phenomenal development of financial commodity products giving birth to innovative solutions, some of which were borrowed from other asset classes. Unfortunately, much of the accumulated experience and know-how seems to have been lost during the years following the credit crisis, which was capitalized upon by some participants to start a witch-hunt regarding structured derivatives products. During the same period, many experienced commodities derivatives practitioners left the field to pursue other interests. Hopefully, this book will help record some of the know-how and lessons learned, making them available for people to come.
R. Arous
I understand that there is a lot to comprehend from past experiences in commodities derivatives and derivatives in general. But, the biggest risks might not be a replay of the past. What is the market uncertainty that concerns you the most?
S.M. Dafir
Mehdi Elmandjra once said, “The illiterate of today is one who does not know how to unlearn in order to learn how to learn again.”
Let me tell you my little story about the “hippopotamus.” There was once a man named BenBer who lived in a huge villa. As a fan of animals, he even kept a hippopotamus in his pool. He was fond of seeing that other smaller animals, such as ducks, cohabited together and shared the same pool.
One morning, BenBer woke up to the surprise that the hippopotamus had left the pool and disappeared. As a result, the water level decreased significantly. Worried about the survival of the animals that became exposed, BenBer rushed to his hose and kept pouring water into the pool until it reached its usual level. Thanks to BenBer's rescue operation, most of the animals remaining in the pool survived…
… But what if the hippopotamus comes back?
Acknowledgments
I would like to offer my sincere gratitude to everybody at Volguard Private Limited, Timothy Sung, Melissa Chia, Kevin Fazaeli, Ouchnid, Junia Sulaiman, and all my friends in Singapore for their advice, counsel, and support during the last 12 months.
I would like to thank Rania Soppelsa from the SORBONNE-ASSAS and all my students for their strong interest and enriching debates.
I extend a special thank you to Uncle Lin and Aunt Lanting for taking care of me when I come to Hainan, without forgetting Qi Guo, You Yingyu, and all my friends in China.
I would also like to thank Mostafa for driving me all the way down to my home town, to Beni-Mellal and beyond.
We would like to thank Samantha Hartley and Thomas Hyrkiel for their invaluable support throughout the publishing process.
We are especially indebted to the International Energy Agency, the International Air Transport Association, and BP for providing their historical data.
I would also like to express my gratitude to my colleagues, Sashi Anumula and Abhinav Jain, for several thought-provoking discussions on physical commodities and refined products markets that were very enriching. I am thankful for the kind words of encouragement and support provided at every stage of the project by my family, friends, colleagues, and well-wishers.
About the Authors
Simo Mohamed Dafir is Managing Director at Volguard, a financial consulting firm specialized in Capital Markets, Wealth Management and Derivatives. He has over 14 years of experience during which he held senior positions in a number of major international banks in Hong Kong and Singapore.
He was Regional Head of Commodity Structuring at Standard Chartered Bank, Head of Commodity Exotics and Hybrids at Merrill Lynch Asia and Trader of Credit Derivatives at Credit Suisse. He is also professor of Global Financial Markets at Sorbonne Assas International Law School and an expert witness for Financial Markets litigations.
Mr Dafir started his career in Aerospace and Telecom at the European Space Agency and Alcatel.
He holds an MBA from INSEAD, a Post Graduate Research Degree from the National Polytechnic Institute of Toulouse, an MSc in Automation from ENSEEIHT and a Bachelors degree in Mathematics.
Vishnu Gajjala is a commodity derivatives professional and is currently a consultant for Volguard, responsible for financial markets analytics. He has extensive experience in commodity derivatives and structured products.
Mr Gajjala started his career at Merrill Lynch in Hong Kong, working on commodities structured notes, exotics and hybrids. He developed many innovative structures catering to commodity investors and hedgers, including airlines, mining companies, private banks, and sovereign wealth funds.
At Standard Chartered Bank in Singapore, Mr Gajjala held positions in commodities sales and structuring, providing commodity hedging and financing solutions to major corporate clients in Asia. He holds a Bachelor's degree in Engineering from IIT Madras and an MBA from IIM Bangalore.
CHAPTER 1
Energy Commodities and Price Formation
“If a commodity were in no way useful… it would be destitute of exchangeable value, however scarce it might be, or whatever quantity of labour might be necessary to procure it.”
Throughout history, the availability of sources of energy and the means to produce, transport and harness it efficiently have been a necessary conditions for the growth of civilizations. Over the last century, fossil fuels have become the dominant source of energy globally, and companies have explored new sources and developed new technologies to access these reserves. But what is fuel without fuel consumers? Fossil fuels could have remained a topic confined to geologists' circles if it were not for the development and popularity of fossil fuel-based transportation machinery – such as cars, planes, and ships – has made these fuels essential to human life. It has been suggested that the usage of fossil fuels is an important factor behind the doubling of the world's population over the last century. Over the past few decades, the scarcity or abundance of these resources has been significantly influenced by the demand for these fuels, as consumers develop new uses for fuels, use fuels more efficiently, or substitute them with other energy sources.
This chapter emphasizes the strategic nature of energy commodities and introduces the energy markets by discussing the principal fuels transacted, the uses of these fuels, their origin, and how they are brought to market. Thereafter, the chapter examines the factors that influence fuel prices, including geopolitical risks and short-term supply/demand balances, as well as long-term fuel market considerations that contribute to the volatility of energy prices.
ENERGY AS A STRATEGIC RESOURCE
The importance of energy for present-day society cannot be understated. Energy is ubiquitous in the modern world, with every conceivable product and service utilizing energy for its production and delivery. Consequently, fluctuations in energy prices affect entities at all levels – from households and small businesses to large companies and governments – and the impact of price volatility is easily apparent. Rising energy prices impact a family's consumption basket, causing everything from transportation to groceries to become more expensive, thereby reducing their purchasing power. Higher fuel prices also mean that companies need to either absorb higher costs, raise output prices to maintain profitability, or otherwise manage the rise in costs. Finally, governments need to balance the subsidies given to energy consumers against deterioration in trade and budget metrics (e.g., fiscal and trade deficits) and potential social unrest. Even governments of energy-rich countries need to calibrate the amount of social support provided during periods of high energy prices in order to maintain a buffer for years when energy prices are low.
This increased awareness of the centrality of energy resources has been accompanied, over the last 30 years, by the development of sophisticated financial markets, the advent of the Internet, and electronic trading technologies allowing for more “democratic” access to commodities trading. Nowadays, investors, hedgers, and speculators are able to take control of thousands