New Tools of the Risk Trade

BY
SALLY STEWART
PRODUCT MANAGER, RISK OF TRANSENERGY MANAGEMENT INC.
(originally published by PMA OnLine Magazine: 07/98)

As the structure of electricity industry unbundles, specialized market sectors wield more sophisticated Wall Street-savvy financial tools and trading systems.

As regulatory change hammers and splinters apart the generation, transmission, marketing and distribution functions of the electricity industry, newly created niche market sectors are looking to help nail down risk with very sophisticated and specialized risk management tools. Despite the chiseled-down functions of these new market sectors, each sector’s ability to identify and manage risk will determine its foothold in the deregulated future.

Within this evolving "new world" order, companies will need to determine what type(s) of risks – research and development, credit, operational (transmission, distribution), market (fuel cost fluctuations, price exposure), marketing, legal, customer service, customer aggregation (retailing function), regulatory – they are willing to accept and manage. In the end, utilities and energy conglomerates will be forced to determine: "What business do we want to be in?" and "What risks do we want to take on?"

Commodity Management and Cross-Over

After a company has decided to take on and manage the mercurial commodities of energy – electricity, natural gas, coal – it should thoroughly evaluate each commodity’s unique market risk and physical properties. Electricity, especially, offers a number of challenges that are not apparent in other energy commodities. Unlike the comforting ability to store natural gas to counter market upswings or dips, non-storable electricity by its sheer physical make-up, exacts a minute-by-minute demand. Consequently, electricity is branded as the most challenging commodity to manage. Not only is the power industry faced with price volatility, as seen in other emerging markets, the physical properties of power (electricity is "consumed" as it is generated) offers less flexibility in managing trading positions. Embedded options are often a significant component of physical power trades, providing traders with the ability to shift on receipt and delivery alternatives.

Yet another property that differentiates electricity from other commodities is its hourly increments of receipts and deliveries. Due to this hourly segmentation, the sheer volume of components for each trade is significantly larger in power trading than in other commodities. As market niches develop further, the level of resolution in power trading will likely become even finer.

Pushing the challenge further, the feedstock for electricity is other energy commodities, making cross-commodity arbitrage crucial. A prudent tool in successful cross-commodity trading is a company’s ability to manage a "Btu Book," positions stated in equivalent units of measure, used specifically for cross-commodity trading. When assessing a deal – in coal, electricity, natural gas – the Btu Book can help traders calculate how a trade breaks down into a single common denominator of Btu units.

To derive power prices from natural gas prices, the gross power cost equals the gas cost multiplied by the heat rate; the net power cost equals the gross power cost (plus the tolling cost and cost of transmission). The spark spread, or the difference between the price of gas and the price of electricity at specified heat efficiencies, is fast becoming a favorite tool among energy traders.

Also opening up exciting new opportunities in the energy marketplace is the practice of coal tolling. Coal tolling, the conversion of coal to electricity for a fee, is currently making an attention-grabbing debut in power marketing. The tolling of coal gives marketers, suppliers and generators a solid opportunity to manage the disparity between coal and electricity prices while providing liquidity to use the volatility between the two commodities.

Already, the segregated and clear-cut boundaries between energy sources are becoming blurred, somewhat indistinct. In the not-so-distant future, it will become commonplace to routinely substitute and trade one form of energy for another, without ever first considering the diverse physical properties of each commodity.

Wall Street Savvy

Due in part to the influx of Wall Street-savvy traders, marketers and arbitrageurs into the electricity industry, the buzz of water-cooler talk now includes the likes of "floors, caps, collars, lookbacks and butterflies."

In short order, energy trading has accelerated from plain vanilla to increasingly exotic flavors of options, risk management and hedging techniques like:

• Lookback – an option that grants the holder the right to buy at the lowest referenced price or sell at the highest referenced price reached, during the life of the option ( an option is a contract that gives the holder the right, but not the obligation, to buy or sell at a certain price prior to or upon an agreed date).
  
  
• Floor – an option contract which sets a minimum sales price for the holder. By establishing a minimum sales price, the holder is protected against falling commodity prices.
  
  
• Cap – also known as a ceiling, is an option which sets a maximum purchase price for the holder. By establishing a maximum price to be paid, the holder is protected from rising commodity prices.
  
  
• Collar – an option position which combines a floor and a cap; establishing commodity price settlements within a defined range. A producer may use a collar to protect against declining commodity prices by limiting the extent of upside benefits related to market increases. With a zero or "costless collar", the strike prices for the floor and cap are set so that the premium charges are eliminated.
  
  
• Barrier Option – an exotic option which is enacted (known as "Knock-in") or terminated (known as "Knock-out") as referenced prices reach specified levels in the contract.
  
  
• Swaptions – an option to purchase or sell a swap at some future date and may include the ability to increase or decrease the swap volume or increase the period of the swap.
  
  
• Double Downs – a swap with an embedded option that allows the seller to reduce the notional quantity of the contract. In exchange, the holder receives a more desirable price. A Double Up is the reverse scenario.
  
  
• Trigger Deal – a form of option, which allows the holder to set a deal price, based on an exchange-traded commodity price.
  
  
• Butterfly Spreads – the simultaneous sale of an at-the-money straddle (a straddle is the combo of a put and a call with the same expiration date and the same strike price) and the purchase of an out-of-the-money strangle (a strangle is the combo of a put and call with the same expiration date, but different strike prices) reducing the risk of market movements to a fixed amount.

Another risk management tool plied by the financial community, and recently employed by the energy community, is Value-at-Risk (VAR). A statistical measure of the largest likely loss expected over a given time with a given probability, Value-at-Risk calculates commodity risk exposure from trading activities. VAR methodologies model how market factors will change over the time the trading company holds a commodity position, and how these changes affect each other. The VAR analysis can assist energy traders, risk managers and upper management professionals evaluate the impact of these changes on the company’s portfolio.

For example, if a firm estimates its VAR over 1 week to be $5 million with a 95% confidence level, the company then would be expected to lose less than $5 million for 95 weeks out of 100. This estimate is based on the market conditions and composition of the portfolio at the time of the calculation. Since these parameters are constantly changing, most companies are performing VAR calculations on a daily basis. Particularly for upper management, VAR can be used to report risk, define risk-reward ratios of trading desks and evaluate trader performance.

Value-at-Risk determines commodity risk exposure from trading activities through the principal methods of Monte Carlo simulations, estimated variance-covariance (correlation or short-term variation) and historical simulations. Statistical methods may be supplemented with stress tests, or worst-case/ "what if" scenario testing. The choice among the various VAR methodologies largely depends upon the composition and complexity of a company’s portfolio. Many of the VAR methodologies are currently packaged in a widening cyber-genre of energy risk management software systems.

Commodity Trading Tools

From power marketers or arbitrageurs who buy and sell electricity as a commodity, to the new marketing division of unbundled utilities, to retail level distribution companies, it is clear that commodity trading systems will play a key role in the successful development of each organization. The "real-time" trading dynamics of this evolving market has resulted in a demand for a whole new breed of trading systems. Not only do the information requirements differ for the specialized units, the complexities of the power industry place even higher demands on finding successful commodity trading solutions.

In order to meet the needs of power marketers or arbitrageurs, a commodity trading system may be adequate if it aggregates physical and financial positions from a standard product perspective for the forward months, with the ability to query non-standard positions. However, for spot month trading, the power marketer requires the commodity trading system to support physical and financial position management on an hourly basis. With this level of resolution, traders can assess the impact of standard and non-standard product positions with schedulers completing physical receipt and delivery transactions.

In contrast, the commodity system requirements of a power marketing arm of a utility are far more comprehensive than that of a power arbitrageur. The hourly resolution of both physical and financial positions for all forward periods is essential to this type of organization. With this level of resolution, the trades are disaggregated into the individual risk components for specific time periods, so the system must be robust. Also, many of these organizations have portfolios well beyond the one-year time frame, so the ability to disaggregate the risks, and then aggregate on selected criteria is critical for traders and risk managers, since this level of resolution quickly becomes impossible to manage. Additionally, real-time position updates of a trading system is a necessary feature for these organizations as they assess trading strategies, power supply and wheeling capabilities with market opportunities.

In effect, a first-rate energy trading system must integrate both derivatives and physical trades for risk management in a real-time environment in order to meet the demands of the marketplace. Further, a command of the complexities of scheduling receipts, deliveries and transmission of the underlying commodity is essential. The commodity trading system that offers the ability to manage a Btu Book, incorporating multiple commodities and risks, is the wave of the future.

In the soon-to-be restructured U.S. power market, competition and sheer market force will make the industry more efficient by carving out specialized niches and widening the assortment of risk management tools and trading systems. With certainty, the current spin-off of previously integrated business functions will continue, as organizations shed more and more risks that no longer fit into the "new world" corporate risk strategy.

Sally Stewart is Product Manager of Risk of TransEnergy Management Inc., a software development company, offering integrated energy trading systems. Transenergy's website can be located at http://www.transenergy.com