Fuel Hedging and Risk Management. Gajjala Vishnu N.

without leaving their chairs. Very often, the person trading these commodities has no personal experience with the physical commodity. Anyone can buy and sell commodities on trading platforms without even knowing the color of palladium, the location of gas pipelines, or the sea lanes used by very large crude carriers (VLCCs). Such abstraction from the details of the underlying physical commodity and its supply chain may be tolerable for some commodities, but is not advisable in the case of a “strategic” resource such as energy. The issue of security of production and supply is especially important for energy commodities, and this gives them a strategic dimension. Even experienced professionals like energy economists, who do a good job explaining energy prices in terms of supply and demand, can falter if they overlook the cost of securing supply and the security of trade routes.

      To understand the importance of these details in the case of energy markets, let us use the analogy of a computer or a tablet. One can think of the commodities' physical platform as the hardware and the financial system as the software installed on it. The luxury of the touch screen and user-friendly graphic interfaces makes electronic technology easily accessible to everybody, to the point that one forgets about the existence of electronic circuits. It is perfectly understandable that more and more users find the workings of the hardware irrelevant, as long as they can use the apps. However if, hypothetically, the computer were to be used in conjunction with other devices to control the heartbeat or any other vital organ in the body, the concerned person would insist on learning about the safety mechanisms of the hardware, reading the manufacturer reviews, and even renegotiating his/her insurance scheme. Similarly, energy security cannot be discussed without a proper understanding of the commodities' physical platform. In a world where major energy chokepoints are prone to instability or turbulence, it is reasonable to assume that consuming nations must, directly or indirectly, bear the cost of securing energy supplies.

      To further illustrate the strategic nature of energy, let us consider the case of China, which has become a major part of the energy equation, accounting for a significant fraction of oil demand growth. As a major oil consumer, China now commands the attention of market participants, who keep a close eye on the growth rate of the Chinese economy as any signs of a slowing of growth could send oil prices south. This simplistic analysis sometimes depicts China as mainly responsible for recent oil price volatility, either due to inappropriate monetary policy or industrial overcapacity, among other reasons. However, the situation looks quite different when viewed in the context of the petrodollar system.

      Since the onset of the petrodollar system in the 1970s, most Asian oil-importing economies, including China, were obliged to export goods to the United States to lay their hands on the US dollars that were necessary to procure oil from Saudi Arabia and other Organization of Petroleum Exporting Countries (OPEC) members. China has been successful in leveraging its large workforce to build a significant manufacturing infrastructure capable of meeting (or exceeding) the US market demand for manufactured goods. This status quo has helped China to build an industrial complex, the OPEC countries to enjoy unprecedented purchasing power, and the USA to pay for goods and services in a currency it can control or even “print.” The consequence of this system is that, in the absence of credible alternative counterparties, economies like China are very vulnerable to contractions in US imports, while the USA keeps the option to shift manufacturing to other countries like Bangladesh or Vietnam. As China's internal market cannot absorb its industrial production at international prices to cover US dollar-denominated commodity costs, any contraction of US imports can have a social impact (such as unemployment) in China and similar repercussions for neighboring economies. With a very large population aspiring to participate in its economic growth, China needs to maintain a minimum level of gross domestic product (GDP) growth, which requires incremental commodities that can only be purchased when margins from exports are significant. If this were not the case, then growth would likely be borrowed from the future in the form of bad loans. Such complex challenges faced by China and other exporter nations are intimately related to the energy market but are not readily apparent just from trading screens.

      Therefore, it is important for market participants to be alert to the geopolitical factors impacting energy prices and the importance of maritime route security and energy chokepoints. In this regard, we will take a closer look at China and how it is reducing its exposure to the petrodollar system through the use of oil and gas trade-offset mechanisms with Russia. We will also discuss how it aims to limit its reliance on the Strait of Malacca and the troubled South China Sea for its energy imports. But before that, we will look at different types of commodities, some characteristics of energy commodities, their provenance, and how they are refined and transported.

      ENERGY AS A TRADABLE COMMODITY

      The commoditization of energy resources unfolded in an accelerated fashion after the collapse of the Bretton Woods system, which ultimately led to the inauguration of crude oil trading on the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX) in 1983. The Bretton Woods system of fixed exchange rates was replaced by a floating exchange rate system that gave rise to increased volatility in financial markets in the 1970s. The need to manage exchange rate volatility led to the development of markets for foreign exchange. Concurrently, oil-producing countries were very concerned about the declining US dollar and started adjusting oil prices to match changes in gold price. In other words, there was reluctance in the oil market to break from the old Bretton Woods system that was pegged to gold. This kept oil prices stable when expressed in the old, “gold-backed dollars” but led to volatility spikes in actual oil prices (expressed in post-Bretton Woods US dollars). Thus, the evolution of the oil market from a regulated market with price controls to a free market necessitated the development of instruments for oil price risk management, akin to agricultural commodities markets. The development of this market depended heavily on the successful commoditization of these energy resources.

      A commodity can be defined as any good or service for which there is demand and which is indistinguishable from other goods of the same type. That is, there is no special feature or additional utility provided by a particular good that is not available from another good of the same type. For example, crude oil produced in the USA is fungible with crude oil produced elsewhere in the world and can be used for similar purposes. Thus, all goods of the same type are treated as equivalent and this facilitates the formation of markets as commoditized goods become substitutable for each other. In practice, commodities which are traded on commodity markets have to adhere to a minimum standard or grade in order for them to be widely traded.

      In this book, the use of the term “commodity” will refer to physical goods, usually natural resources, which are grown, mined, or extracted and are traded in a marketplace. The price of the commodity is generally determined by the market as a whole and not by individual producers or consumers. This assumes that a commodity is not differentiable by source, quality, or other specifications. However, in real life, there are minimum standards of quality and quantity that need to be observed for products to be traded in a marketplace. These minimum standards enable trading of large quantities of commodities as buyers do not have to bear the costs of analyzing the provenance of underlying commodities for each transaction. Markets also assign value to quality differences and, by extension, to the sources of commodities. For example, crude oil with low sulfur content and higher fractions of high-end products such as gasoline and kerosene (called light sweet crude oil) is usually assigned a higher price than crude oil with higher sulfur content.

      As opposed to other asset classes such as stocks or bonds, which represent claims on a corporation or entity, commodities are more difficult to define as an asset class. They can range from precious metals, such as gold and silver, to agricultural products like corn and wheat, as well as energy products such as crude oil and natural gas. Commodities can trade across physical markets, where participants exchange the actual commodity, or financial markets, where participants exchange claims to underlying commodities (akin to stocks and bonds). In this respect, commodities are better understood by observing the markets in which they are traded.

      Commodities can have multiple sources, making classification on this basis impractical. For instance, gold mined in Australia is substantially similar to gold mined elsewhere in the world. It is easier to classify commodities based on shared characteristics such as physical state, method of production, and primary end use. Commodities can be broadly classified under four major classes.

      1.