Managing Governmental Policy Uncertainty Risk

Of all the risks that energy traders manage, there is none more difficult than governmental policy risk, when a change in well established policies may be on the horizon. This past week traders were forced to deal this risk and will likely continue having to manage governmental policy uncertainty for the next several weeks.

The direction of US financial regulatory policy may change dramatically with new proposals voiced by President Obama on Thursday. Appearing with Paul Volcker, instead of current Secretary of the Treasury, Tim Geithner, President Obama announced he will seek restrictions on proprietary trading and impose a levy on bank wholesale funding. In and of itself the market would be able to adjust to these policy changes. The greater and more difficult risk adjustment comes into play with the man standing next to President Obama as he gave his speech.

Lots of questions arise from last Thursday's speech. Where was Tim Geithner as President Obama was speaking? Where was Ben Bernanke? Why was 82 year old Paul Volcker called out of retirement bliss to construct the new regulatory policies? Why are some Democrats now changing their votes against the renomination of Ben Bernanke? Not knowing the answers to these question, traders do what they are trained to do when sudden uncertainty arises; get ahead of the crowd and exit your long positions immediately.

If greater clarity is given that Ben Bernanke will be reappointed, the markets will likely stabilize quickly. Should more Democrats try to separate themselves from President Obama by voting no to his reconfirmation, we are likely to see equities and commodities continue to slide as traders adjust to a potential strong dollar policy with Paul Volcker receiving greater prominence in the Obama administration.

The most conservative risk management tool in this type of political uncertainty is to stay flat on your trading until clarity appears. Energy traders wanting to gain an advantage before clarity is apparent should monitor the DailyFX Carry Trade Index. The index has reversed from 2009 channel highs and now sits poised to break channel support. Should this event occur, it is a clear sign traders are making a trend shift away from the year old arbitrage; sell the US dollar buy commodities. Exiting these positions requires they buy back the US dollar, which will increase downward momentum on the DailyFX Carry Trade Index. This will create more fear in the market and pressure the energy complex lower.

CFTC Energy Position Limits Proposition for the Bigs

The Commodity Futures Trading Commission has proposed new position limit rules for the large trading houses. The new rules will only affect the ten largest position holders. Will these rules make a difference for energy traders? In a nutshell, the rules are likely to not even affect the bigs.

The key points of the new rules are as follows:
1. Position imposed limits on oil, natural gas, heating oil, RBOB gas traded on NYMEX and ICE
2. For all trading months combined limits at 10% on first 25,000 contracts open interest,2.5% next 25,000 lots
3. Single month position limits proposed at 2/3 of the all trading months combined position limits
4. Spot month position limit for contracts physically settled at 25% of estimated deliverable supply

Trading houses knew these rules were coming when Gary Gensler took office in May. The CFTC has been under pressure to strengthen limits due to populace thinking that large speculators were the cause of crude's run up to $147. Since bona fide commodity inventory hedging is exempt from the new rules, most of the bigs have enlarged their physical product trading desks.

The trading limits proposed are very generous. At current trading levels the new rules will have virtually no impact on market liquidity. Had the CFTC wanted to make an impact on speculation the focus should have been on margin requirements. The downside would be higher costs to producers and refiners which would inevitably be passed along to end users, ultimately raising the price of refined products.

It was interesting to see the energy complex remain virtually unchanged Thursday when the rules were released. The market then pulled back on Friday with the exception of nat gas rising .10. The pull back was more related to a strengthening US dollar vs the euro rather than large traders exiting long positions in fear of the new rules. For now, do not expect the trading limits to have any affect. This may frustrate law makers who may seek stronger action should the energy complex break through to new highs in ninety days when the proposition is scheduled to go into effect.

Predictable Arbitrage Hedging Opportunities

Generating additional profit margin for wholesale energy sellers generally requires a willingness to take on added speculative risk. Understanding systematic basis movement tendencies enables sellers to increase margins without greatly increasing risk. This is the essence of arbitrage hedging.

The tendency of basis to narrow over time at a predictable rate in a contango market, is a low risk profit opportunity. In a full carrying charge market, basis will narrow over time at a rate approximately equal to storage costs per unit of time. To profit from this narrowing basis movement simply buy the less expensive cash commodity product and sell the corresponding futures contract. As the basis continues to narrow the loss on the cash position will be offset by the greater gain on the futures contract.

The key to making arbitrage hedging a consistent winner is understanding the type of market the particular energy commodity you are selling is currently trading. Should the outlying futures contracts be trading below current spot prices, the above strategy would result in a loss. In this scenario of a backwardated market, basis movements are not systematically predictable.

There are very few low risk opportunities for energy wholesalers to add profit to each gallon sold. Taking advantage of systematically predictable basis movements through arbitrage hedging, is one strategy that every seller with storage capacity should be aggressively implementing.

Innovative Nat Gas Drilling Technologies Creating Reliable Long Term North American Supplies

In the past few years, natural gas drilling production technology innovation has seen a dramatic increase in efficiencies. Combine these new drilling techniques with the development of unconventional shale gas resources and the stage is set for dramatic production increases and reliable long term supplies throughout North America.

One of the major reasons nat gas is not currently used on a greater scale by transportation and industrial end users is that in the past nat gas supply stocks were not available in reliable quantities to enable the use of long term forward contracts throughout North America. And even in certain areas where supplies were adequate, price volatility made gas a difficult risk proposition.

We are entering a new world now of abundant gas supplies. Encana's, Dave Thorn, states, "The economical recovery of shale gas has been a game changer. Reserve life estimates have increased dramatically, and North American gas supplies could rise by 25 bcf per day."

These estimates are being driven by rig efficiencies. Not too long ago, supply estimates were largely based on the number of drilling rigs in production. However, unconventional gas wells are driving production increases even though active rig counts have fallen 50%.

Not too long ago shrinking nat gas supply stocks created worries that North American gas supplies were in a permanent decline. Liquid Natural Gas was seen as a possible, yet expensive solution to this decline. Those worries are quickly disappearing. The one caveat to the future of natural gas is proposed environmental regulation. These concerns are likely to be overcome by recent environmental research showing the new shale drilling technologies are not harming local water supplies. This research along with the economic and environmental benefits of switching to gas as a bridge fuel will make the future very bright for natty gas.

ExxonMobil's Major Wager On Natty Gas

ExxonMobil will soon be "cookin' with natural gas" after this week's takeover of XTO Energy.
For a mere $3o billion in ExxonMobil stock and assumption of $10 billion in XTO Energy debt, Exxon is now (pending approval of shareholders and regulatory clearance) the leader in developing cleaner fuel technologies in the United States via natural gas. The pay off will likely be realized in a short term and long term scenario parallel to likely changes in fuel stock dynamics.

The immediate benefit to Exxon is access to recent natural gas hydraulic fracturing drilling technology. XTO Energy has had a steady growth rate of 25% per year for the past several years due to its more efficient drilling and storage techniques that has enabled drilling in shale formations that were previously cost prohibitive. Also, Exxon natural gas inventory stocks receive a nice domestic boost. And, it is only paying $2.96 per thousand cubic feet for XTO's proven reserves of 45 trillion cubic feet of gas.

Longer term, the acquisition of XTO is a major domestic piece of the worldwide nat gas purchases Exxon has been accumulating as it positions itself for an anticipated shift in natural gas as a bridge fuel to eventual non-carbon based fuels.

Not too long ago natural gas was burned off at oil field production operations as a waste product due to its past low market price. The future value of natty gas will be much different, especially if current legislation passes requiring nat gas for government fleet vehicles. Exxon is now well positioned to someday even fuel potential future compressed natural gas vehicles.

Improving Hedge Strategy Modeling

Energy product producers and sellers are well aware of the cyclical pricing nature of their respective products. The difficulty is in accommodating for outside economic influences that may exaggerate cyclical pricing volatility into hedge analysis modeling. Get the macro economic direction correct and modeling formulas will provide precision timing for enabling profitable hedging strategies.

The foundation for successful commodity energy hedge modeling generally consists of fundamental inputs of supply stocks relative to current and future demand. The future demand component will be more accurately produced by incorporating energy options greeks as a directional compass on market sentiment on macro economic conditions.

Rising put options premium after the underlying futures has regressed from technical resistance, is a good indication to delay locking in long term pricing. However, this is an excellent indicator to sell calls and hedge a long position.

Conversely, rising call options premium after the underlying futures has held support and begun to trend slope positive, is an excellent indicator to lock in fixed pricing to establish a long position on the underlying futures commodity.

The element of risk can never be eliminated. Long Term Capital found this out the hard way when the Black Scholes model they relied upon failed to accommodate tail risk. Having the proper modeling inputs will however, increase the probability of accurately timing a hedging strategy.

Will the Energy Complex Be the Next Commodities Group to Unwind?

The US dollar vs. the euro broke $1.49 up channel support Friday that traces back to the euro's steady rise beginning in March of 2009. This uptrend channel also coincides with the pricing pattern of crude, gas and diesel. Does this break in the currency pair signal energy is about to reverse from its uptrend channel?

Should the US dollar continue gaining strength the energy complex would shift to pricing primarily on the fundamentals. With OPEC oil producers selling volumes above agreed upon quotas and non-OPEC producers such as Russia and Venezuela producing at full speed, refiners would need to show a dramatic increase in refinery products utilization rates to avoid a massive oversupply of crude. Refiners are still in hunker down mode with utilization runs under 80%.
In this environment, the crude supply is likely to continue to grow.

Refined products are also well supplied with distillates at a 26 year high and gas hitting 17 year inventory highs. Therefore, should the US dollar continue strengthening, the energy complex is very likely to begin slowly drifting below up channel support seeking a new bottom based on pure fundamentals.

Traders will be monitoring comments from the US Federal Reserve bankers on any shift in policy on target interest rates or monetary easing. The current White House regime will apply pressure on the supposively independent Fed to prevent any change its weak dollar policy. Higher interest rates will create higher costs in funding budget deficits. Knowing this, energy traders will probably not be expecting too much of a drop in crude below its current $75 support handle.