• Analysis of five core hedging strategies

• Quantitative assessments of each strategy's cost and benefits

• Price correlations and liquidity effects on Nymex vs IPE

CONTENTS
Preface

Introduction
Hedging instruments
Purposes of hedging crude oil
Volatility reduction
Hedge gain maximization and other extensions of risk management
Speculation versus hedging
Hedgemasters
Portfolios

Five hedging strategies
Pure futures strategies
Always selling 12 months forward
Selectively selling three months forward
Selling forward in backwardized markets

Pure options strategies
Using plain puts to obtain $15 insurance
Using plain puts to lock $19 budget price
Selling options

Options combination strategies
The bear spread
The straddle
The strangle
Collars
Hedging by condition: backwardized and contango markets
Hedging in bear markets
In-, out-of-, and near-the-money options
Layer upon layer
Exotic (Asian) options strategies
Insurance instruments
Three forces for pushing for insurance company involvement
Sample insurance instruments
Blending risks with insurance programs
Conclusions: insurance versus derivatives

West Texas Intermediate (WTI) market depth, liquidity, and hedging effectiveness
Market liquidity
Concepts
Measurement
Market depth
Results
Conclusions
WTI and Brent: who leads and who lags?
Results
Conclusions
Corellations and hedging effectiveness
Risk management example
A crude hedging portfolio

Conclusions
Winners and losers
Energy consumers
The last word: does basis risk render all of this moot?

Notes
Bibliography
Appendix: tables and charts summarizing the outcomes of futures and options strategies under different market conditions and expectations

Reviewed by H Brett Humphreys - Bankers Trust risk management advisory group
For those venturing tentatively into the field of crude oil hedging, Edward Krapels and Michael Pratt of Energy Security Analysis, Inc (ESAI) provide a solid introduction.

This is a report of three parts: the first deals with the basic arguments for hedging. The second gives a detailed analysis of hedging strategies, while the third examines the ideas of liquidity within the New York Mercantile Exchange (Nymex) and London's International Petroleum Exchange (IPE) crude oil markets and the basis risk between Nymex's West Texas Intermediate (WTI) crude oil contract and other oil prices.

It kicks off by defining hedging and presents the standard hedging arguments, where the primary goal of any hedging programme is to reduce cashflow volatility.

The authors explicitly recognise that companies that hedge should give up some cashflow to compensate others for accepting the hedged risks. The classic argument that oil company shareholders want direct exposure to oil price risk is weakened by the fact that oil company share prices are not exceptionally sensitive to oil price fluctuations.

They also discuss the role perceived for some companies as ″hedgemasters″ where risk management has become a core part of operations and they may provide services for other industry players. British Petroleum (now BP Amoco), Enron, Koch, and Elf are identified as hedgemasters.

The second section goes through various hedging strategies, beginning with basic futures plays and moving on to more complex methods. The option hedging analysis goes through a number of methodologies including put spreads, Asian options and collars. One of the best parts is the analysis of self-insurance as a hedging strategy - a topic that is rarely covered.

Overall, the analysis is thorough and evaluates each strategy for bull and bear markets as well as for when the market is in contango or backwardation. However, as a guide for a new hedger or for someone supervising hedging, the analysis may seem too complex. There are also excessive mentions of further analysis available from ESAI.

The third section of Crude Oil Hedging, examining market depth, liquidity and hedging effectiveness, presents original research into the crude oil market. ESAI concludes that Nymex is the more liquid market and the price leader, which is not as obvious as it sounds.

This section of the book, key reading for any company considering a hedging strategy, concludes with an evaluation of basis risk and the effectiveness of using WTI as a hedge if exposure is to another crude oil.

I would recommend this report to those considering entering or evaluating an existing crude oil hedging programme. The three sections provide the basics: why a company should hedge their risk, where the risks should be hedged, and the methods available for hedging.