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
Identify Risks
Limit
Setting
Process
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
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.
28
How is Energy Traded?
Buys
Sells
Different Markets
• Exchange Traded
• Over the Counter
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 Counterparty 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
Derivatives
Options
Forwards
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
Natural Gas Forward Curve
As of Close April 17, 2007
Monthly Gas Forward Curve
Nov-11
May-11
Nov-10
May-10
Nov-09
May-09
Nov-08
May-08
Nov-07
May-07
$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
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 to
buy the underlying at a given price at the
buyer’s sole discretion.
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
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
Underlying Market Price ($/MWh)
$1
00
.0
0
$9
0.
00
$8
0.
00
$7
0.
00
$6
0.
00
$5
0.
00
$4
0.
00
$3
0.
00
$10.00
$2
0.
00
Purchase Price ($/MWh)
$50.00
68
Purchase of a Call Option
Profit and Loss at Expiration
$50.00
$45.00
$40.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$$(5.00)
Underlying Market Price ($/MWh)
$1
00
.0
0
$9
0.
00
$8
0.
00
$7
0.
00
$6
0.
00
$5
0.
00
$4
0.
00
$3
0.
00
$(10.00)
$2
0.
00
Profit / Loss ($/MWh)
$35.00
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
Gas Cost (MMBtu
$8.00
$7.50
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50
0
.0
5
$
5
0
5
.2
.5
.7
5
5
5
$
$
$
0
5
.0
.2
6
6
$
$
0
5
.5
.7
6
6
$
$
0
5
0
.0
.2
.5
7
7
7
$
$
$
5
0
.7
.0
7
8
$
$
5
0
5
.2
.5
.7
8
8
8
$
$
$
0
.0
9
$
Underlying Market Price (MMBtu)
73
Purchase of a $7.00 Call Option
Profit and Loss at Expiration
Profit / Loss ($MMBtu)
$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
7.75
8.00
8.25
8.50
8.75
Market Price (MMBtu)
74
9.00
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
Gas Cost (MMBtu
$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
Profit / Loss ($MMBtu)
$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
Purchase Price (MMBtu)
$7.20
$7.00
$6.80
Gas cost will range from a minimum of
$6.35/MMBtu (floor), to a maximum (cap) of
$7.05/MMBtu
$6.60
$6.40
$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
$2.00
Profit / Loss ($MMBtu)
$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 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.
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
Gas Purchase Cost (MMBtu)
$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
$2.00
P/L ($MMBtu)
$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
9.00
9.50
10.00
10.50
11.00
11.50
12.00
Market Price (MMBtu)
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
Gas Purchase Cost (MMBtu)
$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
8.50
9.00
9.50
10.00 10.50 11.00 11.50
Market Price (MMBtu)
91
Long Futures and Long $5.50 Put
Profit & Loss at Expiration
$3.00
P/L ($MMBtu)
$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
8.50
9.00
9.50
10.00
10.50
11.00
11.50
Market Price (MMBtu)
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
•
•
•
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:
1.
2.
3.
4.
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
Sale of a Covered Call Option
Sales Price
$50.00
$45.00
Sell at strike price of $35.00/MWh
w hen market is > $35.00/MWh
$35.00
$30.00
$25.00
$20.00
Sell in the market w hen market
price is < $35.00/MWh
$15.00
$10.00
$5.00
Underlying Market Price ($/MWh)
$5
0.
00
$4
5.
00
$4
0.
00
$3
5.
00
$3
0.
00
$2
5.
00
$2
0.
00
$1
5.
00
$-
$1
0.
00
Sales Price ($/MWh)
$40.00
101
Sale of a Covered Call Option
Profit and Loss at Expiration
$30.00
Capping Profit at $22.00/MWh
(Market Price of $35.00/MWh)
$20.00
$15.00
$10.00
$5.00
$$(5.00)
Breakeven at $13.00/MWh
Market Price
$5
0.
00
$4
5.
00
$4
0.
00
$3
5.
00
$3
0.
00
$2
5.
00
$2
0.
00
$1
5.
00
$(10.00)
$1
0.
00
Net Profit/Loss ($/MWh)
$25.00
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
Long Put Option and Long Underlying
Sales Price
$60.00
$55.00
$50.00
Sales Price ($/MWh)
$45.00
$40.00
Minimum Sales Price of
$25.00/MWh
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$16.00
$22.00
$28.00
$34.00
Underlying Market Price ($/MWh)
$40.00
$46.00
$52.00105
Long Put Option and Long Underlying
Profit and Loss at Expiration
Net Profit/Loss ($/MWh)
$15.00
$10.00
$5.00
$-
0
8.0
$1
0
0.0
$2
0
2.0
$2
0
4.0
$2
0
6.0
$2
0
8.0
$2
0
0.0
$3
0
2.0
$3
0
4.0
$3
0
6.0
$3
0
8.0
$3
0
0.0
$4
Underlying Market Price ($/MWh)
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
Collar Sales Price
Long $25 Put, Short $35 Call & Long Underlying
$45.00
Sell at cap of
$35.00/MWh (when call is
exercised)
$40.00
$30.00
$25.00
$20.00
Sell at floor of $25.00/MWh (exercising
put) when market is < $25.00/MWh
$15.00
Underlying Market Price ($/MWh)
108
$54.00
$52.00
$50.00
$48.00
$46.00
$44.00
$42.00
$40.00
$38.00
$36.00
$34.00
$32.00
$30.00
$28.00
$26.00
$24.00
$22.00
$20.00
$10.00
$18.00
Sales Price ($/MWh)
$35.00
Collar Profit & Loss at Expiration
Long $25 Put, Short $35 Call & Long Underlying
$25.00
$15.00
$10.00
$5.00
Underlying Market Price ($/MWh)
$54.00
$52.00
$50.00
$48.00
$46.00
$44.00
$42.00
$40.00
$38.00
$36.00
$34.00
$32.00
$30.00
$28.00
$26.00
$24.00
$22.00
$20.00
$$18.00
Net Profit/Loss ($/MWh)
$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)
109
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
•
•
•
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:
1.
2.
3.
4.
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
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
Underlying Market Price ($/MWh)
$5
0.
00
$4
5.
00
$4
0.
00
$3
5.
00
$3
0.
00
$2
5.
00
$2
0.
00
$1
5.
00
$$1
0.
00
Purchase Price ($/MWh)
$40.00
116
Purchase of a Call Option
Profit and Loss at Expiration
$30.00
$25.00
$15.00
$10.00
$5.00
$$(5.00)
$5
0.
00
$4
5.
00
$4
0.
00
$3
5.
00
$3
0.
00
$2
5.
00
$2
0.
00
$1
5.
00
$(10.00)
$1
0.
00
Net Profit/Loss ($/MWh)
$20.00
117
Underlying Market Price ($/MWh)
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 is
collected with the sale of the Put option
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
$50.00
Pruchase Price ($/MWh)
$45.00
$40.00
Minimum Purchase Price
of $25.00/MWh
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
122
$16.00
$22.00
$28.00
$34.00
Underlying Market Price ($/MWh)
$40.00
$46.00
$52.00
Short Put Option
Profit and Loss at Expiration
$15.00
$5.00
$-
$(5.00)
$(10.00)
Underlying Market Price ($/MWh)
$3
4.
00
$3
2.
00
$3
0.
00
$2
8.
00
$2
6.
00
$2
4.
00
$2
2.
00
$2
0.
00
$1
8.
00
$1
6.
00
$1
4.
00
$1
2.
00
$(15.00)
$1
0.
00
Net Profit/Loss ($/MWh)
$10.00
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
Collar Purchase Price
Short $25 Put, Long $35 Call & Short Underlying
$45.00
Purchase at cap of $35.00/MWh (when
exercising the call)
$35.00
$30.00
$25.00
$20.00
Purchase at floor of $25.00/MWh (when put is
exercised - i.e.: when market is < $25.00/MWh
$15.00
Underlying Market Price ($/MWh)
125
$50.00
$48.00
$46.00
$44.00
$42.00
$40.00
$38.00
$36.00
$34.00
$32.00
$30.00
$28.00
$26.00
$24.00
$22.00
$20.00
$18.00
$16.00
$14.00
$12.00
$10.00
$10.00
Purchase Price ($/MWh)
$40.00
Collar Profit & Loss at Expiration
Short $25 Put, Long $35 Call & Short Underlying
$60.00
$55.00
Cost of $2.00/MWh (net option
premiums) on days when neither the
call nor put is exercised.
$45.00
$40.00
$35.00
$30.00
$25.00
$20.00
Underlying Market Price ($/MWh)
$50.00
$48.00
$46.00
$44.00
$42.00
$40.00
$38.00
$36.00
$34.00
$32.00
$30.00
$28.00
$26.00
$24.00
$22.00
$20.00
$18.00
$16.00
$14.00
$10.00
$12.00
$15.00
$10.00
Net Profit/Loss ($/MWh)
$50.00
126