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A Utility’s use of Financial Products

February 6, 2012

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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 indexesReference: 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

Results

Protected against adverse price movement

Removed volatility from price

• Buy a November 2012 swap contract

for $6.00 settled against index.

• Utility purchases gas from producers for delivery in November at index.

$8.00

Physical

$2.00

Financial

$6.00

Net

On October 27th: Market is at $8.00

$-

$2.00

$4.00

$6.00

$8.00

$/d

t$4.00

Physical

$(2.00)

Financial

$6.00

Net

Market at $4.00

$(2.00)

$-

$5.00

$4.00

$6.00

$8.00

$/d

t

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Natural Gas Physical and Financial Settlement

Counter-party

UtilityGas Producer/

Supplier

Receive Floating Price (NYMEX last day)

Pay Fix Price

Receive Physical Gas

Pay Floating Price(Index Price)

+$8.00-$6.00

-$8.00

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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.

04/20/23

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

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Hedge Example with Call

Results

Protected against price spike

Participate in downward price moves.

• 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.

$8.00

Physical

$2.00 less $0.80

Financial

$6.80

Net

On October 27th, Market is at $8.00

$-

$2.00

$4.00

$6.00

$8.00

$/d

t$4.00

Physical

$(0.80)

Financial

$4.80

Net

Market at $4.00

$(1.00)

$-

$5.00

$4.00

$6.00

$8.00

$/d

t

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Hedge Example with Collar

• Buy November 2012 Collar: buy a $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.

$8.00

Physical

$2.00 less $0.50

Financial

$6.50

Net

On October 27th, Market is at $8.00

$-

$2.00

$4.00

$6.00

$8.00

$/d

t$4.00

Physical

Loss of $1.00 plus $0.50

Financial

$5.50

Net

Market at $4.00

$(1.50)

$-

$5.00

$4.00

$6.00

$8.00

$/d

t

Market at $5.25

$(0.50)

$-

$5.00

$4.00

$6.00

$8.00

$/d

t

$5.25

Physical

Loss of $0.50

Financial

$5.75

Net

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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