Risk Profile Modification of Energy Projects: The Impact of Controlling Financial Risk Utilizing Swaps

Abstract

Summary The commodity futures and swaps markets are thought to be the invention of speculators, the bane of the oil business, or possibly something confined to finance departments of major corporations. In actuality, they should be considered more as an insurance vehicle and can be used at the project level to modify the risk profile of a property. In this context, an increased familiarity with them can be useful for an engineer. Either futures or swaps can be used to guarantee or modify product prices. While this does not necessarily maximize cash flow or present worth, it can protect a project or company for several years from downside price risk, thereby reducing the risk of the venture. This can be particularly important if lower product prices would cause unacceptable cash flows or net incomes. Reducing risk by limiting downside price exposure could alter budgeting decisions, allow continued or expanded operations of a particular property, or increase debt capacity. Introduction As commodity markets have increasingly assumed the role of discovering near-term prices for oil and are beginning to affect natural gas prices similarly, several financial products have been developed that can reduce product pricing risk. Risk can be reduced directly in the futures market or in the over-the-counter market with financial institutions and trading companies using hedging products like swaps. The role that these products play and the importance of understanding it are increasing as price volatility becomes more pronounced. Their impact is highest and their cost is lowest over the immediate future (1 to 5 years). This may also be the period of maximum producing rate, highest present worth, and maximum uncertainty concerning price; thus, they can provide substantial risk protection. Futures and swaps markets exist for crude oil, natural gas, and several refined hydrocarbon products. While gas futures and swaps can be executed, that market is less well-developed than the oil market, and the relative prices in the two markets do not necessarily correlate. This paper is limited to crude oil transactions to avoid those complications and to concentrate on the risk-modification aspects of hedging. Most comments and all concepts are equally valid for natural gas production. This paper briefly outlines how oil futures and swaps function and then concentrates on demonstrating the effect of swaps on risk management at the project level through specific examples. An attempt is made to focus on the basic fundamentals of altering project risk rather than dealing with the infinite variability of swaps or the mechanical complexities of executing futures contracts.