86 WORLD ENERGY OUTLOOK Today Ol Scarcity or Abundance? Estimates of ultimately recoverable resources of oil continue toincreaseas technologies unlock types fof resources, such as ight tight oil, that were not considered recoverable only a few years ago. IEA's latest estimates for remaining recoverable resources show 2,670 billion barrels of conventional oil (ncluding NGLs), 345 billion of light tight ol, 1,880, billion of extra-heavy oil and bitumen, and 1,070 billion of kerogen oil. Cumulatively, 790 billion bartels of oll need to be produced in total to meet projected demand in the New Policies Scenario. fl supply rises from 89 mb/d in 2012 to 101 rmb/d In 2035 In the Now Policies Scenario. Key components of the increase are unconventional oil (up 10 mb/d) and natural gas liquids (NGLs) An Energy Boost to the Economy? Share of global export market for energy intensive goods [aropean Union 38 The US, together with key emerging economies, Increases its export market share for ‘goods, while the EU and Japan sce sharp decline linked to the increase in global gas output (up 5 ‘mbja). Corwentional crude oil's share in total oil production falls, from 80% in 2012 te two-thirds in 2035. The role of OPEC in quenching the world’s thirst for oil is temporarily reduced over the next ten years, notably as US light tight oil and Brazilian deepwater output step up, but the share of OPEC countries In global output rises again in the 2020s, fs they remain the only large source of relatively low-cost ol. Iraqis the largest single source of oil production growth, followed by Brazil, Canada ‘and Kazakhstan, The US is the world’s largest oll producer for much of the period to 2038. Based on analysis of more than 1,600 fields, EA estimate the abserved decline rate for conventional fields that have passed their peak is around 6% per year. Unconventional plays, such as ight tight oll or ol sands, are heavily dependent on continuous investment and drilling to prevent the large intial decline rates for individual wells translating Into rapid fleld-leve! declines. Declining output from existing flelds 1s a major driver of upstream fnvestment, Total upstream spending in the oil and December 2013, gas sectors is expected to rise to more than $700 billion in 2013, a new high, and will need to remain ‘round these level for the next decade, before the annual average dips slightly, as lower-cost OPEC Middle East countries then provide most of the Increase in supply. Oil use is increasingly concentrated in just two sectors: transport and petrochemicals, Demand Jn China increases the most (up 6 mb/d), as it overtakes the US as the largest oil consumer by around 2030, followed by India (up 4.5 mb/d). The Middle East becomes the third-largest centre of oll demand, at 10 mb/d in 2085, underpinned by a fast-growing population and by oil subsidies, Which were equivalent to $520/person in 2012. In the OECD, demand for oll declines due to efficiency gains and fuel switching. Among oll products, dese! sees by far the largest increase, rising by more than 5 mbjd ‘between 2012-2085, compared ‘with arise in gasoline demand of 2 mbja. ‘The global refining sector i set for turbulent times over the ‘coming decades asthe Industry 1s reshaped by declining oll demand in OECD markets flongside rapid growth in demand in non-OECD Asia ‘and the Middle East, Pressures fon the refining system are ‘amplified by the changing ‘composition of | feedstocks, Including a growing share of natural gas liquids ‘that often bypass the refining system altogether. The IENS conservative estimate of 13 mb/d of new refineries to 2035, mostly in China, India and the Middle East, adds to global over-capacity, {increasing competition for available crude as well 4s for product export markets. The consequences ‘m terms of lower utilisation rates and potential rationalisation of capacity are mostly borne by (OECD refining sectors, Europe in particular, where oil demand is falling, Over the petiod to 2035, nearly 10 mbjd of global refinery capacity is at isk of low utilisation rates or closure. Changing patterns of demand, supply and refining also have ‘major implications for global oil trade. The net North American requirement for imported crude oil, all ut disappears by 2035, and the region becomes, 4 large exporter of products, Asia becomes the unrivalled centre ofthe global ol trade, drawing in 4 rising share of the available crude not just from the Middle East but also from Russia, the Caspian, Africa, Latin America (mainly Brazil) and North ‘America (Canada). energy-intensiveElectricity Demand Im the New Policies Scenario, world electricity ‘demand increases by more than two-thirds over the period 2011-2035. The power sector represents, ‘over half of the increase in global primary energy use, @ rise comparable to current US total energy ‘demand, Non-OECD countries account for the bull oof incremental electricity demand, led by China (86%), India (139%), Southeast Asia (8%) and the Middle East (69) Fossil fuels continue to dominate the powersector, ‘although their share of generation declines from {68% in 2011 to 579% in 2085. Coal remains the largest source of generation, with strong ‘growth in non-OECD countries far ounweighing reductions in OECD countries, Natural gas expands the most in absolute terms of any source, increasing in most regions. Coal-fied {generation rebounds in the short term in the US, reversing the recent coal-to-gas switch, 4s gas prices recover from very low levels. In Europe, gas-fired generation regains favour versus coal gradually on rising CO2 prices and. the need for flexible capacity, but only gets back to 2010 levels after 2030. Beyond fossil fuels, nuclear power maintains @ 12% share of ‘electricity generation globally, with expansion ‘mainly occurring in Asia. ‘The share of renewables in total_ power generation rises from 20% in 2011 to 31% in 20835, as they supply neatiy half ofthe growth In global electricity generation. Renewables ‘overtake gas as the second-largest source ‘of generation in the next couple of years ‘and approach coal as the leading source by 2035. Rapid expansion of wind and solar PV raises fundamental questions about power market designs ‘and thetr ability to ensure adequate investment ‘and longterm reliability of supply. China sees the biggest absolute increase in generation from renewable sources, more than the gains in the EU, US and japan combined. Global subsidies to renewables reached S101 billion in 2012, up 11% on 2011, and need to ‘expand to $220 billion in 2035 to support the level of deployment in the New Policies Scenario. In 2012, renewable subsidies were highest in the EU (S57 billion) and the US ($21 billion). Wind becomes competitive in a growing number of regions, with about one-quarter of generation over the period to 2035 not requiring any subsidy. Solar PV becomes competitive in only a limited number fof markets (when measured at “cost parity”) and requires an average subsidy of $130 /MWh through to 2035 in order to compete. Thanks to falling Costs, solar PV is now being rapidly deployed, but policymakers need to ensure subsidy schemes do WORLD ENERGY OUTLOOK not place excessive burdens on end-users and that there is a fair allocation of costs for those with and. without solar PV. Biofuels use triples, rising from 1.3 million bartels of oil equivalent per day (mboe/d) in 2011 to 4.1 _mboe/d in 2035, by which time it represents 8% of road-transport fuel demand. Advanced biofuels, Which help address sustainability concerns about conventional biofuels, gain market share after 2020, reaching 20% of biofuels supply in 2035, Subsidy costs forbiofuelsincrease steadily aver time, reflecting limited scope for further cost reductions Renewables Power Up ‘ors bree ‘Chine ll aie Arr The expansion of non-hyro renewables depends om subsldies that more ‘han double to 2035; additions of wind solar have implications for ‘power market design & costs for conventional biofuels and strong growth in use, Global investment in the power sector amounts to S17 tilion through to 2035, with over 40% in transmission and distribution networks, Residential electricity prices increase in nearly all regions, In part due to rising fossil fuel prices. However, electrlcty becomes more affordable over tme in ‘most regions, as income levels increase faster than. hhousehole electricity bills. CO2 emissions from the power sector rise from 13.0 algatonnes (Gt) in 2011 to 15.2 Gt in 2035, retaining a share of around 40% of global emissions ‘ver the period. Increasing penetration of low- carbon technologies and improvements in the thermal efficiency of fossi-fuelled power plants help to slow the growth In COp emissions from the power sector. The evolution of the power sector will, be critical to meeting climate change goals, due to the sector's rapid growth and because low-carbon alternatives are more readily available. * World Energy Outlook, 2013 www.iea.org December 2013 7An Integrated Approach to Commodity & FX Hedging Michelin Case Study: Ramping Up Hedging Programmes In this article, we introduce an integrated approach to hedging for multinational firms with exposures to commodity price and exchange rate fluctuations. Based on our experience, we have identified aseries of key parameters that determine theeffectiveness of a hedging programme. A case study built using Michelin publicly available financial, information illustrates the benefits of an integrated hedging programme for commodity and foreign exchange risk. IN GENERAL, AN effectively designed and executed corporate hedging programme will produce the following three outcomes: 1. High degree of effectiveness under hedge ‘accounting standards. 2. Increased predictability and stability of future financial results, 3. Improved risk adjusted performance over the long run, If these results are mot being achieved by particular hedging programme, its underlying ‘assumptions and methodology should be reviewed. ‘The assessment should focus on the extent to which the parameters of the programme have been ‘optimised, both individually and collectively, ‘A hedging programme consists of multiple ‘dimensions, but from our experience we have identified five key parameters that define ony hedging programme: By Tamir Druz & Carlos Blanco for the underlying exposure is generally the most Important determinant of how well a programme performs under accounting guidelines for hedge effectiveness. However, we should also note that the impact of any single parameter is limited to the degree that the other parameters have been properly configured. For example, while the timing end the size of thehedge positions areof critical importance for improving risk-adjusted perlormance, neither will matter very much If inappropriate instruments are used or if the hedging time horizon is too short In the next sections, we will introduce our ‘approach and highlight some high-level results from our analysis of Michelin publicly available Information, We will focus on illustrating the linkages between a hedging programme's design ‘and is suecess in achieving corporate objectives, Case Study: Foreign Exchange & Commodity Price Risk 8 = 1-year rolling hedge eeeoeauener: Long term, 5 year hedge ~ systematic ond rule based ae Ter dceontesed si. Postion sizes Constant volume rolled forword = Fixed and (in/mman) Eeag aaa = Heating oil to hedge et ae Swaps or Futures vy Instruments and structures | -At-the-maney of out-of the money options ostless cellars Im our practice, we have observed strong linkages between the corporate hedging objectives and programme parameters presented above. It can be demonstrated that, for each of the three objectives, there are just one of two programme parameters that make an especially important contribution For example, while the timing and the sizes of the hedge positions are important, the choice of a proxy December 2013, euros (EUR) to hedge Suis franes (CHF) Michelin's Risk Profile Michelin is one of the two biggest tire ‘manufacturers in the world, along with Bridgestone. Headquartered n France, and ‘with significant operations and sales across the globe, Michelin is heavily exposed to market fluctuations in exchange rates between its home currency (the euro) and ‘major foreign currencies such as the US dollar (USD), the Brazilian real (BRL), the Japanese yen (JPY) and the British pound (GBP). Over 60% of its net sales in the frst half of 2013 (€10.2 billion) were generated outside ff Europe, and even a significant portion of its European sales were in non-euro markets Michelin’s financial performance is also very sensitive to changes in world commodity prices, especially natural and synthetic rubber, which together made up almost 60% of its raw materialscosts in the first half of 2013. And in that same period, raw material costs comprised over 40% of Michelin’ total cost of sales. ‘Thequestion wenowaddressis:“What determines hhow successful Michelin's hedging programme ‘might be in achieving the three objectives presented earlier?” As we shall se, hedging success Js @ function of Michelin’s decisions viso-vis the parameters that shape the programme, Achieving Objective #1 (Hedge Effectiveness For Accounting) One of the key decisions in designing a foreign exchange and commodity price hedging programme for Michelin would be the selection ‘of appropriate proxies for its underlying financial risks. As noted previously, this decision will have an. especially significant impact on Michelin's ability to qualify for the application of special hedge ‘accounting to the bulk of it hedging PEt. results. Most public companies prefer hedge accounting because it allows them to recognize in earnings only those hedging gains and losses whose timing corresponds to the recognition of cash flows being hedged. This avoids excessive earnings volatility due to swings in the mark-to-market value of the entire hedge portfolio, ‘We began by looking at high-level relationships between Michelin's financial results and market prices for its key raw material inputs, and found a very strong correlation (93.5%) between Michelin's, cost of sales and market prices for natural rubber futures. Since Michelin’s next greatest matertals expense is synthetic rubber, which is derived from petroleum, we also examined the relationship between Michelin's costs and crude oil market prices, but found a much weaker correlation. We ‘also analysed the revenue side of Micholin’s cash flows, and found a significant correlation between, the EUR/USD exchange rate and North American A. rigorous effectiveness analysis to determine hedge in accordance with accounting standards would require more detailed information, fon Michelin's historical cash flows, and its physical raw materials and sales contracts. However, four higher level analysis did indicate that given Michelin's exposures, it would be appropriate to explore the use of natural rubber instruments, to regulate the volatility associated with its raw ‘materials costs, and financial EUR/USD contracts to hedge its regional revenues Achieving Objective #2 Financial Performance Predictability & Stability (Once the proxy markets that meet Objective #1 hhave been identified, the decision of how far out HEDGING PROGRAMMES Figure 1: Raw Materials Comprising 1st Half 2013 Cost of Sales (€2.9 billion) to hedge is often the key determinant of success in Increasing the predictability and stability of financial results (Le., Objective #2). At the extreme, if @ firm only hedges one month forward, there is very little chance that is hedging programme will dampen hedging success is a function of [Michelin's] decisions vis-d-vis the parameters that shape the programme the volatility of performance. Infact, depending on the size and timing of is trades, is hedging activity ‘might actually magnify financial uncertainty Returning to the case of Michelin, and building fon our earlier result regarding the effectiveness fof natural rubber instruments in hedging cost volatility, we analysed the degree to which cost Figure 2; Michelin Cost of Sales vs Natural Rubber Prices (June 2007 — June 2013) Michelin Smt Anna Cost Sales (cilion of euror) eo uber Futures Price, USD/b(SICOM fst nearby contrat) Source ne nquancom December 2013 29HEDGING PROGRAMMES Michelin Cost of Sales Uncertainty as Function of Hedge Duration Figure j ere Pree q 3 a i ws jo a md Mie lye ae uncertainty was reduced by hedges of varying durations. As expected, we found that one-month hedges {id not have @ material impact on the variance of semi-annual costs over the period studied (june 2007 through June 2013). Notably, one year hedges did not perform substantially better. A significant reduction in cost uncertainty was only observed MARKETS Coal Prodticers and International Experts + United states Powder River Basin Coal Production and Export Update Rodney Ruston, Chie/ Executive Officer, County Coal Limited Global Energy Market Outlook - Coal vs. Gas Paul Baruya, Gobel Cool Morkets rays, IEA Clean Coal Centre Indonesia insight Bob Kamandanu, Chciman, Indonesian Coal Mining Association IAPBLICMA|, President CEO, PT. Delma Mining Corporation South Africa - Export Projections Zahear Sura, Execuive Director, Osho SA Coal (Pty) Ltd Producing and Pricing Ton of Coal Pandu Sjarir, Chief Financial Ofcer PT Toba: Project Development in Sumatra Iskandar Surya Alam, Serior Marketing Manager, PT. Bukit Asam Sejahtra Tbk: Ponestr © rey Tet ses esta 401 | Fac 1656508 2407 Erni reiterates comes tlre Someet 410-8, Srgepore 23814 Farmers nforaton please conse Customer Sarven Hotine fonce the time horizon was extended to several years. For instance, a five-year hedging horizon reduced the semiannual standard deviation of Michelin's cost of sales by aver €110 million, ‘We observed a similar pattern when we modelled the impact of USdollarhedges of different durations fon revenue uncertainty Unfortunately, the potential need for extended ‘ume horizons Is often overlooked by corporate hhedgers. Inappropriate durations is one of several programme design flaws that can lead to disappointing results, and misguided suspicions ‘that hedging is a losing proposttion. Achieving Objective #3 Improving Risk-Adjusted Performance There is usually little Interest in achieving a high degree of certainty in financial results if it comes at the expense of overall performance. Therefore, the ultimate measure of a hedging programme's success is whether or not it is able to improve a company’s riskadjusted returns, after adjusting for the transaction costs, capital requirements and ‘other resources deployed in its execution, The timing and sizing of hedging transactions plays an especially critical role in determining 24 - 27 February 2014 | Hilton Singapore WHAT IS NEW 72014! © Global Eneray Markets Development andimpact on Coal © Sew industry Round tables + CoalFrieng impact eters and medium term projections + Poms Cnet Roundtable procurement and uly Imanageront Stateciee + Indonesian Coal- What to expctin Supply, Royalty regimes ond ce Parterhpsn Col Transporation and Logisicsoreffciong) and cost management How wi rebound in freight maretsimpact cost of Uonsportaton? CatTide = what to expect fom curency makes and ‘eran shite ‘WP Lach Tables excuive 1 an 1 with top yer ned rineit is generally inappropriate and detrimental, in the longrrun, for hedgers to decide when and. how much to hedge on the basis of market views. for commodity oF foreign exchange prices and volatilities. This approach amounts to speculation, ‘and the capabilities that enable success in that domain are not core competencies of most hedgers. ‘Mest organizations recognize this. Once common, practice to counteract the potential for speculation. is setting hedge position levels at a fixed level, ‘and rolling them forward from period to period. Another is to require that hedges be held through ‘expiration, ‘But constant volume hedging is generally not ‘an optimal approach, and has sometimes led to disastrous results. Instead, optimal hedge levels should be reassessed at regular intervals, noton the basis of market views, but on the firm’s prevailing ‘operating conditions, abjectives and constraints Using Hedge Optimizer (See Box 1), we compared the performance of a strategy that ‘would have hedged a constant 50% of Michelin's US dollar revenues and natural rubber costs from semi-annum to semi-annum, with a strategy that systematically adjusted volumes from period {0 period as Michelin's operating environment hanged. The results are shown in Figure 4 While the constant volume approach did produce ‘slight improvement in average operating margins ‘over the period studied (December 2007 through June 2013), the dynamic volume strategy Improved ‘Michelin's realized margins by over 50 basis point, from 8.396 to 8.896, Moreover, the dynamic volume strategy was able o sidestep the significant hedging losses incurred by the constant volume approach in the second half of 2008. Summary & Conclusions Successful commodity and foreign exchange hedging programmes are those based on achieving a series of dearly defined risk management objectives. New international accounting regulations will emphasize the need of matching the hedging strategy with specifi risk management objectives In this article, we Introduce an integrated ‘approach to hedging for multinational firms with ‘exposures to commodity prices and exchange rate fluctuations using Michelin as an example. We have shown that a hedging programme can be tailored to optimise a set of risk management ‘objectives based on certain constraints. Firms that actively identify the key objectives of a programme ‘and design on integrated hedging strategy to mect ‘those objectives are likely to develop a competitive ‘advantage over firms that approach hedging decisions in a reactive and unfocused fashion. « HEDGING PROGRAMMES sing Hedging Optimizer to Achieve Corporate Hedging Objectives Capea Energy and NQuantX have teamed up to develop a proprietary hedge advisory service and software that takes the {guesswork out of parameter optimization for corporate hedging programmes. Hedging Optimizer™ facilitates the performance of, hedgeeffectiveness testing, risksimulation and strategy backtesting forell relevant commodity and foreign exchange exposures within 4 single, integrated platform. “The result is that users are better ‘ble to decide how, when and how much ta hedge at any given, time. Finally, the system enables the seamless collection, storage ‘and reporting of the results needed to meet hedge accounting, risk ‘management and performance management requirements Figure 4: Michelin's Actual Margins Compared to ‘Alternative USD + Rubber Hedging Strategies (cat A> conten Ytume te Dyan Whine Misia Operating Margin ©) “se Ses pps Se SH LOL EL EL EL & the ultimate measure of a hedging programme's success is whether or not it is able to improve company returns ‘Tamir Druzis Disector of Capra Energy Group (NQuantX’s alliance partner), Carlos Blanco is Managing Disector of NQuantk, ‘nancial engineering firm that develops decision-support software for hedging programs and trading strategies, ‘9 well as valuation and risk measurement of energy derivatives long term contracts and physical astets. He 4 afaculty member ofthe Oxford Princeton Programme, where he heads the Energy Derivatives Pricing, Hedging ‘and Risk Management Ceriicate courses (OPH), as we as other courses on energy trading and risk management. E: carlos@nquantx.com worwanquants.com References ‘Slonco, © and Druz 1. (2013) Optimising commodity edging programmes. Energy Risk une lone, C. Piece, BL. and Aragonés .R. (2012) IFRS 9, hedge effectiveness and optimal hedge ratios. Energy Risk, une December 2013. 91PRODUCTION TEAM PM see Ceca ren Sees omer eras Peers Senate) Preeti’ PNAS SSL CY Abigoo 32 ABN Amro. 8 ADM Investor Services 21 Climate Action Reserve 50 Conenergy / eWorld 2014 35 DataGenic 63 Edison Electric Institute 43 EFETnet 47 EPEX SPOT 64 European Energy Exchange 76,90 IBC 13 Insch Capital Management IFC INTL FCStone 19 IP Week 2014 58 IRN 23 Koch Metals Trading 39,81 marcus evans OBC Marex Spectron 6 NYSE LIFFE 3 Platts IBC Shanghai Metals Market 10 Sharps Pixley 30 Trayport Isherwood Production Ltd 19 Henning Street, London, SW11 3DR, United Kingdom, 1 +44 (0)20 7801 0303, wwrw.commodities now.com © Isherwood Production Ltd., 2013. All Rights Reserved Registered in England No. 3360776 Stee pees eno “The fall subscription rate includes exclusive access toall ports ofthe Commodities Now webste, Back copies ofthe magazine are available fham the publishers a the above address. 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