CHAPTER 12 DEMYSTIFYING THE “D” WORD - A GUIDE TO UNDERSTANDING DERIVATIVES

• Jurisdiction: United States

Oil and Gas Agreements: Midstream and Marketing
(Feb 2011)
CHAPTER 12
DEMYSTIFYING THE "D" WORD - A GUIDE TO UNDERSTANDING DERIVATIVES
Scott R. Smith
Black & Veatch Corporation
Houston, Texas

SCOTT R. SMITH is a Vice President with Black & Veatch Management Consulting and leads the Industry Vertical consulting practice. He has over twenty-five years of energy industry experience. Mr. Smith's expertise includes energy market analysis, storage valuation, risk management, asset optimization, business strategy development, and energy decision analysis. Prior to joining Black & Veatch, Mr. Smith was Sr. Vice President and founding partner of Lukens Energy Group an energy consultancy based in Houston. In addition, he was Vice President of Marketing at Southern Company Energy Marketing, L.P., a joint venture between Southern Company and Vastar Resources, Inc. Mr. Smith also served in several leadership positions in marketing and trading at Vastar Resources and Atlantic Richfield Company.

Agenda:

• What is a Derivative?

• Types of Derivatives

• The Role of Derivatives in Managing Risk

• Examples of Derivative Utilization

• Changing Regulation of Derivatives

• Closing Comments

[Page 12-2]

Definitions of a Derivative

• Derivative (instrument): A contract whose value is based on performance of an underlying financial asset, commodity or market index.

• Bilateral contract (1 buyer, 1 seller)

• 'Derive' their value from an underlying fundamental:

• I.e. - oil, natural gas or electricity

• Cash-settled (no physical deliveries)

• Except - sometimes on futures

• Risk-management tool:

• Used as a vehicle for distributing risk in future value of the underlying fundamental

• Transaction pathways:

• Over-the-counter (OTC) derivatives (brokers)

• Exchange-traded derivatives (ICE, CME, etc.)

• US regulatory oversight:

• Securities and Exchange Commission (SEC)

• Commodity Futures Trading Commission (CFTC)

"Underlying" Fundamental	Examples
Commodity	Energy product (oil, gas, electricity)
Agricultural product (food crop, textile feedstock)
Commodity Supply-Demand Driver	Weather (temperature, degree days, growing days, hurricane activity, precipitation)
Financial asset	Equity (stock)
Bond
Collectible Debt (mortgage, other loans)
Currency	Exchange rate (USD-to-JPY, etc.)
Market Index	S&P 500 (stock index)
DJ Euro (stock index)
Barclay BGCI (carbon emission credits)

"Underlying" Varieties of Derivatives

[Page 12-3]

Type	Provisions
Future	Obligation to buy or sell a specific quantity at an agreed price on (or no later than) a specified future date
Transaction units usually are whole numbers of standard contracts (for example, 1 NG Contract = 10,000 MMBtu gas)
Option	Right (but not obligation) to buy or sell
Put	Owner of put has right to sell at a specific price
Call	Owner of call has right to buy at a specific price
Collar	Arrangement to establish a price ceiling and floor using a paired put / call
Swap	Agreement to exchange a price reflective of one market for a different price reflective of a different market
Several varieties of swaps exist and vary with tenor (timeline) and price points

Contract Varieties of Derivatives

Swap Type	Provisions
Fixed-for-Float Swap	Exchange of payments between two parties (Seller and Buyer) to be settled on (or by) a specific date
Buyer pays a negotiated fixed price to Seller
Seller pays an agreed

...