il producers operate in an environment subject to adverse price movement in the international oil market. This exposure to such risk is enough to increase a company’s costs or dramatically reduce its profits. As risk exposure reduces the producer’s appeal to investors and makes gaining access to debt markets more difficult, the need to efficiently manage exposure to fluctuating commodity prices is clearly one of the greatest challenges facing an exploration and production company today.

In this presentation, we discuss several swap and option based strategies that oil producers can use to manage their market risk. All of these strategies can be structured for a variety of international crudes and products. Hedging periods and protection levels can be customized to fit any maturity and price level.

While the examples in this presentation are denominated in U.S. dollars, Sempra Energy Trading ® Corp. ("SET") can also offer hedging instruments in other major currencies.

Figure 1. WTI 20-Day Moving Average: 1996-2007

Overview

fixed for floating swap is a privately negotiated, financially settled forward contract covering a series of forward pricing periods.

A swap is designed to transfer, or "swap,"specific price risk between the swap purchaser (e.g., the End User) and the swap provider (e.g., SET) through a contractual exchange of payments. It involves the payment of a fixed price times a notional amount by one party, in exchange for a floating price times the same notional amount from another party.

A swap enables oil end users to fix the purchase price of future oil consumption and thus minimize any exposure to rising prices. By locking in prices, producers gain greater control over the variable revenues and costs inherent in their businesses.

The financial settlement ensures that traditional customer (i.e., physical) relationships are not distributed.

There is no commission for a swap.

Reference Price An agreed upon pricing source and calculation method to establish the current or floating price of the commodity.

Fixed Price The agreed upon price which is multiplied by the quantity of the commodity to calculate the size of the fixed payment.

Floating Price The Reference Price as calculated for a pricing period, which is multiplied by the quantity of the commodity to calculate the floating payment.

Swap Maturity The length of the swap contract, which may cover several pricing periods.

Pricing Periods A schedule of agreed upon forward time periods. At the end of each pricing period the floating price is evaluated, and the floating and fixed payments are exchanged. Monthly, quarterly and annual pricing periods are commonly used.

Reference Quantity The notional amount of the commodity used to determine the swap cash flows at the end of each pricing period.

Application

An Oil Producer of 300,000 bbl/month sells crude oil to its customers at an agreed-upon index price. The firm wants more predictable cash flows in order to determine its ability to capitalize on exploration and production opportunities next year.

To help accomplish this objective, the Producer enters into a one-year swap with SET to hedge 1/3 of its production at a fixed price of $22.00/bbl. This swap hedge is financially equivalent to a forward sale of 100,000 barrels of crude oil per month for 12 months.

On each Settlement Date, the Producer receives from SET a fixed payment equal to $22.00/barrel.

The Producer, in exchange, makes a floating payment to SET based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted.

The floating payment paid to SET should closely approximate the payment received by the Producer from its customer(s) for physical deliveries of crude oil. The net result is that by combining the swap with its current physical crude oil contract, the Producer receives $22.00/bbl for its oil sales.

Sample Terms

Results

The table below shows the Swap transaction results, given different monthly average WTI prices.

A Swap enables the Crude Oil Producer to fix the sale price for future periods. The Producer receives a positive pay-off from the swap if crude oil prices fall. However, the Producer faces opportunity cost under the transaction if crude oil prices rise.

Financial settlement ensures that the Producer can offset its SET swap transaction with transactions carried out with traditional customers.

Overview

he participation swap contract establishes a minimum average forward sale price, while offering between 25% -100% participation in upward price moves.

It is an attractive alternative to many other producer hedging strategies because it overcomes the problem of forfeited upside price movements in a conventional swap.

Because of the forward sale, the Producer achieves complete price protection from any decrease in oil prices. If prices rise instead, the Producer participates in the favorable price move at the participation rate once average prices rise above the forward sale level.

The participation swap strategy outperforms the basic swap if prices rise sufficiently. It is most appropriate if strong upward price moves are expected, yet prices also seem vulnerable to sudden downward spikes.

Strategy

The Producer sells forward, establishing a minimum average sale price.

The participation swap price is set at a slight discount to the regular swap price.

In exchange for a lower forward price, the Producer receives the right to participate in favorable price moves above a specified participation price level at an agreed upon participation rate.

There is no up-front payment.

Sample Terms

Overview

pread swaps are designed to allow the Producer to lock in the differentials between commodity prices at different time periods (e.g., calendar swaps), or the price differentials between different commodities (e.g., crack swaps).

In a spread swap, the swap purchaser (e.g., the Producer) pays a pre-agreed fixed spread level in exchange for a floating spread level from the swap provider (e.g., SET). The transaction is usually financially settled.

Through the use of spread swap, the Producer achieves complete price protection from significant shifts in price differentials, without affecting its traditional physical customer relationships..

There is no commission for a spread swap.

aps and floors are options which provide the right, but not the obligation, to enter into a long or short position at a specified price.

Caps, also referred to as "call options," establish a maximum average purchase price for future oil consumption. They provide full protection from rising prices while allowing the buyer to benefit fully from decreases in oil prices. Caps are usually bought by oil end users.

Floors, also referred to as "put options," establish a minimum average sale price for future oil production. They provide full protection from falling prices while allowing the buyer to benefit fully from increases in oil prices. Floors are usually bought by oil producers.

The buyer of the cap or floor agrees to pay a predetermined cash premium for the protection. The premium varies with the selected strike price, term of the contract, and length of the averaging period.

Caps and floors are usually financially settled based on the average oil price over a specified period. While long dated maturities are available, monthly and quarterly averaging periods are the most popular.

Call Option The right, but not the obligation, to buy a fixed quantity of a commodity, for a predetermined price, at a specific date in the future. A Call option ensures a maximum price at which the commodity can be purchased.

Put Option The right, but not the obligation, to sell a fixed quantity of a commodity, for a predetermined price, at a specific date in the future. A Put option ensures a minimum price at which the commodity can be sold.

Premium The price the option buyer pays and the seller receives for the option.

Strike Price The predetermined price at which the commodity can be purchased or sold, if the option is exercised.

Expiration Date The date on which the option contract ends, and the option is either exercised or expires.

Volatility A measure of the price change of a commodity over a period of time.

Caps A Strip of call options with staggered expiration dates. A Cap ensures a maximum purchase price for several future periods.

Floors A Strip of put options with staggered expiration dates. A Floor ensures a minimum sales price for several future periods.

Averaging Period A predetermined time period ending with option expiration. The payoff of an APO's is determined by comparing the average commodity price over this period with the option strike price.

Application

• An Oil Producer is exposed to highly volatile oil prices, which have significant impact on its cash flow and its ability to service its debt. In order to decrease the chance of default, the Producer’s banks and creditors require that the company protect itself against a significant drop in oil prices. Specifically, the Producer and its lenders have determined that oil prices below $20.00/bbl will severely hamper the company’s ability to service its debt.

• In order to gain downside price protection, the Producer enters into a two-year $20.00/bbl strike floor agreement with SET for 100,000 bbl/month at a $1.25/bbl premium. The market price is based on averaging the daily prompt NYMEX crude oil futures contract settlement prices in each forward period over the contract term.

During the life of the agreement,

• The Producer continues to sell 100,000 bbl/month of its oil production to its regular customers at agreed-upon index prices.

• SET receives an upfront $1.25/bbl monthly premium for providing the price protection below $20.00/bbl.

• The Producer receives the market price for oil, as long as the market price is above $20.00/bbl for a given month. If the market price falls below $20.00/bbl, SET pays the Producer the difference between the market price and the floor price.

• Arranged in conjunction with the physical floating price sale, the floor agreement ensures that the oil sale price received by the Producer will never be less than $18.75/bbl (i.e., $20.00/bbl - premium of $1.25/bbl).

Risk-Reward Profile

Floors offer the Oil Producer the opportunity to minimize exposure to unanticipated decrease in oil prices without any loss of participation in favorable price moves.

With cap and floor purchases, all risks are predefined; the maximum "cost" or "loss" incurred by the buyer will always be the up-front premium payment.

The financial downside risks of receiving less than $18.00/bbl for its oil are far greater than the cost of the oil price protection.

Overview

collar, also referred to as "min-max strategy," is a zero or low cost hedging strategy that assures the Oil Producer a minimum / maximum price range for future oil sales.

Under a collar contract, the minimum possible sale price is equal to the floor price and the maximum possible sale price is equal to the ceiling price. For prices within this range, the Producer achieves the market price.

The contract is normally financially settled and often covers several pricing periods.

There is usually no up-front premium payment. Under a standard zero cost collar contract, the Producer can specify either the "floor" or the "ceiling" price level. The other price level is calculated by SET to ensure a zero-premium expense. If the Producer wishes, it can specify both price levels, but then it may incur some premium expense or income.

The Producer gains complete price protection from any prices below the floor price. However, in exchange for zero up-front premiums, any benefit from an oil price increase above the ceiling price is foregone.

The collar is, in many ways, similar to a swap, but it allows for greater flexibility through some market responsiveness. The collar outperforms a swap strategy if prices increase.

Application

• An independent Oil Producer with an annual production of 1.2 million barrels wants to protect 50% of its production from falling oil prices. However, it does not want to pay a cash premium for the protection, and also requires more flexibility than a standard swap can provide.

• In order to achieve this objective, the Producer enters into a one-year WTI zero-cost collar agreement with SET for 50,000 bbls per month. Under the agreement, the Producer is protected with a floor price of $20.00/bbl. In exchange for this protection, the Producer agrees to limit its upside price potential with a price cap of $24.00/bbl.

During the life of the agreement,

• The Producer continues to sell oil to its regular customers at the agreed upon index prices.

• At the end of each month, if the monthly average WTI price is below the $20.00/bbl floor price level, the Producer receives a payment equal to the amount by which the average is below the floor price.

• If the average WTI price is above the $24.00/bbl ceiling price level, the Producer is obligated to make a payment equal to the difference between the ceiling price and the average price.

• If the average prices move within the floor/ceiling range, no payments are required under the contract and the Producer achieves the prevailing market prices.

Sample Terms

Risk-Reward Profile

The collar assures that the Producer receive a fixed price range for crude oil sales at no monetary cost. The costless collar is partially "paid for" by giving up the potential favorable price movement above the ceiling.

The collar can be structured to match specific production characteristics.

Overview

ybrid strategies, sometimes called "hybrids," combine the basic building blocks of swaps and options to create highly structured financial products that oil producers can use to meet specific hedging objectives.

Given the over-the-counter financial tools and the flexibility inherent in the oil end user’s physical system, hybrids can be used to address virtually any risk profile. It is possible to establish a hedging program at higher than market levels and/or to reduce the cost of option based strategies.

Hybrids can take on a variety of forms. The more common hybrid products include:

• Extendable swaps
• Double-up or double-down swaps
• Participating collars
• Swap options (or "Swaptions")
• Cross-commodity indexed swaps
• Range swaps (or other instruments utilizing digital options)
• Extendable collars (or other applications of compound options)
• Barrier or "knock-out" options
• One time settlement options

Extendable Swaps

Extendable swaps are similar to fixed for floating swaps except that SET has the right to extend the contract maturity for a prespecified amount of time for the same Reference Quantity.

The advantage of the extendable swap is that the swap Fixed Price is higher than that of a conventional swap. For example, the Oil Producer enters into a one year extendable swap with SET. Whereas the swap Fixed Price for a comparable fixed for floating swap for the same contract maturity and Reference Quantity would be $22.00 per barrel, the swap Fixed Price for the extendable swap for the crude oil producer would be $22.50 per barrel.

If the prespecified contract extension is set for another year, the Producer will continue to sell prespecified quantities for the period at the same price if SET elects to extend the swap maturity.

Extendable Swaps: Sample Terms

Double-Up Swaps

A double-up swap is similar to a basic swap except that it offers the Oil Producer the opportunity to significantly improve its effective sale price.

Under a double-up swap, the Producer’s swap fixed price is set higher than for an otherwise identical conventional swap. In exchange, the Producer agrees to sell on any settlement date prespecified additional quantities of the commodity at the swap fixed price, if SET elects to buy these additional quantities.

The double-up swap is usually structured for financial settlement.

Participating Collars

Participating collars allow for index flexibility within a specified price range and provide a predetermined percentage gain from any favorable price moves.

Swap Options

Swap Options, or "Swaptions,"provide the right, but not the obligation, to buy or sell a swap at a predetermined fixed price, in exchange for a premium payment.

Cross-Commodity Indexed Swap

Cross-commodity indexed swaps allow the Oil Producer to synthetically shift revenues from one commodity to another to reduce price risk and volatility.

Range Swaps

In a range swap, the Oil Producer sells a swap at a level above the current market. However, the swap ceases to exist if the market settles below the pre-determined level in any individual month.

Application

A Producer sells a crude oil swap to SET at a fixed price of $23.00 (when the market price is $22.00).

If the market settles below $19.00/bbl in any month, the swap ceases to exist for that month, meaning that the Producer does not have a hedge.

Barrier or "Knock-Out" Options

Barrier options are similar to conventional options, except for the addition of a second expiration feature which makes them cheaper to purchase.

In addition to the usual option terms, an "out" price level is specified. If the commodity price is at or moves through the "out" price level, at any time during the life of the option, the option expires immediately. Otherwise, the Barrier option offers the same protection as a conventional option.

empra Energy Trading ® Corp. (SET), formerly AIG Trading Corporation, is a subsidiary of Sempra Energy, a San Diego-based Fortune 500 energy services holding company with the largest U.S. utility customer base. As of December 31, 1999, Sempra Energy had an equity market value of US$4.2 billion, total assets of US$12 billion and total revenues of US$5.5 billion. Sempra Energy has a credit rating of "A."

Sempra Energy Trading ® Corp. trades financial and physical crude and petroleum products, natural gas, natural gas liquids and electricity as a principal in North America and Europe. SET is one of the largest physical and financial market-makers in the natural gas and power industry in the U.S. and Canada, and one of the leading traders of crude and petroleum products in North America and Europe.

Business Objectives :

SET was established to engage in hedging, trading and financing activities related to the energy and other commodities markets. Each of the SET trading departments includes a team of specialists who have extensive experience with trading, hedging, and corporate finance. SET offers a full array of products including spot, forwards, leases, swaps, options and other derivative products. Furthermore, SET's specialists will structure hedging and financing programs to meet the specific needs of each client.