A Utility’s use of Financial Products
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February 6, 2012
Derivative
(Financial Product)
 A security whose price is dependent upon or derived from one or
more underlying assets.
 A contract between two or more parties
 Common underlying assets
 Stocks
 Bonds
 Commodities
 Currencies
 Interest rates
 Market indexes
Reference: Investopedia.com
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Three Basic Uses of Derivatives
1. Speculation
 Attempts to make money based on predicted moves in the
market
2. Arbitrage
 Arbitrage occurs when an investor can take a position for
no cost, with no risk, and make a positive profit
3. Hedging
 Goal is Risk Minimization
 Company or individual already has a position in the market
and uses forwards, futures, options, to minimize risk
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Arbitrage
 Interstate Natural Gas Pipeline Capacity
 Locational spread
 Purchase in location “A” transport and sell in location “B”
 Natural Gas Underground Storage
 Time spread
 Purchase in time period “A” hold in storage and sell in time period “B”
 Power generator
 Tolling (spark spread)
 Purchase fuel and sell power
 Refinery
 Refining Spread (Crack spread)
 Purchase crude oil and sell refined products (heating oil, gasoline, jet fuel)
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Effective Use of Derivatives
 First determine what are the risks.
 Are the risks quantifiable?
 timing and amount
 Make sure the hedge matches your risk or that you
understand when and where it doesn’t match your risk.
 Shift risk to other market participants
 What are the costs to execute the hedge?
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Futures vs. OTC
 New York Mercantile Exchange (NYMEX)
 Standardized natural gas futures and options contracts
 10,000 dt per contract
 Priced for purchase or delivery at Henry Hub, LA
 No credit exposure; post margins
 Trade via Introducing Broker or directly with the floor
 Settled monthly on third to last business day
 Over-the-Counter
 Terms customized to individual customer needs
 Counterparty credit exposure
 Bilateral ISDA master agreements
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Basic Financial Instruments
 Swaps, (Fixed price, Futures)
 A swap is an obligation on both parties’ part
 Options
 Puts (Floor)
 Calls (Ceiling or cap)
 An option is a right, but not an obligation for one party
(buyer); and an obligation for the other party (seller)
 Options are price insurance
 Premiums are paid to purchase insurance
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Financial Products
 Input graph of various derivative %
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Absolute Price Risk
 Reduce price volatility
 Residential heating and electric customers
 Budget
 Certainty to future costs
 Maintain competitiveness
 Airlines
 Fertilizer manufacturers
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Why use financial products?
 Standardized contracts
 Market liquidity
 Disconnect price from physical delivery
 Better pricing
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Physical to Financial Correlation
 Input gas slide
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Hedge Example with Swap
On October 27th: Market is at $8.00
$8.00
$8.00
$6.00
$/dt
• Buy a November 2012 swap contract
for $6.00 settled against index.
• Utility purchases gas from producers
for delivery in November at index.
$6.00
$4.00
$2.00
$2.00
$Physical
Financial
Net
Market at $4.00
 Results
$8.00
 Protected against adverse
price movement
$4.00
$4.00
$/dt
 Removed volatility from price
$6.00
$6.00
$5.00
$Physical
Financial
Net
$(2.00)
$(2.00)
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Natural Gas Physical and Financial Settlement
Counterparty
Pay Fix Price
Receive Floating Price
(NYMEX last day)
Receive Physical Gas
-$6.00
Gas Producer/
Supplier
+$8.00
Utility
-$8.00
Pay Floating Price
(Index Price)
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Swaps vs. Options
 Buying swaps commits you to fixed price
 Options give the buyer price security and also the benefit of
potentially more favorable prices in the future.
 The party buying the insurance pays a premium because they
receive something of value.
 Examples
 Calls are purchased to have the right to pay a fixed price but
not the obligation. (Consumer calls)
 Puts are purchased to have the right to receive a fixed price
but not the obligation. (Producer puts)
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Option Terminology
 Strike Price - the price beyond which the buyer of the
option benefits
 Premium - what the buyer pays for the option
 Pay off - the benefit received by the option buyer
 Difference between strike and settled price
Note: The customer may specify either the strike
price or the premium. Once you know one, the other
is calculated based upon market levels.
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Types of Option Settlements

Options should match the physical and pricing
aspects of your portfolio
 European – exercised only on the expiration date
itself
 American – exercised any time up to the expiration
date
 Asian – average price options
Hedge Example with Call
On October 27th, Market is at $8.00
$8.00
$8.00
$6.80
$6.00
$/dt
• Buy November 2012 $6.00 Call option
for $0.80 premium, settled against
NYMEX last day (index).
• Utility purchases gas from producers
for delivery in November at index.
$4.00
$2.00 less $0.80
$2.00
$Physical
Financial
Net
Market at $4.00
 Results
$8.00
 Protected against price
spike
$4.80
$4.00
$4.00
$/dt
 Participate in downward
price moves.
$6.00
$5.00
$Physical
Financial
Net
$(1.00)
$(0.80)
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Hedge Example with Collar
On October 27th, Market is at $8.00
• Buy November 2012 Collar: buy a
$8.00
$8.00
$6.50
$6.00 Call option and sell a $5.00 Put for
$0.50 premium.
• Utility purchases gas from producers
for delivery in November at index.
• Results
- Protected against price spike
- Set floor price.
$/dt
$6.00
$4.00
$2.00 less $0.50
$2.00
$Physical
Market at $5.25
$8.00
$6.00
$6.00
$5.75
$5.50
$4.00
$5.25
$4.00
$/dt
$4.00
$/dt
Net
Market at $4.00
$8.00
$5.00
$-
$5.00
$-
Physical
$(0.50)
Financial
Financial
Loss of $0.50
Net
Physical
Financial
Net
$(1.50)
Loss of $1.00 plus $0.50
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Power Generation - Spark Spread
 A spark spread is the price difference between the fuel cost input
and market price for electricity.
 Example
 Sell July power for $50/MWh
 Hedge $4/MMbtu natural gas fuel for July 2012, converted to
$40/MWh*
Power price
$50/MWh
Fuel price
$40/MWh
Spark Spread
$10/MWh
* Assumed heat rate of 10,000 Btu’s per MWh
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Crude Oil Prices
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Brent/WTI Spread
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Dodd Frank Impact to Energy Industry
 No impact to exchange traded transactions executed on NYMEX
 Creation of swap repository
 Clear all transactions
 Margin requirements
 Real time reporting
 Increased recordkeeping
 Market participants to registration with CFTC
 End user exemption
 Provide financial security documentation
 Guarantee, LOC, credit support agreement, pledged asset
 Establish position limits
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