Escape Cruise Lines: Fuel Risk Management Strategies James Buckner Brigid Lenahan Meghan Michaels Charles Mohn Derivatives and Financial Markets Concepts Prof. James Bodurtha December 15, 2012
Escape Cruise Lines: Fuel Risk Management Strategies James Buckner Brigid Lenahan Meghan Michaels Charles Mohn Derivatives and Financial Markets Concepts
Escape Cruise Lines: Fuel Risk Management Strategies James
Buckner Brigid Lenahan Meghan Michaels Charles Mohn Derivatives and
Financial Markets Concepts Prof. James Bodurtha December 15,
2012
Slide 3
Escape Cruise Lines is finishing its first full year of
operation. As employees and founders of the company, we seek to
tackle the task of hedging against the risk associated with our
fuel costs for the upcoming quarter. Since there is insufficient
historical data for the company, we will use the Royal Caribbean
cruise line as a benchmark in our hedging process. We are short the
underlying. Business Overview View on Direction and Volatility
Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies
What We Recommend
Slide 4
Cruise ships commonly run on a type of fuel called bunker fuel,
which is very similar to crude oil and a byproduct of the crude oil
refining process. Because there is no real market for this
underlying, we believe it would be best to proxy our study to crude
oil because of the close connections between the two. We would like
to forecast our projections out to March of 2013, or simply to look
into 3 month contracts that have maturities of March 2013. Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 5
Escape Cruise Lines sources fuel from its home port in Miami.
The company pays to have fuel delivered to the Port of Miami. The
company incurs an additional storage cost to keep fuel on site
until the time when the two cruise ships come in to the port.
Escape Cruise Lines understands that fuel expenses have a
significant impact on the cost of operating cruise ships. According
to the Royal Caribbean 2011 10K: Expenditures for fuel represent a
significant cost of operating our business. If fuel prices rise
significantly in a short period of time, we may be unable to
increase fares or other fees sufficiently to offset fully our
increased fuel costs. We routinely hedge a portion of our future
fuel requirements to protect against rising fuel costs. Further
volatility in fuel prices or disruptions in fuel supplies could
have a material adverse effect on our results of operations,
financial condition and liquidity. Business Overview View on
Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 6
Factors: 1) Supply 2) Demand 3) Crude Oil and the US Dollar 4)
Speculators Business Overview View on Direction and Volatility
Inputs Contract Risk Adjustment Option PricesValue @ RiskStrategies
What We Recommend
Slide 7
There is no definitive trend in prices Business Overview View
on Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 8
1) Supply The supply of crude oil is at a historical high,
pushing the price down. Forecasters say that in the fourth quarter,
global oil output will top demand by more than 630,000 barrels a
day, the largest surplus in four years. Currently, U.S. crude oil
inventories are the highest since 1982. Horizontal drilling and
hydraulic fracturing has unlocked oil trapped in shale formations
in North Dakota, Texas and Oklahoma. As of October, U.S. crude
production is at the highest level in over 15 years, at 6.52
million barrels per week. The International Energy Agency earlier
this month forecast supplies from countries outside OPEC will rise
to 53.6 million barrels a day in the fourth quarter, up 600,000
barrels a day from the third quarter. Business Overview View on
Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 9
2) Demand The American Petroleum Institute last month reported
U.S. oil demand in October fell to 18.4 million barrels a day,
which was the lowest October demand seen in 17 years. During the
first 10 months of the year, demand was 2.1% below the comparable
period in 2011. Seasonal changes in weather affect the price of
oil, with heating oil used heavily in the winter. With above
average temperatures this year, however, demand for this oil will
likely decrease. According to The Hill, Hurricane Sandy lowered gas
prices due to decreased demand or demand destruction. The storm hit
gas consumers, not producers, and will take an enormous amount of
gasoline consumption offline. Given the above analyses, therefore,
we believe supply will exceed demand and lower prices. Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 10
3) Crude Oil and the US dollar Oil is traded and sold
internationally in US dollars. Crude Oil prices and the value of
the dollar have an inverse relationship: depreciation of the dollar
tends to increase oil demand and therefore the price of oil.
Currently many analysts predict the value of the US dollar will
rise. If the dollar strengthens, reducing real income in countries
that purchase oil, there will be less demand and oil prices will go
down. Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 11
4) Speculators Speculative purchasing creates a variation in
the cost of oil-based products, as speculators buy and sell futures
in the open market. Historically, speculators have been accused of
bidding up oil prices to unstable levels. President Obama launched
an plan to curb oil speculation in April of this year that may
decrease the affect of speculation. Business Overview View on
Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 12
1) OPEC and Global Oil Prices 2) Historic Trends 3) U.S. Fiscal
Cliff Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 13
1) OPEC and Global Oil Prices OPEC (a consortium of 13
countries) is the largest entity that impacts world oil supplies.
OPEC is responsible for 40% of the worlds oil production, and sets
policies to meet global consumption. The consortium affects the
price of oil by regulating production among member countries.
Decreases in OPEC allocations have historically led to higher oil
prices. We foresee continued violence in the Middle East-
particularly in Egypt and Syria-a region which accounts for 66% of
OPEC production. When the financial markets are uneasy and there is
political unrest, OPEC will protect its member states and lower
production. This will contribute, therefore, to high volatility
Business Overview View on Direction and Volatility Inputs Contract
Risk Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 14
Recently, volatility has been relatively high Business Overview
View on Direction and Volatility Inputs Contract Risk Adjustment
Option PricesValue @ RiskStrategies What We Recommend
Slide 15
2) Historic Trends Oil prices have been especially volatile
this year: increasing more than 10% in February, before falling by
nearly 30% during the summer, before rising again and falling back
to todays price. There has been a large increase in oil volatility
ever since electronic trading proliferated in 2004. In 2008, the
price of WTI tripled over 12 months to $150 per barrel, before
falling all the way down to $33 the next year. Analysts expect oil
prices to remain volatile for the next year amid worries that Saudi
Arabia no longer has the capacity to help fix large disruptions in
supply. Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 16
3) U.S. Fiscal Cliff Government policies are a major
determinant of oil prices along with supply, consumption, and
financial markets There is currently a high level of uncertainty
regarding the looming Fiscal Cliff If a deal IS made increase
confidence businesses need to have to invest, grow and hire If a
deal IS NOT made continued negative impact on investment and
economic health This uncertainty translates to high volatility in
consumer spending, investment, hiring, and commodity prices
Business Overview View on Direction and Volatility Inputs Contract
Risk Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 17
According to Royal Caribbeans 2011 10K, their estimated fuel
costs for the first quarter of 2012 are $228,821,918. Using this
estimate, our exposure value is $10,400,996 $228,821,918/22. Royal
Caribbean has 22 ships in its fleetby dividing by 22 we aim to
isolate the cost for a single ship. Escape Cruise Lines will not
accept more than a 1% risk of its fuel expense exceeding
$10,921,046 (+5% or +$520,050) for the period extending from
December to March. Business Overview View on Direction and
Volatility Inputs Contract Risk Adjustment Option PricesValue @
RiskStrategies What We Recommend
Slide 18
Historical Volatility: 29.3% Risk Premium: NRPO=RP from
1959-2004: 20.67% 1 PS=43.45 (12/31/2004) PE=98.83 (12/30/2011)as
we do not have data for 12/31/2012 NO=8 RPH = (PE/PS-1)/NO RP =
(NRPO*NH+RPH*NO)/(NH+NO) RP=20.35% R: 0.31% (3 month LIBOR Rate)
Futures Contract=87.51 (as of 12/6/2012) T=0.25 1
https://msb040.msb.edu/faculty/bodurthj/unrestricted/teaching/Project/Distributions%20of%20
individual%20commodity%20futures%20returns.htm See attached excel
documents S t market = 0 F t * 1+ (r+RP) * t = 87.51 *
1+(.0031+.0134)* 0.25 = $91.96 1+r * t 1+.0031*0.25 Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 19
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 20
Underlying - SS = MaturityDec '12March '13June '13Sep '13
Now-Current (11/13/12) Settlement Prices ($)85.3887.1788.8289.53
Actual Maturity Date 16-Nov- 12 20-Feb- 13 21-May- 13 20-Aug- 13
SymbolSPZ9SPH9SPM9SPU9 Subsequent (11/20/12) Settlement
Prices86.6788.5589.3889.90 A subsequent date mark-to-market
("now-current" settlement - subsequent prices due to short
exposure) -1.29-1.38-0.56-0.37 **NOTE: 1000 barrels of underlying
is equal to one futures contract Business Overview View on
Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 21
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 22
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 23
S M *e +#(sqrt(T)) = (91.96)*e (2.33*.293*.25) Critical Price:
$129.30 Associated Loss: (87.51-129.37)/(87.51) = - 47.83%
Keep=Target Loss/Actual Loss =5%/47.83% =10.45% Hedge 90% (1-.1045)
Business Overview View on Direction and Volatility Inputs Contract
Risk Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 24
1 Futures contract = 1,000 barrels of oil Contracts equivalent
to exposure = 119 Number of contracts to sell=107 Number of
contracts to leave unhedged=12 Business Overview View on Direction
and Volatility Inputs Contract Risk Adjustment Option PricesValue @
RiskStrategies What We Recommend
Slide 25
Futures Price (12/6/12)=87.51 Call ATM: 8750 Premium: 4.41 Call
OTM: 9000* Premium: 3.24 Call ITM: 8500* Premium: 5.83 Put ATM:
8750 Premium: 4.40 Put OTM: 8500 Premium: 3.33 Put ITM: 9000
Premium: 5.73 *Used a 3% range (87508750*.03)=9012.5; 8487.5
Business Overview View on Direction and Volatility Inputs Contract
Risk Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 26
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 27
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 28
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 29
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 30
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 31
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 32
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 33
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 34
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 35
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 36
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 37
By going +107 F rather than +106F suggested by the @ Risk
Program, we meet our risk limit. Business Overview View on
Direction and Volatility Inputs Contract Risk Adjustment Option
PricesValue @ RiskStrategies What We Recommend
Slide 38
Level of Confidence Vol vs.
marketUnsure-Vol=MarketSure-StableVol vs. market Direction vs.
market view View = Vol up (options cheap) View = Vol Stable
(options prices fair) View = Vol Down (options expensive) Direction
vs. market view Up-Unsure (forward cheap) Up-Sure (forward cheap)
No direction - ? (forward price fair) *(I) * (II) No direction Sure
(forward price fair) Down-Unsure (forward expensive) X *(III)
Down-Sure (forward expensive) Business Overview View on Direction
and Volatility Inputs Contract Risk Adjustment Option PricesValue @
RiskStrategies What We Recommend
Slide 39
StrategyCombinationNotationPurposeMarket ViewName Market
ViewLong Put-F+CInsurance (Trading)Down and unsureSynthetic Long
Put Alternative Market View Long Put ITM-F +C OTM Insurance
(Trading)Down and unsureSynthetic P ITM Alternate View 1 (Neutral
Direction, Volatile) Short Forward, Long 2 Calls -F+2CTrade vol
(Insurance)Volatile (neutral direction) Synthetic Long Straddle
Alternate View 2 (Neutral Direction, Volatility Stable) Short
Forward, Long 2 Puts -F,-2PTrade vol (Income)Stable (neutral on
direction) Short Straddle Alternate View 3 (Down, Volatility
Stable) Short Forward-F+COTM-POTMTrading (Insurance and Income)
Limited Down, Concern about a big up Synthetic Bear Spread Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 40
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 41
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 42
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 43
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 44
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 45
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 46
At Escape Cruise Lines, we are speculative in our assessment
that the price of crude will go down in the next three months. In
this the case, we would choose Alternative 1, which is a Long
Straddle. Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 47
Rationale: If one characteristic of our underlying is more
certain than others, it is that volatility will be a continuing
factor in the near future If we are more uncertain about where
exactly the price would move, we would chose this strategy because
it allows us to gain from the volatility without having to pick a
direction Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend
Slide 48
If we were certain that the price of oil would go down, we
would choose a synthetic long put. As shown in the following
slides, the synthetic long put does better in the down- side, but
is costly on the up-side. Therefore, this position is only
recommended if we are sure the prices will decline. Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 49
o Between the prices of 82.51 and 87.51 the hedged position
provides a greater return. Business Overview View on Direction and
Volatility Inputs Contract Risk Adjustment Option PricesValue @
RiskStrategies What We Recommend
Slide 50
o However, on the down-side, the risk management performs
better (a price roughly halfway between 128.76 and 137.01). At
these prices, the hedged position is quite expensive. Business
Overview View on Direction and Volatility Inputs Contract Risk
Adjustment Option PricesValue @ RiskStrategies What We
Recommend
Slide 51
http://online.wsj.com/article/SB10000872396390444734804578066730415856020.html
http://www.bloomberg.com/news/2012-10-03/oil-declines-after-u-s-supplies-gain-a-fourth-week.html
http://online.wsj.com/article/SB10001424052970203937004578076892015038554.html
http://www.bloomberg.com/news/2012-12-10/gasoline-gains-on-budget-talks-optimism-stronger-
brentprices.html
http://finance.yahoo.com/news/record-production-rates-decade-low132000065.html
http://thehill.com/blogs/e2-wire/e2-wire/265411-sandy-to-drive-gas-prices-lower-through-end-of-year
http://www.bloomberg.com/news/2012-10-09/most-accurate-forecasters-say-dollar-beats-qe3.html
http://www.theatlantic.com/business/archive/2012/04/would-obamas-war-on-speculators-really-reduce-
the-price-of-oil/256076/#
http://www.royalcaribbean.com/customersupport/faq/details.do?pagename=frequently_asked_questions&pnav
=5&pnav=2&faqSubjectName=Ships&faqId=2668&faqSubjectId=319&faqType=faq
http://www.cbsnews.com/8301-505123_162-51337483/why-oil-prices-are-so-volatile/
http://professional.wsj.com/article/SB10001424127887324296604578177680511658970.html?mod=WSJ_fc_L
EFTTopStories&mg=reno64-wsj Business Overview View on Direction
and Volatility Inputs Contract Risk Adjustment Option PricesValue @
RiskStrategies What We Recommend
Slide 52
Business Overview View on Direction and Volatility Inputs
Contract Risk Adjustment Option PricesValue @ RiskStrategies What
We Recommend