Use and Effects of Energy

Derivatives
 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 Quantify Risks

Setting
Process 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 Long Natural

Natural Gas 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
33
• Margin Provisions
 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
 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

M onthly Gas Forward Curve

$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
Nov-07

Nov-08

Nov-09

Nov-10

Nov-11
May-07

May-08

May-09

May-10

May-11
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
62
• Unprofitable Underlying Position
 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

$45.00
Purchase Price ($/MWh)

$40.00

$35.00

$30.00

$25.00

$20.00

$15.00

$10.00

68
Underlying Market Price ($/MWh)
 Purchase of a Call Option
Profit and Loss at Expiration
$50.00

$45.00

$40.00

$35.00

$30.00
Profit / Loss ($/MWh)

$25.00

$20.00

$15.00

$10.00

$5.00

$-

$(5.00)

$(10.00)

69
Underlying Market Price ($/MWh)
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
Gas Cost (MMBtu

$7.50
$7.00
$6.50
$6.00
$5.50
$5.00
$4.50

Underlying Market Price (MMBtu)

73
 Purchase of a $7.00 Call Option
Profit and Loss at Expiration

$2.00
Profit / Loss ($MMBtu)

$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 9.00
M arket Price (M M Btu)
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
Gas Cost (MMBtu

$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

$3.00
Profit / Loss ($MMBtu)

$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 Gas cost will range from a minimum of

$6.35/MMBtu (floor), to a maximum (cap) of
Purchase Price (MMBtu)

$7.05/MMBtu
$6.80

$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

$1.00
Profit / Loss ($MMBtu)

$-

$(1.00)

$(2.00)

$(3.00)
4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 8.00
Market Price ($/MMBtu) 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

$7.50

$7.00
Gas Purchase Cost (MMBtu)

$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 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

$1.00
P/L ($MMBtu)

$-

$(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
$7.00

$6.50
Gas Purchase Cost (MMBtu)

$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

$2.00
P/L ($MMBtu)

$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. Selling Forward at $30.00/MWh
2. Selling an Out-of-the-Money Call Option with a $35.00/MWh
strike price *
3. Buying an Out-of-the-Money Put Option with a $25.00/MWh
Strike Price *
4. 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 $30.00/MWh

Cost of Gen $18.00/MWh
Transmission $ 5.00/MWh
Net Margin $ 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
$50.00
Sales Price
$45.00 Sell at strike price of $35.00/MWh
w hen market is > $35.00/MWh
$40.00

$35.00
Sales Price ($/MWh)

$30.00

$25.00

$20.00

Sell in the market w hen market

$15.00
price is < $35.00/MWh

$10.00

$5.00

$-
00

00

00

00

00

00

00

00

00
0.

5.

0.

5.

0.

5.

0.

5.

0.
$1

$1

$2

$2

$3

$3

$4

$4

$5
Underlying Market Price ($/MWh) 101
 Sale of a Covered Call Option
Profit and Loss at Expiration
$30.00
Capping Profit at $22.00/MW h
(Market Price of $35.00/MW h)
$25.00

$20.00
Net Profit/Loss ($/MWh)

$15.00

$10.00

$5.00

$-

$(5.00)
Breakeven at $13.00/MW h
Market Price
$(10.00)

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
$60.00
Sales Price
$55.00

$50.00

$45.00
Sales Price ($/MWh)

$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 $40.00 $46.00 $52.00105

Underlying Market Price ($/MWh)

 Long Put Option and Long Underlying
Profit and Loss at Expiration

$15.00
Net Profit/Loss ($/MWh)

$10.00

$5.00

$-

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
$40.00 $35.00/MWh (when call is
exercised)

$35.00
Sales Price ($/MWh)

$30.00

$25.00

$20.00
Sell at floor of $25.00/MWh (exercising
put) when market is < $25.00/MWh

$15.00

$10.00
$18.00

$20.00

$22.00

$24.00

$26.00

$28.00

$30.00

$32.00

$34.00

$36.00

$38.00

$40.00

$42.00

$44.00

$46.00

$48.00

$50.00

$52.00

$54.00
Underlying Market Price ($/MWh) 108
 Collar Profit & Loss at Expiration
Long $25 Put, Short $35 Call & Long Underlying
$25.00
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)
$20.00
Net Profit/Loss ($/MWh)

$15.00

$10.00

$5.00

$-
$18.00

$20.00

$22.00

$24.00

$26.00

$28.00

$30.00

$32.00

$34.00

$36.00

$38.00

$40.00

$42.00

$44.00

$46.00

$48.00

$50.00

$52.00

$54.00
Underlying Market Price ($/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. Purchasing Forward at $30.00/MWh
2. Buying an Out-of-the-Money Call Option with
a $35.00/MWh strike price
3. Selling an Out-of-the-Money Put Option with
a $25.00/MWh Strike Price
4. Buying Call and Selling Put to create a long
“Collar”
111
1. Forward Purchase

Forward Purchase at $30.00/MWh

Cost of Gen $60.00/MWh

Purchase Price $30.00/MWh
Transmission $ 5.00/MWh
Net Margin $ 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

$35.00
Purchase Price ($/MWh)

$30.00

$25.00

$20.00

$15.00

$10.00

$5.00

$-

116
Underlying Market Price ($/MW h)
 Purchase of a Call Option
$30.00
Profit and Loss at Expiration

$25.00

$20.00
Net Profit/Loss ($/MWh)

$15.00

$10.00

$5.00

$-

$(5.00)

$(10.00)

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

119
collected with the sale of the Put option
 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

$45.00
Pruchase Price ($/MWh)

$40.00
Minimum Purchase Price
of $25.00/MWh
$35.00

$30.00

$25.00

$20.00

$15.00
122
$10.00 $16.00 $22.00 $28.00 $34.00 $40.00 $46.00 $52.00

Underlying Market Price ($/MWh)

 Short Put Option
$15.00
Profit and Loss at Expiration

$10.00
Net Profit/Loss ($/MWh)

$5.00

$-

$(5.00)

$(10.00)

$(15.00)

123
Underlying Market Price ($/MW h)
 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

$40.00 exercising the call)

$35.00
Purchase Price ($/MWh)

$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

$10.00
$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

$22.00

$24.00

$26.00

$28.00

$30.00

$32.00

$34.00

$36.00

$38.00

$40.00

$42.00

$44.00

$46.00

$48.00

$50.00
Underlying Market Price ($/MWh)
125
 Collar Profit & Loss at Expiration
Short $25 Put, Long $35 Call & Short Underlying
$60.00

$55.00

$50.00 Cost of $2.00/MW h (net option

premiums) on days when neither the
$45.00 call nor put is exercised.
Net Profit/Loss ($/MWh)

$40.00

$35.00

$30.00

$25.00

$20.00

$15.00

$10.00
$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

$22.00

$24.00

$26.00

$28.00

$30.00

$32.00

$34.00

$36.00

$38.00

$40.00

$42.00

$44.00

$46.00

$48.00

$50.00
Underlying Market Price ($/MW h) 126