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Commodity Risk - Oil Markets In this short video, we will discuss, the
oil markets. We will touch on the instruments that are used to trade the oil market, oil
market dynamics, and the risks that are inherent within oil transactions.
Commodities are a broad asset class ranging from well known financial products to less
known physical transactions. The most actively traded commodity is the petroleum market.
The risks on oil products include physical storage risks, basis risks, transportation
risks and intricate market directional risks. Oil is traded globally, but many of the same
products are not fungible. In general Oil is a leading indicator for both inflationary
and deflationary economic environments. Oil a physical asset and therefore there are
risks that are not seen in stocks, bonds and currencies. Oil is the largest input fuel
used to power transportation and manufacturing across the globe.
Instruments: Financial instruments are the most liquid
of the global commodity products, but there are substantial physical product markets that
are conducted between counterparts along with a broker conduit. Each market trades in a
different manner, and the nuances need to be studied prior to engaging in transactions.
The most liquid of the commodities is oil, which is traded as a futures contract, along
with having a presence in the ETF market, the over the counter market, and the physical
market. Theoretically, the futures market along with ETFs remove the credit risk from
oil trading. Futures are generally cleared through a regulated clearing exchange, such
as the Chicago Mercantile Exchange where segregated customer funds, are margined to facilitate
transactions. Recently the system has been put to the test, as the bankruptcy of MF Global
created a huge customer deficit as segregated funds were loaned to cover MF Global's liability.
Oil Markets: Oil is traded globally, 24 hours a day, 6
days a week. The majority of oil trade is transacted through the financial markets via
futures contracts, over the counter agreements or physical contracts. The futures markets
are dominated by the New York Mercantile Exchange and the Intercontinental Exchange. Both exchanges
offer contracts on benchmark West Texas Intermediate (WTI) along with North Sea Brent. The majority
of global crude prices are created as a basis to one of these two benchmarks.
Historically, the only risks associated with futures has been market and liquidity risk.
The oil market is relatively volatility, with historical volatility running near 40% on
average, with peaks as high as 100%. The futures market for oil which exists in the US, UK,
EU, Japan, Singapore and Australia, is a leveraged market, in which the exchanges monitor positions
and generate margin calls if funds fall below a specific thresholds. The CME for example
which uses a SPAM risk array to generate risk profiles on margined accounts.
Although benchmark oil prices are liquid, there are many basis oils that are opaque.
Many commodity portfolio managers use WTI or Brent to hedge positions in less liquid
oils creating an illiquid basis that needs to be analyzed. Other types of tradable petroleum
products include gasoline and distillate fuel. Distillate includes heating oil and jet fuel,
which are also traded on major exchanges. These products also trade as a spread to benchmark
crude oils, and are driven by the supply and demand of the end consumer.
Financial oil trades as a leveraged product, where investors can place initial margin of
approximately 10 to 15% of the value of the contract. Physical oil mostly trades on a
cash basis. The largest issue related to physical oil is the actual specifications of the grade
of the oil received. Investors who look to benefit from oil storage or oil transportation
should have access to experienced inspectors who can determine if the products are reliable.
Financial oil markets settle differently relative to many other financial instruments. Oil contracts
on the New York Mercantile Exchange are physically delivered contracts. This means that the financial
instruments becomes physical oil when the contract settles. Investors who are not willing
to take physical deliver need to exit these contracts prior to the delivery notice date.
Another difference in the financial oil markets is that many of the contracts settle on a
financial basis that is calculated on an average rate basis. This means that the settlement
prices is an average prices based on the daily settlements of a specific contract through
a given period. In most cases this period is a month, but it can also be a quarter or
a year. This type of settlement, known as Asian or Average Price Settlement, removes
some of the volatility in the oil markets. Risks
Options are available for oil and petroleum products and have risks that are different
than most financial products. The most liquid options are Asian style options which are
average priced options. These options have a different linear approximation when compared
to European or American style options where the volatility is somewhat muted due to the
average calculation. Portfolio managers who are generating oil
options risk need to monitor the specifics of the numerous types of options available
in this sector. In addition to European, Asian and American style options, many exchanges
over options on oil spreads. This means that an investor or commercial entity can trade
an option on the calendar spread of oil prices. For example, a trader can by a call or a put
on a June 2012 contract versus the December 2012 contract. These types of calendar spread
options add an additional risk component called correlation, which is added to a bi-variant
Black Scholes model to create the value of the
spread option. The oil market is a vast and complex marketplace,
and portfolio managers should be aware of all the risk inherent in this market prior
to initiating risk.