surviving in a world with high energy prices
TRANSCRIPT
Surviving in a World with High Energy Prices
September 19, 2007
PV Krishna Rao
Citigroup Energy Inc.
Citigroup’s Global Commodities Group is comprised of specialists and traders that work closely with clients to structure relevant, cost effective, and creative solutions
Citigroup’s five capital commitment desks actively trade the following commodities and can thus ensure efficient global pricing
Crude Oil– IPE Brent– Dated Brent
• Distillates*• Metals
• Natural Gas• Gas Basis• Electricity• WTI Crude Oil• Propane / NGLs
• Crude Oil– Dubai– Tapas
• Distillates*
London – European Hub
Singapore – Asian Hub
HoustonNew York• International Crude• Unleaded Gasoline• Distillates*
– Heating Oil– Diesel Fuel– Jet Fuel
• Residual Fuel
Calgary• Natural Gas
Citigroup Commodity Trading Capabilities
* Products trade at various locations, including US Gulf Coast, New York Harbor, ARA (Amsterdam, Rotterdam, Antwerp), Mediterranean Cargos, Singapore
While higher costs are expected to hurt many companies, the impact may be different across sectors
Impact of Higher Energy Costs
Energy Volatility: % Volatility High and Stable vs. Surging $ Volatility
Energy, FX and IR Volatilities (Annual)
Source: Bloomberg and FactSet
Energy Dollar and Euro Volatilities (Annual)
Annual percent volatility of crude oil and gas remains relatively stable. Current energy volatilities are materially higher than FX and IR volatilities. FX rates volatilities in developed countries are about 10% while oil volatility is about 35%.
Energy volatility in Dollar and Euro terms has increased dramatically over last 8 years.
Note: Before 1999 we use the German Mark
0%10%20%30%40%50%60%70%80%90%
100%
1998 1999 2000 2001 2002 2003 2004 2005
Annual Natural Gas Volatility (%)Annual Crude Oil Volatility (%)Annual ST Int Rate Volatility, US 90D Libor (%)Annual Currency Volatility, Euro (%)
0
100
200
300
400
500
600
1998 1999 2000 2001 2002 2003 2004 2005
Annual Crude Oil Volatility ($)Annual Natural Gas Volatility ($)
Annual Crude Volatility (Euro)
Annual Natural Gas Volatility (Euro)
Note: The volatility of oil and gas in euros are left out of the graph as they are nearly identical to the volatilities of oil and gas in USD
An Increasing Impact on the US Economy
Cost of Oil and Gas is Increasing as % of GDP
Source: EIA and FactSet
1.5 1.8 1.6 1.1 1.42.1 1.8 1.7 2.0 2.6
3.30.60.7 0.7
0.5 0.6
1.00.9 0.7
1.11.2
1.6
0%
1%
2%
3%
4%
5%
6%
7%
8%
1995 1997 1999 2001 2003 2005
Gas % of GDPOil % GDP
2.0 2.4 2.21.5 1.9
3.0 2.5 2.5 2.8 3.54.51.0
1.2 1.10.9
0.8
1.51.4 1.2
1.92.0
2.6
0%
1%
2%
3%
4%
5%
6%
7%
8%
1995 1997 1999 2001 2003 2005
Gas % of GDP (Impact of One Standard Deviation Move)
Oil % GDP (Impact of One Standard Deviation Move)
…and Impact on the Downside Getting Larger
Cost of oil and gas increased as a percent of GDP from about 2% in 1995 to 5% in 2005
The impact of a one standard deviation price movement in oil and gas prices increased from 3% of GDP in 1995 to 7.1% in 2005
⎥⎦
⎤⎢⎣
⎡ ∗+∗
t
tttt
GDP)Price Gas Natural AveragenConsumptio Gas (Natural)Price Oil AveragenConsumptio (Oil
Note: Yearly total cost as % of GDP was calculated using the following formula:
Energy Price Changes …Uncertain ConsequencesThe impact of energy price increases on the economy and on corporate profits is complex
Because of the complexity and the potential lagged effects, firms may underestimate the impact
A World with High Energy PricesEnergy prices have risen to record levels in the past few years. This can alter the cost structure of firms, the competitive dynamics of a sector, and even the attractiveness of a sector altogether.
In the long run, protracted high energy prices can have an economic impact through inflation, resource allocation and political influence, that could affect all industries.
Key effects of rising energy prices:
– The effect of energy on the economy is higher today than it has been in the last ten years.
– Energy is more volatile than interest rates and currencies.
– Energy price increases negatively affect most sectors, except for the energy sector. This trend has increased, now extending beyond sectors that were traditionally affected through the impact of energy prices on the cost or revenue side.
– The magnitude of the impact is substantial.
Implications:
– Companies have traditionally focused on currency and interest rate exposures. Today, the valuation and cash flow impact from energy price moves can be more important.
– A firm should examine risks holistically, not in isolation.
– Rising energy prices impact a firm’s tactical and strategic financial decisions.
Value At Risk Analysis - Inputs for Integrated Risk Analysis
Sales Expenses
We consider market risk exposures in a simplified case of a US-based multinational company– Energy price risk: Energy costs are 5% of total expenses – FX risk: 42% of sales denominated in FCY and 30% of debt in JPY– Interest Rate Risk: Interest expense is 2% of total expenses; 100% of the debt is floating
Value At Risk Analysis – Hedging StrategiesDistribution of Net Income
Net Income (USD mm) EBITDA Margin (%) Debt/EBITDA (x)
Unhedged Case: – In the 95% downside scenario Net Income is
$0.3bn, a decrease of 67% from expected Net Income of $1bn
Hedging Market Risk:– Energy risk: improves Net Income downside
risk by $52mm (recall: energy is only 5% of expenses)
– FX risk: improves Net Income downside risk by $267mm
Integrated Hedging Strategy:– Hedging energy and FX together: eliminates
almost 90% of the risk. In the 95% downside case, Net Income is $0.9bn
Hedging Products for Different CustomersEND USERS PRODUCERS REFINERIES / MARKETERS
COMMONLY HEDGED COMMODITIES
Natural Gas
Unleaded Gasoline
Distillates (Heating Oil, Diesel Fuel, Jet Fuel)
Residual Fuel
Electricity
Base Metals
Crude Oil
Natural Gas
Electricity
Base & Precious Metals
Crude Oil
Unleaded Gasoline
Distillates (Heating Oil, Diesel Fuel, Jet Fuel)
Residual Fuel
NGLs (Propane & Butane)
TYPICAL CUSTOMER TYPES
Industrial Companies
Chemical Companies
Airlines & Cruise Operators
Shipping & Transportation
Local Distribution Companies
Utilities
Municipalities
E&P Companies
Power Generators
Mining Companies
Refineries
Storage Operators
Pipeline Operators
Financial Institutions
Professional Counterparties
STANDARD HEDGING INSTRUMENTS
Fixed-Price Swaps
Purchase Call Options
Costless Collars
Fixed-Price Swaps
Purchase Put Options
Costless Collars
Three Way Collars
Fixed & Floating Price Swaps
Crack Spreads
Options (Calls and Puts)
Costless Collars
Swap Example for an LDCLDC’s new marketing program allows industrial customers to lock in price of natural gas they use
LDC buys its gas at spot-price index from producers and is exposed to index fluctuations.
An Energy marketer can provide a swap to LDC exchanging the floating index for a fixed price
LDC can provide guaranteed price protection of $5.00 to its customers without risking financial loss caused by increasing natural gas prices
LDC
Producer
Customer Marketer
50,000
MMBtu/day Index
50,000 MMBtu/day
$5.00/MMBtu $5.00/MMBtu
Index
Crack Spread Swap for a Refiner“Cracking” is breaking down larger and heavier hydrocarbon molecules into lighter one with higher economic value
Refiners exposed to the price difference (“crack spread”) between their inputs and outputs.
Gasoline spread swap: Refiner exchanges the floating gasoline spread (Unleadeded gasoline –Crude) with a fixed spread payment thereby protecting his margin.
Marketer
Seller of Crude
Buyer of Unleaded
Crude Index
+ fixed spread
Crude Index
Crude Unleaded
Unleaded Index
Refiner
Unleaded Index
Crack Spread Option for a RefinerThe refiner can alternatively use a spread option
Unhedged refiner loses if the crack spread decreases, ie. if crude price increase relative to unleaded
Refiner can hedge by buying a put option on the spread.
Put payoff = Max { K – (Unleaded price – Crude price), 0 }
Example parameters:– Tenor: 90 days– Forward unleaded price: $85.00/bbl– Forward crude price: $80.00/bbl– Strike (at-the-money): $5.00/bbl– Volatility (unleaded): 50%– Volatility (Crude): 50%– Correlation: 90%– Interest rate: 5%– Put option premium: $3.665/bbl
Collar Example for a ProducerCollars provide energy producers and end users with price protection by forcing the price paid to move within a defined range.
An electric utility generates power using residual fuel oil.
It can pass through increases in fuel oil prices, but only until price reaches $90/bbl.
If fuel oil prices fall, it shares the windfall with customers
The utility can purchase the fuel oil at floating index and combine it with a collar (call@90 – put@40) to protect itself from price increases.
The short put premium offsets the cost of the long call.
Effe
ctiv
e O
il C
ost (
$/bb
l)
Index Price ($/bbl)
Index
Index with Floor & Cap
40
90
40 90
Hedging Products for Different CustomersEND USERS PRODUCERS REFINERIES / MARKETERS
COMMONLY HEDGED COMMODITIES
Natural Gas
Unleaded Gasoline
Distillates (Heating Oil, Diesel Fuel, Jet Fuel)
Residual Fuel
Electricity
Base Metals
Crude Oil
Natural Gas
Electricity
Base & Precious Metals
Crude Oil
Unleaded Gasoline
Distillates (Heating Oil, Diesel Fuel, Jet Fuel)
Residual Fuel
NGLs (Propane & Butane)
TYPICAL CUSTOMER TYPES
Industrial Companies
Chemical Companies
Airlines & Cruise Operators
Shipping & Transportation
Local Distribution Companies
Utilities
Municipalities
E&P Companies
Power Generators
Mining Companies
Refineries
Storage Operators
Pipeline Operators
Financial Institutions
Professional Counterparties
STANDARD HEDGING INSTRUMENTS
Fixed-Price Swaps
Purchase Call Options
Costless Collars
Fixed-Price Swaps
Purchase Put Options
Costless Collars
Three Way Collars
Fixed & Floating Price Swaps
Crack Spreads
Options (Calls and Puts)
Costless Collars
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