2. Outline
1. Outlook for Prices
2. Counterparty Credit Risk amidst the Credit Crunch
3. Hedging Policies & Instruments in a hyper-volatile era
4. Current Situation
5. KOCH Industries
4. Prices, a bird’s eye view in 4 phases
5 years, continuous 1st nearby ICE Brent
Credit c
c
oli
ab
r
pa
r
unch
ing
Go
The new “asset” class
Healing Mode
5. An Asset Class was born
• Accommodative availability of credit
• Tolerance for high leverage
• Light touch regulatory environment
• Digitalization of trading
+
• Above-trend growth of consumption in Asia
• Low OPEC spare capacity
= overly aggressive allocation of capital in energy
financial markets, some even called it a “bubble”.
6. Oil Price elasticity vs. Credit Crunch
• Prior to Credit Meltdown, energy prices fulfilled their
“signal role” in fostering physical demand destruction.
• This physical demand destruction kicked in as soon as
2007 while in parabolic phase. Timing varied from slate to
slate due to wide crack product differentials.
• Credit Crunch shocked the appetite for oil financial
exposure, a mix of risk aversion and major de-leveraging.
• The manufacturing sectors across time zones slumped in
unison, furthering weakness. Petchems a perfect
example.
9. Port of Los Angeles Traffic
(in TEUs)
A TEU is a 20-foot-long cargo container
10. Prices, where are we today?
6 months, continuous 1st nearby ICE Brent
Bottomed out?
$45/bbl
11. A market in need of Healing (1)
• Extreme Price ranges lowers participants' pain
threshold. Capital de-leveraging cuts VAR
allocations in financial institutions hit by balance-
sheet constraints. Shock absorbers are cautious.
• Such extremes make long term industrial and
infrastructure investment planning hazardous.
12. A market in need of Healing (2)
• Parabolic Prices triggered a political outcry
aiming for a major regulatory overhaul in
OTC trading. Prices receded since then, not
the political will…
• Ratable hedgers step back, stop and amend
hedge programs, rethink Risk Management
policies.
• Oil markets have to mean-revert to Supply &
Demand balances. In other words,
speculators typically exacerbate trends,
rarely contrarians to S&D.
13. Prices: participant’s framework
After many years building our presence by either being
directly involved in various physical and paper oil
businesses or by adding tangible economic value to
our customers’ relationships, we believe at Koch
Industries that we are in a good position to analyze
and anticipate oil market trends:
Invista / Flint Hill Resources / Georgia-Pacific / KS&T
14. Slates, Runs and Freight
• Excess refining capacity active in international trade
– Jamnagar 2 not in full force yet, RFCC ramping up next month
– Japan demand low, Kashiwazaki-Kariwa nuclear plant re-
commissioned shortly?
• Distillates plentiful despite above-average Northern hemisphere HDD
season. The coldest season in 24 years in NWE
• Gasoline picture much better balanced, yield switching reverse of 2008
• Naphtha weak but supply impaired
• Fuel Oil comparatively healthy on tight sour and discriminatory
steadiness in maintaining conversion utilization. High-Lows narrow as
OPEC cuts heaviest grades.
• TCE* rates depressed
TCE= Time Chartered Equivalent
17. Documentation – importance of
standards
• Most derivatives contracts have standardized features regarding
pricing conventions and settlement
• Protect both parties in the transaction while maintaining uniformity
among portfolio of positions
• International Swaps and Derivatives Association (ISDA) maintains
and refines industry standards
Index definition
Settlement calculations
Credit terms
Payment instructions
17
18. Credit considerations
• Bilateral transactions involve credit exposure
• All dealers and most large institutional users of bilateral
derivatives maintain a credit evaluation capability to monitor their
counterparties
• Credit exposure managed primarily via stated credit thresholds
either in confirmations or in ISDA Credit Support Annexes
• Cash or securities can be used to guaranty performance on
derivative settlement
• Other clauses may allow parties to close out of transactions if
sufficient evidence exists that a counterparty may default
18
19. Guarantees
• Frequently the contracting parties to a bilateral transaction are not
publicly-rated entities
• They may require more onerous credit terms, such as tighter
thresholds
• Alternatively, they may seek guarantees from rated parent
companies
19
20. Enforceability and regulation
• Over-the-counter derivatives are acknowledged in most
jurisdictions
• They are typically not as highly regulated as listed futures
markets
Self-monitoring by industry groups tends to be the norm
• Unlike listed futures markets, OTC derivatives may not be
enforceable in all countries
• There is an added level of exposure to counterparties in these
countries who may decide not to perform on a derivative that is
out-of-the-money
20
21. Rebalancing of Exchanges and OTC
• IPE/ICE now offering clearing of OTC contracts
• Fulfills necessary role of credit intermediation
• Credit risk borne by clearing members
• Enables price risk managers to hedge risks
customized to their needs while not taking on
counterparty credit risk
• Cost is upfront margin and subsequent margining,
which may not be necessary in bilateral OTC
contracts
23. Classification of hedging programs
Ratable Opportunistic
No Yes
Discretionary
Yes Constrained
Non-discretionary
23
24. Discretionary vs. nondiscretionary
• A small number of hedgers take a discretionary approach
Market timing, based on knowledge gained from other
participants and dealers
Role of research, consulting agreements
• The vast majority of hedgers are less discretionary
Reflects their admission of not having superior market
knowledge
Price takers
Trend followers
24
25. Discretionary programs
• Discretionary hedging programs may be extremely flexible
• Buying and selling hedges based upon market point of view
gathered internally or with input from outsiders
• But difficult to explain to shareholders
• Also may not dampen volatility of physical exposure as traders
may choose not to be hedged or even to increase exposure
25
26. Nondiscretionary: two main types
• Constant-volume, or ratable-volume
Involves defined-volume, defined-frequency accumulation of
hedges regardless of price
Can involve any particular structure (swaps, collars, caps)
• Structured opportunistic
Accumulates hedges according to price levels
May also dictate structures employed at any given price level
26
27. Constant-volume programs
• Example: buying 1-year forward once per quarter in
volumes corresponding to 10% of total consumption
– After four quarters, hedge volume equal to 40% of that period’s consumption;
30% of 2nd quarter’s consumption; 20% of 3rd quarter’s consumption; and
10% of 4th quarter’s consumption
– Total volume of hedge position equal to full quarter’s consumption
– Price appreciation/depreciation should affect hedge book and physical
exposure similarly, though not perfectly given “beta” effect
– Given the dollar-weight averaging of entry prices, the value of the hedge will
have somewhat dampened volatility vs. entry levels
27
ISDA®
ISDA®
28. Structured Opportunistic programs
• May be as rigidly applied as constant-volume programs
(i.e. without discretion)
• But rigid in a very different way – via statistical analysis of
historical prices
• Hedges are entered according to how forward prices
relate to historical averages
• Hedge volumes grow as prices drop, and vice-versa
• Choice of instruments may also be a function of price
levels
29. Structured Opportunistic pros/cons
• Benefit from lower volatility of hedge value vs. ratable programs
All other things equal, the size of a S.O. hedge position is equal to
or lesser than the size of a ratable hedge position
• Effective as long as market behaves according to historical price
distribution
• Downside: leave consumer un-hedged in persistently strong market
• Alternatively, can saddle hedge book length in persistently weak
market
• Tends not to benefit from term structure as ratable programs do
• Indeed, structured opportunistic programs generally hurt by term
structure (buying in contango market; exposed in backward market)
30. Price Dive and Consumer Hedging
• Regardless of the robustness of your Monte-Carlo risk engine, it
is unlikely that the $147 through $35 move constituted a
reasonable or even likely price scenario.
• Consumers hedgers got scattered in all quadrants:
From
– Reactive and cutting losses relatively early.
All the way to
– Did not do anything at all.
in
• But all are revising their hedge program parameters,
particular how recursive the decision-making
process should become.
31. Choice of instruments
• Typical: Buy swaps at relatively low prices
1.5+ standard deviations below long-term averages
Probability of hedge losing value is relatively low
Potential mark-to-market costs (margin) lowest
• Enter collars or ceilings at median prices
Provides more flexibility on MTM should market decline from
average levels
• Buy caps or do nothing at higher prices
Potential for hedge losses proportionately greater
32. Rules of thumb on allocation of
instruments
• One simple rule of thumb is to hedge one-third of exposure via
swaps; another third via collars; and leave the balance unhedged
• Justified by its risk profile as halfway between hedged and
unhedged
• In practice, this is just a point on the continuum; there may be solid
reasons to choose alternative points
• For structured opportunistic, the decision regarding mix of hedges
may be a function of forward prices
33. Views on structures
• New structures marketed as offering greater value than existing
products
There is no free lunch, please do not fall for smoke & mirrors!
Any structure can be offered more cheaply if the buyer is willing to
maintain or increase exposure
Always calculate your leverage ex-ante! TARS horror stories…
• A derivatives dealer can develop risk-management tools for any
specific exposures via existing or novel structures
Need to establish client objectives
Relative importance of net cash cost
Predictability vs. buying low
34. Example #4: storage hedge collar
• Strip of European-style zero-cost collars (floor vs. cap) on
crude oil term structure to protect against severe
backwardation and/or benefit from contango shape.
• Inventory hedges are typically rolling short futures positions
• The storage hedge collar provides protection against
backwardation, not necessarily spike in outright price
• Another example of a spread option
34
36. We don’t do Price forecasts
• But it appears that once excess physical inventory is
eventually mopped up, all necessary conditions are in place
for the resumption of a bullish bias:
– Vastly expansionary monetary stance in key Central Banks
impacts the differed part of the forward curves.
– E&P, Refining and Downstream investment in slowdown mode.
– The return of speculators to Oil, the “macro trade” is alive and
well. Inflation hedge, diversification from the $, lack of alternatives
have led to higher open interest and volumes on ICE.
40. Oil Supply adjusting to crisis
• With lower price environment, some Projects
schedules delayed, some scrapped.
– In non-OPEC, IEA estimates 1 mm bpd for 2009/10
• Steeper decline rates from mature fields as
maintenance spending is trimmed.
• Those factors impact with a lag even in case the
market rebounds, some are non-reversible. [sticky
factor]
41. What matters today? (1)
• Do we still have too much oil supplied and what is
OPEC doing about it?
– Inventories plentiful, have been rising for 7 months.
– Still building but not as fast.
– Contango shape allows storage balancing mechanism.
• OPEC in catch-up mode for cuts while demand
revisions pace quicken
– OPEC tightening compliance and will persist
– Refiners adjusting to low-run world as refining in excess
capacity.
42. What matters today? (2)
• The macro-trade is alive and kicking. Risk/reward is
alluring. How much downside left?...
• Speculative positions (OI & Volumes) on the oil exchanges
have increased again since a low in October 2008
• A recent survey of 1,000 hedge funds by Deutsche Bank
indicates that a quarter of $294 billion held in cash should
find its way into highly favored “global macro strategy”
within 6 months.
43. What matters today? (3)
• Asia seems to be leading the way on bottoming
out process. Ethylene crackers now in full runs
again in Korea, Taiwan, etc…
• How sustainable is China as the new world growth
leader? How reliable is domestic demand for the
medium-term? Besides infrastructure spending…
44. Recent regulatory developments
• Pension and hedge funds in the crosshair last July
• Now very much a CDS story as oil receded.
• Last February, anti-speculation measures specific to
commodities markets passed House but vetoed
• On the agenda of the new administration but unclear which
House Committee is taking the lead between Financial
Services Committee and Energy and Commerce
Committee.
• Unregulated OTC trading defended by financial institutions.
• OTC Clearing trend versus speculative position limits
• London loophole, what London loophole?
45. Prices: a word about Natural Gas
• Natural Gas world in Europe still has a split personality: NBP in the UK
and GO/FO formulas on the continent due to long-term supply contracts
pricing mechanism.
• NBP is still the dominant hub in NWE Europe as competition restriction
prevent the other continental hubs from taking their rightful place - still
influenced by oil prices in the forward season but will break below
European Benchmark Prices and surrender to UK Supply / Demand in
short-term.
• Our NBP Point of View: rather bearish for summer given supply situation,
initially we think winter prices will be supported by utility hedging and lack
of storage.
• European Benchmark Price (a rough estimate of the oil index formula
prices - e.g. German average import price)
47. Koch Industries - Overview
• Koch Industries is among the world's largest private companies. Founded in
1940, it is owned and managed by Charles and David Koch.
• Koch has interests spanning involvement in commodities (metals, petroleum,
minerals etc.) and securities trading through to owning and operating refining and
manufacturing facilities.
• As evidence of its financial strength Koch Resources, LLC maintains a long-term
S&P A+ and Moody’s Aa3 credit rating.
• Trading operations located in London, Geneva, Singapore, Houston, New York,
Wichita, Kansas (Corporate Headquarters), Rotterdam and Mumbai.
• Information: www.kochind.com www.ksandt.com www.kochmetals.com
http:/derivatives.kochind.com www.kochsteel.com www.kochbullion.com
48. Koch Business Groups
Koch Industries owns a diverse group of companies that exercise capabilities in
trading, operations excellence and investments on a global scale in core
industries that include: trading; petroleum; asphalt; natural gas; gas liquids;
chemicals ;metals, plastics and fibers; chemical technology equipment; minerals;
fertilizers; ranching; pipelines; pulp; securities and finance, as well as a range of
other ventures and investments. Some of the principal companies include:
Koch Financial Corporation
Koch Supply & Trading, LP
Koch Materials Company
Koch Supply & Trading, Sàrl
Koch Chemical Technology Group
Koch Metals Trading Limited
KoSa
Flint Hills Resources
INVISTA
Koch Mineral Services, LLC
Georgia-Pacific
Koch Capital Markets
Koch Ventures
49. Koch Supply & Trading - Overview
• Koch Supply & Trading, LP (KS&T) is a global supply, marketing,
trading and risk management group conducting business in crude
oil, refined petroleum products, petrochemical feedstock, freight,
base metals, steel and other commodities.
• Today KS&T is among the world’s top five crude oil traders and
actively trades about 50 types of crude oil around the world.
• KS&T trades in physical commodity markets and is also an active
market-maker of innovative risk management solutions for a wide
range of customers, including several large oil producers
• KS&T emphasizes a disciplined, strategic approach, with a focus on
customer needs, market analysis and risk-management
capabilities.
• Information: www.ksandt.com http:/derivatives.kochind.com
50. Koch Supply & Trading: Activities
• Worldwide trading and risk management activities in crude oil, refined petroleum
products, metals and other commodities:
– Global Crude Oil (trading some 50 different types of crude)
– Light Products and Chemicals
– Natural gas and gas liquids
– Heavy Products (e.g. industrial and bunker fuels)
– Base Metals (Al, Cu, Zn, Pb, Ni, Sn and brass) incl. online trading
– Steel (hot and cold rolled coils)
• For additional information see: www.kochmetals.com
51. Koch Supply & Trading – Contacts
Structured Products
New York Ilia Bouchouev (212) 759-8146 ilia.bouchouev@kochind.com
Nicholas Dazzo (212) 319-4895 nicholas.dazzo@kochind.com
Patrick Melia (212) 759-8123 patrick.melia@kochind.com
Adam Glassman (212) 355-3417 adam.glassman@kochind.com
Joseph Master (212) 644-0286 joe.master@kochind.com
Ashutosh Tayshete (212) 319-5163 ashutosh.tayshete@kochind.com
Wichita Arian Fouquet (316) 828-3888 arian.fouquet@kochind.com
Brett Johnson (316) 828-8884 brett.johnson@kochind.com
Wes Osbourn (316) 828-5882 wes.osbourn@kochind.com
Brett Unrein (316) 828-7178 brett.unrein@kochind.com
Geneva Olivier Raevel 41-22-737-4229 olivier.raevel@kochind.com
George Christie 41-22-737-4225 george.christie@kochind.com
Christian Jestin 41-22-737-4221 christian.jestin@kochind.com
Brian Carpani 41-22-737-4244 brian.carpani@kochind.com
Singapore Dennis Ho 65-6831-6560 dennis.ho@kochind.com
Mumbai S. Ramani 91-22-2403-8437 ramanis@kochind.com
52. Disclaimer
Note: These forecasts/data/analysis are based upon a number of estimates and
assumptions. Actual results may vary significantly. No assurance or guarantee is made
that these forecasts will be achieved.
Please be advised that the analysis, examples and prices provided above are for
illustrative purposes only. Although the information has been compiled by Koch from
sources believed to be reliable, these financial forecasts are based upon a number of
estimates and assumptions that are subject to significant business, economic, regulatory
and competitive uncertainties. Forecasts are inherently subjective and speculative, and
actual results and subsequent forecasts may vary significantly from these forecasts. Koch
makes no representation, warranty or guarantee as to, and shall not be responsible for the
accuracy or completeness of, this information and has no obligation to update any
information provided to you. Koch shall not be liable to recipient or any third party for its
use of or reliance on the information contained herein. Koch is not acting as your agent or
advisor and you are encouraged to seek independent advice, as necessary, prior to
entering into any transaction. This information may not be reproduced, distributed or
published by any recipient for any purpose.