Black-Scholes Energy, Inc. Eunice Chin, Cecilia Shi, Namgu Kim, Sebastian Sotelo FINC Fall 2013: Derivatives & Financial Markets Final Project

Business Problem  Black-Scholes Energy (NYSE: BSE) is an oil producing company with assets in the Gulf of Mexico extracting light crude sweet oil  BSE sells oil at West Texas Intermediary (WTI) prices  BSE just produced 102,000 barrels of oil and, the equivalent of 102 contracts of crude oil futures. BSE is long crude oil. BSE must hedge its position against declining commodity prices.  With the United States and its allies close to reaching a deal with Iran, the markets expect an influx of oil supply in the market, putting downwards pressure on oil prices  Furthermore, excess production in the Gulf of Mexico is pushing WTI prices down  BSE has a risk tolerance of 10% to lose up to 5% of its underlying position

Historical Crude Oil Prices chart

Volatility and What Influences Oil Prices?  SUPPLY  Trends in oil production  Amounts  Location  DEMAND  Trends in oil demand  Amounts  Location  INVENTORY MANAGEMENT OF OIL RESERVES  The oil market is one of the most volatile markets in the world  Supply and demand, inventory management, the state of the global economy, climate (weather extremes such as very cold winters), oil futures trading, government policies, and various other factors all influence the volatility of oil prices

Oil Industry Outlook  The largest consumer of oil in the world is the United States  Spike in oil production in the United States this year  Positive momentum in the domestic manufacturing sector and especially from the Chinese economy have increased oil prices to 2- year highs of around $110 per barrel this year  The ongoing Syrian conflict, particularly with tension over possible U.S. military intervention, is expected to put a pressure in the price of a barrel of oil in view of the output loss from disruptions in Libya  Global oil consumption is expected to increase from sustained strength in China, the Middle East, Central and South America that continue to expand. Western economies however have sluggish growth prospects  The Energy Information Administration (EIA), provider of official energy statistics from the U.S. Government, in its most recent Short-Term Energy Outlook, expects global oil demand to grow by 1.2 million barrels per day in 2014, adding to the growth of 1.1 million barrels per day in 2013  EIA’s latest report assumes that world supply is likely to go up by 0.8 million barrels per day this year and by 1.2 million barrels per day in 2014

Oil Forecast  EIA expects that WTI crude oil prices will average $96 per barrel during the fourth quarter of 2013 and $95 per barrel during 2014  Energy price forecasts are highly uncertain, and the current values of futures and options contracts suggest that prices could differ significantly from the forecast levels  “U.S. Oil Prices Fall Sharply as Glut Forms on Gulf Coast” – WSJ 12/05/2013  “Iran Nuclear Deal Pushes Oil Prices Lower” – FT 11/25/2013

Risk Management Assumptions  Light Sweet Crude Oil Futures Contract Price (12/7/13): $97.94/barrel  Contract Maturity Date: 3/14/14  Days Remaining: 97  Number of Barrels in Each Futures Contract: 1000  Number of Futures Contracts: 102  Number of Barrels Required: 102,000  Total Exposure Value: $9,989,880  Target Loss (5%): $499,494  Associated Loss Probability: 10% ( Standard Deviations)  Risk Free Rate: %  Risk Premium: %  = % (geometric avg of commodity returns from 1959~ returns from 2008~2013 for Light Sweet) %  σ: 16.86%  From Bloomberg 250-day regulatory estimate

Expected Future Price Calculation Inputs  0 F t :  0 R t : %  RP: %  t: 97/365 Calculation  Expected Spot Price:

Upper and Lower Critical Levels Inputs  Expected Spot Price:  #:  σ: 16.86%  T: 97/365 Calculation  For a long exposure, the lower critical price level is:  For a long exposure, the upper critical price level is: Interpretation  There is a 10% chance that the underlying will be at or below in 97 days  The associated loss relative to buying the underlying at the current futures price of is 7.15%  = (90.94 – 97.94)/97.94

Contracts Needed to Satisfy Risk Limits  Keep: 70.00%  = 5%/7.15%  Hedge: 30.00% or $2,999,  =  = $9,989,880 * 30.00%  Contracts of Underlying Exposure: 102 contracts  Contracts Must Sell: 31 contracts  102 contracts * 30% Interpretation  For the underlying risk, we should sell 30.00% forward-futures and leave a maximum of 70.00% unhedged to meet our risk management guidelines  This means that we should sell 31 futures contracts in order to satisfy risk limits

Value at Risk We must sell 31 contracts to meet our risk targets.

Market Views

Market Data

Synthetic Long Put ATM Market View: Down and Unsure By holding this position we are limiting our losses to $287,692.80, well above our loss limit of $499,494. Since oil prices have been going down, we will profit from further decreases in price and insure against increases in price.

Synthetic Long Put ITM Market View: Down and Unsure By holding this position we are limiting our losses to $371,347.99, well above our loss limit of $499,494. Since we believe oil prices will go down but are not sure, we will profit from further decreases in price and insure against increases in price.

Bear Spread Market View: Limited Down, Worry About Big Upside By holding this position we are limiting our losses to $94,858, well above our loss limit of $499,494. There is a small gain if prices drop and a limited loss. In this position we gain income from shorting a put and insurance from buying the call.

Synthetic Long Straddle with OTM Call Market View: Volatile and no direction By holding this position we are limiting our losses to $497,510, just above our loss limit of $499,494. This position would limit our losses given oil’s high volatility with a slight upside if prices go down significantly.

Long Straddle Market View: Limited Down, Worry About Big Upside By holding this position we are limiting our losses to $494,790, well above our loss limit of $499,494. There is no gain in this position but. The purpose of the long straddle is to insure our position given oil’s high volatility.

Recommendation  The two best options are to make a synthetic long put ATM or a bear spread given that they limit our losses the most  Given our views that prices will go further down, a synthetic put ATM has a larger upside given a decline in price but we pay a higher price for the premium  A bear spread will limit our loss the lowest but limits us from gains if prices fall in line with our view.  Our best hedging strategy would be the bear spread. It is consistent with our view that prices will go down and provides the least possible loss from all the options.