Volumetric Production Payment Contracts

Natural gas storage facilities allow producers to inject excess supply during “shoulder months” for withdrawal during peak demand months and provide producers with the convenience of a shortened injection and withdrawal cycle (a day or a few days), giving the producers and traders the ability to capitalize on the differential between forward prices and spot prices.
For most non-energy commodities, the cost of storage is one of the key determinants of the differential between current and future prices. Although storage plays a smaller role in price determination in some energy markets. It can be important for heating oil and natural gas.

Volumetric Production Payment Contracts

A volumetric production payment contract (VPP) is both a prepaid swap and a synthetic loan. Unlike a normal swap, where the differences between the fixed and variable payments are periodically settled in cash, the buyer (usually a producer) is paid the present value of the fixed payments in advance. In exchange, the seller receives an agreed-upon amount of natural gas or other product over time. These deals typically last for 3 to 5 years. VPPs have been purchased by natural gas producers in the past, and in some cases they appear to have been used in project finance. In function, VPPs are identical to loans paid off with product.

The obvious problem with VPPs is that the seller, usually an energy trader, invests a large amount in advance, risking both buyer default and adverse price movements In addition, VPPs can be used in place of loans to hide debt. What Enron and others often did was to find users of the product who were willing to pay up front in exchange for a price guarantee, use part of those payments to make the advance payment on the VPP, and then hedge their price risks by securing guarantees in the event of default.

Paper Refinery

This is the relationship between refinery margins traded on paper using petroleum futures (the paper refinery) and the physical trade of crude oil into the US. Computations of a 3:2:1 crack spread were constructed using daily observations of second- and third-nearby unleaded gasoline and heating oil futures contracts traded on the New York Mercantile Exchange (NY MEX) and spot Brent crude oil prices.

The crack spread represents the margin between the cost of crude oil feed stock today and the value of the products produced by a refinery in the future. Unit root tests on each of the time series found crack spreads to be stationary while crude oil imports were found to be non-stationary. As the two series were found to be integrated of different order, co-integration analysis of the two series was not deemed appropriate. Instead, linear relationships between crack spreads and imports were examined using causality tests. It was found that the 2-month 3:2:1 crack spread Granger-causes crude oil imports and that this causality is unidirectional. The significance of these findings lies in the fact that other industries like tanker shipping derive their demand from the demand for, and trade in, petroleum. Crack spreads, therefore, can provide a leading indicator for short term developments in tanker demand. For a chartering manager who has ships on the spot market, crack spreads can help him/her anticipate demand developments and influence vessel deployment and chartering decisions.


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