APPA s Business and Financial Conference:

Transcription

1 APPA s Business and Financial Conference: Derivatives and Public Power Austin, Texas September 25, 2007 Joanie C. Teofilo, P.E. Director, Risk Management East/Midwest

2 Statement of Disclosure HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. 2

3 Who is The Energy Authority? A not-for-profit, stand alone trading and marketing corporation for municipal utilities. Formed in 1997 by JEA, MEAG, and Santee Cooper Providing trading and risk management services for over 20,000 MW of generating assets 3

4 Who is The Energy Authority? 4

5 Derivatives and Public Power Objectives Examine framework of Risk Management Review Energy Markets (Power and Natural Gas) Define and evaluate both commodity and interest rate derivatives and how they can be used to help manage risk 5

6 Derivatives A derivative is a financial instrument whose value is based upon the underlying physical product/commodity (e.g., electricity, natural gas, oil, coal, interest rates). 6

7 Derivatives and Public Power I. Risk Management Framework II. III. Energy Markets How Derivatives can be used to manage risk 7

8 Risk Management Framework 8

9 What is Risk? 9

10 Risk is What? - The probability of experiencing a loss How large? - The magnitude of a potential loss - how large a loss may be How Correlated? How much diversification (a natural risk reducer) do you have? 10

11 Example of Risk For a house it is often the risk of a financial loss due to: Fire Storm (Katrina, Rita!) Burglary Liability The homeowner s concern is typically: The probability that these losses will occur The potential magnitude of these losses 11

12 What are Energy Risks? Power generation consumption of fuels? Forced unit outages (especially during periods of high power prices) Risk of industrial customer flight The risk that cash flow is uncertain? (Leading to a requirement to have more capital on hand and/or lower ratings.) Political pressure to meet budget Ability to pass through fuel costs? Changing Interest Rates 12

13 Why Hedge? Self Insuring is an alternative Considerations include: Requisite cash reserve Volatility of fuel costs Potential impact on rates 13

14 Risk Protection How do individuals or corporations protect themselves against risk? Take steps to reduce the probability and/or magnitude of the loss? Diversity their risk or portfolio Buy insurance? How much coverage? Deductible? Internalize the risk 14

15 Why Manage Risk? The business has changed today there is significantly more risk in the wholesale market. Rating Agencies now look more closely for Risk Management Customers and Boards are expecting it more and more! 15

16 Hedging and Risk Management Determine goals and objectives for managing risk Recognize that risk management is the shifting of unacceptable amounts of risk into another form of risk that is more acceptable E.g.: outright price risk into credit risk 16

17 Risk Limits Risk limits should be established based on the net of physical and financial exposures and positions Many utilities focus on risk limits for only financial transactions while ignoring the net exposure of physical plus financial Risk limits should be established based on reducing the net exposure 17

18 Risk Limits (cont.) A separate measurement of financial exposures only is important for managing potential capital requirements to meet the collateral obligations of financial transactions. Many utilities are running probabilistic analyses of cash-flow-at-risk and value-at-risk to assist with hedge planning and limit setting/compliance. These models often blend traditional production cost modeling with the affect of physical and financial hedge transactions. 18

19 Hedge Program Design: Risk Management Objectives Many municipal utilities, despite their ability to pass-through rising energy costs, are implementing risk management programs to reduce the probability of future rate increases, and to achieve increased rate stability for ratepayers. Best practice risk management objectives for municipal utilities should focus on price stability or volatility reduction 19

20 Derivatives and Public Power I. Risk Management Framework II. III. Energy Markets How Derivatives can be used to manage risk 20

21 Development of the Financial Markets - Originated from the economic need to manage commodity price risk - In 1848, the Chicago Board of Trade opened as the first organized commodity market in the United States. - Today s organized futures exchanges provide an efficient way to manage commodity price and credit risk. 21

22 Who are the Participants in the Energy Markets? Those with a Physical Interest Those without a Physical Interest 22

23 Those with a Physical Interest Electric Utilities Oil and Gas Producers Industrial Oil/Gas Consumers Coal Mines 23

24 Those without any Physical Interest Financial Entities - Hedge Funds, Banks Private Investors - via Commodity Indexes Local Traders on the Exchanges 24

25 WHY Participate in the Market? For utilities (and other entities with a physical interest), the intent is to manage (and typically offset) risk. For those without a physical interest, the intent is to take on risk in hopes of a reward or arbitrage opportunity. 25

26 Types of Market Participants Three types of participants in forward markets: Hedgers Speculators Arbitrageurs 26

27 Types of Market Participants Hedgers Intent is protection, to avoid exposure to adverse price movements Speculators Intent is profit, willing to take a position in the market, betting that the price will go up or down. 27

28 Types of Market Participants Arbitrageurs Intent is profit Lock in profit by concurrently taking positions in two different markets Important group for liquid markets and keeping markets in balance Existence ensures minimal arbitrage opportunities for liquid markets 28

29 Relationship between the Physical & Financial For those with a physical interest in the market, they are naturally short (in need of a commodity) or naturally long (with an excess of a commodity). Their participation in the market is in direct relationship to their naturally short or naturally long position. 29

30 Relationship between the Physical & Financial Those with a physical interest will use the market to balance their naturally short or long position. This takes much of the risk out of the commodity prices and allows the utility to focus on its core business. 30

31 Physical & Financial PHYSICAL FINANCIAL Naturally Short Natural Gas Long Natural Gas Contract This utility needs (is short) natural gas; it hedges the price risk by purchasing (going long) a financial natural gas contract. May also hedge physical delivery risk by entering into a physical purchase with index based pricing. 31

32 How is Energy Traded? Buys Sells Different Markets Exchange Traded Over the Counter 32

33 Exchange An organization formed to provide an orderly market for trading futures and options. Provides the requisite infrastructure and support to facilitate trading. Facilitates the shifting of risk between counter-parties and price discovery. 33

34 Exchange Traded Contracts Product Terms are standardized and non-negotiable (set by the Exchange) Counter-party risk is assumed by the clearing members of the exchange Most contracts are Financially Settled (though a small number may be Physically Delivered) 34

35 Exchange Traded Contracts The trade is between the Exchange and the buyer or seller. The parties buying and selling with the Exchange are required to post a Margin (to mitigate counterparty credit risk) 35

36 Exchange Traded Energy Contracts New York Mercantile Exchange (NYMEX) - Henry Hub Natural Gas - Central Appalachian Coal - Light, Sweet Crude Oil (WTI) - Brent Crude Oil - Heating Oil - Unleaded Gasoline - Propane 36

37 Margin Requirements Before buying or selling an exchange traded contract, each party is required to post a percentage of the value of the contract with the exchange. This goes into each party s margin account. The margin provides insurance against a loss. The terms of the contract specify both initial and maintenance margin levels for each commodity. 37

38 Over-the-Counter (OTC) All transactions completed outside of a regulated exchange (e.g., NYMEX) are considered over-the-counter (OTC). An OTC deal is negotiated between two counter-parties or with a broker. The counter-parties take on credit risk. The terms of an OTC deal are negotiable and can be customized. 38

39 Over the Counter (OTC) Electronic Exchange - e.g., Intercontinental Exchange (ICE) Through a Broker Directly with Counterparty via bilateral contracts 39

40 Bilateral Contracts A contract between two parties. The contract can be customized as agreed to by the two parties. Both parties will be subject to credit risk. Some standardized bilateral contracts have been developed. 40

41 Standardized Bilateral Contracts International Swaps and Derivatives Association (ISDA) Standard agreement for financial trading Edison Electric Institute (EEI) Standard agreement for trading physical power North American Energy Standards Board (NAESB) Formerly GISB (Gas Industry Standards Board) A standard agreement for trading physical gas 41

42 Derivatives and Public Power I. Risk Management Framework II. III. Energy Markets How Derivatives can be used to manage Risk 42

43 Derivatives A derivative is a financial instrument whose value is based upon the underlying physical product/commodity (e.g., electricity, natural gas, oil, coal, interest rates). 43

44 Derivatives Options Forwards Futures Swaps Physical Commodity (Electricity or Natural Gas) or Interest Rate 44

45 Derivatives Thus a Forward, Futures, Swap or Option Contract is a derivative of the underlying physical commodity or interest rate. 45

46 Forward Contract An agreement between two counter-parties to buy/sell the commodity in the future at an agreed upon price. The terms of the contract are negotiable and may be customized. Since forward contracts are not traded on an exchange, each counter-party takes on credit risk. Forwards can not always be easily liquidated with an off-setting trade. 46

47 Forward Contract A forward contract is considered must take energy. Many forward contracts for electricity are fixed price (though they can also be based upon an index) and are traded in monthly blocks. Financially Firm is the standard, although System/Unit-Contingent are also traded. May be physically delivered or booked out. 47

48 Impacts of a Forward Purchase Secures physical supply and transmission Avoids uncertainty of spot market Provides diversity (assuming some purchases in the spot market) Locks in a fixed price If the market price decreases, this will result in a loss of opportunity (to buy at a lower price) 48

49 Impacts of a Forward Sale Secures revenue Avoids uncertainty of spot market Provides diversity (assuming some sales in the spot market) Locks in a fixed price If the market price increases, this will result in a loss of opportunity (to sell at a higher price) 49

50 Futures Contract A futures contract is a standardized contract to buy or sell the underlying commodity or interest rate at a given price, at a specified time. It is traded on a futures exchange and thus is a contract with the exchange. The terms of the contract are non-negotiable and are set by the exchange. 50

51 Swaps A swap is a financial contract in which two parties agree to exchange one stream of cash flows against another stream. Typically this involves one fixed or set prices versus a floating or varying price. 51

52 Forward Price Curve A strip of forward prices starting with the prompt month and ending with some point out in the future. Represents the term structure of forward prices. This is NOT a price forecast! It is the current view of the market on forward prices. 52

53 Nov-10 $ $ $9.500 $9.000 $8.500 $8.000 $7.500 $7.000 $6.500 $6.000 $5.500 $5.000 NG Forward Curve Natural Gas Forw ard Curve 53 Sep-10 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 May-07 Jul-07 $/MMBtu 6/21/2007 7/20/2007 8/21/2007 9/21/2007 Mar-07

54 54

55 Option ABCs 55

56 Options Options are financial instruments that provide the right, but not the obligation, to buy or sell energy in the future. Buying a call option provides the right to buy. Buying a put option provides the right to sell. 56

57 What is a Call Option? A Call is an option to buy the underlying at a given price. Calls set CEILINGS! 57

58 Buying and Selling a Call The buyer of a Call option has the right, but not the obligation, to buy the underlying at a given price. - Protects against a higher market price. The seller of a Call option has an obligation to sell the underlying at a given price, at the buyer s sole discretion. 58

59 What is a Put Option? A Put is an option to sell the underlying at a given price. Puts set FLOORS! 59

60 Buying and Selling a Put The buyer of a Put option has the right, but not the obligation, to sell the underlying at a given price. - Protects against a lower market price. The seller of a Put option has an obligation to buy the underlying at a given price at the buyer s sole discretion. 60

61 Option Terminology Exercise and Assignment describe the conversion of the option into the underlying forward contract. The Option buyer exercises the option. The Option seller is assigned the option. 61

62 Buying vs. Selling Options Buying ( Long the Option) Option Buyer exercises the Option Involves Choice Pays Premium Profitable Underlying Position Selling ( Short the Option) Option Seller is assigned the Option No Choice Receives Premium Unprofitable Underlying Position 62

63 Strike Price A strike price is the price at which the underlying is bought or sold in an options contract. E.g., $50.00/MWh Call Option $6.50/MMBtu Put Option 63

64 Option Example: Long Call Option Power 64

65 Specifics Utility ABC is economically short generation for the summer, with a cost of generation of $65.00/MWh Utility ABC is considering the purchase of a call option. 65

66 Purchase of a $50.00/MWh Call Option Provides price protection (a cap) for Utility ABC The strike price is below Utility ABC s cost of generation (of $65.00/MWh) Utility ABC will pay an option premium ($5.00/MWh) for the purchase of this option 66

67 Purchase a Call Option What: Buy a $50.00/MWh Call Option for $5.00/MWh Why: To provide price protection 67

68 $90.00 $ $60.00 $55.00 $50.00 $45.00 $40.00 $35.00 $30.00 $25.00 $20.00 $15.00 $10.00 Long a Call Option Purchase Price 68 $40.00 $50.00 $60.00 $70.00 $80.00 Underlying Market Price ($/MWh) $30.00 $20.00 Purchase Price ($/MWh)

69 $ $50.00 $45.00 $40.00 $35.00 $30.00 $25.00 $20.00 $15.00 $10.00 $5.00 $- $(5.00) $(10.00) Purchase of a Call Option Profit and Loss at Expiration 69 $30.00 $40.00 $50.00 $60.00 $70.00 $80.00 $90.00 Underlying Market Price ($/MWh) $20.00 Profit / Loss ($/MWh)

70 Option Example: Long Call Option Natural Gas 70

71 Purchase of a $7.00/MMBtu Call Option Provides price protection (a cap) for Utility ABC s gas cost The strike price is $7.00/MMBtu Utility ABC will pay an option premium ($0.73/MMBtu) for the purchase of this option 71

72 Purchase a Call Option What: Buy a $7.00/MMBtu Call Option for $0.73/MMBtu Why: To provide fuel price protection 72

73 Purchase of a $7.00 Call Option Purchase Price of Gas $9.00 $8.50 $8.00 $7.50 $7.00 $6.50 $6.00 $5.50 $5.00 $ $5.00 $5.25 $5.50 $5.75 $6.00 $6.25 $6.50 $6.75 $7.00 $7.25 $7.50 $7.75 $8.00 $8.25 $8.50 $8.75 $9.00 Underlying Market Price (MMBtu) Gas Cost (MMBtu

74 Purchase of a $7.00 Call Option Profit and Loss at Expiration $2.00 Profit / Loss ($MMBtu) $1.00 $- $(1.00) $(2.00) Market Price (MMBtu) 74

75 Option Example: Interest Rates 75

76 Interest Rate Derivatives An interest rate derivative is a derivative where the underlying asset is the right to pay or receive an amount of money at a given interest rate. Trading in the interest rate derivative market is primarily transacted over-thecounter. 76

77 Interest Rate Derivatives Many interest rate derivatives are comprised of the following instruments: Forward Rate Agreement Interest Rate Future Interest Rate Swap Interest Rate Cap or Floor Interest Rate Swaption Bond Option 77

78 Interest Rate Cap An interest rate cap limits a utility s exposure to upward movement in interest rates. The cap establishes a ceiling for the total dollar amount of interest that the utility will pay out over the life of the cap. The interest rate cap is paid for upfront. The benefit of the cap is realized by the hedger (utility) over the life of the instrument. 78

79 Option Example: Short Put Option Natural Gas 79

80 Sale of a $6.00/MMBtu Put Option This involves the sale of a put option, which obligates Utility ABC to buy natural gas at the strike price. The strike price is at Utility ABC s budgeted natural gas cost of $6.00/MMBtu). Utility ABC will receive an option premium of $0.20/MMBtu for the sale of this option. The premium received will offset gas costs. 80

81 Sale of a $6.00/MMBtu Put Option This is a Short Put since Utility ABC is short natural gas The strike price is at Utility ABC s budgeted natural gas cost of $6.00/MMBtu) Utility ABC will receive an option premium of $0.20/MMBtu for the sale of this option The premium received will offset gas costs 81

82 Sale of a $6.00 Put Option Purchase Price $8.00 $7.50 Gas Cost (MMBtu $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $ Underlying Market Price (MMBtu) 82

83 Sale of a $6.00 Put Option Profit and Loss at Expiration $3.00 Profit / Loss ($MMBtu) $2.00 $1.00 $- $(1.00) $(2.00) $(3.00) $(4.00) Market Price (MMBtu) 83

84 Option Example: Long Collar 84

85 Long Collar Long a Call and Short a Put Combining the Sale of a Put Option with the Purchase of a Call Option The long Call provides a Cap for the purchase price The short Put premium offsets the cost of the Call option Premiums: Buy $7.00 July Call = $0.15/MMBtu Sell $6.30 July Put = $0.10/MMBtu Net Premium Cost of $0.05/MMBtu 85

86 Long $7.00 Call and Short $6.30 Put Purchase Price of Natural Gas Purchase Price (MMBtu) $7.20 $7.00 $6.80 $6.60 $6.40 $6.20 Gas cost will range from a minimum of $6.35/MMBtu (floor), to a maximum (cap) of $7.05/MMBtu $ Market Price (MMBtu) 86

87 Long $7.00 Call and Short $6.30 Put Profit & Loss at Expiration $2.00 $1.00 Profit / Loss ($MMBtu) $- $(1.00) $(2.00) $(3.00) Market Price ($/MMBtu) 87

88 Option Example: Long Call and Short Put Spread 88

89 Long Call and Short a Put Spread Combining the purchase of a Call option with the sale of a higher strike Put option and the purchase of a lower strike Put option The Call option provides upside price protection The short put option premium offsets the cost of the call. The long put option allows for some participation in a downward market. 89

90 Long Call and Short a Put Spread Upside price protection is fixed Price floats down with the market down to the short put strike price If the market drops below the long put strike, this position will be above the market (by the difference in the put strike prices), but will float down, providing some benefit from lower market prices. Premiums: Buy $7.00 Call = $0.38/MMBtu Sell $6.00 Put = $0.18/MMBtu Buy $5.00 Put = $0.11/MMBtu Net Premium Cost of $0.31/MMBtu 90

91 Long $7.00 Call, Short $6.00 Put & Long $5.00 Put Purchase Price of Natural Gas $8.00 Gas Purchase Cost (MMBtu) $7.50 $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $

92 Long $7.00 Call, Short $6.00 Put and Long $5.00 Put Profit and Loss at Expiration $2.00 P/L ($MMBtu) $1.00 $- $(1.00) $(2.00) Market Price (MMBtu) 92

93 Scenario Analysis $15.05 $15.50 $15.95 $16.40 $16.85 $17.30 $17.75 $18.20 $18.65 $19.10 $19.55 $20.00 $10.00 $8.00 $6.00 $4.00 $2.00 $- $(2.00) $(4.00) $(6.00) $(8.00) $(10.00) Scenario Analysis: Collar vs. Three Way vs. Call 93 $6.50 $6.95 $7.40 $7.85 $8.30 $8.75 $9.20 $9.65 $10.10 $10.55 $11.00 $11.45 $11.90 $12.35 $12.80 $13.25 $13.70 $14.15 $14.60 Expiration Price Three Way Collar Call $6.05 $5.60 $5.15 $4.70 $4.25 $3.80 $3.35 $2.90 $2.45 $2.00 Cash Flow ($/MMBtu)

94 Potential Hedging Strategies I. Hedging Strategies for a Naturally Long Utility 1. Sell Forward 2. Sell Call Option 3. Buy Put Option 4. Sell Collar (Sell Call, Buy Put) II. Hedging Strategies for a Naturally Short Utility 1. Buy Forward 2. Buy Call Option 3. Sell Put Option 4. Buy Collar (Buy Call, Sell Put) 94

95 Risk Reporting: Showing the Impact of Derivatives 95

96 Impact of Hedging With Hedging Probability No Hedging Cash Flow at 5 th percentile Cash Flow 96

97 Cash Flow Probability Distribution Probability Density 95 CFaR Value Difference Between Average Tail Value and Median 95 CFaR Difference Between 5% Lower Bound and Median Average of the Value in the 5% Tail Cash Flow 97

98 $11.00 $10.50 $10.00 $9.50 $9.00 $8.50 $8.00 $7.50 $7.00 Portfolio Report Fiscal Year Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 Unhedged Cost Hedged Cost Blended Cost Feb-07 Jan-07

99 Sample Risk Metrics Summary 95th Percentile Gas Cost ($/MMBtu) Probability of Exceeding Price Spike of $6.50 Probability of Exceeding Budget Average Out of Market Cost ($/MMBtu) Average Gas Cost ($/MMBtu) 95th Percentile CFaR ($000) Current Fiscal Year Next Fiscal Year Base Case $10.13 $9.67 Existing Positions $8.77 $9.66 Proposed Positions $8.68 $9.60 Base Case 38% 7% Existing Positions 30% 36% Proposed Positions 28% 34% Base Case 54% 60% Existing Positions 49% 58% Proposed Positions 50% 59% Base Case $0.00 $0.00 Existing Positions $0.12 $0.00 Proposed Positions $0.14 $0.02 Base Case $6.10 $5.90 Existing Positions $5.82 $5.90 Proposed Positions $5.83 $5.92 Base Case $5,742 $7,507 Existing Positions $5,524 $7,494 Proposed Positions $5,405 $7,427 99

100 13.60 Gas Cost at Risk Expected Natural Gas Cost 95th Percentile Gas Cost at Risk 95th Percentile Natural Gas Cost Natural Gas Cost ($/MMBtu)

101 Gas Cost at Risk The 95 th percentile Gas-Cost-at-Risk (95% GCaR) measures the difference between the expected gas cost (of the entire portfolio) and the 95 th percentile gas cost. This number states that, 19 out of 20 times, the actual spot cost of gas will not exceed the expected gas cost plus the 95% GCaR. The GCaR number gives a statistical maximum for a utlity s gas cost with a certain degree of confidence. 101

102 Questions 102