London Aromatics Forum Platts assessment of benzene paper swaps

1
London Aromatics Forum Platts assessment of
benzene paper swaps
Thomas Giaever-Enger Director, Methodology RD
London May 6, 2008
2
Agenda

• Platts assessment of benzene paper swaps
• How and why benzene paper swaps are used
• An introduction to hedging

3
Agenda

• Platts assessment of benzene paper swaps
• How and why benzene paper swaps are used
• An introduction to hedging

4
What does the benzene swaps contract look like?

• Basis FOB Korea
• Volume 500mt lot size
• Price tick US 0.01/mt
• Timing Monthly contracts three months forward.
• Settlement Arithmetic average of Platts daily
  spot marker physical cargo assessments in the
  contract month, rounded to 3 decimal places.
• Assessment From March 10, daily at 4.30 pm SG
  time at close of assessment window.

5
Why now? Demand growth for paper swaps in Asia
6
24 companies have tried aromatics paper swaps
7
Use of Platts physical spot assessments in pricing

• Platts daily spot benchmark for physical cargoes
  FOB Korea is used to price term contracts across
  Asia
• Platts daily spot benchmark for physical cargoes
  FOB Korea is used to price derivative benzene
  paper swaps FOB Korea

Term contracts
Paper Swaps
Spot
8
Paper swaps are derivative of physical prices

• PCA 206
• Asian benzene daily spot physical cargo
  assessments 31 Mar 08
• (US/mt) FOB Korea On day
  FOB SEA On day
• LC at sight Change
  LC at sight Change
• Marker 1094.00-1095.00 2.00
  1091.00-1092.00 2.50
• H1 Apr 1082-1084 1.00
  FOBK -6.00
• H2 Apr 1092-1094 2.00
  FOBK -4.00
• H1 May 1095-1097 2.00
  FOBK -2.00
• H2 May 1098-1100 3.00
• H1 Jun 1095-1097 3.00

9
Settlement uses monthly average of daily physical

• PCA 206
• Asian benzene daily physical cargo assessments
  31 Mar 08
• (US/mt) FOB Korea On day
  FOB SEA On day
• LC at sight Change
  LC at sight Change
• Marker 1094.00-1095.00 2.00
  1091.00-1092.00 2.50
• H1 Apr 1082-1084 1.00
  FOBK -6.00
• H2 Apr 1092-1094 2.00
  FOBK -4.00
• H1 May 1095-1097 2.00
  FOBK -2.00
• H2 May 1098-1100 3.00
• H1 Jun 1095-1097 3.00
• Marker used to generate physical monthly average
  1073.250
• (calculated to 3 decimal places, for settlement).

10
Daily swaps assessments published from March 10

• PCA 766
• Asian benzene daily paper swaps assessments 10
  Mar 08
• (US/mt) FOB Korea
• Bal-Mar 1089.00 - 1091.00
• Apr 1094.00 - 1096.00
• May 1099.00 - 1101.00
• Jun 1104.00 - 1106.00
• (No balance month assessments from 16th of each
  month).
• Benzene (Feb) physical monthly average 1073.250
• (calculated to 3 decimal places, for settlement).

11
Physical paper assessments are aligned in time
Windows compress liquidity so that best prices
meet at a point
Firm offers
Firm bids
430pm SG time market-on-close assessment
4.00pm SG time cut-off for new bids/offers
12
Swaps allow for accurate floating price cargo
deals
13
Swaps allow triangulation of prices with physical
Physical fixed price paper swap differential
(premium / discount)
Platts will host monthly seminars in Singapore to
explain this assessment methodology in
detail. In-office training courses in Seoul also
available upon request.
Swap
Differential
Fixed price
14
Mean of Platts Korea (MOPK) Premiums / Discounts

• A physical cargo traded at a premium/discount,
• e.g. May cargo done at MOPK 5/mt
• expresses the differential between the fixed
  price and the swaps level for that specific
  timeframe.
• i.e. If the underlying swaps market in the MOC
  assessment window at that time was trading at
  1095/mt, and a cargo was traded with a MOPK
  premium of 5/mt, the fixed price equivalent
  would be 1100/mt, which Platts could use for its
  assessments.

15
MOPK / swaps relationship backwardated market
Fixed price May equivalent at 1100/mt
1100
Any May cargo traded at MOPK5/mt premium
1095
x
Any May swap trading at 1095/mt
1090
x
Any June swap trading at 1095/mt
1085
1080
H1 Jun
H2 Jun
H1 May
H2 May
H2 Apr
16
Triangulation of fixed, swaps and floating prices

• Physical fixed price paper swap differential
  (premium / discount)
• e.g.Trade of 1100/mt May cargo Trading of
  1095/mt May swaps and trade of cargo at MOPK
  plus 5/mt
• The spot market relationship between fixed
  prices, premiums, and swaps can be realized
  happen outside the assessed marker period (the
  2nd and 3rd half months forward from date of
  publication).
• But we can extend the forward curve forwards or
  backwards in time to compare prices.

17
MOPK / swaps relationship backwardated market
Marker assessment Average of H1 May H2 May
1000/mt
1105
Fixed price H1 May equivalent 1102.50/mt
H1 May cargo MOPK5/mt
Fixed price H2 May equivalent 1097.50/mt
1100
x
H2 May cargo at MOPK5/mt premium
Bal. Apr swap 1098/mt
1095
x
Any May swap trading at 1095/mt
1090
x
Any June swap trading at 1090/mt
1085
H1 Jun
H2 Jun
H1 May
H2 May
H2 Apr
18
MOPK Premiums / Discounts

• Premiums will usually rise when the market is
  backwardated (prompt prices are higher than
  forward prices).
• In a contango market (prompt prices are lower
  than forward prices), premiums will have a
  tendency to turn into discounts.
• The steeper the forward curve, the greater the
  premium or discount will usually be.

19
Comparing fixed to floating, and floating to fixed

• To make an accurate assessment, Platts converts
  all floating premiums into fixed prices, and all
  fixed prices into floating premiums, to see which
  numbers are sharpest.
• Physical bids will often take the form of either
  fixed or floating basis
• e.g. BP bids any May at 1100/mt or MOPK5/mt
  3kt
• Q. Which is a better price?
• A It depends if May swaps are under or over
  1095/mt.

20
MOPK / swaps relationship backwardated market
Platts assessment of tradeable value
Any May cargo offer at MOPK10/mt
1105
Fixed price H2 May offer 1100/mt
1100
H2 May cargo bid at MOPK5/mt equivalent to
1099/mt
1095
x
Fixed price H1 May bid 1095/mt
H2 May swap (May 23rd) equivalent _at_ 1094/mt
1090
x
Any May swap trading at 1095/mt
Any June swap trading at 1090/mt
1085
H1 Jun
H2 Jun
H1 May
H2 May
H2 Apr
21
Swaps assessment

• Accurate measure of swaps market values is
  essential.
• This happens at 4.30 pm SG time to align paper
  prices with fixed and floating physical prices.
• Swaps prices are still adjusting right upto
  market close, unlike physical cargoes which are
  frozen at 4.28pm.

22
Agenda

• Platts assessment of benzene paper swaps
• How and why benzene paper swaps are used
• An introduction to hedging

23
What are paper swaps?

• Financially settled derivatives
• Paying a difference between a derivative swap
  value and underlying physical price, settled
  against a published marker (Platts physical
  benzene FOB Korea assessment)
• Commoditized swaps are traded directly often
• e.g. Gasoil or fuel oil FOB Singapore, Dubai
  crude oil swaps
• Traded over-the-counter (customized to users
  needs)
• Facilitated by brokers all day (and in
  assessment windows)

24
What is actually being swapped, and how?

• The swap exchanges fixed-for-floating price risk
• Fixed price is the agreed purchase / sale price
  of the paper swap
• Floating price is the monthly average of daily
  physical assessments
• How do the swaps price out?
• Settlement is against Platts published monthly
  average of FOB Korea physical marker assessment,
  calculated to 3 decimal places, and published on
  the last working day of the month.
• Cash settlement
• No physical transaction or cargo ownership
• No immediate payment of the difference between
  the swap and physical monthly average, until the
  end of the traded month.

25
Who would use a paper swap, and why?

• Producers of benzene can stabilize monthly
  revenues
• Processors of benzene can fix input (feedstock)
  costs
• Producers / processors can safely offer
  fixed-price products to their customers
• Integrated refiners can (partially) fix cracking
  margins
• Traders can manage physical spot price
  volatility
• Traders can thus offer better spot value for
  physical cargoes to producers and consumers
• Banks can write custom-made swaps (e.g. Q2 or H2
  2008 or calendar year 2009) on behalf of
  producers end-users

26
Example 1 Producer hedges against falling prices
Profit / Loss

• Underlying position (Long)
• Exposed to prices falling
• If profit is made from physical cargo price rise

• Derivative hedge (Short)
• Covers risk of prices dropping
• Then paper loss from physical cargo price rise

Physical and swap profit loss balance to
fix income
27
Example 2 Consumer hedges against rising prices
Loss / Profit

• Derivative Hedge (Long)
• Covers risk of prices rising
• Then paper profits made from physical cargo
  price rise

• Underlying position (Short)
• Exposed to prices rising
• If costs rise from physical cargo price rise

Swap and physical profit loss balance to fix
costs
28
Anatomy of a swap An exercise

• Producer (one 3,000mt cargo long each month) is
  exposed to physical cargo prices falling.
• Producer goes short by selling April and May
  benzene paper swaps (e.g. to a trader bidding at
  1000/mt).
• 6 swaps of 500mt traded (via a broker, cleared
  by SGX) for each month of April and May at fixed
  price 1100/mt
• Producer is 100 hedged for 3,000mt per month.
• Producer hereby locks in his April and May cargo
  sales at 1100/mt.

29
Anatomy of a swap An exercise

• In April, published index price (floating)
  settles below swap price (fixed)
• e.g. on Apr 30, Platts physical monthly average
  (floating) 1085/mt.
• April swap (fixed) was traded at 1100/mt.
• So buyer (trader) pays seller (producer) the
  difference of 15/mt
• Swap settlement (for the seller)
• Contracted volume x (Fixed price Floating
  price)
• e.g. (6 x 500mt) x (1100-1085/mt)
• 3,000mt x plus 15/mt
• Therefore the producer covered a potential 15/mt
  loss incurred
• by selling its April cargo at the typical spot
  price of 1085/mt.

30
Anatomy of a swap An exercise

• In May, published index price (floating) settles
  above swap price (fixed)
• e.g. on May 31, Platts physical monthly average
  (floating) 1105/mt.
• May swap (fixed) was traded at 1100/mt.
• So seller (producer) pays buyer (trader) the
  difference of 5/mt
• Swap settlement (for the seller)
• Contracted volume x (Fixed price Floating
  price)
• i.e. Swap settlement for the seller (6 x 500mt)
  x (1100-1105/mt)
• 3,000mt x minus 5/mt
• Therefore the producer cancelled out a potential
  5/mt gain by
• selling its May cargo at a typical spot price of
  1105/mt.

31
A perfect hedge locks in a fixed profit stream
5
15
1100/mt
1100/mt
-15
-5
May
April
32
Why hedge with a swap rather than a forward cargo?

• Swaps have a smaller minimum clip size (500mt)
• Swaps are therefore easier to trade quickly
• Swaps are a purely financial instrument
• Swaps are thus easier to handle operationally
• Swaps enjoy more participants greater
  liquidity
• Swaps prices are therefore more competitive

33
Agenda

• Platts assessment of benzene paper swaps
• How and why benzene paper swaps are used
• An introduction to hedging

34
What are the main reasons to consider hedging?

• Managing exposure to price risk
• Avoid disastrous spot price movements
• Reduce cash flow volatility
• Hedging can be done at any time and with a lot of
  flexibility.
• Help corporate financial planning
• A long term insurance policy with swaps is most
  effective when the hedger believes that the
  physical market price is at a significant or
  longer-term high or low.
• Free capital reserves held against shocks
• A near-perfect hedge of production / consumption
  volumes against inevitable price shocks is
  possible with swaps in multiples of 500mt.

35
Price risk Benzene is more volatile than oil
36
Processing margins are also highly volatile
37
Upstream indicators are poor hedging instruments
38
The difference between hedging and speculating

• Hedging is great, we always make money on
  swaps
• Hedging with swaps is not about winning or
  losing money, it is about locking in profits
  with cash flows in opposite directions
• We hedge speculatively sometimes 0 and
  sometimes 100
• Even the best traders get market direction wrong.
  Lack of a clear risk control policy means cash
  flow management will suffer.
• Prices are too high / too low we cant start
  hedging now
• Successful hedgers plan ahead and make a
  long-term commitment to reducing cash flow
  volatility, building experience and expertise.
• Hedging is too expensive to set up its not
  our core business
• Producers and end-users have millions of dollars
  of price exposure. Marginal success or failure
  has a huge effect on business financials.

39
Why use benzene paper swaps for hedging?

• No counterparty risk
• Credit concerns now removed
• Swaps trade now standardized
• Hedging at little upfront cost
• Flexibility, ease of use
• Basis risk is neutralized
• High correlation with underlying
• Competitive advantage
• (Next four slides in more detail)

40
Why use benzene paper swaps for hedging?

• No counterparty risk
• During 2007, emerging bilateral paper swaps trade
  in Asia was limited to only the biggest players
  with good credit standing.
• Counterparty risk in paper trade is lower
  compared with the logistical / quality concerns
  of transporting physical cargoes, but paper
  losses could still be great.
• Now, the risk of any medium or small counterparty
  defaulting on paper losses is mitigated fully by
  SGX clearing facility.

41
Why use benzene paper swaps for hedging?

• Credit concerns are now removed
• Bz paper BP offer July swap at 1030/mt FOB
  Korea, basis MOPK daily, 3kt, (trigger L/C
  standard condition for non-open account
  counterparty)
• Bz paper Vitol offer July swap at 372cts/gal,
  basis July USCP, 1kt (100k triggered standby
  L/C)
• Paper swaps trade can now be standardized
• Bz paper Landmark offer Apr swap 1100/mt FOB
  Korea, basis MOPK daily, 500mt
• Bz ppr Interchem bid Apr/May spread at 10/mt,
  3kt

42
Why use benzene paper swaps for hedging?

• Hedging at little upfront cost
• No requirement of production, storage or
  transport facilities.
• No extra capital sunken into owning 3,000mt
  cargoes at a cost of 1100/mt each.
• A deposit with SGX covers day-to-day margin
  calls.
• Broker fees proportional to physical cargo trade,
  on per mt basis. No costs of trade via assessment
  window.

43
Why use benzene paper swaps for hedging?

• Flexibility, ease of use
• The user can arrange a very specific hedge with a
  single instrument, to meet its physical supply /
  demand requirements.
• Basis risk is neutralized
• Product, location, time basis risk is eliminated
  by a swap matching the physical conditions of
  cargo trade.
• High correlation
• Hedgers typically look for an instrument which
  can supply a correlation of between 85 to 115
  of the physical underlying.
• Competitive advantage
• Is achieved by locking in better prices than
  competitors, who may be exposed to sudden spikes
  or collapses in spot prices.

44
Are there risks when using paper swaps?

• Opportunity cost
• Speculative elements
• Limitations
• Hedging traps
• (Next four slides in more detail)

45
Are there risks when using paper swaps?

• Opportunity cost
• By limiting potential losses from physical spot
  market price fluctuations, the hedger also risks
  missed opportunities to profit.
• It is important that management sign off on this.
• But locking in a fixed income stream helps to
  steady cash flow and plan plant operations.

46
Are there risks when using paper swaps?

• Speculative elements
• Speculation has an important role in market price
  discovery and in boosting liquidity. Speculative
  positions are often a useful counterpart to
  hedger positions.
• Speculation exaggerates swaps price volatility,
  but derivative swaps do not significantly
  influence underlying physical value.
• Swaps markets have fewer big speculators (e.g.
  pension funds) than futures (e.g. WTI crude on
  NYMEX exchange).

47
Are there risks when using paper swaps?

• Limitations
• Understand the limitations and dangers of
  derivatives markets you are going to use! (e.g.
  lesson of China Aviation Oil)
• Identify and plan for price risks of plant start
  up / outage / position reversal - dont wait to
  hedge until it is too late!
• Basis risk - is there a good correlation of paper
  swaps with underlying physical prices?
• Seek advice from banks, derivatives experts (or
  hire them)

48
Are there risks when using paper swaps?

• Checklist to avoid hedging traps
• Adequate staff experience / knowledge
• Management understand implications, derivatives
  accounting and M2M
• Risk management controls, e.g. segregation of
  front and back offices, volume limits
• Clear policies and procedures for trading,
  reporting, management accountability
• Deliberate fraud is rare - its usually basic
  human error
• (e.g. Enron / CAO)