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Trade flows are fundamentally driven by the "supply-demand" balance in any market, be it oil, money, consumer goods, pharmaceuticals, apparel, etc. The footprint of "supply-demand" is apparent in each and every business function across the life-cycle of the commodity, from planning, manufacturing, trading, logistics, to finance. In the portfolio of an energy company, there exists a blend of different types of contracts involving different players in the industry. A producer/consumer for various reasons would like to secure term contracts with customers for a decided portion of its portfolio, while contracting for the rest of the volumes on a spot basis. This article discusses the pros and cons of spot and term contracting, and offers opinion of achieving a judicious balance between "term" and "spot" contracting.

What Are Spot & Term Contracts?

Spot contracts by definition are agreements for immediate sale/purchase of the commodity. While "immediate" may be a misnomer, it is perceived in the trading lifecycle as the earliest possible delivery cycle for the commodity. A few examples of spot trading time-cycle are mentioned below:

• In the power industry, the spot contracts are often traded for delivery on the next trading day;
• On the NYMEX, the spot crude contracts are traded for delivery in the next calendar month;
• The European products "cargoes" spot market trades for delivery between 10-25 days from date of trading,
• The European products "barge" spot market trades for delivery between 3-15 days from date of trading.

As mentioned above, each market has a different delivery time-lag for trading spot contracts. Hence, a spot contract can be better defined as an agreement for sale/purchase of a commodity in the most immediate delivery cycles in a market.

Term contracts are by definition, contracts that continue for a longer duration. Typically in the industry, term contracts are for a period ranging from one year to fifteen years. There are various forms of term contracts -- (a) fixed premium contracts, where the premium is fixed over the entire duration of the contract, (b) evergreen contracts -- where the contract can be extended by mutual agreement for the next year, (c) long term contracts -- which are typically for five years and beyond, etc.

Why Term Contracts?

This section explores the main various variables that are encountered in the decision process of term contracting.

Cash Flow, Debt and Portfolio Management: Energy companies are capital-intensive in their projects and debt forms a major part of their capital budgeting. An oil refining company, for example, would enter into hedging contracts for covering their refinery margins, i.e., difference between their product v/s crude values. Another effective way of hedging is to enter into long term contracts in crude and products proportionately, thereby ensuring a sustained cash flow for the contract period and hence better debt servicing. Term contracts across diverse commodities in a company's portfolio balance its term exposure of various products, thereby distributing market risk across various pricing-markers and different markets. The below chart illustrates the cash flow scenarios of different spot term ratios:

Figure 1 - Cash-flow scenarios of various Term-Spot ratio profiles

As can be observed from the above chart, the cash flow scenarios of 100% spot and 100% term strategies form the boundary conditions and selecting a scenario of cash flow on a strategy of spot-term ratios (dotted red & black lines) can optimize the company's cash-flow profile, in line with its management philosophy. It can be observed that risk of downside is apparent in the 100% spot profile, but so are opportunities for maximization of profits.

Credit Risk Management: A trend which has emerged from trading in a tight credit environment is swap contracting, where counterparties enter into offsetting agreements to settle the accounts. For example two counterparties in the Oil business agree to offset the value of the crude purchased by the consumer against the value of the products supplied to the producer. In effect, this type of term contracting effectively reduces credit exposure of either counterparty in the deal.

Market Risk Management: One of the main unhedgeable risk in the markets is the market premium which changes on a day to day basis and accounts for a considerable portion of the volatility. Fixed premium term contracts are in fact, a form of a hedge contract where the premium of a commodity is fixed, and hence not subject to the movements of the spot market.

Structural Trade Flow: In a region, structural demand v/s supply creates opportunities for both producer and consumer to look at broader term contracts than spot contracts. In a regime where a trade-flow is already established, term contracting could be both an economic & strategic solution for both players. Taking an example of a region where there is a base demand for a commodity throughout the year, a retailer would mitigate risk of supply by securing a supply term contract to cover a major portion of the base demand.

Market behavior: On a price curve, the volatility in the front end of the curve is much higher than the back end as market events affect the short term prices, while not impacting as much on the long term. Term contracts effectively minimize the market risk associated with short term volatility.

Security of Supply: Ensuring security of supply is vital to all consumers, more so in the energy space, where supply is a heavily dependent on capacity, disruptions in production, disturbances induced by political factors, changes in weather, etc. The spot market is prone to sharp price movements due to various political factors. A terrorist strike, war, embargoes, sanctions, etc can affect physical supply or restrict logistics and hence affect the prices in the spot market. The consumer/producer is exposed to market risk due to such disturbances in the spot market, and would benefit by entering into diverse term contracts to mitigate risk to an extent in such circumstances.

Figure 2 - Decision variables in Term contracting

Counterparty Relationships: Term contracts enhance business relationships due to the fact that agreements are reached for a longer duration, consequently enhancing traction between the counterparties. Term contracts offer flexibilities in operations, finance, trading, etc and open opportunities in optimization and co-operation. Such flexibilities often act as risk-mitigation agents and offer better control of contracts for either player. Often, strategic term contacts offer counterparties the advantage of right of first refusals, and foraying into niche markets where barriers to entry are very high.

The factors listed in the preceding section clearly seem to indicate the advantages of contracting volumes on a term basis. So why don't we see 100% terming up of volumes?

Spot Market Dynamics

At any given point of time, the spot market is a true reflection of the value of the commodity for that instant. A combination of speculators, arbitrageurs and hedgers form part of the price discovery process. Spot prices change with short term supply-demand and other current factors and offer opportunities in trading. Seasonal changes in demand give the players the flexibility of optimizing grades, volume, etc in tune with the market sentiment which would be typically difficult to achieve under a structured term contract.

Spot markets offer players opportunities in arbitrage due to swiftly changing market prices, freight, etc and hence maximizing profits by participating in market with higher realizations. Risk in the spot market is apparent, but so is the potential for reward. Also, there exists opportunity in adversity. In situations of short-supply, refinery breakdowns, supply disruptions, force-majeure, etc., players in the spot market have the advantage of catering to the critical requirements of the market at better-than-market realizations. A large dependence on term contracts would mean that while supply risks are covered, opportunities in participation in the spot market are reduced.

Risk Profile of a Company

The degree of the capability to take risk exposure varies across market participants owing to the structure of their assets, capital requirements, debt structure, position in market-hierarchy, business proximity to supply/consumer base, regulatory controls, etc. For example, a trader whose business depends on absorbing various risks would typically have a smaller portion of his trade-volumes contracted in term, and would prefer to contract more on spot basis. A refiner who has a substantial debt-serviced capital intensive portfolio, would prefer to balance his book by a larger proportion of term contracts to ensure comfortable cash-flow. A crude oil supplier would look at a balance between keeping enough volumes on the spot market to play an active role in pricing, while strategically terming up the remaining portion of his volumes on term. The risk profile of a company plays a major role in deciding the percentage of term volumes.

Conclusion - Finding a Balance between Term and Spot Contracting

In the current challenging times for trading managers in the ETRM space, it is imperative to find a balance between term and spot contracting. Pros and cons of each type of contract must be weighed and a judicious mix of spot and term contract volumes must be decided on a company level instead of a desk level.

At a company level, senior management must be stakeholders in the decision process of spot/term contracting volume mix and it should reflect the company's risk profile. An effective methodology should be developed to record and match various commodities under term and spot to measure the level of term/spot mix on a near real-time basis at a high level, and discrepancies if any from the mandate levels need to be reviewed and rectified to achieve a balance. A balance must be reached between strategic and economic benefits of a spot term ratio.

By focusing on the risk-reward relationship of term and spot contracts, energy companies will realize benefits of implementing a balancing strategy that truly reflects the company's appetite for risk.