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Slippery Slope

Monte Carlo simulations can guide your hedging strategy.
Vincent Ryan, CFO Magazine
March 1, 2012

Last month's run-up in oil prices is a reminder that CFOs can't afford to become complacent about energy prices. But assessing the volatility of oil prices, and developing a strategy to cope with them, stymie many finance departments.

One useful input may be a Monte Carlo simulation of West Texas Intermediate (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, such as calculating risk.) The company's model currently finds that there is a 35% chance that the price of WTI crude will rise above $120 a barrel and stay there, and those odds increase to 50% if the oil market gets decidedly bullish. Kase's statistical model can help CFOs decide how much of a company's oil consumption to hedge and whether buying forward or using options is the appropriate method.

Probability of an oil price increase, based on the current market

With crude prices above $100 a barrel now, buying a fixed-price forward is too risky, says Kase and Co. president Cynthia Kase. "We forget that the market was in the low $70s just a couple of months ago," she says. If a drop in price were to trigger a strong bear market, for example, there would be a 30% chance that the market would average $71.90 over the next 12 months. A company that had fixed its oil buying at $100 per barrel would incur a big loss.

When prices reached the low $90s, Kase clients switched from buying forwards 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 let the option expire without exercising it. "Don't wait until prices hit $120; by then it'll be too late," Kase says. "At that level, 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."




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