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Is It Time to Hedge Against Oil Hikes?

Instead of trying to forecast movements in benchmark crude, CFOs can use a Monte Carlo simulation to gauge the probability of oil hitting certain price points.
Vincent Ryan, CFO.com | US
February 16, 2012

Benchmark crude oil prices rose this week, with West Texas Intermediate (WTI) crude for delivery in March hitting five-week highs at more than $102 per barrel.

CFOs who haven't hedged their fuel consumption this year might think they can ignore that small move above $100/bbl may. But here's a number that can't be ignored: in a "neutral" oil market - where price movements stem from volatility more than anything else - there's a 5% chance that the price of WTI crude will rise above $120/bbl and stay there. 

While that's far out on the distribution curve, in a market where bias is slightly to the up side - the current market state - the chance of a $120 price point rises to 35%. And if the oil market gets decidedly bullish, the probability of sustained $120/bbl oil is 50%.

Those numbers come from a Monte Carlo simulation of WTI crude oil prices developed by Kase and Co., an energy trading and hedging consultancy. (Monte Carlo simulations are used to model phenomena with significant uncertainty in inputs, like calculating risk.)

The probability of higher oil prices in 2012.

Kase's Monte Carlo simulation (see below) is not for predicting where oil prices will go; instead, consumers of oil use it to examine the probabilities of oil averaging a certain price for the next 12 months. The simulation uses the current 12-month "strip": the forward curve for crude-oil prices.

The chart reflects the assumption that the current market is in a weak "up" state, meaning a bias to slightly higher prices, and a rise on the y axis indicates an increase in probability.

"CFOs need to know the maximum price they can deal with and still meet all their business goals and function normally as a company," says Cynthia Kase, president of Kase and Co. Rather than trying to guess what's going on in the Strait of Hormuz, for example, it's "better to say what are the probabilities of higher prices taking place and how much is it worth to me to protect myself against such higher prices," she says.

Kase's statistical model can help a CFO decide how much of a company's oil consumption to hedge and whether buying forward or using options is the appropriate method.

With crude prices above $100/bbl now, there is too much risk buying a fixed-price forward, says Kase. "We forget that the market was in the low $70s just a couple of months ago," she says. If prices turned down and a strong bear market resulted, for example, there would be a 30% chance that the market would average $71.90 over the next 12 months. If a company had fixed its oil buying at $100 per barrel, that would be a big loss.

Kase's clients were buying forward when crude was in the low $80s, but when prices moved into the low $90s they switched to buying call options - a contract to buy an instrument at a specified price within a specific time. Call options mitigate downside risk, because the buyer can just let the option expire without exercising it.

If crude oil prices continue their rise, "the main thing is not to wait until $120, because by then it will be too late," Kase counsels. "When [oil] is at $120/bbl, buying forward won't be smart because you'll have too much downside risk, and buying a call [to protect against even higher prices] will be expensive."

What price movements should CFOs watch for? If crude oil breaks above $105/bbl for a couple of weeks, the odds increase that oil has moved decidedly into a bullish market, Kase says. On the other hand, a lot of what is supporting the current price level is geopolitics. "What happens if that goes away and you have to support the market purely on demand?" asks Kase. "That's a real risk in a market like this." The U.S. Energy Information Administration cut its global oil demand forecast for a sixth consecutive month the week of February 10.

The EIA expects WTI crude to average $100/bbl this year, which would be $6 above last year. Using futures and options data, EIA's calculations say there is a 1 in 15 (6%) chance that by June the average price of WTI will exceed $125 per barrel.

But Kase cautions that it is very difficult - and even unwise - to try to forecast the 12-month average for crude prices, much less put it into a budget. "Prognostication works in a 1-week to 12-week horizon," she says, "but the butterfly effect is just too intrusive to make market calls longer than three months."




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