THE PROFESSIONAL RISK MANAGERS' GUIDE TO THE ENERGY MARKET Edited by PETER C. FUSARO New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto
C O N T E N T S DEDICATION v ABOUT THE CONTRIBUTORS xvii Chapter 1 Introduction to Energy Financial Risk Management 1 Introduction 1 Energy is an Immature Financial Market 3 The Market Drivers of Energy Trading 3 Organization of this Book 5 Chapter 2 Energy Futures Today 7 Introduction 7 Futures: Where's the Risk? 8 Risk Premiums 10 The New Market Fundamentals 11 The Future of Energy Futures 14 Notes 16 Chapter 3 Overview of the Over-the-Counter Energy Derivatives Market 17 Introduction 17 Overview of Energy Markets 18 OTC Trading 20 OTC Instruments 22 The Convergence of OTC and Futures 24 Futures Contracts Settlement on Expiry 24 Settlement of Swaps Contracts on Expiry 25 Where Have OTC Trading and Clearing Platform Progression Left the Market? 28
viii Contents A Short History of Energy Trading 28 Conclusions 30 Note 30 Chapter 4 Energy Derivatives Structures 31 Risk and Risk Management Themes 31 Market Risk Exposure 33 Basic Derivatives Instruments 35 Derivatives Packages 42 Structuring and Derivatives Structures 46 Reference 50 Chapter 5 The Nordic Electricity Markets 51 Introduction 51 The Nordic Electricity Market 51 History and Development of the Nordic Electricity Market 55 Nord Pool Spot: The Physical Day-Ahead Market 56 Determination of Day-Ahead Market Clearing Prices 56 Area Prices and Market Characteristics 57 Settlement 59 The Electricity Derivatives Market: Nord Pool Financial Market 60 Counterparty Risk 62 The Emissions Market: Nord Pool Carbon Dioxide Allowance Market 63 Conclusions 65 Chapter 6 Market Risk Measurement and Management for Energy Firms 67 Introduction 67 Measure of Market Risk 68 Estimating Measures of Market Risk with a Mean-Reverting Jump-Diffusion Process 71 Modeling Spreads 74 Stress Tests and Scenario Analysis 77 Organizational and Qualitative Aspects of Risk Management 78
References 79 Notes 79 Chapter 7 Best Practices in Credit Risk Management for Energy and Commodity Derivatives 81 Introduction 81 Internal Risk Ratings: Obtaining and Analyzing Credit-Related Information from Counterparties 82 How Bad Can It Get? Potential Future Exposure 83 Counterparty Credit Risk Charges 88 Credit Loss Distributions 88 Economic Capital and Credit Risk 89 Conclusions 93 References 93 Chapter 8 Introduction to Natural Gas Trading 95 What Is Natural Gas? 95 Consumption Commodity 96 Pipeline Grid 96 Supply and Demand 97 Financial Market 98 The Physical Market Meets the Financial 101 Characteristics of Natural Gas Risk 104 How the US Gas Industry Developed 106 Where Are We Going? 108 Chapter 9 Structured Transactions in Natural Gas 111 Introduction 111 Natural Gas Storage 112 Valuation Techniques 112 Optimization Overview 121 Swing Options 124 Asian Options 127
Swaptions 129 References 130 Notes 130 Chapter 10 Liquidity Risk Measurement and Management for Energy Firms 133 Introduction 133 Components of a Liquidity Risk Framework 133 Infrastructure 140 Conclusions 143 References 143 Chapter 11 Value of Technical Analysis in Energy Markets 145 Introduction 145 What Is Technical Analysis? 146 The Principles of Technical Analysis 147 Trendlines 148 Trendline and Breakout 150 Other Types of Charts 152 End of Trend Signal 155 Fibonacci Retracement Levels 157 Chart Reading 159 Mathematical Indicators 159 Interpretation 162 Conclusions 164 Reference 165 Chapter 12 Risk Management in Energy-Focused Commodity Futures Investing 167 Introduction 167 Risk Is the Flipside of Return 167 The Most Important Element of an Investment Process 168 Product Design Issues 168
Viability of a Futures Program 169 Standard Risk Management Methodology 169 Understanding Price Behavior 170 Value at Risk 171 Scenario Testing 172 Deep Out-of-the-Money Options 173 Exit Strategy 173 Diversification and Concentration Risk 173 Understanding the Fundamental Drivers of a Strategy 174 Extraordinary Stress Testing 180 Risk Management Reports 182 Conclusions 183 Acknowledgements 184 References 185 Chapter 13 The ISDA Master Agreement Ten Years On, ISDA 2002 187 Introduction 187 The ISDA Agreement 187 The ISDA Master Agreement 189 Useful ISDA Publications 189 Pre-confirmations and Long-Form Confirmations 190 ISDA Documentation Processing 191 Trading Before an ISDA Is Signed 194 The Main Differences between ISDA 2002 and the ISDA 1992 Master Agreement 195 Appendix A: ISDA Agreement 201 Appendix B: Sample Letter 206 Notes 207 Chapter 14 Creation and Transfer of Price Risk in European Energy Markets 209 Introduction 209 Creation of Risk 210
xii Contents Risk Transfer 213 Financial Risk Transfer 219 The Impact of Policy and Regulation 223 Conclusions 225 References 227 Notes 227 Chapter 15 Energy Options 101 231 Introduction 231 Basics of Oil Derivatives Structures (Exchange Traded and Over-the-Counter) 233 Basic Derivatives Structures 234 Option Pricing Methodology/Overview of Option Pricing 238 Conclusions 242 Notes 243 Chapter 16 Energy Trading, Transaction, and Risk Management Software: A Key Component in Risk Management 245 Introduction 245 Historical Perspectives 245 Current Status of ETRM Software 247 A Dichotomy of Requirements 250 A New Era of ETRM Software? 251 ETRM Software as an Essential Part of Risk Management Policy 252 Risk Management Tools and Methods 253 Conclusions 254 References 254 Chapter 17 Electricity Options 255 Introduction 255 History of Electricity Options 256 Who Uses Electricity Options? 257 Option Basics 257 The Greeks 258
The Valuation of Options 259 Electricity Option Basic Structures 261 Commonly Observed OTC Electricity Option Products 262 Potential Portfolio Applications 265 Conclusions 268 Notes 268 Chapter 18 The New Weather Risk Market Hedging and Trading Strategies 269 Why Is Weather Important? 269 Developing a Weather Strategy: How to Identify and Quantify the Risk 271 Developing a Weather Strategy 276 Conclusions 281 Further Information 282 Notes 282 Chapter 19 Outlook for Asian Energy Markets 283 Introduction 283 Asia's Risk Profile 284 Different Market Evolution 284 The Market Drivers of Energy Trading 285 Market Development 285 The Asia-Pacific Region in the Global Supply Scheme 286 Other Fundamental Changes Under Way in Asian Oil Markets 288 Changes in Oil Suppliers 289 Tanker Market Developments 289 Asian Market Characteristics 290 Challenges to Change 291 Conclusions 293 Chapter 20 Green Trading: Environmental Financial Markets and Energy Trading 295 Introduction 295 Market Developments Now Under Way 297
xiv Contents Where is Green Trading Today? 299 The New Investment Model for the Green Space 301 Climate Change as an Investment Opportunity 303 Cleantech Investment Indexes 304 Get to Know Your Risks 304 Why Environment Is Rising as Both a Corporate Financial Issue and Investment Opportunity 305 Chapter 21 Lessons Learned from the US Experience in Trading Sulfur Dioxide Allowances 307 Introduction 307 Summary of SO 2 Allowance Trading 308 Experience to Date 311 Lessons Learned 317 References 324 Chapter 22 The Complexities of Trading Regional Emission Markets 327 Introduction 327 Houston/Galveston Mass Emissions Cap and Trade (MECT) Program 330 San Joaquin Valley Emission Reduction Credit Trading Program 333 Notes 336 Chapter 23 Climate Risks and Electric Utilities 337 Introduction 337 States Taking the Lead in the USA 340 Focus on Electric Power Companies 341 IGCC Holds Promise 348 Outlook for US Carbon Regime 352 References 353 Notes 353
Chapter 24 Green, White, and Red Certificates Trading in Italy 355 Introduction 355 Green Trading 356 White Trading 358 Red Trading 360 Conclusions 362 Note 362 Chapter 25 Carbon Trading: A New Commodity Is Born 363 Introduction 363 The Genesis of Carbon 364 The Policy Framework 366 The Kyoto Protocol 367 Flexibility Mechanisms 369 The EU Emissions Trading Scheme 375 Drivers of Carbon Pricing in the EU ETS 377 Future Uncertainties in European Gas and Power Affecting Carbon Pricing 383 Emergence of Multiple Carbon Product Markets in the Short Term 384 Will the EU ETS Set the Global Price for Carbon? 384 Impact on the European Power Sector 387 Concluding Remarks: Post-2012 Scenario 390 Chapter 26 Entrance of Energy and Environmental Hedge Funds 393 Introduction 393 Energy Hedge Funds 394 Why Enter Energy Now? 396 Oil Trading Market Opportunities 399 Structural Changes in Commodity Trading 399 Waiting for Mean Price Reversion 400 What Is a Hedge Fund? 402
Types of Hedge Funds 403 Why the Hedge Fund Factor Is Here to Stay 405 How Are Oil and Gas Prices Determined? 405 Energy Trading Is Now Rebuilt 407 What the Future Holds 410 Acknowledgments 412 References 412 Note 412 Chapter 27 Forward-Looking Energy and Environmental Trading Market Developments 413 Introduction 413 Energy Hedge Funds 417 Nature of Risk-Taking Is Changing 418 Other Market Changes 419 The Future in Energy and Environmental Trading Will Be Different 420 Conclusions 420 GLOSSARY 423 INDEX 451