Category Archives: commodities

The unorthodox model of risk pricing behind the UK EMR #6: it gets better

Earlier this week, the UK government submitted draft legislation on its Electricity Market Reform (EMR).  In a series of blog posts from last July, I critiqued the central premise underlying this insurance proposal. The touted benefits overlook the cost of risk passed along to UK taxpayers or ratepayers. They are based on a fanciful imagination of the costs of nuclear new builds, how risk factors into investment decisions, and the ease with which the relevant risks can be transferred at the stroke of a pen. Of course, so long as the government’s scheme remains an abstract plan, this critique remains a theoretical one. It will only be once an actual price insurance contract is laid on the table in order to finance an actual nuclear new build that the faults in the government’s scheme will reveal themselves in specifics. The new draft legislation includes a little more information, but not much. However, I did enjoy the footnote to a curious calculation, which reads: “The following simplifying assumptions have been made: that required debt returns are fixed as long as minimum cover ratios are met, and that equity investors’ hurdle rates do not vary with gearing/variability of prospective equity returns.” (emphasis added) That’s exactly the type of simplifying assumption one needs to make sense of the plan.

Delta’s Refinery Gambit: It’s Not About Volatility

Delta Airlines’ deal to buy the Trainer Refinery owned by Phillips66 was formally announced yesterday. The 8K filing is available here and includes the press release and slide show. Until yesterday the deal was being talked about as a way to hedge the fluctuating price of jet fuel oil. But the announcement makes clear that the objective is something different entirely: battling the rising jet fuel crack spread in the Northeast U.S. where Delta has critical hubs at LaGuardia and JFK.

This is one of the key charts from Delta’s slideshow highlighting the rising crack spread Delta has paid over the last three years.

The possibility of further closures of East Coast refineries threatened to drive the local spread even higher, Delta claimed. Delta believes that by investing in the refinery, including $100 million in investments to shift even more of its production to jet fuel, it will be able to source its fuel cheaper and able to bargain better for the balance of its needs.

The title of Delta’s presentation reads “Addressing Rising Jet Fuel Risk”, and it does contain talk about how “jet fuel crack spreads cannot be cost-effectively hedged”, among other language evocative of risk management and hedging. But it would be a mistake to try and understand this as a hedge in the traditional sense. Delta isn’t trying to limit volatility: at least not volatility around a mean. It’s trying to put direct pressure on the mean level of the jet fuel spread. That’s a different thing entirely.

This is an attempt to gain a strategic advantage in the airline industry. Will it payoff? Apparently yes, according to Delta’s projections. Even if the Brent-WTI spread reverses and becomes negative and many East Coast refineries reopen for business, that will likely take longer than one year, as much time as Delta believes is needed to payback the investment. Time will tell.

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Update: Liam Denning at the WSJ provides some useful statistics:

The Justice Department considers a market with a Herfindahl-Hirschman Index score above 2,500 to be “highly concentrated.” In 2010, the East Coast refining market’s score hit 3,255, against a nationwide one of 680, according to the Federal Trade Commission. If Pennsylvania’s Trainer facility had stayed idle rather than be bought by Delta, the score would likely have surpassed 4,000, according to the American Antitrust Institute.

Morgan Stanley says potahto

You like potato and I like potahto,

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. Continue reading

Reading the Term Structure of Futures Prices

Over the last few years, natural gas prices in the U.S. have been pounded by a variety of factors. Front and center are the continuing breakthroughs in horizontal drilling and hydraulic fracturing. On top of this, the winter of 2011-2012 was the fourth warmest on record, according to the National Oceanic Atmospheric Administration (NOAA), and those temperatures slashed demand. From a peak of over $13/mmBtu in July 2008, the price fell to almost $2/mmBtu in March 2012.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

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So that’s Delta hedging!

Lots of commentary on the web about the news that Delta Airlines is thinking about buying ConocoPhillips’ Trainer Refinery as a way to hedge the cost of jet fuel. Liam Denning at the WSJ’s Heard on the Street column offers a concise statement of the critical view.

Reply to “jump”

In a previous post, I criticized a report by the consulting firm IHS on the potential impact of the Volcker Rule on the US energy industry.  Kurt Barrow, Vice President of IHS Purvin & Gertz and co-author of that report, has sent me the following reply:

Thank you for your interest in our report.  We wanted to take an opportunity to clarify a few points about our work.

The first point in your Blog refers to “bans banks from proprietary trading” but should instead speak to “restrictions on market makers.”  We have no issue with bans on bank proprietary trading, and the banks have already exited, or are Continue reading

Sweeping for cash in the hedges

Natural gas producers in the US are faced with tough choices. Advances in drilling technology have made low cost production from shale resources viable on a large scale, and the industry has been in a race to lay claim to the most valuable properties and to capture a competitive advantage in mastering the technology. But at the very same time, the price of natural gas has collapsed, erasing profits. This has pinched budgets and forced companies to be creative in finding fresh sources of capital. It has also forced companies to re-evaluate development plans and resource acquisitions.

The price of natural gas in the US has been falling almost continuously since mid-2008 when it peaked at over $13/mmBtu. It now lies just above $2/mmBtu.

Despite the falling price, natural gas production in the US has continued to climb. According to data from the EIA, between July 2008 and January 2012 US production increased 17%. Companies have been slow to adjust their expansion plans to the falling price. Finally, in late 2011 and early 2012, companies have begun to adjust their capital expenditures to the current low natural gas price reality. Gregory Myers has reported on this in the Financial Times, citing decisions at Chesapeake Energy and ConocoPhillips. In 2011, Encana Corp finally confronted reality and abandoned its 2008 pledge to double production.

Even as capital budgets are cutback, companies still face a need to raise new cash. The new technologies can also be applied to production of unconventional oil resources, like the tight oil in North Dakota’s Bakken Shale or Texas’ Eagle Ford Shale, as well as to development of liquid rich gas fields. Since the price of oil remains high, it can pay to develop these resources. But many natural gas companies with experience in the new technologies find themselves cash poor due to the low operating profits on their gas properties. Cash poor, and prospect rich.

These companies are selling their traditional gas assets to buy higher value shale deposits. Equity issuance is also at historically high levels. Dealogic estimates that share issuance by the sector represents one-fifth of all the US equity raised this year.

A more interesting development is to get cash from accrued gains with pre-existing hedges as reported by Ajay Makan in the FT. An example would be of a company which had entered in 2009 into short positions in forward/futures natural gas contracts for the next six years, until 2015. Right now, in March 2012, the company has on its books gas contracts with maturities varying from June 2012 to 2015. Since the gas yield curve back in 2009 when the company initiated the positions was significantly higher than the current gas yield curve, the company is sitting on significant unrealized gains. Consider just one of its many futures positions: 1000 contracts sold in 2009 with maturity March 2014. The price in 2009 of a March 2014 contract was around $4. Now the same 2014 futures price is around $3.4. Since each contract is for 10,000 mmBTU, the company can close the position and make a profit of 10,000 mmBTU x ($4-$3.4) = $6,000 per contract, for a total of $6 million.

The companies can close out these contracts in order to cash in on the gains.

A couple of questions are in order:

1. Why would the companies want to do that?

2. If the companies sold the hedges wouldn’t they become unhedged and exposed to greater risks?

The answer to the first question lies in the fact that with low gas prices, companies are not able to generate enough cash from operations to fund investment in land, drilling and exploration of shale gas fields, when the industry faces a lot of competition to own such assets.  Faced with an operating cash squeeze, the companies are tapping their reservoir of gains generated by pre-existing hedges.

But, going forward, won’t the companies be much more vulnerable to price gyrations if they liquidate their hedges?

No.

The companies can immediately lock into new forward contracts at the prevailing forward price. The companies are simply realizing past gains on their outstanding contracts in order to plough the money back into their businesses. Unrealized gains are a wasted resource. The companies are free to establish new hedges. Analysts who claim that companies are taking on more risk to avoid cutting back on investment are just wrong.  There is not a conflict between cashing in on unrealized gains from past hedges and being hedged going forward.

The quickest way to a conclusion, … jump.

Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.

It’s a hatchet job.

Why?

Continue reading

NERA Doubles Down

In a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs companies would face as the Dodd-Frank reform of the OTC derivative markets is implemented. NERA is working on behalf of a group of energy companies lobbying to avoid some of the law’s mandates. Last week, NERA filed a “Briefing Note” with the CFTC specifically addressing my criticism and explaining the reasoning that leads them to stand by their original numbers.

What is at issue? Dodd-Frank forces companies to margin swap trades that previously could be executed without margins. Does this impose extra costs on those companies? If so, how large are these costs?

Continue reading

The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

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