The presentation explains how to apply risk management to trading companies active in oil markets

1. Risk management in
international oil markets
Alessandro Mauro
Presentation delivered to the students of a Master program
1

2. TOPICS
Case study in
Risk
Management
Risk
Management. A
business process
The physical oil
business &
market prices
2

3. TOPICS
Case study in
Risk
Management
Risk
Management. A
business process
The physical oil
business &
market prices
3

4. • Petroleum or crude oil is a naturally occurring, flammable liquid found in rock formations in
the Earth consisting of a complex mixture of hydrocarbons of various molecular weights, plus
other organic compounds.
• COMPOSITION
Carbon = 83 – 87 %
Hydrogen = 10 – 14 %
Sulphur = 0,06 – 8 %
Oxygen = 0 – 1,5 %
Nitrogen = 0 – 0,1
Metals = 0 – 0,03 %
Others = Salts, water, sediments
• every crude oil quality is different !
Oil Business WHAT IS CRUDE OIL ?
4

5. Exploration &
production
Refining &
Marketing
Transportation
Transportation
Oil Business SUPPLY CHAIN
5

6. Oil Business OIL EXTRACTION
6

7. Oil Business OIL EXTRACTION
7

8. 1 Barrel = 159 liters
Oil Business OIL SHIPPING
8

9. - different products
- different customers
- different locations
- different Incoterms
- different prices
Oil Business REFINING
9

10. 10
simple refinery, maximizing the production of Motor gasoline (summer)
VALUE
-
+
Oil Business REFINERY SLATE

11. Vertically integrated
oil companies
Oil extraction
refining
Distribution
and sales
trading
trading
modern model
Oil Business
11
BUSINESS MODELS

12. BUY:
• good = x
• quantity = a
• index = y
• market = z
• time = t1
SELL:
• good = w
• quantity = b
• index = j
• market = q
• time = t2
BY MEANS OF
• Vessels
• Storages
• Processing & Blending
• Physical swaps
• Financial derivatives
in the oil market there is a continuous TRANSFORMATION of Locations,
Qualities, Quantities and Time
Oil Business
12
TRADING BUSINESS MODELS

13. Oil Business
13
OIL PRICE HISTORY (1)
SOURCE: BP

14. Trader A
Trader B
Trader C
Platt’s
Oil Business
14
PRICE ASSESSMENTS

15. Oil Business
15
PRICE ASSESSMENTS – Platts Ewindow
SOURCE: PLATTS

16. Brent oil price
Oil Business
16
OIL DAILY PRICE

17. Oil price as central price and volatility engine
ILLUSTRATIVE
BRENT
GASOIL
Diesel 10
ppm
GASOLINE US GASOLINE
FUEL OIL
Jet Fuel
Vacuum Gasoil
URALS
crude oil
17
Oil Business OIL PRICES

18. TOPICS
Case study in
Risk
Management
Risk
Management. A
business process
The physical oil
business &
market prices
18

19. 19
RISK MANAGEMENT
“Activity which integrates recognition of risk, risk
assessment, developing strategies to manage it, and
mitigation of risk using managerial resources“
(ISO/IEC Guide 73)
R.M. – Case study DEFINITION

20. 20
Establish the context
Identify risks
Analyse risks
Evaluate risks
Treat risks
Communicateandconsult
Monitorandreview
ISO 31000 Process for managing risk
R.M. – Case study DEFINITION

21. 21
R.M. – Case study ESTABLISH THE CONTEXT

22. Successfully hedging jet fuel costs 22
R.M. – Case study
FLYTOMORROW

23. 23
R.M. – Case study RISK IDENTIFICATION
OPERATIONAL EXPENSES
Fuel ………………….…. 40%
Personnel ……………….. 20%
Landing & Co ……….…. 10%
Marketing …………….. 10%
Deprec. & Maint. ..……. 10%
Others …………………. 10%

24. 24
R.M. – Case study RISK IDENTIFICATION
• For next JULY, “Flytomorrow” plans to
buy on average every business day 500
ton of Jet fuel for its planes
• the price formula is the following:
(“Jet CIF NWE” + 5) USD/t

25. 410 +
5
USD/MT
Days in July
Buy 500 Mt Buy 500 Mt Buy 500 Mt
25
R.M. – Case study RISK IDENTIFICATION
407 +
5
401 +
5
Jet CIF NWE
premium

26. DEFINITIONS
PRICE INCREASE PRICE REDUCTION
LONG
+ -
SHORT
- +
LONG EXPOSURE :
An INCREASE in PRICE will INCREASE PROFITS or REDUCE LOSSES
SHORT EXPOSURE :
An INCREASE in PRICE will REDUCE PROFITS or INCREASE LOSSES
26
R.M. – Case study RISK IDENTIFICATION

27. Profit
& Loss
110
Profit
& Loss LONG
POSITION
110
price
SHORT
POSITION
price
27
R.M. – Case study RISK IDENTIFICATION

28. average Jet Fuel
Price in July
Profit/loss
28
R.M. – Case study RISK IDENTIFICATION
“Flytomorrow” has a short
exposure to Jet Fuel prices

29. SHORT exposure
on PHYSICAL
Pricing period
JulySHORT 10,000 tons
Before July starts
29
R.M. – Case study RISK IDENTIFICATION

30. 30
R.M. – Case study RISK TREATMENT

31. 31
Risk treatment
“Process utilized for selecting and
implementing measures in order to
modify the risk”
Risk treatment
“Process utilized for selecting and
implementing measures in order to
modify the risk”
SOURCE: “Definitions in Risk Management” by the International Organization for Standardization.
(“ISO/IEC Guide 73”)
R.M. – Case study RISK TREATMENT

32. Expected
Return
price riskBack-to-
back
in Energy Markets :
• there is an “efficient frontier”
representing the best available
trade-offs between risk and return.
• A company should get to the
curve and select a point
according to its own risk appetite
(best “risk-adjusted return”)
• Risk lovers can speculate, risk
adverse can hedge. Role of
speculation is fundamental.
Speculation is different from
manipulation
32
R.M. – Case study RISK TREATMENT

33. 33
R.M. – Case study RISK TREATMENT
The Board of Directors meets to discuss
the risk and possible risk responses

34. RISK RESPONSE PROS CONS
Introduce Fuel
Surcharge
• Simple • Possible reduction in sales
• Becoming more expensive
than competitors
• Could potentially not cover
future increases in Jet fuel
prices
RISK RESPONSE PROS CONS
Hedge with
financial
derivatives
• Fix the fuel prices in
advance, while selling
tickets
• Possible advantage on
competition
• Less simple
34
R.M. – Case study RISK TREATMENT

35. 35
R.M. – Case study RISK TREATMENT
The Board of directors approve the utilization of
financial derivatives to hedge the exposure

36. SPOT
FORWARD
FUTURES
SWAPS
Oil Derivatives
Physical Oil
OPTIONS
36
R.M. – Case study RISK TREATMENT

37. 37
Flytomorrow First strategy
- Hedging with SWAPS -

38. Trader A
Trader B
Trader C
38
R.M. – Case study SWAPS
“Over-The-Counter” (OTC) derivatives

39. SWAP
“a financial derivative in which counterparties
exchange cash flows ”
39
R.M. – Case study SWAPS

40. Fix price
Variable (Floating) price
• There is only a net cash flow at expiry of the swap, and no physical good
exchange is involved.
• “A sells the swap and B buys it”
Counterparty A Counterparty B
A B
PAYS variable price fix price
RECEIVES fix price variable price
40
R.M. – Case study SWAPS

41. Bank Flytomorrow
Fix price Jet Fuel=
320 $ / Ton
Average price in July
for Jet Fuel
(*) 10,000 = 500 * 20 business days.
41
R.M. – Case study SWAPS
• “Flytomorrow” buys a 10,000 tons (*) July swap on the index
“Jet CIF NWE” from a bank at 320 $/Ton.

42. Time
FLOATING price
Is determined
FLOATING price
Is determined
Settlement
of difference
FIX price
is agreed
FIX price
is agreed
Pricing period
350 351 345 …… 356350 351 345 …… 356
320 USD/Mt320 USD/Mt
average of SPOT prices
PL is realized
42
R.M. – Case study SWAPS

43. Fix price Jet Fuel=
320 $ / Ton
Average price in July
For Jet Fuel
Bank Flytomorrow
Profit for Bank Profit for FlyT.
Example 320 – Pvariabile Pvariabile – 320
General PFIX – Pvariabile Pvariabile – PFIX
43
R.M. – Case study SWAPS

44. Swap Exposure
for Bank
Swap Exposure for
FlyTomorrow
(average Jet Fuel
price in July)
Profit
& Loss
320
320
who pays variabile
Who pays fix
Profit
& Loss
(average Jet Fuel
price in July)
short exposure
on physical deal
SWAP exposure
SWAP exposure
44
R.M. – Case study SWAPS

45. quantity
Price
SUPPLY (OFFER)DEMAND (BID)
Forward curveJuly swap market
45
R.M. – Case study SWAPS
Like any other market, the Fix price is given by the crossing of
demand and supply curves
Who “decides” the Fix price in a swap ?

46. 46
Flytomorrow Second strategy
- Hedging with FUTURES -

47. FUTURE
“An obligation to buy or sell an underlying
instrument(s) at a future date but at a price
agreed upon beforehand”
47
R.M. – Case study FUTURES
•Legal obbligation between the PartiesLegal obbligation between the Parties
•StandardizationStandardization
•Price is agreed todayPrice is agreed today

48. EXCHANGESELLER BUYER
AT EXPIRYAT EXPIRY
48
R.M. – Case study FUTURES
Physical delivery payment
NETTINGNETTING
beforebefore
EXPIRYEXPIRY
BUY BACK
FUTURES
SELL BACK
FUTURES

49. www.cmegroup.com
www.theice.com
www.lme.com 49
R.M. – Case study FUTURES

50. • standardized contracts (quality specifications, lots, etc).
• Liquidity and fast execution (some milliseconds).
• It does not “price” like a swap.
• long-dated maturities (e.g. ICE Brent 72 months).
• in many cases non-deliverable contract (or anyway not delivered).
• no credit risk, with margining system (Initial and Variation margins) and
clearing.
• Market Access: direct or through “Executing” Brokers.
• standardized contracts (quality specifications, lots, etc).
• Liquidity and fast execution (some milliseconds).
• It does not “price” like a swap.
• long-dated maturities (e.g. ICE Brent 72 months).
• in many cases non-deliverable contract (or anyway not delivered).
• no credit risk, with margining system (Initial and Variation margins) and
clearing.
• Market Access: direct or through “Executing” Brokers.
50
R.M. – Case study FUTURES

51. FUTURE Exposure for
FlyTomorrow
400
Profit
& Loss
(GASOIL FUTURE price)
short exposure
on physical deal
FUTURE exposure
51
R.M. – Case study FUTURES

52. SHORT exposure
on PHYSICAL
Pricing period
JulySHORT 10,000 tons
Before July starts
52
R.M. – Case study FUTURES

53. LONG exposure
on FUTURE
53
R.M. – Case study FUTURES
SHORT exposure
on PHYSICAL
Pricing period
JulySHORT 10,000 tons
Before July starts

54. 54
R.M. – Case study
SWAPS vs FUTURES

55. 55
R.M. – Case study SWAPS vs FUTURES
• Basis risk
• Liquidity & Execution risk
• Tenor

56. 56
R.M. – Case study SWAPS vs FUTURES

57. • Risk reduction often hindered by low correlations and lack of a sufficient number of derivatives
instruments.
• Basis Risk is probably the most relevant issue for Risk management in the oil industry.
ILLUSTRATIVE
BRENT
GASOIL
Diesel 10
ppm
GASOLINE US GASOLINE
FUEL OIL
Jet Fuel
Vacuum Gasoil
URALS
crude oil
57
R.M. – Case study SWAPS vs FUTURES

58. Trader A
Trader B
Trader C
EXCHANGESELLER BUYER
• BID/OFFER
spread
• Transaction
costs
58
R.M. – Case study SWAPS vs FUTURES

59. Time
SWAP is
simpler
Pricing period
ONE MONTH
Pricing period
3 DAYS
SWAP is
impossible
FUTURE is
simple
59
R.M. – Case study SWAPS vs FUTURES

60. Swaps, Futures, Options….
… handle with a lot of care
60
R.M. – Case study DERIVATIVES MARKET

61. Volumes Traded Annually
3% 5%
92%
OPEC product ion
Rest of t he world product ion
Tot al volume (physical+ paper) t raded
Paper market
=10 to 15
times the
size of the
physical
market
61
R.M. – Case study DERIVATIVES MARKET

62. • 2004. BP Products North America
Propane market cornering.
• 2006/8. MotherRock- Amaranth - Saracen
Speculation on time spreads in the natural gas futures
market.
• 2007. Bank of Montreal
Wrong mark-to-market evaluation of natural gas
positions.
• 2008. MF Global
Overnight electronic speculation on Wheat on CBT
62
R.M. – Case study DERIVATIVES MARKET

63. • lack of controls
• not adequate evaluation of future commitments
(Mark-to-market systems)
• willingness to influence/control the market
• lack of proper risk management
63
R.M. – Case study DERIVATIVES MARKET

64. TOPICS
Case study in
Risk
Management
Risk
Management. A
business process
The physical oil
business &
market prices
64

65. 65
TRADING
DEPARTMENT
Strategic / Governance
Tactical / Policy
Operational / Control / Support
Executive Committee
Risk Oversight Committee
OPS
MIDDLE
OFFICE
DERIVATIVES
BACK OFFICE
&
COMPLIANCE
FRONT OFFICE RISK MANAGEMENT
Head of Risk
Management
Managing
Director of
Trading
R.M.- Business process GOVERNANCE

66. 66
R.M.- Business process RISK POLICY
• Clarification of the need for a risk management
policy.
• Identification of core responsibilities within the
organization and “vertical” allocation to the Board
of Directors, the ROC, the HRM and risk
management function.
• Distinction between Front, Middle and Back
Office and “horizontal” allocation of duties.
• General overview of the deal life cycle with
further identification and allocation of
responsibilities.
• Clear definition of the different steps which
together constitute the risk management process
(identification, estimation, treatment)
• Specific information about the crucial topic of
Mark-to-market methodology.
• A comprehensive list of definitions, in order to
clarify terms used in the policy and foster the
inception of risk terminology standardization
within the Company.

67. GROUP
VaR limit … $
COMPANY
VaR limit … $
LoB “A”
VaR limit … .$
LoB “B”
VaR limit … $
LoB “…”
VaR Limit ….$
Port. “1”
VaR limit … $
Port. “…”
VaR limit .. .$
Book “..”
VaR limit … $
Book “..”
VaR limit … $
Trans.“..”
VaR limit … $
Trans.“..”
VaR limit … $
Trans.“..”
VaR limit …$
Global book 1
VaR limit … $
Global book 2
VaR limit … .$
Group level
Company/Global book level
Line of Business level
Portfolio level
Book level
Transaction level
67
R.M.- Business process TRADING LIMITS

68. GASOLINE
Risk analyst
HEAVY PROD
Risk analyst
CRUDE
Risk analyst
LIGHT PROD.
Risk Analyst
Risk
Manag.
Risk
Analyst
(2)
subsidiaries
Derivatives management
DIRECTOR OF RISK MANAGEMENT
Global Risk Coordinator
CEO
HEADQUARTERS
68
R.M.- Business process RM ORGANIZATION

69. Integrated Market Risk Management
 A full scale department dedicated to Risk management, with specialised risk analysts.
 Data are collected and aggregated daily, covering all subsidiaries and branch offices.
 Procedures are standardized all over the world.
 All physical and financial deals are controlled and included in the analysis.
 Rules and responsibilities are clearly set in a Risk Management Policy
Control Activity
 Strong segregation of duties between Front, Middle and Back offices.
 Controls on quality and timeliness of data inputting in the system
 Controls of users’ rights and access to information
 Monitoring of accuracy of prices and evaluation of positions
 Continuous cross-checking against external information
 Risk limits are in place and the respect is constantly monitored.
69
R.M.- Business process RM PILLARS

70.  All physical and financial deals stored in a central
software (Bulldog).
 Recalculation of Profit & Losses (P&L) based on
standardized procedures and public prices.
 Monitoring of PL changes and investigation of drivers
 Calculation of Volumetric exposures for the unrealised
(i.e. risky) part of the P&L.
 Reporting where the P&L is vulnerable in terms of
markets, indexes and future maturities.
 Assessing the possible impact of prices changes on the
P&L because of volatility in prices.
 Giving advice to traders about how risk can be reduced.
PROFIT & LOSSES
VOLUMETRIC EXPOSURES
VALUE-AT-RISK
70
R.M.- Business process KEY RISK INDICATORS

71. Data inputs (contracts +
logistics)
C/ETRM
Market prices
71
R.M.- Business process IT SYSTEMS

72. PROFITS &
LOSSES
VOLUMETRIC
EXPOSURES
VALUE-AT-RISK
KEY
RISK
INDICATORS
Data inputs (contracts +
logistics)
C/ETRM
Market prices
72
R.M.- Business process IT SYSTEMS

73. • Automatic feed of information in the trading and risk management system
(ETRM)
• Access to information limited by user rights
73
R.M.- Business process IT SYSTEMS
MKT
DATA
ETRM
DB

74. CONTRACT CAPTURE RISK IDENTIFICATION RISK EVALUATION REPORTING
ETRM MATLAB PDF WRITER
 Purchases and sales,
physical and derivatives
 Freights and secondary
costs
 Scheduling
 Profits & Losses
 Volumetric Exposures
 Value-at-Risk
 Stress Testing
 Reconciliations
 Global Company
 Global books
 Subsidiaries
SQL
Risk management duties
74
R.M.- Business process IT SYSTEMS

75. 75
R.M.- Business process REPORTING & COMMUNICATION

76. alessandro.mauro@gmail.com
ch.linkedin.com/in/alessandromauro
goo.gl/2lqMUk
76

77. Thank you
77