Energy Swaps

The birth of the market for energy swaps occurred through the initiative of Chase Manhattan Bank in October 1986.¹⁰ Estimates of OTC dealer activity are currently believed to be approximately 300 to 400 million barrels of oil equivalent traded per day. Of this, approximately 75% of all OTC transactions are swaps, 20% are options and 5% are structured transactions.¹¹ Exchange trading accounts for roughly another 300 million oil barrel equivalents. Thus, the entire energy complex trades close to 10 times daily world oil production on a daily basis.

Swaps are a natural product for the energy markets. For example, producers are subject to fluctuating revenue based on the price of oil over which they exert little control. End-users are subject to the risk of rising energy prices for needs which are often price inelastic. The presence of natural buyers and sellers creates a foundation for an active swap market with a niche for financial intermediaries. Further, the addition of new long-term crude oil futures to the NYMEX energy complex has made swaps of medium and longer terms easier to hedge without having to be subject to a "stack and roll" strategy.¹² The NYMEX has exempted swap traders from position limits, further contributing to the growing liquidity of the OTC market.¹³

In a basic "fixed for floating" swap, the underlying is some fixed amount of a commodity on which payments are based but which never physically changes hands. Producers are natural swap sellers (receivers of fixed) while end-users are natural buyers (payers of fixed). Intermediaries are important for ensuring confidentiality, assuming credit risk, and being able to absorb (and hedge) residual market risk which may arise from contracts with slightly different terms.

The floating prices of nearly all crude oil and a large portion of natural gas swaps are average prices. Often these are indexed to an average of NYMEX prices over a reference period. Alternatively, the swap may be indexed to an average of prices listed in trade publications such as Platt's Oilgram Price Report or Inside FERC. Although OTC deals can be customized in any way, the reference period for most crude oil swaps is the entire calendar month. For natural gas, the reference period is often the last three trading days of the NYMEX contract.

Two examples follow. The first is an example of a simple fixed for floating swap with monthly settlement and the second illustrates the same swap, but with settlement based on a monthly average price instead of one day's "floating" price.

 

Exhibit 1 details a simple fixed for floating NYMEX-based crude oil swap. In this case, the floating price is deemed to be the prevailing NYMEX settlement price on the swap settlement date. For ease of illustration, assume a three-month swap for three million barrels of oil (1 million each month) which settles monthly on the same date as the expiration of the NYMEX futures contracts.

Exhibit 1

Fixed for Floating Swap

Amount (barrels per month) 1,000,000

Start Date Nov. 21, 1995

Term (months) 3

Swap Price ($/barrel) $17.7734

Period	Settle Date	Calendar Days	Futures Contract	Interest Rate	Discount Factor	Barrels/ Month	Futures Price	Barrels	PV	Hedge
1 2 3	Dec 19 Jan 22 Feb20	28 33 28	Jan 1996 Feb 1996 March 1996	4.54% 5.27% 5.30%	0.9965 0.9953 0.9960	1,000,000 1,000,000 99601,000	$17.97 $17.75 $17.60	996,529 995,257 995,950	.35 .94 .71	996.53 995.26 995.95
								2,987,737	.99

Interest rates are used in combination with the number of calendar days in the settlement period to arrive at a dis­count factor. For example, in period 1, an annual interest rate of 4.54% for 28 days produces a discount factor of .9965 as per the following: 1/[1 + (.0454x(28/365))]. The fixed price of the swap, $17.7734, is derived by multiply­ing each futures price by the appropriate discount factor and dividing by the sum of the three discount factors.¹⁴ The hedge is calculated by multiplying the discount factor by the number of barrels to be hedged each month (giving the present value — PV — of the barrels of oil) and then dividing by 1,000 to arrive at the appropriate number of futures contracts. This will have the effect of introducing rounding errors which are difficult to circumvent since futures cannot be bought and sold in fractional amounts.

Assume that a bank had entered into the above swap with an oil producing firm. The bank would agree to make fixed payments to the producer and receive floating. To hedge this swap, the bank has two alternatives; it can either be hedged OTC or with NYMEX futures contracts. Liquidity on the NYMEX becomes a definite concern for maturities past one year; however for three months a NYMEX hedge can be easily constructed.

In order to offset their exposure to floating oil prices (akin to being long a futures contract) the bank would sell the quantity of futures contracts in each month designated in the "hedge" column. If the actual floating prices realized were $18.11, $18.04 and $17.63, the hedge would perform as illustrated in Exhibit 2.

Exhibit 2

Hedge Date	Performance Futures Price	Producer's Position	Bank's Swap Position	Bank's Hedge
Dec 19 Jan 22 Feb20	$18.11 $18.04 $17.63	($336,700.00) ($266,700.00) $143,300.00	$336,600.00 $266,600.00 ($143,400.00)	($139,514.20) ($288,625.40) (29,878.50)
			$459,800.00	(458,018.10)

As mentioned above, rounding errors create the difference between the bank's swap position and its hedge ($459,800 - $458,018.10 = $1,781.90) but the difference is negligible in terms of the total size of the trade.

Had this swap been based on the average of daily settlement prices rather than the settlement price on the expira­tion date, the hedge would be constructed differently. It is possible to use NYMEX futures contracts to hedge an average price swap, but the hedge requires more vigilance since futures contracts need to be repurchased each day. This swap is illustrated in Exhibit 3.

Exhibit 3

Average Price Swap

Amount (barrels) 3,000,000

Number of business days 61

Number of futures per day 49.18

	Start	Settle	Business	Future
Period	Date	Date	Days	Contracts
1	1Nov17	Dec 19	20	983.6
2	Dec 20	Jan 22	21	1032.78
3	Jan 23	Feb20	20	983.6
			61	2999.98

For an average price swap, determining the number of business (trading) days in the settlement period is important. The bank must average their price exposure evenly over each of those business days. The swap in the example has 61 business days, therefore the number of futures contracts to be repurchased each day would be: [3,000,000÷1,000]÷ 61= 49.18. (Again, rounding errors will be a factor.) To hedge this swap with exchange futures contracts, the bank would sell the number of futures contracts shown for each period (49.18 x number of business days) and buy back 49 each business day. This procedure gives them the appropriate exposure to the average contract price against which the swap will settle.¹⁵

Often, average price swaps will settle against a reference index other than NYMEX. Valuing these swaps using only NYMEX prices is likely to lead to mispriced deals and suboptimal hedges. For example, a natural gas swap may be referenced to an average of pipeline prices on three forward dates as posted in a trade publication, such as Gas Daily. Because the basis between the NYMEX and the reference pricing point will not be constant, it would be necessary to price the swap using the specific pipeline price, not the NYMEX. However, Gas Daily does not list forward prices. A bank valuing a referenced index swap will look to the basis market to price the swap. There is a liquid mar­ket that trades forward basis prices. From these prices, a bank could value the swap by backing out the referenced index forward price.

In the natural gas OTC market, basis swaps are very common. These are swaps used to hedge fluctuations in the spread between NYMEX natural gas futures (based on prices at the Henry Hub in Louisiana) and gas prices at distant delivery points.¹⁶ With respect to certain pipelines, active basis markets exist, allowing banks to participate in these swaps and hedge them OTC.