Commodities 1

BP Canada Energy Trading

Case Tutorial
Introduction

The Commodities case is a trading case that tests a traders ability to react to fundamental news
releases and understand how that news will affect the price of an asset. This case uses a simple
commodity, natural gas, and introduces random demand and supply shocks that will cause the price of
it to fluctuate throughout a trading session. Traders are expected to use these news releases with a
simple pricing model to compute expected settlement prices for each months contract. Traders can
then compare their computed estimates with the market prices and generate profits by capturing
perceived discrepancies between the actual value and market value of the asset.

Trading, Information, and Strategy

The key drivers behind the value of the natural gas contracts are the monthly supply and usage of
natural gas. The difference between these two factors can conveniently be characterized as the
amount of gas stored (or drawn from storage). When we compare the difference between the
amounts that we expect to store versus the amount that we actually store, we get a storage shortfall (a
negative storage shortfall would be excess storage).

The final settlement price of a Natural gas contract, for a given month m, is defined in the case as:

Where;
,

This equation is extremely simple. It states that the final price of the natural gas contract is equal to
the expected price (given in the table below), plus the storage shortfall (you forecast and then it is
eventually revealed) divided by the standard deviation of the shortfall (also given in the table below).

Given Data:
July August September
Expected NG Supply 2000 1980 1940
Expected NG Usage 1760 1620 1520
Expected NG Stored 240 360 420
Expected NG in Storage 6840 7200 7620
(at the end of the month)
Actual NG Supply
Actual NG Usage
Actual NG Stored To be released during the trading case
Actual NG in Storage
Storage Shortfall/Excess
Standard Deviation 90 70 60
Expected Price $6.00 $5.80 $6.00
*There is 6600 NG in storage on Jun 30th.

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BP Canada Energy Trading
Case Tutorial
Intuition:

If no news happens in an entire month of July - the expected amount of supply is realized, the
expected usage is realized, the result is that the expected amount of gas goes into storage. There is
no storage shortfall. Result:

We can substitute all of the known (given) values, as well as the realized shortfall of 0.

Our result:

The final settlement price for July is $6.00 because nothing happened to change the supply or usage
(and as a result, the storage shortfall) of Natural Gas in July.

Advanced Situation:

Lets assume that a natural gas pipeline were to be shut down for maintenance, causing producers to
shut down 50 BCF of natural gas production (supply) for the month. (Consider a simple scenario
where if the pipeline is turned off, those companies that use the pipeline to ship their production will
also have to shut down their production of natural gas.)

Result:

We can substitute all of the known (given) values, as well as the realized shortfall of 50.
Expected supply for July = 2000 BCF. Actual supply due to pipeline maintenance is 1950 BCF
Expected usage for July = 1760 BCF. Actual usage is 1760 BCF (nothing happened to affect usage!)
Expected storage for July = 240 BCF. Actual = 1950 1760 = 190 BCF.
Realized Shortfall = Expected Actual = 50

Our result:

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Case Tutorial
As a result of the pipeline shutdown, there was less natural gas supplied to the market. Since there
were no usage shocks, the amount that was left over and stored was only 190 BCF instead of the
expected 240. Hence, the drop in supply caused the price to increase from $6.00 to $6.55.

Weekly Data:

In RIT, actual values are released on a weekly basis - that is, every 2.5 minutes the actual data for
Week 1 (2, 3, 4) is released. The actual data shows the amount of natural gas supplied, used, and
stored. The case assumes no intra-month seasonality which means that if gas supplies for July are
expected to be 2000 BCF, one could expect each weeks supply in July to be 500 BCF.

You should use the weekly numbers to help refine your estimates for the monthly supply and usage.
For example, the base scenario for July is 500 BCF per week. If after week 1, the data is released
and 525 BCF were supplied, you can assume, without any other data, that the months supply will
probably be around 2025 BCF (assume that each following month will be as expected, unless there is
news to indicate otherwise.) You can do the same for the usage and storage results. One way to
think about it is as follows:

After week 1 release:

Expected Supply Expected Usage Actual Supply Actual Usage
Week 1 500 440 525 440
Week 2 500 440 A D
Week 3 500 440 B E
Week 4 500 440 C F
July 2000 1760 525 + A + B + C 440 + A + B + C

Your July supply is actually made up of 4 variables: each weeks supply. Likewise your July usage is
made up of 4 variables: each weeks usage. As time passes and these figures are released, fewer
variables are used to calculate the total months supply & usage. Week 4s values are reported prior
to the end of trading so there is a brief time when you will know the exact settlement price and still be
able to trade.

Storage Shortfalls & Surpluses Persist:

If the amount of natural gas stored in July is below expectations, one can also expect August and
September storage to also be below expectations. Total storage in a given month is equal to the
amount in storage the previous month plus the amount stored this month.

Consider the following example:

There is 6600 in storage on June 30th (prior to the case)

The market expects 240 BCF to be stored in July, July total storage should be 6840.
The market expects 360 BCF to be stored in August, August total storage should be 7200.

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Case Tutorial
If theres a supply shock in July, and only 190 BCF are stored, the final July storage number will be
6790. Furthermore, if August storage meets expectations of 360BCF, the final August total storage
number is 7150, still below the expectation.
The intuition behind this result is that a supply/usage shock to a single month will also affect all other
months. The amount of the effect will be different, because the sensitivity to the natural gas shortfall
for each month (standard deviation) is different.

Trading

So far the focus has been on modeling and calculating the value of the months natural gas contract
based on the supply and usage for the month. How does one turn it into a trading strategy?

The simplest trading strategy is to compare the expected natural gas settlement price (the one that
you have calculated based on the news that youve received) to the market price, and to purchase
contracts when they are undervalued and sell them when they are overvalued.

The second way is to trade a calendar spread by taking an opposite position on another months
contract to hedge your trade. For example, if you think that July is undervalued, you can purchase the
July contract and then short sell the September contract. If unforeseen news events happen, which
cause prices to unexpectedly fall, your September hedge contract will help offset your losses on your
long July position. If nothing happens, your July contract will eventually settle (hopefully at the higher
price that you forecast) and you can remove your hedge.

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