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ASIA PACIFIC JOURNAL OF MANAGEMENT VOL. 7, Special Issue: 97-107 Hedging Spot Fuel Oil in Singapore: Will The New SIMEX Contract Succeed? Warren Bailey and Annie Koh* We assess SIMEX' s new market for fuel oil futures by examining its effectiveness in hedging a cash fuel oil position in Singapore. Wefind that the S1MEX contract can eliminate about two-thirds of the volatility of a Singapore cash position and is many times more effective than a cross-hedge constructed with overseas contracts. Given its potential usefulness as a hedging toot for the regional petroteum industry, we anticipate that the new contract will be a success. INTRODUCTION The latest innovation in Asian securities markets is the High Sulphur Fuel Oil (HSFO) futures contract launched by the Singapore International Monetary Exchange (SIMEX) on February 22nd, 1989. The HSFO trading pit is the first market for energy futures in the Asia Pacific region. The new contract is written on 100 tonnes of fuel oil, is priced in U.S. dollars, and specifies delivery at the Port of Singapore. After an opening session in which 27,261 contracts were traded, the market has settled into trading close to ten thousand contracts each day. Singapore is an important centre for trading and refining petroleum products. Singapore ranks third worldwide in terms of refining capacity and enjoys capacity greatly in excess of domestic needs. At the same time, a decade of global deregulation of the energy industry has increased the volatility of petroleum product prices. Thus, there is clearly a need among producers, brokers, refiners, and other participants in the regional petroleum industry to hedge the risk associated with petroleum product prices. The importance of petroleum to the region~il economy and its increased price volatility in recent times explains SIMEX's decision to launch the fuel oil contract. The success of other energy futures markets is also encouraging. A heating oil futures * Assistant Professor, Faculty of Finance, Ohio State University, USA, and Lecturer, Department of Finance and Banking, National University of Singapore. We are grateful to Mobil (New York) for making the Platt oil price data available to us and to Jim Bovenage specifically for accessing the data for us. 97

Hedging spot fuel oil in Singapore: Will the new SIMEX contract succeed?

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ASIA PACIFIC JOURNAL OF MANAGEMENT VOL. 7, Special Issue: 97-107

Hedging Spot Fuel Oil in Singapore: Will The New SIMEX Contract Succeed?

Warren Bailey and Annie Koh*

We assess SIMEX' s new market for fuel oil futures by examining its effectiveness in hedging a cash fuel oil position in Singapore. Wefind that the S1MEX contract can eliminate about two-thirds of the volatility of a Singapore cash position and is many times more effective than a cross-hedge constructed with overseas contracts. Given its potential usefulness as a hedging toot for the regional petroteum industry, we anticipate that the new contract will be a success.

INTRODUCTION

The latest innovation in Asian securities markets is the High Sulphur Fuel Oil (HSFO) futures contract launched by the Singapore International Monetary Exchange (SIMEX) on February 22nd, 1989. The HSFO trading pit is the first market for energy futures in the Asia Pacific region. The new contract is written on 100 tonnes of fuel oil, is priced in U.S. dollars, and specifies delivery at the Port of Singapore. After an opening session in which 27,261 contracts were traded, the market has settled into trading close to ten thousand contracts each day.

Singapore is an important centre for trading and refining petroleum products. Singapore ranks third worldwide in terms of refining capacity and enjoys capacity greatly in excess of domestic needs. At the same time, a decade of global deregulation of the energy industry has increased the volatility of petroleum product prices. Thus, there is clearly a need among producers, brokers, refiners, and other participants in the regional petroleum industry to hedge the risk associated with petroleum product prices.

The importance of petroleum to the region~il economy and its increased price volatility in recent times explains SIMEX's decision to launch the fuel oil contract. The success of other energy futures markets is also encouraging. A heating oil futures

* Assistant Professor, Faculty of Finance, Ohio State University, USA, and Lecturer, Department of Finance and Banking, National University of Singapore. We are grateful to Mobil (New York) for making the Platt oil price data available to us and to Jim Bovenage specifically for accessing the data for us.

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Spot Oil Hedging

contract has traded successfully on the New York Mercantile Exchange (NYMEX) since November 1978. NYMEX has also operated a successful crude oil futures market since 1983. Other energy futures markets have operated in Europe at various times.

The presence of established energy futures markets outside Singapore raises a critical question: is the SIMEX fuel oil futures market redundant? Fuel oil, heating oil, and gas oil are very similar products. If businesses with a need to hedge Singapore spot fuel oil can hedge (or cross-hedge) effectively with New York (or European) contracts, there is no real need for SIMEX's new contract and, in the long run, the market will not sustain enough trading volume to survive.

The purpose of this paper is to study the effectiveness of NYMEX and SIMEX contracts in hedging a spot fuel oil position in Singapore. We anticipate first, finding considerable variability in relative spot prices in Singapore and New York, and second, finding that NYMEX futures contracts perform poorly in hedging the spot Singapore fuel oil price. Such evidence will offer strong justification for the initiation of the SIMEX contract based on local fuel oil. Under such circumstances, we may also predict that the new contract will be a success.

Energy futures markets have spawned a small number of academic studies. Gjolberg and Johnsen (1986) and Ma (1989) study the efficiency of the NYMEX market. Abken (1989) studies the NYMEX heating oil market for arbitrage opportunities. Chen, Sears, and Tzang (1987) document the ability of NYMEX contracts to hedge spot positions in the underlying assets while Overdahl (1987) examines the utility of hedging tax revenues in oil-producing regions with crude oil contracts. This paper uses summary statistics, plots, and empirical hedging tests to study the effectiveness of NYMEX and SIMEX contracts in hedging a spot position in Singapore fuel oil. We offer evidence that the SIMEX contract is considerably more effective as a hedging instrument and, thus, justify SIMEX' s decision to launch its new fuel oil contract.

DATA AND METHODOLOGY

Our tests require daily quotes for spot fuel oil in Singapore and spot heating oil in New York. Data for the period 1984 to 1988 were obtained from Platt's publications. The database includes prices for both "barge" and "cargo" spot heating oil in New York. Daily settle prices for both NYMEX heating oil and crude oil futures contracts were obtained directly from NYMEX. This data also spans the 1984 to 1988 period. Because SIMEX initiated trade in energy futures in early 1989, daily SIMEX quotes are not available to match the 1984 to 1988 data collected for the other markets. SIMEX has supplied daily price, volume, and open interest data for the period that the new market has been operating.

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We begin by examining the behaviour of spot prices in Singapore and New York. The strength of the relationship between spot prices in the two markets hints at the degree to which NYMEX heating oil futures can be used to hedge spot fuel oil in Singapore. ARIMA models are fit to each price series. If the two markets are closely related, the time series behaviour of their prices will be similar. Correlations employing a variety of observation intervals and lags are presented to document the relationship between Singapore and New York prices. A strong correlation suggests that cross-hedging with New York contracts will be effective.

Direct tests of the ability of futures contracts to hedge the price of spot fuel oil in Singapore are based on regression analysis. Ederington (1979) pioneered the use of empirical hedge ratios for risk management with futures. Let S(t) represent the price of spot fuel oil in Singapore and F(t) a futures price, both observed at time t. We regress changes in S(t) on changes in F(t):

In {S (t)/S (t-l)} = 130 + ~1 In {F (t)/F (t-l)} + e (t) (1)

130 and 131 are coefficients while e(t) is an error term. We employ a regression tech- nique which corrects for serial correlation in this error term. Hedging effectiveness is judged by examining the statistical significance of 13~ and the size of the regression R 2. The regression is repeated with NYMEX heating oil futures prices, NYMEX crude oil futures prices, and SIMEX fuel oil futures prices as the right-hand side variable. Each regression is computed for daily, lagged daily, weekly, and monthly changes in S(t) and F(t). 1

A final test of hedging effectiveness begins by re-estimating all regressions using only the first half of the available data. The resulting slope coefficient estimate, l]x, is used as follows. Hedging ability is assessed by forming portfolios: an "unhedged" portfolio consisting of one unit of spot Singapore fuel oil and "hedged" portfolios consisting of one unit of spot fuel oil and ~ short futures contracts (one such portfolio for each of the two NYMEX futures contracts studied).2 Each portfolio' s average return and standard deviation of return are computed using the second half of the data. The degree to which a hedged portfolio's standard deviation is less than that of the unhedged portfolio measures its effectiveness.

RESULTS

Spot Prices

Table 1 reports estimated time-series models for spot prices in Singapore and New York. Serial correlation is more severe and more significant in Singapore than in New York. This suggests that the two spot markets differ substantially in the statistical distribution of pricesv price behaviour in New York is not mirrored in Singapore. Table 2 reports correlations between percentage spot price changes. The correlation between New York and Singapore is statistically significant. Furthermore,

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Spot Oil Hedging

the daily lagged correlation results suggest that events in the New York market lead those in Singapore. Nonetheless, the small size of the daily correlations (about ten or fifteen percent) suggest that day-to-day fluctuation in the two spot markets are largely independent. Weekly and monthly horizons may correspond more closely to realistic hedging strategies than daily changes. Indeed, the correlations measured weekly and monthly are much larger than the daily correlations presented in the previous table. Nonetheless, these correlations are still considerably less than unity. Again, this suggests that the linkages between the two markets are not very strong. Given this evidence, one can almost predict that New York heating oil futures will perform poorly in hedging the spot price of fuel oil in Singapore.

Figures 1 and 2 offer additional evidence on the relationship between New York heating oil and Singapore fuel oil. The figures plot the spread, or difference, between Singapore fuel oil and New York barge and cargo heating oil. The spread appears to be quite volatile, suggesting again that there is no consistent, strong relationship between the two markets. We have also computed the standard deviation of daily changes in these spreads and find that it is approximately US$.45 per barrel, indicating a considerable amount of instability in the relationship between the two markets.

Cross-Hedging With NYMEX Futures Contracts

The degree to which Singapore and New York petroleum markets diverge is confirmed by tests of the ability of NYMEX contracts to cross-hedge a position in spot Singapore fuel oil. Cross-hedging results based on NYMEX heating oil and crude oil futures contracts are reported in Tables 3, 4, and 5.

Table 3 shows that the correlation between Singapore spot fuel oil and NYMEX futures prices is often statistically significant but always substantially less than one. Regression tests reported in Table 4 also show that the correlation can be significant for weekly or monthly hedging horizons. However, the R 2 statistics are considerably less than one, indicating that hedging will befar from perfect. Explicit tests of hedging effectiveness are reported in Table 5. Hedge ratios are estimated using the first half of the available data. Returns from hedge portfolios constructed using the estimated hedge ratios are tracked over the second half of the data. Ideally, the hedge portfolio returns should be very small (approximately equal to a riskless return) and have zero variability. However, the results in Table 5 indicate that hedge portfolio returns differ little from unhedged returns: at best, hedge portfolios using NYMEX contracts reduce variability by about 25 %. We can conclude that NYMEX contracts are of little use in hedging spot Singapore fuel oil prices.

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FIGURE 1

S i n g a p o r e / N e w Yor l< Fue I Oi I G ~ s o i I v e r s u s #2 H e a t i n g O i l (C~rgO)

Spreaa

L

5

1 840118 840'626 841211 850528 851112 860430 851015 870403 870924 8B0318 880902

4

3

2

1

0

- 1

- 2

- 3

- 4

- 5

- 8

- 7

- 8

- 9

FIGURE 2

S i n g a p o r e / N e w Yor l< F u e l Oi I GCtSOi I v e r s u s #2 H e a t i n g 0 i l QB~rge ]

S p r e a d

5

4

3

2

I

0

- 1

- 2

- 3

- 4

- 5

- 5

- ?

-8

-9

-10

-11

840110 840626 841211 850528 851112 860430 861015 870403 890924 880316 880902

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Spot Oil Hedging

TABLE 1 Summary Statistics and Time Series Models for Log-Differences of Daily Spot

Prices, t0th January 1984 to 22nd December 1988 a

Mean

Standard Deviation

Estimated Time Series Model: b

Mean

AR(1)

AR(2)

AR(3)

I AR(4)

AR(5)

Singapore Spot Fuel Oil

-3.565 E-4

1.306 E-2

-0.0003 (-.35)

0.3020 (10.75)

0.0936 (3.20)

0.2458 (8.61)

-0.0825 (-2.82)

0.0362 (1.29)

New York Spot #2 Heating Oil (Barge)

-3.622 E-4

1.837 E-2

-0.0003 (-.52)

0.0842 (3.02)

0.0569 (2.04)

0.0813 (2.92)

New York Spot #2 Heating Oil (Cargo)

-3.574 E-4

1.871 E-2

-0.0004 (-.50)

0.0663 (2.38)

0.0711 (2.56)

0.0957 (3.44)

a Daily prices are estimated with the average of daily high and low prices from Platt's yearbooks.

b Specifications were selected by examining autocorrelation plots for the raw time series. T statistics are reported in parentheses beneath each coefficient estimate.

Hedging With The SIMEX HSFO Futures Contract

Tables 3, 4, and 5 also present results on the effectiveness of the new SIMEX contract in hedging spot Singapore fuel oil prices.3 Table 3 shows that the correlation

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TABLE 2 Correlations (p-values) for Log Differences of Spot Prices, 10th January 1984 to

22nd December 1988

New York Spot #2 Heating Oil (Barge)

New York Spot #2 Heating Oil (Cargo)

New York Spot #2 Heating Oil (Barge), One Day Lag

New York Spot #2 Heating Oil (Cargo),

tOne Day Lag

Correlation with Singapore Spot Fuel Oil: a

Daily

0.101 (<.001)

0.12t (<.001)

0.160 (<.001)

0.142 (<.001)

Weekly

0.227 (<.001)

0.236 (<.001)

Monthly

0.527 (<.001)

0.542 (<.001)

a Weekly differences are computed from Wednesdays while monthly differences are computed from the first trading day of each month.

between Singapore spot fuel oil and SIMEX futures prices for both daily and weekly intervals are statistically significant. These correlations are also higher than those for spot fuel oil and NYMEX futures prices.

Turning to Table 4, the hedging effectiveness measures show that over the period of five months when the SIMEX contract has been traded, the futures contract reduces 20% of the risk for on daily hedging horizon. The results are even better for a weekly hedging horizon, with 67.5% of the cash position's risk being reduced by hedging with the SIMEX contract.

SUMMARY AND CONCLUSION

The results of this paper lead us to conclude that the SIMEX high sulphur fuel oil contract is necessary. Currently, the NYMEX heating oil and crude oil futures enjoy higher liquidity than any other petroleum futures traded outside the United States. However, cross-hedging the risk of Singapore spot fuel oil prices using NYMEX reduces the variability of the value of a spot position by at best only 25%.

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Spot Oil Hedging

TABLE 3 Correlations (p-values) for Log-Differences of Singapore Spot Fuel Oil Price and

Futures Prices a

NYMEX Heating Oil Futures:

NYMEX Crude Oil Futures:

NYMEX Heating Oil Futures, One Day Lag:

NYMEX Crude Oil Futures, One Day Lag:

SIMEX Fuel Oil Futures:

Correlation with Singapore Spot Fuel Oil:

Daily

0.072 (.011)

0.080 (.005)

0.214 (<.OOl)

0.247 (<.OOl)

0.435 (<.001)

Weekly

0.267 (<.o01)

0.312 (<.001)

0.843 (<.001)

Monthly

0.620 (<.001)

0.688 (<.001)

Futures prices are for a near maturity contract, defined as the nearest maturity contract until the first day of the maturity month. Correlations are measured with 1984 to 1988 data, except for those involving SIMEX fuel oil futures which use data from February 22, 1989 to August 4, 1989.

While the liquidity of the NYMEX contracts explain their success, their usefulness outside the U.S. is limited because U.S. domestic crude and heating oil prices often move independently of world petroleum product prices.

In spite of the fact that only five months of data are available for the SIMEX contract, it appears the SIMEX performs better at reducing the variability of Singapore spot fuel oil prices. The risk reduction is about three times more effective than either the NYMEX crude or heating oil contracts can provide. Therefore, participants in the regional petroleum industry are substantially better off using the SIMEX futures contract than keeping New York hours and using the NYMEX contracts.

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TABLE 4 In-Sample Regression Tests of Effectiveness of Futures Markets in Hedging

Daily Returns of Singapore Spot Fuel Oil: Daily, Weekly, and Monthly Hedging Horizons a

Data begins: Data ends: Daily Returns:

Intercept

Slope

R 2 T o t a l R 2 c

Daily Returns, NYMEX Lagged: Intercept

Slope

R 2

Total R 2 Weekly Returns:

Intercept

Slope

R 2

Total R 2 Monthly Returns:

Intercept

Slope

R 2

Total R 2

Futures Market Employed: b

NYMEX Heating Oil

840110 881222

-3.033 E-4 (-.39) 1.319 E-3 (.i0) <0.001 0.227

-2.790 E-4 (-.38) 7.264 E-2 (5.67) 0.026 0.224

-1.653 E-3 (-.52) 0.1540 (3.69) 0.052 0.215

-1.830 E-3 (-.14) 0.7795 (5.97) 0.386 0.386

NYMEX Crude Oil

840110 881222

-3.009 E-4 (-.39) 5.511 E-3 (.43) <0.001 0.226

-2.615 E-4 (-.35) 8.433 E-2 (6.47) 0.33 0.248

-1.518 E-3 (-.51) 0.1820 (4.32) 0.070 0.222

-2.115 E-4 (-.00) 0.8143 (7.16) 0.473 0.473

NYMEX Fuel Oil

890222 890804

1.205 E-3 (.58) .2637 (5.16) 0.200 0.315

6.213 E-3 (1.12) 0.6447 (6.28) 0.675 0.712

Log-differences in the Singapore spot fuel oil price are regressed on log-differences of futures price. T statistics are reported in parentheses. Using nearest maturity contract until first day of maturing month. Difference between R 2 and Total R 2 is due to presence of lagged error terms designed to correct for autocorrelation in OLS residuals. The Yule Walker procedure of the PROC AUTOREG routine of the SAS statistical package is employed. Lag structure is (1, 2, 3, 4) for NYMEX daily, (1, 3) for NYMEX weekly, (3, 4) for SIMEX daily, and (1, 2) for SIMEX weekly while NYMEX monthly was found to require no colxection .for autocorrelation.

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Spot Oil Hedging

TABLE 5 Out-of-Sample Tests of Futures Ability to Hedge Returns of Singapore Spot Fuel

Oil: Daily, Weekly, and Monthly Hedging Horizons

Estimation Period: Test Period: Hedge Ratios"

Daily:

Daily, NYMEX Lagged:

Weekly:

Monthly:

Average Unhedged Returns b

Daily:

Weekly:

Monthly:

Average Hedged Returns c

Daily:

Daily, NYMEX lagged:

Weekly:

Monthly:

NYMEX Heating Oil Futures

840110 860631 860701 881222

-3.744 E-2 (-3.27)

1.886 E-2 (1.63) 2.935 E-2 (.91) 0.4O85 (3.22)

6.740 E-4 (0.01624) 2.830 E-3 (0.05160) -2.392 E-2 (0.07953)

6.964 E-4 (0.01642)

6.659 E-4 (0.01613) 2.756 E-3 (0.05108) -1.286 E-2 (0.06761)

NYMEX Crude Oil Futures

840110 860631 860701 881222

-4.918 E-2 (-4.05)

5.748 E-2 (4.73) 3.541 E-2 (.95) 0.4556 (4.31)

6.740 E-4 (0.01624) 2.830 E-3 (0.05160) -2.392 E-2 (0.07953)

6.951 E-4 (0.01648)

6.571 E-4 (0.01590) 2.774 E-3 (0.05091) - 1.202 E-2 (0.06121)

Slope coefficient from estimate of regression specification identical to previous table, but using estimation period data only. T statistics are reported in parentheses. Standard deviation of returns in parentheses. Return on portfolio consisting of one unit of Singapore spot fuel oil and short futures units equal to hedge ratio. Standard deviation of returns in parentheses.

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ENDNOTES

1. Bailey and Stulz (1989) show that covariance estimates often vary widely with the length of the differencing interval and can also be affected by lead/lag relationships across international markets in different time zones.

2. Given the limited number of data points for the SIMEX contract, we did not divide the observations into two halves to examine the out-of-sample performance of hedged portfolios.

3. Note that we use the mean of the Singapore high and low spot fuel oil reported by Platt's, rather than the cash index reported by SIMEX.

REFERENCES

Abken, Peter A., (1989) "An Analysis of Intra-Market Spreads in Heating Oil Futures." Journal of Futures Markets 9 (February), 77-86.

Bailey, Warren, (1989) "The Market for Japanese Stock Index Futures: Some preliminary Evidence." Journal of Futures Markets 9 (August), 283-96.

_ _ , and Stulz, Rene, (1990) "Measuring the Benefits from International Diver- sification with Daily Data: The Case of pacific-Basin Stock Markets." Journal of Portfolio Management, forthcoming.

Chen, K.C., Sears, R. Stephen and Tzang, Dah-Hein, (1987) "Oil Prices and Energy Futures." Journal of Futures Markets' 7 (October), 501-18.

Ederington, Louis, (1979) "The Hedging Performance of the New Futures Markets." Journal of Finance 34 (March), 157-70.

Gjolberg, Ole, and Johnsen, Thore, (1986) "The Performance of the NYMEX Energy Futures Trade." Columbia University Working paper Series CSFM # 142 (May).

Koh, Annie, (1988) "A Study on the Effectiveness of Hedging Dollar and Non- Dollar Borrowing Costs Using Eurodollar and Currency Futures." Unpublished New York University Ph.D. dissertation.

Ma, Cindy W, (1989) "Forecasting Efficiency of Energy Futures Prices." Journal of Futures Markets, forthcoming.

New York Mercantile Exchange, (1987) "NYMEX Energy Complex." (pamphlet).

Overdahl, James A, (1987) "The Use of Crude Oil Futures by the Governments of Oil-Producing States." Journal of Futures Markets 8 (December), 603-17.

Singapore International Monetary Exchange Ltd, (1988) "Clearing House Manual: Fuel Oil Futures." (mimeo).

• SIMEX Newsletter. (March 1989).

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