Transcript Title

Refining Outlook
and
Risk Management
Mr. S.V.Narasimhan
Director(Finance)
Indian Oil Corporation Ltd
0
Presentation Covers….
 Refining
Outlook
 Features of oil refining
 Refining capacity utilization
 Capacity addition vs demand
 Risk
Management
 Need for Risk Management
 Hedging tools and markets
 Practical considerations
1
Oil Refining – Defining features



Capital and Technology intensive
Long gestation period
Large investment needs:
 To meet rising demand for oil
 Spec changes for modern engines &
environment issues
 Transport fuel the drivers – need for upgrading
bottom of the barrel

Low margin – occasional cycles of boom
Investment - a risky proposition
2
$/bbl
Singapore: Gross Refining Margin (Dubai)
10
8
6
4
2
0
-2
Dubai (Hydrocracking Singapore)
Occasional boom
Source- IEA
Jan-95 Apr-96 Jul-97 Oct-98 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07
• Prolonged periods of low, even negative margins
• Considerable volatility in the margins from month to month
• Occasional boom serves to tide over long periods of poor margins
• Domestic pricing policies restrict oil companies much needed
margins to fund future expansions,quality upgradation projects, etc
3
90000
87
86
85
84
83
82
81
80
79
KBD
85000
80000
75000
70000
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
65000
% utilization
Global refinery utilization rate
Refining Capacity
% rate
Source:BP
• In last 5 years, despite refining capacity additions, utilization
rates soared to new highs.
• Effective utilization rates exceeded 95% at times considering
planned and unplanned shutdowns.
4
Planned refinery additions(mid 2008-end 2009)
Company
Location
Sinopec
Qingdao, China
201
Jun’08(commissioned)
PetroChina
Dushanzi, China
104
Q3’08
PetroChina
Dalian, China
150
Q4’08
CNOOC
Huizhou, China
240
Q4’08
Others
Global
389
2008
2008 Total
Additional
capacity (kbd)
Expected
completion
1084
Reliance Petroleum
Jamnagar, India
580
Q109
Sinopec
Fujian, China
161
Q109
Dung Quat Refinery
Vietnam
130
Q209
Sinopec
Tianjin, China
150
Q409
Others
Global
409
2009
2009 total
1430
Grand Total (2008-09)
2514
Source: Goldman Sachs
5
Refining additions Vs. Demand- 2001-12
3
2.5
2
1.5
1
0.5
0
Trend reversal
• Substantial refining capacity
additions - 2008 onwards
(million barrels per day)
2001
2003
2005
Capacity addition
2007
2009
2011
Incremental demand
• During 2002-07, Refinery capacity additions lagged demand, leading
to high margins/prices.
• Refining capacity additions to exceed incremental demand over
2008-2012, pointing towards softening margins
Source: BP,Goldman Sachs and PEL
6
Refineries’ Dilemma : To build or not?
Build capacity
Risk of unsustainable margins
Delay capacity additions
Loss of opportunity
Risks to Refining investments:
• Demand growth uncertainty, particularly transport fuels
• Light/Heavy differentials and sweet/sour differentials
• NOC structure of Asia– not geared purely to economics – can
lead to overcapacity
Derivatives available to mitigate risk of poor economics.
7
Indian Refiners:Need for Risk Management
Existing refineries
 Extreme
volatility in
refining margins
 Under-recoveries from
domestic products sale
 Customers seeking fixed
prices
 Fluctuation in inventory
valuation
New Refinery Projects
 Over capacity- weak


margins
High investment – poor
returns
Competition in
international market for
export oriented
refineries
RBI regulations:
• Permits hedging of risks to existing refineries like
margins, inventory, domestic product sales, etc.
• Hedging of new refinery projects not permitted
8
Risk Management - Advantages

Smoothens/reduces
existing refiners
revenue
volatility
for

Facilitates remaining within budget

Enables judicious deployment of funds, thereby
ensuring timely project implementation

Protect against price spikes

Flexibility to hedge limited volumes allowing to
tap market opportunities for remaining volume

Exit possible under unfavourable circumstances
9
Markets for hedging
MARKETS
PETROLEUM EXCHANGES
1. NYMEX, NEW YORK
2. IPE,LONDON
3. TOCOM, TOKYO
4. DME,DUBAI
5. MCX/NCDEX, INDIA
OTC MARKETS
1. SINGAPORE
2. LONDON
3. NEW YORK
10
Dubai Forward price volatility:Q308
$/bbl
140
130
120
110
100
90
80
70
10-Jan-08
Final settlement
price for
Q308:$113.48/bbl
11-Feb-08
Source: Morgan Stanley, Platt’s
10-Mar-08
10-Apr-08
Actual price
13-May-08
12-Jun-08
Q308 forward price
11
GO vs Dubai Forward price volatility:Q308
$/bbl
50
45
40
35
30
25
20
15
1010-Jan-08
Final settlement
price for
Q308:$25.7/bbl
11-Feb-08
Source: Morgan Stanley, Platt’s
10-Mar-08
Actual Price
10-Apr-08
13-May-08
Forward Price
12-Jun-08
12
Hedging tools available for Refiners


Refining margins hedging
 Options and swaps

Individual Crack spreads

Composite refining margins
Inventory hedging
 Options and swaps

Crude oil

Products
13
Refiners hedging (illustration)
 Hedging
assures fixed margin
 Mechanism
of hedging margin:
Refinery Margin hedging- Illustration
Crack ratio is based on product
pattern of the refineries
Margins go up: Higher revenue on
physical sales offsets outgo on
derivative contract.
Margins go down: Lower revenues
on physical sales offset by inflow
on derivative contracts
Crude 100%
Buy
 Domestic price controls: Higher
margins not realised on physical
1000 bbls
sales but cash outgo on derivatives
occurs. This poses additional risk.
Hence, need for a consistent and
transparent policy.
Naphtha: 15%
(Sell 150 bbls)
Kerosene: 15%
( Sell 150 bbls)
Gasoil: 50%
(Sell 500 bbls)
HSFO 20%
(Sell 200 bbls)
14
Swap: Gasoil-Dubai Crack (illustration)
Realised Margin with hedging
Realised Margin without hedging
USD/bbl
35
30
25
20
Swap transaction
15
15
20
25
Actual price
Swap level - $25/bbl
30
35
15
Put Option- Gasoil vs Dubai (illustration)
Realised margin with hedging
Realised margin without hedging
USD/bbl
35
Strike-$25/bbl
30
25
Premium-$3/bbl
20
15
15
20
25
Actual price
30
35
Strike Price: $25/bbl, Premium : $3/bbl
16
Hedging practice – Oil companies
S.No Company
Practice (As per trading sources)
1
Shell
20%(appx)
2
Nippon Oil(Japan)
Only export volumes are hedged
3
Suncor(Canada)
40% hedged. (Opportunity loss - USD 100 million,
decided not to renew hedges)
4
Valero
Not significant volumes
5
Kerr Mcgee
Oil production: 80% Hedged
6
Cosmo Oil
50% max (Actual volumes hedged are lower)
7
Idemitsu
50% max (Actual volumes hedged are lower)
8
Amerada Hess
Oil production: 70% Hedged (Reported opportunity
loss of USD 1.05 billion in 2004)
9
BP
Not significant volumes
10
Exxon
Exxon does not hedge.
Oil companies follow diverse hedging strategies, but volume is
typically limited unlike end users who hedge large volumes.
17
Hedging activity – Refiners in SE Asia
S.No
Country
Refinery
Risk Management
activity
1
Korea
SK Corp, KNOC, Hyundai Oil
Active
2
Thailand
PTT (NOC)
Active
3
Malaysia
Petronas (NOC)
Not so active.
4
Indonesia
Pertamina (NOC)
Not so active.
5
Taiwan
CPC (NOC), Formosa
Active
6
Japan
Idemitsu, Nippon Oil, Cosmo
Active
7
China
Sinochem
Active
As per trading sources
18
$/bbl
Practical considerations- Steep backwardation
Gasoil vs Dubai
42.67
42
40.23
39.8
39.33
38
35.13
37.5
37.45
36.07
35.76
34
36.84
33.47
36.465
35.25
34.74
33.15
33.81
34.95
33.35
302-Jun-08
32.22
10-Jun-08
18-Jun-08
Spot
33.24
32.79
32.28
32.2
26-Jun-08
Q4 08
37.03
4-Jul-08
Q1 09
Source: Platt's, Morgan Stanley
• When Gasoil/Dubai spot cracks were at record high of $42.67, Q-4-08 and
Q-1-09 were available at $6.6/bbl and $7.7/bbl respectively higher than the
spot level.
• Such Backwardation present a serious dilemma for the hedgers!
19
Practical considerations -Steep contango
125
Brent crude oil
120
Dollar/Barrel
115
110
105
100
95
90
Brent Dated Q109
Brent Dated Q209
Brent Dated Spot
85
80
01-Sep-08
08-Sep-08
15-Sep-08
22-Sep-08
29-Sep-08
Source: Platt's, Morgan Stanley
• When Brent spot price was at $86.69/bbl on 16th Sep 08, Q-1-09 and Q-2-09 were
at $94.81/bbl and $96.26/bbl respectively viz. almost $8.1/bbl and $9.6/bbl higher
than spot price.
• Such sharp contango present a serious dilemma for the hedgers!
20
Practical considerations: When to hedge
$/bbl
37
GO vs Dubai: Forward Curve - Entry Timing
15/7/08
32
31/7/08
27
15/8/08
15/9/08
22
Q408
Q109
Q209
• Forward prices changed dramatically in a span of few days .
• Timing of entry is crucial – Yet no scientific way to time the market
Source:Morgan Stanley
21
Practical Consideration: Options premium
Premium Level for WTI call options (as of 3rd Oct 08)
Dec’08
Jun’09
Dec’09
Strike ($/bbl)
Premium ($/bbl)
93.0
7.37
95.0
6.39
98.0
5.22
94.0
13.65
96.0
12.81
99.0
11.63
96.0
16.13
98.0
15.32
101.0
14.17
Source: NYMEX
•
Buying Call Options ‘At the Money(ATM)’ or ‘Out of the Money’(OTM)
involve significant premium payout.
22
Risk Management Policy – Key issues
Volume limits
Corporates should have clearly defined volume limits,
based on the risk appetite.
Tools
Swaps: To ensure a pre-determined price.
Options:
 Call:
Caps maximum price(Buyer of crude/products)
 Put:Ensures
minimum price(Producer/Refiner for margin)
 Collar:Combination
Tenor
 Based
of call & put to limit premium
on the risk appetite.
 Prompt
positions prone to significant volatility. Hence,
positions at back end of curve preferable.
Hedging/
Speculation
 Short
term entry and exit are speculative in nature.
 Need
for clear policies on holding position till maturity.
23
Risk Management Policy – Key issues
CounterParties
Criteria: Sound financial standing, experience, trade/bank
references, credit rating, etc.
Market
OTC:
Based on exposure of crude oil/products
Singapore market relevant for Asian crude oil/products
Overseas
Exchanges:
 Brent and WTI crude oil
 Products like Gasoline, Heating Oil, Gasoil, etc.
Need for clearly defined authority for approving deals
Approving
Authority

Trading
procedure
 Competitive
Controls
 Daily
basis through bid/offers from 3-5 parties or more
is desired.
Mark to Market report, segregation of duties between
Trading and Settlement functions, audit, etc essential
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Risk Management - Adequate Controls



Prudent Risk Management strategy is essential.
Systematic reconciliation of internal transaction/positions
Periodic reporting to Board, Management and regulatory
agencies
Derivative Disasters
China Aviation Oil
(2004)
Amaranth (2006)
Mitsui (2006)
Societe Generale
(2008)
$ 550 million loss. Resulted from selling
Options & faulty M2M reports
$ 6 billion loss. One of the biggest collapses in
Hedge fund history
$81 million loss. Inappropriate trading and
reporting
Euro 5 billion(approx) loss. Failure of internal
controls and faulty reporting systems.
25
Thank You
26
US Gulf Coast(USGC)-Gross Refining Margin (Brent crude)
19
Source- IEA
$/bbl
14
9
4
-1
-6
Jan-95 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08
• Prolonged periods of low, even negative margins
• Considerable volatility in the margins from month to month
• Occasional boom time serve to tide over long periods of poor margins
Source- IEA 27
North West Europe - Gross Refining Margin (Brent crude)
12
10
Source- IEA
Brent (Cracking NWE )
$/bbl
8
6
4
2
0
Jan-95 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08
-2
• Considerable volatility in the margins from month to month
• Occasional boom time serve to tide over long periods of poor margins
Source- IEA 28
High volatility in prices: WTI (2007-2008)
Daily Change ($/bbl)
Year
2006
0.9
Max
4.4
2007
1.1
4.4
2008
2.3
16.4
Avg
150
140
130
120
110
100
90
80
70
60
50
2
09 .
04 .
2
07 .
23 .
2
06 .
10 .
2
04 .
28 .
2
03 .
14 .
2
01 .
31 .
2
12 .
13 .
2
11 .
01 .
2
09 .
20 .
2
08 .
08 .
2
06 .
26 .
2
05 .
14 .
2
03 .
30 .
2
02 .
15 .
2
01 .
03 .
008
29
007
007
007
007
007
007
007
007
007
008
008
008
008
008
Source: Platt's
Dubai Forward price volatility:Q408
150
140
130
120
110
100
90
$/bbl
4/1/08
5/1/08
5/31/08
6/30/08
Q408
7/30/08
8/29/08
9/28/08
Source: Morgan Stanley
30
Trading on Exchanges – Some issues

NYMEX and ICE are the major energy international exchanges.

Use of exchanges involves huge basis risk

During the period Jan’07 to Sep’08,
• Brent dated and ICE Brent showed a strong positive correlation of 0.93.
$/bbl
Actual ICE Brent vs Brent (Dated) differential showed substantial variation viz
high basis risk
3
2
1
0
-1
-2
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Source: Platt’s
31
Risk Management – To summarise
Universal
• Does not ensure best margin – Only predetermined margin can be hedged.
• Options hedging involves substantial costs
• Backwardated markets – can lock into lower margins than currently
prevailing
• Timing of entry – crucial in margin that can be locked into
India Specific

Exposure of Indian companies essentially to Asian oil and petro-products

NYMEX and IPE are major petroleum exchanges but do not have liquid
Asia specific commodity contracts.

No AG related derivative contracts – Singapore market used as proxy.
32