Oilshaft Inc. Is a trading firm specializing in the marketing of oil products to retail concerns such as gas stations and heating oil distributors. The firm does not produce oil, but instead profits by the sale and hedging of delivery contracts to its customers. In this sense, it assumes the classical role of insuring consumers of the product against future fluctuations in prices. In the past, the firm has been successful in profiting by a strategy of delivering oil, and purchasing futures contracts to match anticipated future needs. This strategy was the brainchild of Henry Knobloch, an oil-futures trader and marketing manager for Oilshaft, inc. In 1992, Knobloch observed that his customers wanted long-term contracts for fixed quantities of oil. In fact, there was a strong demand for a standard contract that guaranteed 100 barrels of oil per month every month for the next ten years at a fixed price. The only problem was how to deliver such a contract, how to hedge it, and how to price it.
In 1992, the company began to offer the fixed ten-year contract, and was immediately successful. Customers rushed to buy their contracts, and by December of 1992, Oilshaft was as committed to delivering 160 million barrels of oil to its customers over the next ten years at fixed prices. It looked profitable, too. Average delivery prices were $3.00 per barrel HIGHER than prevailing spot prices.
In order the hedge out the firm's risk of delivery, Knobloch took a rolling position in short-term oil futures contracts, once the month's deliveries were made. For every barrel of oil the company had committed to deliver in the future, it took a LONG position in a futures contract with one month to maturity. In other words, the firm bought a barrel of oil one month forward. When the contracts matured in a month, Knobloch sold them and took another long position in oil futures with one month to maturity. This new position was equal in quantity to the outstanding contracts. Despite the mis-matched maturity of the short-term futures contracts and the long-term liability to deliver oil in the future, rolling over the futures each month appeared to provide a reasonable hedge against fluctuations in oil prices. In December of 1992, an elated Knobloch calculated the profits from this strategy: $3/bbl times 160 million bbl.
In 1993, the firm began to incur trading losses. In particular, the strategy of "selling" the expiring future (equal to the spot price at the date of expiration) and "buying" the future with a month to expiration began to lose money. The market was suddenly in contango -- i.e. futures prices were higher than spot prices. As expiration of each contract approached, the firm had to meet the daily settlement payments. The long side of the contract (Oilshaft) had to pay the short side of the contract the amount the futures price moved down each day. For instance, when the price of a single contract dropped from $20/bbl at the beginning of the month to $18/bbl when it expired, the firm effectively ended up paying $2 over the period they held the contract. Spot oil prices were dropping in 1993, and the futures prices were not falling as fast. This relationship between futures prices and spot prices suddenly caused Oilshaft some concern.
Gerald Pabst, the CEO of Oilshaft was worried about the huge cash needs required to maintain the hedge, but Knobloch assured him that as the price of oil dropped, the contracts written at high fixed prices were becoming that much more valuable. The company only needed to maintain its position, and a profit of $3/bbl was guaranteed. Indeed, if oil prices remained low for the long term, the effective profits from the ten-year contracts were that much more valuable!
The oil markets continued in contango for all of 1993. By January, 1994, the firm had exhausted its cash resources on the hedging strategy. Pabst was forced to seek additional sources of funding. He approached Eaglebank, a partial owner of Oilshaft, for an increase in the firm's line of credit.
Eagle's evaluation of the request for funding was based upon the following assumptions:
Oilshaft's entire assets at the end of 1993 are contracts for delivery of 144 million barrels (that is, the nine remaining years on the outstanding ten year contracts as of the beginning of 1992) of oil at $23/bl. The barrels are to be delivered monthly, in equal quantities over nine years. I.E. each month, the company must deliver 144/108 million bbl. The company has hedged their position one-for-one. That is, in the first month of 1993 they hold 144 million bbl of futures positions.
1. Calculate the roll-over costs Oilshaft incurred over the year 1993. How much did the hedging strategy cost them? Was the drop in oil prices the major source of their losses?
2. Historically, the oil market has been in backwardation, i.e. spot prices have been higher than futures prices by about 30 cents/ contract. If 1993 had been similar to history, what kind of profit or loss would Knobloch have expected from rolling over the one-month contract?
Consider the present value [PV] of Oilshaft at the beginning of 1994, ignoring the hedge:
3. What was the PV of the assets of the firm? What discount rate makes sense to use for this estimate?
4. What was the PV of the liabilities of the firm, under the assumption that oil prices will remain fixed for the remaining nine years.
5. How much would the firm have incurred in hedging costs in 1993 if it had only hedged the present value of their liabilities? Here you may assume that expected future oil prices move in lock-step with current oil prices.
7. Commodity prices tend to be mean-reverting. That is, they drop or rise in the short term, but they tend to revert back to historical averages. In this situation, a $1 drop in oil prices today may only be indicative of a 50 cent drop in expected future oil prices. In other words, the "delta" of the future liabilities with respect to current oil price changes is .5. Would this induce you to increase or decrease the amount of the hedge?
Estimate how much money will be needed to maintain the hedge position over the next year, assuming that the average contango continues at the present level.
What will happen if the market moves to its historical level of backwardation in the oil market? By what percent will this change the firm's value?
Is Oilshaft's hedging strategy appropriate? Are there ways to further reduce their risks? Should you continue to support their strategy, or recommend a major change?