Transcript Day 1: Foundations of Energy Trading & Risk Management
APPA GAFA Spring Meeting:
A Primer on the Use and Effects of Energy Derivatives
Washington, D.C.
April 19, 2007 Joanie Teofilo Director, Risk Mgmt - East
A Primer on Energy Derivatives: Objectives
• Review framework of Risk Management • Develop an understanding of the Energy Markets (Power and Natural Gas) • Discuss Tools (such as Futures and Options) used to manage Risk 2
What is Risk?
3
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?
4
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 5
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 6
Energy Risks
• Forecast of energy consumption over budget year?
• Ability to pass through cost increases?
• Type of exposure • fixed • • floating uncertain 7
Why Hedge?
• Self Insuring is an alternative • Considerations include: • Requisite cash reserve • Volatility of fuel costs • Potential impact on rates 8
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 9
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!
10
Hedging and Risk Management
• Risk management is the
shifting
of unacceptable amounts of risk into another form of risk that is more acceptable • outright price risk into credit risk (and possibly basis risk) • basis risk into credit risk • volumetric risk into credit risk • option risk into credit risk • credit risk into less credit risk • All risk is shifted, to an extent, into operational, liquidity, legal, and systemic risks 11
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 12
Limit Setting Process
Limit Setting Process
Identify Risks Quantify Risks Establish Hedge Targets to Reduce Risk to Acceptable Levels
13
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 • More attention is being paid to the establishment and monitoring of credit risk limits 14
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
15
Energy Markets
Development of the Financial Markets
Originated from the economic need to manage commodity price risk Original “futures” markets were for agricultural products Markets soon developed for other industrial “raw materials” 17
Development of the Financial Markets
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.
18
Who are the Participants in the Energy Markets?
• Those with a Physical Interest • Those without a Physical Interest 19
Those with a Physical Interest
• Electric Utilities • Oil and Gas Producers • Industrial Oil/Gas Consumers • Coal Mines 20
Those without any Physical Interest
• Financial Entities - Hedge Funds, Banks • Private Investors - via Commodity Indexes • Local Traders on the Exchanges 21
WHY?
• For utilities (and other entities with a physical interest), the intent is to manage risk.
• For those without a physical interest, the intent is to take on risk in hopes of a reward or arbitrage opportunity.
22
Types of Market Participants
Three types of participants in forward markets: • Hedgers • Speculators • Arbitrageurs 23
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.
24
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 25
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.
26
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.
27
Physical & Financial
PHYSICAL
Naturally
Short
Natural Gas
FINANCIAL
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.
28
How is Energy Traded?
Buys
Different Markets • Exchange Traded • Over the Counter
Sells
29
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.
30
Different Exchanges
• New York Mercantile Exchange (NYMEX) • Chicago Mercantile Exchange (CMEX) • Chicago Board of Trade (CBOT) 31
Exchange Traded Contracts
• Pit Traded (in person) • Via Electronic Trading e.g., NYMEX’s Globex 32
Exchange Traded Contracts
The Exchange specifies the following: • Product Quality • Delivery Location • Amount of the Asset to be delivered per the contract • Delivery Period • Margin Provisions 33
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
) • Characterized by generally greater
liquidity
than Over-the-Counter 34
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
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
Margin
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.
38
Determination of Margin Amounts
• Each Futures Exchange determines the amount of initial and maintenance margin levels for each commodity.
• Margin levels will generally reflect the historical volatility of that commodity.
• The margin levels for each commodity are set to protect the Clearinghouse from a large one day move in price.
39
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 is the
Initial Margin
and goes into each party’s “margin account.” • The initial margin provides insurance against a loss.
40
Margin Requirements
• As the market moves up or down, each party will either need to put additional dollars into their margin account or will receive additional dollars in their account.
• The
Maintenance Margin
is the minimum level of funds that must be maintained in the account at all times.
• This again provides insurance against a loss for the broker and/or clearinghouse.
41
Margin Call
• If the market moves sufficiently against a current position, then a margin call will be issued.
• This is a request to deposit additional funds in the margin account, in order to bring the amount of money in the margin account up to the minimum level.
42
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.
43
Over the Counter (OTC)
• Electronic Exchange e.g., Intercontinental Exchange (ICE) • Through a Broker • Directly with Counter party via bilateral contracts 44
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.
45
“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 46
Defining Derivatives
47
Derivatives
A derivative is a financial instrument whose value is based upon the underlying physical product/commodity (e.g., electricity, natural gas, oil, coal).
48
Forwards
Derivatives
Options Futures Physical Commodity: Electricity or Natural Gas 49
Derivatives
Thus a Forward, Futures or Option Contract is a derivative of the underlying physical commodity.
50
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.
51
•
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.
52
Futures Contract
• A futures contract is a standardized contract to buy or sell the underlying commodity 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.
53
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.
54
$10.00
$9.75
$9.50
$9.25
$9.00
$8.75
$8.50
$8.25
$8.00
$7.75
$7.50
$7.25
$7.00
$6.75
$6.50
$6.25
$6.00
Natural Gas Forward Curve
As of Close April 17, 2007 Monthly Gas Forward Curve
55
Option “ABCs”
56
What is a Call Option?
• A Call is an option to
buy the underlying
at a given price.
•
Calls set CEILINGS!
57
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
What is a Put Option?
• A Put is an option to
sell the underlying
at a given price.
•
Puts set FLOORS!
59
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
buy the underlying
at a given price at the buyer’s sole discretion.
to 60
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
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
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
Option Example: Long Call Option Power
64
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
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
Purchase a Call Option
What: Buy a $50.00/MWh Call Option for $5.00/MWh Why: To provide price protection 67
Long a Call Option
Purchase Price
$60.00
$55.00
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$ 20 .0
0 $ 30 .0
0 $ 40 .0
0 $ 50 .0
0 $ 60 .0
0 $ 70 .0
0
Underlying Market Price ($/MWh)
$ 80 .0
0 $ 90 .0
0 $ 10 0.
00 68
Purchase of a Call Option
Profit and Loss at Expiration
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$ $(5.00) $(10.00) $ 20 .0
0 $ 30 .0
0 $ 40 .0
0 $ 50 .0
0 $ 60 .0
0 $ 70 .0
0
Underlying Market Price ($/MWh)
$ 80 .0
0 $ 90 .0
0 $ 10 0.
00 69
Option Example: Long Call Option Natural Gas
70
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
Purchase a Call Option
What: Buy a $7.00/MMBtu Call Option for $0.73/MMBtu Why: To provide fuel price protection 72
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
$4.50
$5 .0
0 $5 .2
5 $5 .5
0 $5 .7
5 $6 .0
0 $6 .2
5 $6 .5
0 $6 .7
5 $7 .0
0 $7 .2
5 $7 .5
0 $7 .7
5 Underlying Market Price (MMBtu) $8 .0
0 $8 .2
5 $8 .5
0 $8 .7
5 $9 .0
0
73
Purchase of a $7.00 Call Option
Profit and Loss at Expiration $2.00
$1.00
$ $(1.00) $(2.00) 5.00
5.25
5.50
5.75
6.00
6.25
6.50
6.75
7.00
7.25
7.50
Market Price (MMBtu) 7.75
8.00
8.25
8.50
8.75
9.00
74
Option Example: Short Put Option Natural Gas
75
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.
76
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 77
Sale of a $6.00 Put Option
Purchase Price $8.00
$7.50
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
4.00
4.25
4.50
4.75
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
Underlying Market Price (MMBtu)
78
Sale of a $6.00 Put Option
Profit and Loss at Expiration $3.00
$2.00
$1.00
$ $(1.00) $(2.00) $(3.00) $(4.00) 3.00 3.25 3.50 3.75 4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25 6.50 6.75 7.00
Market Price (MMBtu)
79
Option Example: Long Collar
80
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 81
Long $7.00 Call and Short $6.30 Put Purchase Price of Natural Gas
$7.20
$7.00
$6.80
$6.60
$6.40
Gas cost will range from a minimum of $6.35/MMBtu (floor), to a maximum (cap) of $7.05/MMBtu $6.20
$6.00
4.00 4.25 4.50 4.75 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
Market Price (MMBtu)
82
Long $7.00 Call and Short $6.30 Put Profit & Loss at Expiration $2.00
$1.00
$ $(1.00) $(2.00) $(3.00) 4.00
4.25
4.50
4.75
5.00
5.25
5.50
5.75
6.00
6.25
6.50
Market Price ($/MMBtu) 6.75
7.00
7.25
7.50
7.75
8.00
83
Option Example: Long Call and Short Put Spread (3-Way)
84
Long Call and S hort 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.
85
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 86
Long $7.00 Call, Short $6.00 Put & Long $5.00 Put Purchase Price of Natural Gas $8.00
$7.50
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
8.50
9.00
Market Price (MMBtu) 9.50
10.00 10.50 11.00 11.50 12.00
87
Long $7.00 Call, Short $6.00 Put and Long $5.00 Put Profit and Loss at Expiration $2.00
$1.00
$ $(1.00) $(2.00) 4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
8.50
Market Price (MMBtu) 9.00
9.50
10.00
10.50
11.00
11.50
12.00
88
Option Example: Long Futures and Long Put (Synthetic Call)
89
Long Futures and Long Put
• Upside price protection is fixed • Purchasing a put option provides a floor for the value of the futures contract.
• This position is a synthetic call option • Future price and put option premium: – Long Jan Futures = $7.20/MMBtu – Buy $5.50 Jan Put = $.23/MMBtu 90
Long Futures and Long $5.50 Put Purchase Price of Natural Gas $7.00
$6.50
$6.00
$5.50
$5.00
$4.50
$4.00
3.50
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
Market Price (MMBtu) 8.50
9.00
9.50
10.00 10.50 11.00 11.50
91
Long Futures and Long $5.50 Put Profit & Loss at Expiration $3.00
$2.00
$1.00
$ $(1.00) $(2.00) 3.50
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
8.00
Market Price (MMBtu) 8.50
9.00
9.50
10.00
10.50
11.00
11.50
92
Hedging Strategies
93
Hedging Strategies – Part I Agenda
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
• • •
Long Hedging Example
1.
2.
3.
4.
Assume Utility ABC is long energy for a given month at a cost of $18.00/MWh Assume underlying market price for this month = $30.00/MWh Possible Hedges for Utility ABC include: Selling Forward at $30.00/MWh Selling an Out-of-the-Money Call Option with a $35.00/MWh strike price * Buying an Out-of-the-Money Put Option with a $25.00/MWh Strike Price * Selling Call and Buying Put to create a Short “Collar”
*
Selling Calls and Selling Puts generates premium revenue and reduces total net delta exposure, but does not provide price protection.
95
1. Forward Sale
Forward Sale at $30.00/MWh Sales Price Cost of Gen Transmission Net Margin $30.00/MWh $18.00/MWh $ 5.00/MWh $ 7.00/MWh 96
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) 97
2. Sale of a $35.00/MWh Call Option
• • • This is a “covered Call” since Utility ABC is long the energy The strike price is above Utility ABC’s cost of generation (of $18.00/MWh) Utility ABC will receive an option premium ($5.00/MWh) for the sale of this option 98
Short Call and Long Underlying
What: Own Generation at $18.00/MWh (long underlying) Sell a $35.00 Call Option for $5.00/MWh (short Call) (“Covered Call”) Why: To obtain Premium from the Sale of the Call Option (Premium can be used to offset overall energy costs) Note: Assuming gas is the marginal unit, consider purchasing a daily call option on gas (in order to hedge the potential fuel cost if and when the option is assigned).
99
Risks Associated with Sale of a Covered Call Option
• Price Risk/Opportunity Loss – The Call will only be exercised when the market price is higher than $35.00/MWh (ie: Utility ABC could otherwise be selling in the daily market at a price > $35.00/MWh on these days) • Operations Risk – If a unit fails (or system load is significantly greater than anticipated), Utility ABC may be unable to deliver the energy. A standard Call option is an “FLD” product. If Utility ABC does not deliver the energy, then they must pay the cost of replacing it in the market.
100
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$ $ 10 .0
0
Sale of a Covered Call Option
Sales Price
$ 15 .0
0 $ 20 .0
0 Sell at strike price of $35.00/MWh w hen market is > $35.00/MWh Sell in the market w hen market price is < $35.00/MWh $ 25 .0
0 $ 30 .0
0 $ 35 .0
0
Underlying Market Price ($/MWh)
$ 40 .0
0 $ 45 .0
0 101 $ 50 .0
0
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$ $(5.00) $(10.00) $ 10 .0
0
Sale of a Covered Call Option
Profit and Loss at Expiration
Capping Profit at $22.00/MWh (Market Price of $35.00/MWh) $ 15 .0
0 $ 20 .0
0 Breakeven at $13.00/MWh Market Price $ 25 .0
0 $ 30 .0
0 $ 35 .0
0
Underlying Market Price ($/MWh)
$ 40 .0
0 $ 45 .0
0 $ 50 .0
0 102
3.
Purchase a $25.00/MWh Put Option
• • • The purchase of a Put option provides Utility ABC with a floor for the sales price of this energy.
In return for the option premium ($3.00/MWh), Utility ABC locks in a minimum sales price (a floor) of $25.00/MWh for this block of energy.
This results in an effective price of no less than $22.00/MWh ($25.00 - $3.00 premium) for this block of energy.
103
Purchase of a Put Option and Long Underlying
WHAT: Long Underlying Generation at $18.00/MWh Buy a $25.00 Put for $3.00/MWh Premium WHY : To lock in a floor for the Sales Price of $25.00/MWh 104
$60.00
Long Put Option and Long Underlying Sales Price
$55.00
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Minimum Sales Price of $25.00/MWh $16.00
$22.00
$28.00
$34.00
Underlying Market Price ($/MWh)
$40.00
$46.00
$52.00
105
$15.00
Long Put Option and Long Underlying Profit and Loss at Expiration
$10.00
$5.00
$ $ 18 .0
0 $ 20 .0
0 $ 22 .0
0 $ 24 .0
0 $ 26 .0
0 $ 28 .0
0 $ 30 .0
0 $ 32 .0
0
Underlying Market Price ($/MWh)
$ 34 .0
0 $ 36 .0
0 $ 38 .0
0 $ 40 .0
0 106
4. Short Collar Sell a Call and Buy a Put
• Combining the Sale of a Call Option with the Purchase of a Put Option (and the long underlying) creates a “collar” • The long Put provides a floor for the sales price • The short Call limits or caps the sales price, but offsets the cost of the Put option.
• Premiums: Buy Put = $3.00
Sell Call = $5.00
107
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Collar Sales Price Long $25 Put, Short $35 Call & Long Underlying
Sell at floor of $25.00/MWh (exercising put) when market is < $25.00/MWh Sell at cap of $35.00/MWh (when call is exercised) 108
Underlying Market Price ($/MWh)
Collar Profit & Loss at Expiration Long $25 Put, Short $35 Call & Long Underlying
$25.00
$20.00
Margin ranges from a minimum of $9.00/MWh (floor), to a maximum (cap) of $19.00/MWh (with a generating cost of $18.00/MWh) $15.00
$10.00
$5.00
$ 109
Underlying Market Price ($/MWh)
Hedging Strategies – Part I Agenda
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) 110
Short Hedging Example
• • • 1.
2.
3.
4.
Assume Utility ABC is “economically short” energy for a given month, with a cost of generation for the next block of $60.00/MWh Assume underlying market price for this month = $30.00/MWh Possible Hedges for Utility ABC include: Purchasing Forward at $30.00/MWh Buying an Out-of-the-Money Call Option with a $35.00/MWh strike price Selling an Out-of-the-Money Put Option with a $25.00/MWh Strike Price Buying Call and Selling Put to create a long “Collar” 111
1. Forward Purchase
Forward Purchase at $30.00/MWh Cost of Gen Purchase Price Transmission Net Margin $60.00/MWh $30.00/MWh $ 5.00/MWh $ 25.00/MWh 112
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) 113
2. Purchase of a $35.00/MWh Call Option
• • • Provides price protection (a cap) for Utility ABC The strike price is below Utility ABC’s cost of generation (of $60.00/MWh) Utility ABC will pay an option premium ($5.00/MWh) for the purchase of this option 114
Purchase of a Call Option
What: Buy a $35.00/MWh Call Option for $5.00/MWh Why: To provide price protection 115
Purchase of a Call Option
Purchase Price
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$ $ 10 .0
0 $ 15 .0
0 $ 20 .0
0 $ 25 .0
0 $ 30 .0
0 $ 35 .0
0
Underlying Market Price ($/MWh)
$ 40 .0
0 $ 45 .0
0 $ 50 .0
0 116
Purchase of a Call Option
Profit and Loss at Expiration
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$ $(5.00) $(10.00) $ 10 .0
0 $ 15 .0
0 $ 20 .0
0 $ 25 .0
0 $ 30 .0
0 $ 35 .0
0
Underlying Market Price ($/MWh)
$ 40 .0
0 $ 45 .0
0 $ 50 .0
0 117
3. Sale of $25.00/MWh Put Option
• • The sale of a Put option obligates Utility ABC to purchase energy at the strike price of $25.00/MWh in return for the option premium of $3.00/MWh When the market is < $25.00/MWh, the Put will be exercised and Utility ABC will be obligated to purchase energy at $25.00/MWh 118
Comparison of a Forward Purchase and the Sale of a Put Option
• Both a forward purchase and the sale of a Put option involve
potential opportunity loss
(energy could be purchased for a lower price on the days the market is lower than the strike or forward price) • The difference is that a forward purchase is
“must take” energy
; energy will only be supplied by the Put option on the days when the market is lower • In return for this optionality, a
premium
collected with the sale of the Put option is 119
Risks of Selling a Put Option
• A Put option will only be exercised when the market is lower than the strike price, resulting in opportunity loss on the days it is exercised (e.g., Utility ABC could have purchased in the daily market for a lower price than the strike price on these days) • The strike price is still significantly less than Utility ABC’s cost of generation for the next block (e.g., $25.00MWh vs. $60.00/MWh) • Selling a Put option has downside risk which is significantly less in the electricity market than upside risk (e.g., floor of about $14.00/MWh) 120
Sale of a Put Option
WHAT: Next block cost of generation at $40.00/MWh Sell a $25.00/MWh Put for $3.00/MWh Premium WHY : To collect premium to offset purchase price of physical energy. Obligation to buy at $25.00/MWh is “economically attractive” for Utility ABC given their cost of generation. Net purchase price is $22.00/MWh.
121
Short Put Option Purchase Price
$60.00
$55.00
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Minimum Purchase Price of $25.00/MWh $16.00
$22.00
$28.00
$34.00
Underlying Market Price ($/MWh)
$40.00
$46.00
$52.00
122
Short Put Option Profit and Loss at Expiration
$15.00
$10.00
$5.00
$ $(5.00) $(10.00) $(15.00) $ 10 .0
0 $ 12 .0
0 $ 14 .0
0 $ 16 .0
0 $ 18 .0
0 $ 20 .0
0 $ 22 .0
0 $ 24 .0
0 $ 26 .0
0
Underlying Market Price ($/MWh)
$ 28 .0
0 $ 30 .0
0 $ 32 .0
0 $ 34 .0
0 123
4. Long Collar
• • Long Call and Short Put (at a lower strike) while being
short the Underlying (e.g., native load can be equated to being short a forward contract)
This position establishes a ceiling for the purchase price (cap of $35.00/MWh) Selling the Put option offsets the cost of the Call, but also establishes a minimum floor for the purchase price (Utility ABC will pay at least $25.00/MWh for this block of energy) 124
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Collar Purchase Price Short $25 Put, Long $35 Call & Short Underlying
Purchase at floor of $25.00/MWh (when put is exercised - i.e.: when market is < $25.00/MWh Purchase at cap of $35.00/MWh (when exercising the call)
Underlying Market Price ($/MWh)
125
$60.00
$55.00
$50.00
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Collar Profit & Loss at Expiration Short $25 Put, Long $35 Call & Short Underlying
Cost of $2.00/MWh (net option premiums) on days when neither the call nor put is exercised.
Underlying Market Price ($/MWh)
126