ENERGY DERIVATIVES & RISK MANAGEMENT
There is also a USD/EUR exposure as the overall
costs are a function of the change in and the EUR/USD exchange rate. The foreign exchange is dynamic because its magnitude is a function of oil prices.
Analysis of Sample Contract Let’s assume that we are a utility based in Great
Britain and have a Euro-based oil-linked contract for calendar year 2015. Our revenues are in British Pounds, so we are interested in forecasting and managing the cost of gas in British Pounds as well. Our contract is linked to Fuel Oil and Gasoil. The
contract is priced in EUR/MWh and its formula is the following: The contract terms are shown in Table 3 below:
The calculation of the expected costs in EUR/ MWh and GBP/MWh is performed following a series of steps.
Step 2. Calculate the Fuel Oil & Gas Oil Components
a. Calculate Fuel oil and Gasoil in EUR/Mt; b. Convert fixed costs to EUR/Mt; c. Calculate total Fuel Oil & Gasoil costs in EUR/Mt; d. Convert it to EUR/MWh using coefficients a and b respectively;
e. Convert price to GBP/MWh by applying GBP/ EUR cross-rate.
Table 3. Contract Terms Product
Unit 1 (x) 0 (y)
Commodity Price 1 0.1% Gasoil USD/Mt 0.0169 Commodity Price 2 1.0% Fuel Oil USD/Mt 0.0339 Structure
Multiplier Fixed Costs $ 30.00 $ 25.00
1 (z) The gas price will be recalculated monthly based
on the price of Fuel Oil and Gasoil the prior month. The market inputs required to estimate the costs
for calendar year 2015 are the forward curves for Fuel Oil and GasOil in USD/Mt, and the forward exchange rates for EUR/USD and GBP/USD.
Step 1. Collect market inputs to value the expected costs in EUR/MWh & GBP/MWh
1.0% Fuel Oil Curve (USD/Mt)
Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 May 15 Jun 15 Jul 15
Aug 15 Sep 15 Oct 15 Nov 15 Dec 15
584.77 586.84 583.94 581.77 582.57 580.23 578.16 578.57 576.04 573.8
571.45 569.19
Source: NQuantX 56 March 2014
Gas Oil 0.1%
(USD/Mt) 890.4
889.58 885.35 881.43 876.96 872.52 869.47 867.83 866.52 864.44 861.68 858.31
FX
(EUR/ USD)
1.3684 1.3684 1.369 1.369 1.369
1.3699 1.3699 1.3699 1.373 1.373 1.373 1.373 1.373
FX (GBP/ USD)
1.643 1.643
1.6412 1.6412 1.6412 1.639 1.639 1.639
1.6339 1.6339 1.6339 1.6339
Commodity & FX Hedging Corporations that face commodity and foreign
exchange risks such as those arising from oil-linked contracts need to develop integrated hedging programmes based on achieving a series of clearly defined risk management objectives. In some organizations, the commodity price
component is not hedged by the same functional unit as the foreign exchange risk. For example, treasury may handle the EUR/USD forward deals, while the commodity trading group is responsible for hedging the Fuel Oil and Gasoil exposures. Due to the dynamic and sometimes inter-related behaviors of these exposures, it is critical that there be an integrated and centrally managed hedging programme in place. This is necessary to account for natural hedging effects across exposures, and to avoid the unintended accumulation of large residual risks. As we discussed in our previous article2
, a
hedging programme can be tailored to optimize a set of risk management objectives based on certain constraints. Firms that actively identify the key objectives of a programme and design an integrated hedging strategy to meet them are likely to develop a competitive advantage over firms that approach hedging decisions in a reactive and unfocused fashion.
Steps to hedge the commodity price and foreign exchange risk of the contract From the perspective a utility with revenues
In our sample contract, the expected costs for calendar year 2015 would be 29.8 EUR/MWh, which converted to GBP would yield 24.93 GBP/MWh. The calculations are fairly simple, and they just require paying special attention to the Fuel Oil and Gasoil average and lag component, as well as converting expected future cashflows using the prevailing forward exchange rate. For those readers interested in the spreadsheet with the calculations, they can write us at:
carlos@nquantx.com
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