.
» The world is facing a period of uncertain global politics. Strategic fault lines are emerging. Rising
powers are increasingly and confidently asserting what they see as their national interests.
– Key drivers going forward : G20 governance | The China-US relationship | Sharing the burdens of adjustment | New policy
paradigm
» Behavioral economics has enhanced our ability to understand how consumers make choices. It has
helped governments find ways to reduce energy demand without losing votes. It has helped businesses
develop more innovative and profitable ways to serve consumers. Hydro-gen engines may be the next
big thing in utility driven energy markets suggesting shifting trends as the economy of scale introduces
the cost effectiveness in car manufacturing with such engines.
» The environment and climate change were overshadowed by concerns about economic security as the
financial crisis deepened in the last decade. Events such as the Gulf of Mexico oil spill, while hardening
public attitude towards energy providers, did little to change the energy consumption habits of
consumers.
» A new communications boom is also creating marked shifts in consumer behavior. While connectivity
accelerates the spread of information, it can also deepen uncertainty. Research shows that the structure
of the network connections people use can strengthen or weaken the spread of behavioral trends in
unpredictable ways.

Financial Algorithms
» Financial Algorithms offers wide variety of services including derivatives pricing, model
validation, valuation of exotic and structured products.
» Advisory services includes advisory in trading derivatives & structured products, hedging of
various exposures in Interest Rates, Foreign Exchange, Commodities and Equities.
» Quant trading services includes algo-trade (technical) and quant strategies across asset
classes.
» For Banks’ ALM, we offer advisory in behavior modeling of Loans and Deposits including
prepayments, delinquencies, deposit run-off. Besides, we also offer detailed models for
usage of facilities etc. for matched maturity of assets and liabilities.
» To know more about Financial Algorithms service offerings, please visit :
www.financialalgorithms.co
» Or email at contact@financialalgorithms.co

Rakesh Sharma
Executive Director & Head of Financial Engineering Team
Financial Algorithms
18, Scheme No. 59 (II), Western Ring Road
Indore – 452001, India
Email : contact@financialalgorithms.co
www.financialalgorithms.com
Copyrights reserved by Financial Algorithms

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