ArrowHead Solutions – Trading Risk and Hedging

ArrowHead Solutions Help Clients Understand Future Markets to Aid Their Trading Risk and Hedging Decisions

ArrowHead Solutions for Risk/Return

Trading is inherently a risky business. Companies buy something for which they think the price will escalate, and sell something for which they think the price will decay. Clients are betting their perspective on price and price movement against everyone else’s. If companies are to win consistently, they need an authentic, accurate probability distribution over market price and the key drivers. They need to watch these drivers, these precursors, so they can keep ahead of counterparties. Traders are often in the basis business, trading a price in one region or time against a price in another region or time. Therefore, they need to know probability distributions over basis as well.

The probability distribution must not be purely subjective and judgmental. The analysis and methodology must never naively assume independence between product and factor prices. Without a careful understanding of joint, dependent probabilities over price, one cannot possibly quantify, understand, or mitigate risks through trading, contracting, joint venturing, or other mechanisms. This understanding is incorporated in the design of the ArrowHead models so they correctly represent these interdependent probabilities.

ArrowHead Solutions for Trading and Hedging

There are myriad hedging decisions ranging from contracting to “stacked” purchase of forwards and/or options. Trading and hedging decisions require intrinsic, accurate, and “earliest in class” understanding of future market prices and quantities under different assumptions about potential events that can occur and possible market driver changes. You’ve got to be there first, and you’ve got to be right more than the competition.

Examples of Trading and Hedging Issues:

  • If we are offered a firm transportation agreement, is it worth what they are asking us to pay for it? Should we be the first to buy an FT on a new pipe? If we do, at what price will it be re-traded? Will we make money? Will we lose money? What is the fair market value of the FT? IT? If gas price falls, what is the FT worth? If gas price increases, what is the FT worth? If nuclear plants are decommissioned, what is the FT worth?
  • If we have a firm LNG terminal use agreement (TUA), what is it really worth? What if it is out of the money? How long before it is renegotiated into the money? Will it ever return to being in the money? For what price can we sell it? Will we have to dump it and take our losses, or will it appreciate in value so that we can use it or sell it profitably?
  • If we project the probability distribution over forward gas price to be increasing with an increasing variance, should we buy or sell instruments such as call options? Should we buy or sell puts? How much? What proportion of our gas sales should we cover with options or other derivatives?

ArrowHead Solutions for Asset Portfolio Hedging

An important type of hedging involves analysis of each asset within a portfolio to maximize the intrinsic hedging of these assets. Companies must answer questions such as:

  • Are our gas wells in the Rocky Mountains correlated with our gas wells in the Marcellus, i.e., are we just buying into a bigger lottery with bigger risk if we diversify regionally?
  • Do gas prices rise and fall together in both places, or are they independent to some degree? What makes them independent? What makes them dependent? What are the precursors for correlation? What do we have to watch out for if we see our asset mix becoming riskier, i.e., just a bigger piece of the same underlying lottery over profit?
  • What is the lowest or highest contract price we should consider? When do contract prices go out of the money?

How ArrowHead Solutions Help:

ArrowHead consultants can use our models to provide properly correlated probability distributions of commodity prices and quantities that account for joint, dependent probabilities over price. In our models, we embed no assumption of independence or dependence; the model determines the proper dependencies and correlations. Companies do not want to miss this dimension because they want to know how big their dependency on price is and thus how big their price risk really is. Using our services (our consultants using our models) to analyze the markets provides accurate commodity price and quantity distributions to inform any trading and hedging decision. With the modeling method and the transparency of assumptions, data and probabilities, we help you get it right, and you will have confidence in your results and decisions.