Planning Ahead

In the first of a series of educational articles on basic forms of risk management, we look at energy futures contracts.

Derivative! Ok, I said it. To long-time readers of EPRM the term is nothing new. But in some energy companies the term is still misunderstood or even considered taboo. In this first of a series of tutorials, we cover one of the most basic of derivative instruments: futures contracts.

When you have read this tutorial you should have a better understanding of what futures contracts are, how they are traded, the function of the clearing house, and physical delivery.

Many companies are of the belief that if a Barings Bank or Orange County, California could fail so miserably at using derivatives, they could be next - so they think the best policy is to steer clear of them altogether. In fact, it is well documented that the use of derivatives was not the problem at all in the cases mentioned. It was a lack of proper trading controls that allowed for the abuses to take place.

While more organisations are now more comfortable using derivatives in the energy business, it is still not uncommon to deal with firms that consider futures contracts to be strictly off-limits. This is occasionally due to regulatory issues, but more often down to a lack of understanding of the product.

WHAT ARE FUTURES CONTRACTS?

The futures contract is not some financially engineered product designed to extract money from unsuspecting users, but a well documented, firmly established financial instrument.

Its origin dates back to the mid- to late nineteenth century in the agriculture sector. The instruments we use today in the energy sector are loosely based on those very products. Today we see futures contracts on everything from interest rates, foreign exchange rates, equities, weather and, of course, energy.

For a formal definition of futures contracts, let us look to the New York Mercantile Exchange (Nymex), the world's largest energy futures exchange, which gives the following description: "A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price at a specified location. Futures contracts are traded exclusively on regulated exchanges and are settled daily based on their current value in the marketplace."

We can add to this by saying that they are standardised contracts that call for future delivery of a commodity. By standardised, we mean here that the only item to be negotiated is the price at which the contract will change hands.

It should be noted that a futures contract is, first and foremost, a financial instrument. Delivery will only occur if, at expiration, a trader is left with an outstanding position in the futures contract.

HEDGING RISK

The primary purpose of a futures contract is to transfer risk from one party to another. That is, risk in a financial sense is transferred from a party that wants to get rid of it, to another party willing to take it on.

Specifically, the risk we are dealing with is that of price risk. The transfer of risk can either be speculative in nature or as a hedge against price movement in a current or anticipated physical position.

Many users of futures contracts are also commercial users of the physical energy commodities they trade. An entity may want to hedge the amount of risk it holds in the physical commodity.

A company will often use a futures contract that is opposite to that of their physical position to minimise the risk of financial loss from holding the asset should the price change. As such, the purpose of a futures contract is to lock-in a price - this will become more important later in this series of tutorials.

The sole purpose for using a futures contract as a hedge is to guarantee us a fixed sales or purchase price for a commodity.

So who would be willing to take this risk away from the hedger noted above? A speculator, who hopes to profit from changes in the price of the futures contract. Unlike a hedger, the speculator does not own the underlying commodity and, therefore, will never take delivery of the product the contract represents.

BUYING AND SELLING FUTURES

The trading of futures contracts takes place on an official and regulated exchange. Only those individuals who are members have the right to trade. Everyone else must use a broker to conduct business.

Deals are transacted in two main ways - by a process called open-outcry or electronically.

Originally, business was only conducted by open-outcry in a 'pit' - essentially an arena that allows for the trading of a specific commodity on the floor of the exchange. Traders wear coloured jackets to identify themselves and their firm, and shout to communicate their intention of buying or selling. They also use hand signals to communicate volume, quantity and the month in which they intend to buy or sell.

In the past few years, many existing exchanges decided to add electronic trading to their existing open-outcry system. In some cases, electronic trading opens when the traditional open-outcry market closes. Other, newer, exchanges have begun operating electronically right from their inception. Essentially, these exchanges do not have an open-outcry mechanism. Instead they trade on a computer terminal and may be open for trading 24 hours a day and not just during normal business hours.

Futures contracts can be bought or sold much like any other common goods. Specifically, when we buy a futures contract, we are said to be long that instrument. Long implies a bullish market view - one that expects the market to rise. A long position obligates the buyer to take delivery of the physical commodity at expiration.

Figure 1 shows the profit and loss of having gone long a futures contract. As is shown, if a futures contract is purchased at $3 and the value of this instrument rises to $3.50, a profit can be realised. Hence the trader will liquidate the contract and collect more than what was paid for it.

Short, on the other hand, implies having sold a futures contract. Specifically, having sold something that you do not own. This is considered to be a bearish position - one that expects the market to fall over time. A short position obligates the seller to make delivery of the physical commodity at expiration. The profit/loss profiles shown in figures 1 and 2 help explain the expectation.

Figure 2 shows the profit and loss expected from being short a futures contract at $3. In other words, a trader has sold a futures contract at $3. As an example, the trader now has an obligation to deliver natural gas to the buyer at a price of $3. If he or she does not have the gas to deliver, the trader must buy it for less than $3 in order to profit from the trade.

Remember, though, that the delivery mechanism is only triggered at expiration and if you still have the long or short position outstanding. If physical delivery is not your intention, then taking a position that offsets, or is opposite to that of your existing position, will close out the original position. For example, if you are short a futures contract, to liquidate this contract and avoid delivery, you will go long a futures contract for the same contract month.

GUARANTEED PERFORMANCE

One advantage of a futures contract is that its performance is guaranteed by the futures exchange the instrument trades on. This helps to eliminate the credit risk you have in the physical market.

The exchange guarantees the trades of its members. Should one party fail to perform, the exchange will step in and make the transaction whole. In effect, the exchange is a third party to every transaction on the floor. It becomes the party selling to the buyer and the party buying from the seller.

To date, no exchange has gone bankrupt as a result of improper trades that could not be covered financially by the exchange. So, while no risk is ever too small to disregard, credit risk does exist. It is, however, sufficiently small enough to be discounted from our immediate concerns.

So how does the exchange limit this credit exposure? The answer is that the exchange does not directly assume the exposure. The credit exposure is borne by the clearing house, which is made up of brokerage firms that service that particular exchange. The clearing house is responsible for the matching and processing of all the trades done on the exchange floor.

All trades pass through the clearing system. Buys and sells are matched up by the clearing house and checked for accuracy to make sure both buyer and seller are in agreement. If the trades match, the trade is accepted. If there is a discrepancy, the clearing house is charged with finding the error and correcting it between the buyer and seller.

POSTING MARGIN

In order to trade in futures contracts entities must be able to show ability to pay for the contract. They accomplish this not by making full payment for the commodity, but by 'posting margin'.

Margin in this sense involves posting collateral of some sort, equal to a percentage of the actual commodity value. This is referred to as 'initial margin'. In most cases, this initial margin can be in the form of cash or certain other types of securities. This deposit is posted with the clearing house and held there until the entity liquidates the futures position. Upon liquidation, the clearing house will return the initial margin, plus any profits or less any losses.

The profit and loss received will be based on the full value of the commodity you control, not the amount posted into margin. As a result, futures are considered highly leveraged instruments - implying that the profit and loss potential of the instrument is greater than the capital at risk. This is all the more reason to have proper trading controls in place before undertaking a hedging programme involving futures contracts.

These types of controls are in place at the exchange for the protection of the participants. Only when the proper controls are not in place at the firms using futures do problems arise.

DELIVERY

We will close by discussing the physical delivery aspect of a futures contract. Upon expiration, futures contracts finish their life with the delivery of the physical commodity.

But not all contracts end in delivery - some (such as Brent Crude) are settled financially at expiration. Depending on the commodity, as little as 2% of energy commodities traded via futures contracts ever end up in delivery of the physical commodity.

The majority of all contracts are bought for financial purposes as a hedge or for speculative purposes. As a result, they are used only as a financial tool, not as a mechanism for delivery. Those entities using the contract simply as a financial tool will liquidate it prior to expiration.

Ultimately contracts end up cancelling each other out, long to short. What we end up with is a net outstanding position of something close to zero as expiration approaches.

Dan Rowe is senior energy consultant at The Oxford Princeton Programme.

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