Analysis of Light Sweet Crude Oil (WTI) Options Trading on NYMEX

Q1

a) Assume that you are trading Light Sweet Crude Oil (WTI) options on the NYMEX. You bought a June 2019 European Call Option with a strike price of $50.00/barrel for a premium of $3.00/barrel. You also bought a June 2019 European Put Option with a strike price of $50.00/barrel for a premium of $2.00/barrel.

i. Analyse the relationship between your profit/loss and the price of the underlying asset of these two options.

ii. Discuss the potential motivation for you to use the above option strategy.

b) “Oil and natural gas price volatility may pose significant threats to the revenue of oil and gas producers; therefore, whenever such risk has been identified, it must be fully hedged with derivatives”. 

With references to the nature of oil/gas price risk and the commonly-used price risk management techniques, critically assess this statement. 

c) Use a simple numerical example to illustrate why investors often prefer buying crude Call Options to buying physical crude to speculate on a potential rise of crude price.      

Q2

a) The 6-month forward price for Brent Crude is $40.00 per barrel. The spot price for Brent Crude is $36.00 per barrel. The risk-free interest rate is 2% per annum with continuous compounding and the cost for storing one barrel of crude oil for 6 months is $1.5. Suppose that the quoted spot price is for instant delivery and the estimated convenience yield for holding crude oil is 6% per annum with continuous compounding. In addition, the following assumptions about the Brent forward and spot markets hold:

· Market participants pay no transaction cost.

· Market participants pay the same tax rate on all types of income.

· Market participants can borrow and lend funds at the same risk-free interest rate.

· Market participants can long and short crude in the spot and forward markets.

· Market participants have the capability to take advantage of any arbitrage opportunity as it occurs.

Required:

i. Based on the information provided in this question, analyse whether an arbitrage opportunity exists. If so, discuss how to take advantage of this opportunity. Note that you need to provide detailed calculations to support your answer.  

ii. With reference to the commodity forward pricing formula, discuss how the storage costs affect the prices of crude forward contracts.       [15 Marks]

b) Compare and contrast the Natural Gas (Henry Hub) Physical Futures and Options traded on the NYMEX.   

c) The following figure shows the Henry Hub Natural Gas futures prices observed at the end of February 2017. Discuss the economic implications of the price pattern revealed by the figure.      

Q3

EcoFuel Inc is a Texas-based, independent refinery. It has agreed to buy 80,000 barrels of crude oil from a local oil producer. The crude is scheduled to be delivered on 22 August 2019. Both parties agreed to use the WTI Cushing Price published by Argus on the delivery date to settle this transaction. Assume that the WTI Cushing price published by Argus is $62.00/barrel on the day (2 April 2019) when the crude supply contract is signed.

a) From EcoFuel Inc’s point of view, identify the price risk resulting from the proposed purchase of crude oil.   

b) Discuss how to use WTI Crude Forwards, and the WTI Futures, Call and Put Options traded on the NYMEX to hedge the price risk identified in a), noting the limitations of each as a hedging instrument.                                               

Assume that on Day 1 a trader bought a WTI Crude Oil Futures contract traded on the NYMEX. The initial margin was $3850 per contract and the maintenance margin was $3500 per contract. The futures contract is bought at $33.00 per barrel and closed on Day 6 at $32.00 per barrel.

Based on the settlement prices of futures contracts listed in Table 1, calculate the daily margin account balance at the close of each trading day.  

Table 1      

Connex Energy Inc is a California-based oil producer. To hedge the price risk resulting from an oil supply contract, it decides to purchase the following crude oil swap (see Table 2) from an investment bank. Assume that the discount rate for all maturities is 3% per annum with continuous compounding. Also, on the initiation date, WTI futures contracts are traded at the following prices (see Table 2). Calculate the fair price of this swap on the initiation date, assuming there is no arbitrage opportunity and transaction cost.

Compare the WTI swap contract described in c) and the forward contracts with the same underlying asset.