ING Financial Markets IBC: 2012 Commodities Seminar

Jens Vrolijk Antwerpen, October 2012

Agenda • Why commodity hedging? • So how can a company hedge? supplier contracts, futures, and OTC • OTC hedging instruments • How is the hedging price determined? • Moving to the products •

From the barrel to the pump: Crude oil , refined products and coal

•

Store of value or raw material: Base and precious metals

•

The global food stock: Agricultural and soft commodities

• Procedures, risk and documentation •

ISDA documentation or “contrat cadre”

•

CDD, MIFID

• Concluding remarks

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Why commodity hedging?

Commodity prices are dictating headlines…

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If your company is a part of the commodity supply chain… Producers

Traders, distributors

Refiners, smelters, roasters, processors

Traders, inventory, warehousing

Utilities, breweries, transport etc

Lending Bonds FX, interest M&A PCM, Leasing

Financial and Risk management

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…NOT hedging your commodity exposure is taking a conscious risk Which revenues next year? How much CapEx for the coming years? And if prices fall below production costs?

What if my raw material costs more than sales prices?

What if I have to buy at suddenly huge prices?

What if energy costs go up so my profits disappear?

What if I don’t know yet how much volume I need to buy next year?

What if next year more refineries appear? What happens to the value of my inventory if prices suddenly drop?

What if my trade margins get squeezed? What happens my inventory if prices suddenly drop?

Producers

Traders, distributors

What if my trade margins get squeezed?

Refiners, smelters, roasters, processors

Traders, inventory, warehousing

Utilities, breweries, transport etc

Fin/Risk mgmt

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So how can a company hedge?

Using supplier, futures or OTC price fixations Commodity Physical Market

Commodity Financial Market

• Appeared hundreds years ago and available for all the commodities

• Appeared in the 80’s for some specific commodities • The objective is not a physical delivery but only cash settlement

• Over-the-Counter transactions

Standardized Market

• With physical delivery settlement

• Stocks market (Nymex, ICE, LME)

+

• Tailor-Made transactions

+

• Controlled by the supplier

-

• No price transparency • Important counterparty risk • Difficult to find a counterparty

• Clearinghouse (no counterparty risk)

OTC • Over-the-Counter transactions • Tailor-made transactions

+

• No Margin Call but Credit Risk (exposure to the banks)

• Standardized contract (volume , underlying, maturity)

-

• Margin Call (cost of capital) • Limited access for company (costs)

• Diversification against the supplier control

-

• ING limited trading mandate: The availability of a specific commodity depends on the liquidity on the standardized markets

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OTC hedging instruments

Hedging instruments By combining swaps and buying/selling call/put options, different hedging structures can be created to more specifically target the individual companies’ exposure profile, market view, budget levels, etc.

Swaps

All products can be expressed in different currencies (USD, EUR, GBP)

• Vanilla – Asian/European

• For a determined period, ING takes over the market price of the commodity product, while the buyer of the swap pays an agreed fixed price • Net settlement is calculated over a pre-agreed index (independent source), typically market Marketscan • A swap contract requires no upfront premium payment Options • Caps and Floors

• Protection against price increases or decreases above or below pre-agreed index levels • An upfront premium must be paid to reflect the level of protection derived

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Fixed-for-floating Swap • The Fixed-for-floating Swap provides maximum predictability of commodity cost or revenue, as it locks the price rate for the required tenor and notional quantity volume

Swap pay-off Effective Rate

Underlying market price assessment

• Client pays or receives floating commodity price assessment • Client receives or pays a fixed rate • The diagram below illustrates the cash flows under physical purchase or sale and the swap accordingly Swap Level

xxx.xx US$ per MT

xxx.xx US$ per MT

Underlying market price assessment

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Fixed-for-floating Swap Client fixes the price of the physical product purchase At the end of each settlement period during the life of the swap, the daily price quotations, as published during this period, are used to calculate the average floating price of the settlement period. The floating price is compared to the fixed price of the swap: • If the average of the product prices is above the agreed fixed price, Client pays the difference (times the volume) to ING • If the average of the product prices is below the agreed fixed price, Client receives the difference (times the volume) from ING •The monthly average is most often based on daily physical price indices

125 120 115 110

Client Receives Client Pays Month Average Daily Price Fixed Price

105 100 95 90 85 80 Dec

Nov

Oct

Sep

Aug

Jul

Jun

May

Apr

Mar

Feb

Jan

75

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Cap option • The Cap provides protection against a rise in the price above the Cap Rate • And allows client to fully participate in decreasing rates

Cap pay-off Effective rate

• The Cap comes at a premium • The Cap Rate can be set at client’s discretion • The diagram below illustrates the effective payment under physical purchase combined with a Cap

Cap rate

xxx.xx US$ per MT

xxx.xx US$ Swap rate per MT

xxx.xx US$ per MT

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Zero - cost collar • The Collar provides protection against a rise in market price assessment below the Floor Rate • And allows Client to benefit from decreasing rates up to the Cap Rate

Collar pay-off Effective rate

Underlying market price assessment

• The Collar is a zero-cost solution • Either the Cap or Floor can be set at Client’s discretion

Cap rate

xxx.xx US$ per MT

xxx.xx US$ Swap rate per MT

xxx.xx US$ Floor rate per MT

xxx.xx US$ per MT

xxx.xx US$ per MT

Underlying market price assessment

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Zero - cost collar 1. Purchases a Cap protection 2. Sells a Floor protection to finance the Cap • If the average of the product prices is above > the agreed Cap Price, ING pays the difference (times the volume) to Client • If the average of the product prices is below < the agreed Floor Price, ING receives the difference (times the volume) from Client • No premium is exchanged •The monthly average is most often based on daily physical price indices

125 120 115 110

Client Receives Client Pays Month Average Daily Price Fixed Price Cap Price Floor Price

105 100 95 90 85

80 80 80 Dec

Nov

Oct

Sep

Aug

Jul

Jun

May

Apr

Mar

Feb

75 Jan

Client

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Products compared All products are effective hedges against adverse commodity price rate movements Product

Commodity Swap

Pro

Con

 Rate fixed, hence no uncertainty at all

 No benefit from rate movements your favor

 Zero cost solution  Benefit from rate movements down to the Floor Rate

Commodity Collar

 Protection at a higher level vis-à-vis standard Swap

 Protection against rate movements above the Cap Rate  Zero cost solution  Full participation in rate movements in your favor

Commodity Cap or Floor

 Protection comes at premium payable

 Full protection against rate movements above the Cap Rate or below Floor Rate

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How is the hedging price determined?

So how is the hedging price determined? • The forward/futures yield curve can be positive (contango) or negative ( backwardation) • The forward/futures level depends on the offer and demand for each future contract • The shape of the curve reflects the characteristics of underlying on the physical market  Seasonality ( harvest for soft, winter for energy), economy growth expectations, geopolitical tension (oil conflict) • The shape of the curve can be an opportunity in term of timing to enter in a hedge position

Contago

Backwardation

• Increasing Forward price level

• Decreasing Forward price level

• No arbitrage pricing theory (cost of capital and cost of storage)

• High inelasticity of fundamentals explains a convenience premium

• Positive premium between forward and spot price

• Negative Premium between forward and spot price

• Premium for fixed payer , good timing for fixed receiver

• Good timing for fixed buyer, premium for fixed receiver

• No booming market, costly stocking underlying (metals)

• Booming market, risk of shortage (“normal backwardation” with oil)

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Moving to the products

Crude Oil & Refined Products From the barrel to the pump

Oil product interdependency in financial markets The prices of refined oil products in financial markets reflect cost and market conditions: • The price of its raw material: Crude oil (Brent or WTI as benchmarks, approved in trading mandate) • Transportation costs • Cost of processing crude oil into refined products (refining cost and margin) • Storage costs • Market conditions at each stage along this way and in the local market (Location, FOB, CIF, Lot size)

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Oil product interdependency in financial markets In the financial market, three strongly related but slightly differing groups of refined products are traded: • Residual fuels • Middle distillates • Light ends

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Oil product interdependency in financial markets Volatilities and price trends have a strong relation because: • The price of its raw material: CRUDE OIL (BRENT OR WTI as benchmarks, approved in trading mandate) is the same for all refined products • Transportation costs are similar • Refining market conditions are similar Differences in absolute level between price indexes occur because: • Market conditions at each stage along this way and in the local market (Location, FOB, CIF, Lot size): - Location hubs are ARA (Adam/Rdam/Antwerp), NWE (North-west Europe), MED (Mediterranean), SING (Singapore), US Gulf etc. - Inco terms: FOB (Free on Board), CIF (Cost Insurance & Freight) - Lot size: Cargoes (tanker size), Barges (river boat, truck)

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Oil product interdependency in financial markets Products are traded as spreads in a refining margin basket:

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Base & Precious Metals Store of value or raw material

Base metals underlying references • Copper (Grade A) • Zinc (Special High Grade) • Primary Aluminium • Standard Lead • Tin • Primary Nickel

• World market for fungible grades and specifications • Exchange trading with physical delivery is setting benchmark prices • Strong correlation between geographically dispersed markets 25

Agricultural & Soft Commodities From the fields to the silos

US CBOT, EU LIFFE, and more… • CBOT • NYSE-LIFFE Euronext • Grains / wheat • Oilseeds • Corn • Softs • Livestock

• World market for fungible grades and specifications • Exchange trading with physical delivery is setting benchmark prices • Strong correlation between geographically dispersed markets

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Which underlying products can be hedged?

Energy products (i) Crude Oil

Refined products (cont’d)

• Brent

• Naphtha

•

ICE: COA Comdty, 5 yrs

• •

• Dated Brent •

Platts fixing, 5 yrs

• WTI •

• Gasoil • • • • • • • • • •

NYMEX: CLA Comdty, 5 years

Gas

• Henry Hub •

NYMEX: NRA Comdty, 5 years

• European gas: •

Naphtha CIF Cargoes NWE Naphtha FOB Barges Rotterdam

A.o. NBP, ZBT, TTF

Refined products

ICE Gasoil: QSA Comdty (5 yrs) 0.1 CIF Cargoes NWE (3 yrs) 0.1 FOB Cargoes MED (3 yrs) 0.1 CIF MED (3 yrs) 0.2 FOB Barges Rotterdam (2 yrs) 0.2 FOB Cargoes MED (2 yrs) 0.5 FOB Cargoes Singapore (3 yrs) Gasoil 50ppm FOB Barges Rotterdam (3 yrs) Gasoline Premium Unleaded FOB Barges Rotterdam (3 yrs) Nymex RBOB Gasoline (5 yrs)

• Fueloil • • • • • • • • • • • •

Fueloil 1% CIF Cargoes Med Fueloil 1% CIF Cargoes NWE Fueloil 1% FOB Barges Rotterdam Fueloil 1% FOB Cargoes Med Fueloil 1% FOB Cargoes NWE Fueloil 1.5% FOB Barges Rotterdam Fueloil 3% US Gulf Cost Water Fueloil 3.5% CIF Cargoes Med Fueloil 3.5% FOB Barges Rotterdam Fueloil 3.5% FOB Cargoes Med Fueloil 180cst FOB Cargoes Singapore Fueloil 380cst FOB Cargoes Singapore

• Jet Fuel • • • •

Jet Aviation FOB Cargoes Med (3 yrs) Jet Kerosene CIF Cargoes NWE (5 yrs) Jet Kerosene FOB Barges Rotterdam (3 yrs) Singapore Jet Fuel (3 yrs)

Products: •

Swaps

•

Caps / Floors / Collars

•

Other structured solutions 29

Energy products (II) Refined products (cont’d)

• Diesel • • • • • • •

Diesel ULSD 10ppm CIF Cargoes NWE (5 yrs) Diesel ULSD 10ppm CIF Cargoes NWE UK (3 yrs) Diesel ULSD 10ppm FOB Barges Rotterdam (5 yrs) Diesel ULSD 10ppm CIF Med (3 yrs) Diesel ULSD 10ppm FOB Med (3 yrs) Diesel ULSD 50ppm CIF Cargoes Med Diesel ULSD 50ppm FOB Cargoes Med

Coal

• API #2 •

FOB ARA

• API #4 •

FOB Richard’s Bay, South Africa

• API #6 •

Newcastle, Australia

Products: •

Swaps

•

Caps / Floors / Collars

•

Other structured solutions

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Commodities traded: agricultural and soft commodities (Product, Bloomberg Generic Ticker, Max Tenor)

Agriculture / Grains

Softs

Livestock

• Wheat

• Sugar

• Live Cattle

•

US: W A Comdty, 5 yrs / EMEA: CAA Comdty, 2 yrs

• Corn / Maize •

US: C A Comdty, 5 yrs / EMEA: EPA Comdty, 1 yr

• Rapeseed •

•

O A Comdty, 3 yr

•

CTA Comdty, 3 yrs

•

LCA Comdty, 2 yrs

• Feed Cattle •

FCA Comdty, 2 yrs

• Lean Hogs

• Coffee

•

LHA Comdty, 2 yrs

NYBOT Arabica KCA Comdty, 3 yrs / LIFFE Robusta DFA Comdty, 1 yrs

• Cocoa •

ICE Cocoa CCA Comdty, 2 yrs, LIFFE Cocoa QCA Comdty, 2 yrs

• Orange juice

S A Comdty, 5 yrs / BOA Comdty, 5 yrs / SMA Comdty

• Oat •

•

RRA Comdty, 1 yr

• Soybean, soybean oil, soybean meal

US: Nr. 11 raw SBA Comdty, 5 yrs, EMEA: LIFFE white sugar QWA Comdty, 3 yrs

• Cotton

LIFFE Rapeseed, IJK Comdty, 3 yr / Canadian Canola, RSA Comdty, 1 yr

• Rice •

•

•

ICE Frozen Orange Juice Conc, JO1 Coomdty

• Lumber •

LBA Comdty, 1 yr

Products:

Products:

Products:

•

Swaps

•

Swaps

•

Swaps

•

Caps / Floors / Collars

•

Caps / Floors / Collars

•

Caps / Floors / Collars

•

Other structured solutions

•

Other structured solutions

•

Other structured solutions 31

Commodities traded: base & precious metals Base metals

Precious metals

• Aluminum

• Gold

•

LME: LMAHDY Cmdty, 5 yrs

• Copper •

LME: LMCAD Comdty, 5 years

•

COMEX: HGA Comdty, 5 years

•

• Silver •

LME: LMZSDY Cmdty, 5 yrs

•

PLAT Comdty (3 yrs)

• Palladium

• Lead •

SILV Comdty (5 yrs)

• Platinum

• Zinc •

GOLDS Cmdty (5 yrs)

•

PALL Comdty (3 yrs)

LME: LMPBDY Cmdty, 5 yrs

• Nickel •

LME: LMNIDY Cmdty, 5 yrs

• Tin •

LME: LMSNDY Cmdty, 5 yrs

Products:

Products:

•

Swaps

•

Swaps

•

Caps / Floors / Collars

•

Caps / Floors / Collars

•

Other structured solutions

•

Other structured solutions

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Procedures, Risk and Documentation How to get from origination to hedging

Documentation • ISDA documentation or contrat cadre / raamcontract • MIFID

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Any remaining questions? Thank you for your time!

Disclaimer

This presentation was prepared to serve as a platform for discussion and does not carry any right of publication or disclosure. Neither this presentation nor any of its contents may be used for any other purpose without the consent of ING. The information in this presentation reflects prevailing conditions and ING’s judgement as of this date, all of which are accordingly subject to change. Specifically, the recommendations contained in this report represent ING’s judgement only. In preparing this presentation, ING has relied upon and assumed, without independent verification, the accuracy and completeness of all information. Available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. Please note that the terms and conditions contained herein are for discussion purposes only and that the issuing of this presentation is no commitment to enter into any transaction or to negotiate the terms of conditions thereof.

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