Section II Understanding and using risk management tools

1
Section IIUnderstanding and using risk
management tools
Measuring risk is essentially a passive activity.
Managing risk is a proactive process, where, in
dynamic markets, people are actively seeking to
change their positions so that their institution
has the risk profile they want it to have.
Patrick BrazelSun Guard Capital Markets, Risk,
January 1996
2
Overview

• Internal risk management tools
• The evolution of gas marketing and pricing
• Derivatives
• Alternative risk transfer

3
1. Internal risk management tools
Risk management is a comprehensive process that
combines philosophy, principles and methodology
to produce a culture of risk management
permeating the firm. Bankers TrustRAROC and
Risk Management, 1995
4

• Traditional risk management
• Reduce discretionary spending when revenues are
  low
• Lock in prices through physical contracts when
  they are at an attractive level
• Keep high cash reserves
• Keep stocks of the physical commodity
• Use insurance for standard risk (separate
  policies for separate risks).

5

• Traditional risk management can be boosted by
  incorporating it in a corporate risk management
  policy.
• This can include
• better gathering and use of information (reduces
  uncertainty, and allows more time to respond to
  changing conditions)
• a more objective determination of how much money
  to keep in cash and what credit lines to get
  from banks.
• longer-term contracts that allow back-to-back
  matching of input and output pricing
• diversification, and vertical integration.
• All these have a place in a risk management
  programme, but they have a cost.

6
 Optimal  risk management combines elements of
such  internal  risk management, of insurance,
and of use of market-based instruments.
7
2. The evolution of gas marketing and pricing
The future is full of growth opportunities for
nimble firms, intensely competitive at the burner
tip, and unforgiving of ponderous bureaucracies
or strategic errors. The business prizes will go
to those who can shed their past intellectual
baggage and embrace the new world of natural gas
entrepreneurship. Vinod K. Dat,
Resolve Conflicting Interests, Oil Gas
Journal, July 1985
8
Much of the investments necessary for gas
production and distribution are large, and to
protect investors, long-term contracts, at times
with long-term fixed prices, have been quite
common. At the same time, by the very nature of
natural gas use, consumption is volatile, so
natural gas buyers would prefer more flexible
marketing arrangements. In recent years, the
balance of power is shifting from producers to
consumers, and thus, long-term contract are
giving way to spot trading.
9
For example in the USA
Source International Energy Agency
10

• Developments in the US domestic gas market
• In 1982, hardly any spot market for natural gas.
• In late 1980s, spot market accounted for 80 of
  total gas market.
• By 1992, spot transactions had fallen back to
  about 35 to 40 of total gas trade and this has
  since remained stable.
• What happened around 1990 was that market players
  started using new types of long-term contracts,
  in which prices were not fixed, but indexed to
  the futures market prices.

11
This shift is not necessarily to producers
disadvantage. They already have had to adapt to
consumers variable demand by storing gas, at a
cost. And use administrative mechanisms to deal
with peak demand. Market instruments are more
efficient. In more developed markets, gas storage
is now used not just as a way to ensure
availability in peak demand periods, but also to
give producers extra possibilities to profit from
opportunities in the spot market. Having a
vibrant spot market for natural gas is thus a
win-win situation. And it will change the way
companies trade. For example, in the crude oil
market, it is common that cargoes are diverted en
route to take advantages of price differentials.
12

• With spot markets for natural gas, companies that
  invest in the proper management systems will see
• the costs of idle assets
• the impact of production decisions on
  profitability
• the impact of storage decisions on
  profitability.
• They will also be better able to assess the
  likely profitability of acquisitions,
  investments, and longer-term marketing contracts.
• This should normally change companies behaviour.

13
Spot markets for natural gas are inherently
volatile. This gives new profit opportunities to
those who have flexibility, whether in their
supply or (if they have longer-term contracts) in
their demand. The volatility of the spot market
gives rise to the development of new, financial
contracts, to enable gas buyers and sellers to
mitigate these risks futures, options and swaps.
These financial contracts, combined with the
flexibility of the spot market, are often
superior to the old longer-term arrangements, and
these longer-term arrangements are likely to
disappear, or at least, to change (to volume
contracts with a price indexed to the spot price).
14
3. Derivatives
They're here, they're weird, and they're not
going away. Yes, these beasties bite, but
companies that tame them have a competitive edge.
Terente P. Paré, Fortune, July 25, 1994
15
Overview

• Price volatility
• Overview of hedging instruments
• Hedging with futures
• Hedging with options
• The over-the-counter market
• Choosing the proper instruments

16
Price volatility
17
(No Transcript)
18
In the USA, natural gas prices are very volatile,
more so than crude oil or coal prices. But US
natural gas trade is spot-market oriented. In
other parts of the world, longer-term contracts
still dominate, and the prices in these contracts
are less volatile than those seen at the level of
Henry Hub.
19
Hedging with futures
The market offers instruments to deal with
volatility. The most commonly used are futures
contracts. THESE ARE PRIMARILY FINANCIAL TOOLS
TO MANAGE VOLATILITY, AND NOT TOOLS FOR PHYSICAL
TRADING. The first futures contracts, for grain,
were introduced in the mid-19th century. Oil
futures markets only developed strongly during
the 1980s. Natural gas markets followed in the
USA in the 1990s, and in the late 1990s,
electricity futures were introduced in the US and
Europe.
20
Spot sales
Producers selling on a spot basis are fully
exposed to rising and falling commodity prices.
21
Spot sales and forwards
Beneficial Price Developments
Adverse Price Developments
Spot sales leave producers fully exposed to
price variations, good and bad.
22

• Fixed-price forward contracts make it possible to
  lock in prices.
• However, they have a number of disadvantages
• dependence on the counterpartys willingness
• counterparty risk
• lack of flexibility (what if you want to get out
  of the contract?)
• pricing may not be optimal.
• Instead of using forwards,one can use futures
  contracts, as traded on futures exchanges.

23
Futures contracts are standardized 1. Quantity
stated in an agreed unit of measure 2. Quality
Stated in accordance with international standards
3. Expiration months specifies the duration of
the contract 4. Delivery terms details how
delivery is to be executed 5. Delivery dates a
firm fixed future date 6. Minimum price
fluctuation the minimum band within which price
fluctuation may be allowed 7. Daily price
limits 8. Trading days and hours They are traded
anonymously.
24
Hedging with futures
25
Hedging with futures
Underlying position (long)
26
You do not have to hedge your whole underlying
position. You can also hedge part of it.
27
Hedging - the principle use the fact that your
physical market and the futures market move in
parallel, and take a position on the futures
market that offsets the risk exposure that you
have in the physical market. In this case, you
plan to sell in March.
Physical market price Futures
price 1/1 100 110 sell futures lt 110gt
(you don t get the money, but you have
to pay a margin of say, 10) 1/3 90 100
sell physicals 90 close
futures (buy) lt-100gt profit on futures
10 Total
earnings 100
28
Basis risks correlation between the two markets
may be imperfect
Physical market price Futures
price 1/1 100 110 sell futures lt 110gt
(margin 10) 1/3 90 105 sell physicals
90 close futures (buy)
lt-105gt profit on futures
5 Total earnings 95
29

• Even if there is no relevant natural gas market,
  hedging may be possible. In particular,
  internationally-traded LNG is normally
  benchmarked to competing fuels, so there are
  different regional markets
• In the USA, LNG vs. pipeline gas. Benchmark
  Henry Hub
• In Europe, LNG vs. Low-sulfur residual fuel oil.
  Prices lower than in the US, and less volatile.
• In Asia, LNG vs. crude oil explicit indexation.
  Higher prices than in the rest of the world.

30
The price index used in many Asian LNG contracts
is the Japan crude oil index, JCC (the average
price of 17 crude oils imported into Japan).
This is not optimal for hedging, as there is a
basis risk compared to the international crude
oil futures contracts, WTI in New York and Brent
in London. Still, this basis risk is manageable
(and basis risk provides not just risk, but also
opportunity). The basis risk is least with the
Brent contract WTI is at times influenced by
purely domestic US factors. Over time, natural
gas futures markets specific to Asia or even to
India will develop. But even once these exist,
it will probably be useful to look at arbitrage
possibilities with the crude markets.
31

• When actually using futures markets, there are
  many practical issues that have to be taken into
  consideration.
• In particular
• basis risk (how well do price developments on
  the futures market reflect prices on the relevant
  physical markets normally, there are quality-
  and location-related risk, but in the case of
  natural gas, only the location-related basis is
  significant)
• contract structure is the market in
  backwardation or in contango, how typical is
  todays situation, and what does this imply for
  the period at which one hedges?
• margin call considerations.

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price
Backwardation. Common nowadays for many
commodities, including crude oil, metals other
than gold, and sugar
Time of contract expiration
March 99 May Sept Dec Mar 2000 May etc.
price
Contango. Common nowadays only for precious
metals, and often visible in markets for coffee,
cocoa, and grains
Time of contract expiration
March 99 May Sept Dec Mar 2000 May etc.
33
Futures contracts can be used - to avoid
the effects of fluctuations in prices for
producers who, because of their limited
production volume or seasonal factors, are
not able to spread out their sales over the year
or for consumers, who because of their
limited size cannot spread out their
purchases - to protect the value of
inventories, or partly finance the cost of
storage - to secure a processing margin -
to "lock in" future prices at an attractive
level and - to improve marketing policies.
The main disadvantages of using futures
contracts are that - they freeze up working
capital - although they may provide protection
against unfavourable price changes, they
do not permit profiting from favourable ones.
- they cannot be used for uncertain volumes.
34
Hedging with options
Using futures to cover price risks can provide
price protection, but has one important
disadvantage while strongly reducing the
likelihood of losses, the possibility to benefit
from price improvements is also lost. Options do
not have this disadvantage By buying an
option, protection can be obtained against
unfavourable price movements, while the
possibility to profit from favourable ones
remains.
35
This is the basic reason for the use of options
for hedging purposes. To determine what option
might be useful to protect against price risks,
firstly the risks have to be identified are
price rises, or on the contrary, price declines
the risk? Then, to protect against the effects
of a price change, an option can be bought giving
profits when prices move in the direction that
the buyer wants to protect against. Losses on the
physical goods will then be compensated by
profits on the options, just like is the case for
futures contracts.
36
In the case of futures contracts this kind of
price protection is paid for by giving up the
possibility of profiting from improved prices.
In the case of options, a fixed price has to be
paid the premium.
For example, if money would be lost when prices
decline (such as is the case for a producer who
is to sell his production, or for a trader who
has unsold commodities in stock), an option that
gives a profit when prices decline should be
bought. This is called a put option.
Graphically, this looks as follows
Put option
As can be seen in the chart of the put option,
declining prices cause losses on the physical
transactions, but buying a put option gives a
profit.
Profit/loss
Strike price
Unlimited profit
Spot price of the physical at the term period
Max. loss equal to the premium paid
37
If a price increase would involve a loss of money
(such as is the case for a consumer who still has
to buy the commodities he needs, or for a trader
who has sold commodities for a fixed price, while
he does not have these commodities in stock), an
option can be bought which gives a profit when
prices increase. Such an option is called a call
option. Graphically, this looks as follows
When prices increase, losses are made on the
physical position, but buying a call option will
then give profits. The result is protection
against price increases, but with still the
possibility to profit from price declines.
Call option
Profit/loss
Strike price
Unlimited profit
Max. loss equal to the premium paid
38
The option is like an insurance it provides
protection against price declines (put option) or
price increases (call option), and simultaneously
the possibility to profit from reverse price
movements.
more
39
Generally speaking, an option is a contract
granting its buyer a right, but not the
obligation to buy or sell a defined quantity of
the underlying product (for example a futures
contract) at a pre-fixed price, and to do so
during a period agreed beforehand or upon the
contract's expiry. The option buyer, also
called its holder, can choose to let the option
expire or to exercise it. On the contrary, the
writer or seller of an option has the obligation
to fulfil the contract when
the buyer decides to exercise. So with these
two options, four option positions can be taken
40
An option is determined by
European-style options may only be exercised at
the date of expiration.
the strike price which is the exercise price

the style which determines when the holder of an
option can exercise his right)
European-style
American-style
Intrinsic value
the premium which is the price of the option . It
is composed by
Time value
41
An option is determined by
the strike price which is the exercise price

the style which determines when the holder of an
option can exercise his right)
European-style
At the time of transaction, a price is set in
terms of the option contract, specifying a price
at which the underlying, for example a futures
contract, may be bought or sold. This price is
called the strike price, or the exercise price.
The option buyer may take (call) or make (put)
delivery of the contract against this price.
American-style
Intrinsic value
the premium which is the price of the option . It
is composed by
American-style options may be exercised at any
time between the date of purchase and the date of
expiration.
Time value
42
Options traded on most exchanges are American
options. Regardless of what option type is
involved, beyond the expiration date, the buyer
can no longer exercise his right.
An option is determined by
the strike price which is the exercise price

the style which determines when the holder of an
option can exercise his right)
European-style
American-style
When buying an option, a premium has to be paid
to obtain the rights laid down in the contract.
The premium is the price of the option. It is,
like other prices, determined by market forces of
supply and demand. As are other
market-determined prices, premiums are subject to
fluctuations.
Intrinsic value
the premium which is the price of the option . It
is composed by
Time value
43
It is either positive or zero and indicates the
value of the option at any time. For a call
option, the intrinsic value is the price of the
underlying futures contract minus the strike
price the intrinsic value of a put option is
equal to the strike price less the futures price.
So, a US 17
crude oil option will have a positive intrinsic
value for call options with a strike price below
US 17 and for put options that have a strike
price of above US 17.
44
When the futures price rises compared to the
strike price of a call option, its premium will
probably increase because of increased intrinsic
value (since it becomes more likely that
exercising the call will be profitable). The
premium of a put decreases when the price of the
underlying future rises, since the intrinsic
value diminishes it will become less and less
interesting to exercise the rights conveyed under
the option contract. Following the same
reasoning, for a futures price decrease, the
premium for a call option with a certain strike
price gets less since the chance of its exercise
diminishes, and the price for a put option goes
up.
45
The life-time of an option is one of the factors
that determines the time value. Suppose the
other factors - the price of the underlying
futures, the strike price, volatility and
short-term interest rates - remain the same.
Then, the time value decreases when maturity
approaches. The time value is highest when the
strike
price equals the price of the underlying asset.
When these two prices diverge, the time value
decreases. For then, the chances of exercise of
a put as well as the losses of an options seller
will be higher. The time value is, so to say, a
time-related flexibility value of an option.
e.g.
46
Imagine that all factors determining the time
value remain stable and only the volatility of
the price of the futures contract underlying the
option increases. Bearing in mind that the
option serves as an insurance against price
changes of the futures contract, it is obvious
that the price that has to be paid to obtain this
protection will rise. When the futures price is
more volatile, there is a growing chance that in
its life the option may become worthwhile to
exercise. This induces sellers to ask a higher
premium, for the risks they run get higher.
e.g.
47
Regardless of the fact if the buyer of the option
decides to exercise his right, the premium, once
paid to the seller of an option, remains in the
hands of the seller. The maximum amount the
options buyer can lose on his option position, is
the premium paid for the option. His profit
potential is virtually unlimited. A seller, on
the other hand, can only have profits limited to
the premium size his loss can be unlimited,
since prices may move to unforeseen low or high
levels. If the price of the underlying asset
drops below the strike price minus the premium
paid, the buyer of a put will exercise his right
and the seller has to take delivery against
payment of the, relatively high, strike price.
48
If a call buyer decides to exercise his option
when the strike price is below the price of the
underlying, the seller is obliged to deliver the
underlying asset. If he does not possess it, he
will have to buy the asset on the market and
suffer a loss equal to the difference between the
market price and the strike price (less the
premium which he has collected), which can be
enormous when supply is tight. The sale of a
call without the previous purchase of the
underlying asset, is said to be "naked". It is a
position meant to collect the premium, a purely
speculative and very risky position.
49
An option trader who has a net selling position,
in other words he has sold more option contracts
than he bought, is said to be short in options.
If a market participant has bought more contracts
than he sold, he is having a long position.
Following the same reasoning, a price decline
is beneficial to participants having a long put
position, for they can sell the underlying
at the strike price and will be able to procure
the underlying asset on the market at a lower
price. And short call investors will also
benefit from a price drop the buyer of a call
will not exercise his right and the premium paid
remains at the seller's account.
e.g.
50
Before option contract expires
When closing out an options position, attention
should be paid not only to the expiration date,
the offsetting position, and if course the
underlying asset, but also to the strike price of
the relevant option. This means that a long call
The seller can
Wait for the option to expire
The buyer can
Close his position
Let the contract expire
position can be closed out by selling calls with
the same expiration date and the same exercise
price similarly, when having the same expiration
date and equal exercise prices, a short call can
be closed by a long call transaction, a long put
can be offset by the sale of a put, and a short
put position can be closed by the purchase of
put options.
Exercise it
Close his position
51
You can also hedge only part of your downside
risks.
Profit
After hedging
Before hedging
Loss
52
When buying option contracts, the right, but not
the obligation, to buy or sell a futures contract
at a given price is obtained. When prices move
favourably, this right will not be exercised,
and therefore, the purchase of options provides
protection against unfavourable price movements,
while permitting to profit from favourable
ones. Only the sellers of options have to pay
margins. To buy an option, one has to pay a
premium - when prices increase, this is the
maximum loss from the option purchase. But,
simplifying a bit, when prices decline, an
options buyer will make a profit which is more or
less commensurate with the extent of the price
decline. Options may be a better hedging vehicle
than futures in the case of an uncertain supply -
e.g. in the case of a gas company that can not be
sure of the quantity it will be able to supply.
They are often used to protect prices in deals
with not fully reliable partners. If a fixed
price deal with a seller has been concluded, and
this position is covered with a futures contract,
one may get stuck with a loss-making uncovered
futures contract if the physical leg of the
transaction disappears. The sale of options
also allows the generation some profits, but at a
high risk, at least if those selling ("writing")
are not properly protected by, for example,
physical inventory.
53
No need to fear  speculators  Unlike physical
markets, the markets (commodity exchanges) on
which futures and options are traded need a good
dose of speculators. These can be small,
individual speculators, or large investment
funds. This is good for the hedgers (the physical
trading community). Speculators provide
liquidity, which means that hedgers can buy or
sell when they want at or near the price that
they can see quoted on the market even if the
hedging community feels that prices will move in
one way, speculators will act as
counterparties. Speculators rarely push futures
prices away from supply/ demand equilibrium, and
if they do, this does not last long. And it
provides new profit opportunities for hedgers.
54
The over-the-counter market
Exchange-traded futures and options may not fully
meet the companies requirements. In response,
banks and trading companies have developed an at
times baffling range of  over-the-counter 
products. The simplest of these are swaps
similar to futures and average-price options.
But there are many more, often combinations of
simpler products, at times new products based on
mathematical models.
55
Risk management
Marketing
Finance
Organized exchanges
Over-the counter
Forward contracts
Futures contracts
Options contracts
Swaps
Commodity loans bonds
In general, instruments are not traded
Bought by institutional investors eager
to take on risks
Traded among banks and large institutional investo
rs
Instruments are traded on exchanges, in a
transparent manner
Not traded - banks lay off risks through various
operations, including on futures exchanges
56

• Over-the-counter markets offer a wider range of
  products, most of which do not require daily
  margin payments.
• Thus, they may be easier to use for many market
  participants. However, there are some
  disadvantages, compared to the futures and option
  contract traded in organized exchanges
• pricing is not transparent
• the contracts may be difficult to revert
• there is a real counterparty risk (imagine that
  you had a long-term contract with Enron).
  Futures exchange clearing houses have started
  offering clearing (guarantee) services for the
  over-the-counter market, but this is still in its
  inception.

57
Swaps
A swap is a purely financial instrument under
which specified cash-flows are exchanged at
specified intervals. A swap can be described as a
series of forward contracts each with the same
price but does not involve deliveries of physical
commodities. In summary, swaps transactions are
purely financial instruments that are used to
reduce price risks and to manage cash flows.
Obtain easier and cheaper access to capital
Guarantee income streams
Lock in long-term prices
Long term instrument
No or less-strict margin calls
From financial operations or new investments
Combination of price hedging and investment
securitization
Low administrative costs once structured
Tailor-made to cover the needs of the company
58
Although they are normally provided by banks,
swaps can be arranged by producers too.
59
Example of a straightforward swap
Assume a fertilizer company who wants to protect
himself against rising natural gas pices and
therefore wants to lock in the price of his
purchases of 1 MBTU of natural gas annually, over
a period of 5 years. A bank accepts to carry the
price risks for these sales.
Commodity Natural gas Amount 5 MBTU Payer of
fixed price Fertilizer company Payer of floating
price Commercial bank Tenor Five years, with
annual payments Fixed priced (0.05 premium
above the market price) Floating price The
average of the daily closing spot prices of the
natural gas prices quoted in over the year
preceding each payment date. Settlement Netting-o
ut
60
The swap deal
The swap deal can be described as
follows 1. The fertilizer company undertakes to
pay the bank an agreed fixed price (i.e. ) times
a specified tonnage of the product (), and in
return the bank is obliged to pay the fertilizer
company an average of the daily closing spot
price of the white sugar over the year preceding
each payment date. 2. At regular intervals (i.e.
annually) and during the life of the swap (i.e.
five years), the fixed and the moving prices are
compared and the difference, netted out, is paid
to the deserving party. If the average
fluctuating (world) price is gt than the agreed
fixed price, the bank has to pay the difference
to the trader or If the average fluctuating
(world) price is lt than the agreed fixed price,
the trader has to pay the bank. 3. A fixed
deposit in addition to the potential compensating
payments have to be paid by the trader to the
bank, as performance guarantee.
61
The plant has fixed a purchasing price at
The gas seller has fixed its selling price at
Fertilizer plant
Bank
Gas seller
Spot price
Spot price
Spot price
Spot price
Spot market
Spot price
Spot price
Over the next five years, the fertilizer company
will be buying natural gas at the spot price but
will be effectively receiving this variable price
from the bank. In order to lay off price risks,
the bank may conclude a similar deal with a
market participant (a gas seller) that wishes to
sell at fixed price in exchange for the market
prices. Alternatively the bank can lay off its
risks on the futures market.
62
Swap results
Price
The bank pays the fertilizer company
15
The swap allows the fertilizer company to lock in
the purchasing price of his gas at .
14
13
Pays cash when gas prices are low
12
The fertilizer company pays the bank
Cy
Bank
Pays cash when gas prices are high
Feb Mar Apr May Jun Jul Aug
Sep Oct Nov Dec Jan
Swap fixed price. Market price.
63
Benefits from the swap

• The fertilizer company has hedged his cash flows
  from natural gas procurement. Even if prices
  double, his real cost stay the same.
• The company will actually buy the natural gas in
  the spot market but will receive whatever price
  he pays from the bank shifting away price risk
  fluctuations.

• The reduced risk will
• improve the companys credit rating and thus,
• enhance marketing offer,
• lower the cost of financing working capital or,
• provide access to new lenders.

64

• More complex forms of swaps are available.
• Basis swaps. These allow a client to lock in
  the price difference between, say, the Henry Hub
  price and a more relevant local or regional
  price. With such a basis swap in place, the
  client can hedge on the Henry Hub natural gas
  futures without having to worry much about basis
  risk.
• Swaps that integrate minimum or maximum prices,
  or  profit sharing  clauses.
• Calendar spread swaps lock in the difference
  between, say, the spot price and the (average)
  price of the market some time in the future.
  This can protect buyers from backwardation. It
  can also lock in profits from storage.
• Volumetric Production Payment contracts the
  producer is paid the present value of fixed
  payments in advance.

65
Over-the-Counter Options
The use of average prices is one of the reason
that users may prefer OTC-rather than
exchange-traded options. For example, a shipping
companys ships take on bunker fuel at
unpredictable moments, when available at
reasonable prices-an option which is fixed to one
moment in time is thus difficult to use. Other
reasons one may use OTC options is that they are
available on products not traded on the exchange,
and are available in more complex forms.
66

• Choosing the proper instruments
• Different ways of looking at this
• how best to reach the companys global risk
  management goals.
• the operational implications of using different
  instruments (e.g., staffing requirements, margin
  requirements of futures, regulatory implications
  of swaps).
• how to  neutralize  client demands on pricing
  (e.g., clients want ceiling prices, or prices
  that ensure natural gas does not become more
  expensive than coal)
• how to optimize the contractual possibilities
  offered by natural gas suppliers.

67

• Indian or international natural gas markets
• For the international part of natural gas trade,
  one could use international markets, particularly
  for crude oil (but internationally, the crude oil
  link is weakening).
• However, domestic natural gas prices in India are
  unlikely to reflect international prices any time
  soon
• high import duties and taxes
• transport costs
• regulatory constraints.
• Thus, it is likely that  a  domestic natural
  gas spot and futures market will develop (or more
  likely, several regional markets).

68
Hedging on petrochemical markets
Commodity chemical and plastics prices can swing
sharply, often with little or no warning. The
price of crude oil strongly influences
petrochemical prices, with a time lag of about 4
months. The correlation may be as high as 80.
Endusers of chemical products are also becoming
more demanding. In international markets, among
other things, they are asking for longer contract
terms than the customary 6 months, and ask for
more creative pricing formulas.
69
Nowadays, chemicals companies are managing these
risks through a range of derivatives, including
swaps, collars, caps and floors. Such contracts
go from one year to five 18 months is a common
time horizon. For example,  A non-integrated
producer or a producer that may have little or no
flexibility in the feedstock it consumes can use
a derivative to synthetically create vertical
integration without having to make a plant
investment. For example, a merchant ethylene
buyer at a polyethylene manufacturer must manage
the margin between the purchase price of ethylene
and selling price of the polyethylene. A deal can
be structured whereby the parties swap ethylene
for ethane plus another material. (GlobalView
Software Market Focus May 2003)
70
Most risk management trades are done
over-the-counter, with swaps and the like offered
by banks as well as companies such as Shell
Chemical Co. Contracts are also offered on
ChemConnect. Products for which there are
over-the-counter instruments polyethylene  
ethylene ethane   polypropylene
  propylene propane   Naphtha polystyrene sty
rene   butane   MEG PVC benzene
  xylene butadiene PET   tolulene methanol
  MTBE NYMEX trades a propane futures
contract.
71
Over-the-counter instruments include things like
 fractionation spreads .
Gas processor
Dry gas
Wet gas
well
Propane, Butane etc.
A frac spread would lock in the processing margin
between the purchase of the wet gas and the sales
price of the gas liquids.
72
Natural gas seller considerations Large LNG
producers in the past tried to shift as many
risks as possible to buyers. This is changing.
They have moved to term contracts which may not
include price floors, while still agreeing to
include price ceilings are willing to sign
shorter (5-10 year) contracts offer a wider
range of pricing possibilities and they may
agree to flexibility for the buyer in terms of
quantities delivered. GAIL needs to have the
systems to evaluate all these possibilities in
order to be able to choose what is best in terms
of the companys risk management strategy.
73
Offtaker considerations Many of the countrys
large natural gas offtakers are financially
constrained. They are thus highly exposed to the
risk of price increases. In the case of
electricity plants, they can often chose between
natural gas and other fuels which may be
subsidized (coal). Buyers are likely to
appreciate contracts with integrate ceilings, or
price guarantees in terms of competitiveness with
alternative fuels (e.g., coal-indexed natural gas
prices with a ceiling). They may even start
asking for netbacks (that is to say, the natural
gas price is determined  ex-post  as a function
of the price that the buyer gets for his products
or reference products-, ensuring the buyers
profit margin).
74
Fertilizer companies and others can avoid price
peaks with hedging but they cannot buck the
trend.
Source Agrium
75
Derivatives make it possible to get the best
possible on international markets
Price paid
Gas seller offers
And then convert it into what domestic buyers
want/need
Price paid
Domestic buyer wants
Market price
THIS IS A WIN-WIN GAME
Market price
76
Hedging on electricity markets Electricity
markets liberalize in a similar way to natural
gas markets. This will give a whole range of new
marketing and risk management possibilities. E.g.,
 spark spreads , futures contracts on the
price difference between electricity and natural
gas. Developments on the natural gas market may
also make it more attractive for large industrial
users to become electricity co-generators.
77
4. Alternative Risk Transfer
Alternative risk management a passing fashion,
or risk management for the 21st century? Title
in an AON brochure, 1999 Alternative risk
management magic pudding or Bermuda triangle?
Clayton Utz, Insurance and Reinsurance Review
2000
78
How to approach Alternative Risk Transfer
The Philosophy of ART You choose The
actual use of ART
79
The philosophy of ART (also called ARM)
Alternative Risk Management (ARM) is a
non-traditional method of thought. It reveals
how to recognize, locate and correct the
inaccurate beliefs inherent in all people. ARM
manages risk at the level of cause. When the
cause of loss is removed, the loss CANNOT EXIST.
Its a glorious awakening that was integrated
into our risk management strategy.
80
The result...
Enlightened banker
Confused client
81
The actual use of ART
Investors lose 75 of their principal if the
event is not completed before August 31, 2007
(scheduled dates June-July 2006)
FIFA
Pre-financing the 2006 FIFA World Cup in Germany,
October 2003
260 million US
Total exposure 1.7 bn
Golden Goal Finance Ltd.
Sponsors
SP did not want to rate the catastrophe bonds
Future sponsoring
A3-rated
Moodys
SP
Bonds backed by future sponsor revenue, sold for
260 million US
260 million US
Cancellation bonds (4 tranches, 3 currencies)
25 paid back 6 months before the event, rest
could be lost. LIBOR150 points
Rated A
Investors
Investors
For the Japan/Korea FIFA World Cup, FIFA had
already done a derivatives deal on the risk of
earthquakes in Japan.
82
Some other examples of ART as used in recent
years - Deutsche Bank credit default swap
insurance cover - Société Générale and Swiss Re
New Markets (SRNM) banking and insurance capital
facility (contingent capital) - WestLB flood
catastrophe bond issue - Aon Capital Markets
coverage for risks associated with satellite
launches, involving a swap structure. In effect,
for the past five to seven years, there has been
a lot of talk about ART for corporates and
relatively little action (Andrew Tunnicliffe,
MD Structured Finance, Marsh, June 2003)
83
The result when focusing on actual deals done in
the West...
Banker coming with a deal structure
Confused client
84
So, perhaps a need for a more eclectic approach -
ART as a philosophy towards risk and finance.
Structure
What is Alternative Risk Transfer (ART)? Why is
it relevant for GAIL
85
What is Alternative Risk Transfer (ART)
ART is one of the expressions of the break-down
of the traditional barriers between the players
active in the international commodities and trade
area.
Investors
Banks
Traders
Insurers
86
The weakening of the old walls between the
specializations...
Investors
Banks
Principal finance
Trade-financing funds
Catastrophe bonds
Securization
Contingent finance
Traders
Insurers
Bancassurance
Captives
87
What is Alternative Risk Transfer (ART)
ART 'Where insurers start feeling sexy and
bankers start feeling nervous The insurers
perspective a cheaper way of providing
insurance. The bankers perspective a better
way for the client to ensure that the clients
cash flows are sufficient to cover debt service
obligations the banker replaces traditional,
intrusive mechanisms by more flexible ART tools.
88
What is Alternative Risk Transfer (ART) - the
insurer s perspective

• Traditional insurance very cyclical, in terms
  of rates and availability of coverage
• insurance cover itself becomes a source of risk
• during part of the cycle, traditional insurance
  is too expensive.
• Traditional insurance has difficulty coping with
  new risks (e.g., cyber risk, terrorism)
• Some risks go beyond the capacity of the
  insurance market (e.g., earthquakes).
• In the USA, ART premium revenue is now 60 higher
  than traditional insurance premium revenue.

89
What is Alternative Risk Transfer (ART) - the
bank s perspective
Traditional approach
Bank
Evaluation of the capacity of the client to
generate sufficient cashflow
Taking of physical collateral
Client
90
What is Alternative Risk Transfer (ART)
Traditional approach
Bank
Evaluation of the capacity of the client to
generate sufficient cashflow
Taking of physical collateral
Client
Therefore, cumbersome collateral and covenants
Normally, many doubts and uncertainties
91
What is Alternative Risk Transfer (ART)
ART approach
Bank
Evaluation of the components and implicit risks
of capacity of the client to generate sufficient
cashflow
Dynamic cash flow risk management
Client
and are then managed through a combination of
flexible finance, hedging, capital market
instruments and insurance.
The main sources of cash flow risk are identified
92
The bank may be able to provide a better risk
management tool than an insurer. An insurance
premium is typically equal to the Net Present
Value of expected claims, plus administrate
costs, plus overhead. The latter two typically
absorb some 30-40 of the premium. By building
high-frequency risks into a financing structure,
rather than forcing the client to insure
themselves, the bank can allow major savings on
risk management costs (which can then be shared
with the client).
93
What is Alternative Risk Transfer (ART) - major
characteristics

• Finance and risk management tend to be
  integrated
• Custom-tailored
• Multi-dimensional
• Risk allocation between different categories of
  players (insurance, derivatives, capital
  market)
• Finance is used as an explicit way to manage
  uninsurable risk.

94
What is Alternative Risk Transfer (ART)

• The major applications
• Various forms of self-insurance
• Enterprise risk management (holistic risk
  management)
• Holistic future flow structured financings and
  securitizations
• Securitization of risk (shifting of risk to the
  capital market), e.g.,
• catastrophe risks
• credit risks
• terrorism risks
• Weather risk management
• Contingent capital

95
Weather risk management can be a vehicle to
manage volume risk
ART can make it possible for commodity firms to
manage otherwise difficult-to-control commodity
risks. E.g., on the volume that they will
handle. Ex. Agricore United, Canada 35 market
share of Western Canadas wheat exports. Since
1999, has had insurance that pays out when total
Western Canadas grain shipments fall below a
certain  out of the money  level.
Agricore United
Swiss Re
Integrated insurance package property risk,
casualty risk, and handling volume risk.
96

• Another example risk management for a
  hydro-power plant.
• Situation if there is not enough rainfall, the
  company has to buy natural gas in the spot market
  to run its gas-fired generators. So, double risk
• low rainfall
• high gas prices when rainfall is low.
• Average rainfall is 52 inches/year. If rainfall
  is less than 42.5 inches, the company is in
  problems.

97
Thus, the company buys put options (3 options for
three years, 2000-2003) For every 0.1 inches
that rainfall is below 42.5 inches, the company
will receive 52,500 average daily Henry Hub gas
price from February to August.
The company pays for this put option by selling
call options with a strike of 56 inches, and a
maximum payment at 78 inches.
Source Enron
98
Contingent capital
Michelin (France)
Swiss Re Société Générale
5-year committed 1 bn subordinated loan
facility which is triggered if the combined GDP
growth of the US and the EU falls below 1.5
(first 3 years), resp. 2 (last 2 years)
Contingent capital protects companies against the
risk of a double whammy negative business
developments combined with suddenly expensive
access to finance. Several forms subordinated
loans conditional share purchases (equity puts
e.g., Royal Bank of Canada-Swiss Re New
Markets 200 mln C in preferred share purchases
should the banks portfolio suffer extraordinary
losses) contingent surplus notes (right to sell
notes).
99
Enterprise risk management multi-trigger products
Multi-trigger insurance products only provide a
payment for losses if a second event or risk is
triggered. This second risk is normally
expressed in terms of an independent index. This
form of ART can be very attractive to commodity
firms. For example, ART fire insurance for an
aluminium plant high deductible in the case of a
fire when aluminium prices are high (or if the
aluminium price divided by the electricity price
is above a certain level), small deductible when
aluminium prices are low and the company cannot
afford much financial risk. Or an electricity
plant can get insurance against the risk of a
power outage which is linked to the spot price
for power during the outage.