Ace in the hole

Energy traders use new tricks to manage risk

By April C. Murelio

Associate Editor

Before the 1992 Energy Policy Act and orders 888 and 889 by the Federal Energy Regulatory Commission (FERC), “price transparency” typically involved a few friendly phone calls between utility dispatchers.

Reminiscent of the hand-shake deal and a “game among gentlemen,” these power swaps noted on scraps of paper and dry erase boards seemed light years from OASIS (Open Access/Same Time Information System); NERC tags; the `98 June price spikes; and buzz phrases like the “seamless integration of all front-, mid- and back-office functions.”

Since March 1996, when the New York Mercantile Exchange launched the first electricity futures contracts, those on today`s trading floors say the game looks less like a rollicking hand of bridge and more like saloon poker, where everyone needs an Ace up the sleeve.

“See these gray hairs? I`m only in my 20s,” said an energy marketer from a Midwest trading house unwinding at a local club. “It gets so intense, and there`s so much at stake.”

As Gary L. Lavey, Ameren Energy`s credit risk management director, pointed out, the electricity market does indeed carry a substantial amount of risk. (See “The house that risk built”)

“Due to insufficient or, in some cases, nonexistent risk management practices, the utility and power marketing industry suffered more than $500 million in losses. Since then, credit and risk management ranks as a top priority,” Lavey said.

“Establishing a risk management function requires a great deal of time, effort and expertise. However, as some companies discovered, it can be priceless.”

The info ace

Before June 1998, when electricity prices spiked to more than $7,000/MW, many trading floors anticipated “some type of volatility” and hit pay dirt with early efforts to manage risks with new tools and methods for price discovery and counterparty credit verification.

During an industry gathering last October, Dean Jones, vice president of gas and power origination for Williams, quipped, “Although I hate to say it, those who lost big just weren`t paying much attention, or they didn`t have all the information. We did fairly well.”

With remarkable clarity, those traders and chief executives who “weren`t paying attention,” can today point to the exact moment and skyrocketing price in June when they realized information is the Ace.

Through the tribulations of price spikes, the industry took an evolutionary leap, with information and its management now crucial to buying and selling electricity and warding away risk.

Andrew S. Lese, a partner with Ernst & Young`s risk management and regulatory practice, said one of the most important bits of information involves understanding the company`s current exposure and risk tolerance and how it relates to and changes with the risks inherent in the energy market and the company`s strategic direction.

“The risk tolerance for a company focusing on a national marketing strategy will be very different from one focusing on being an efficient transmission and distribution company,” Lese said. “Developing a risk profile, therefore, requires an in-depth understanding of the company`s strategies, its projected fuel inputs and power output, and the structure of the contracts surrounding these exposure factors.”

In some ways, he said a company`s operations must be viewed as a portfolio of businesses, each with its own risk/return profile. By evaluating how these activities fit their strategic directions and risk tolerance, management can determine how to effectively structure the company.

Derek Porter, with Henwood Energy Services, Inc. (HESI), said today`s market risks fall into three general segments: wholesale, retail and asset management, with the latter two gaining influence as the retail market develops and generation divestitures turn traditional utilities into energy service companies (ESCOs).

“The traditional utility is used to having the long position, but as it divests its generation assets, it essentially becomes an ESCO,” Porter said. “ESCOs have a contractual obligation to serve, and they need to determine how to do that and make a profit.”

To hedge their risks, Porter said, ESCOs need:

– A supply procurement strategy that draws from a variety of sources.

– They must understand the dollar risks involved and the need to mitigate those with tools like weather derivatives, which “take the sting out of options.”

– And because ESCOs continuously add and change customers, they need tools in place that accurately forecast their positions daily, monthly, yearly, and beyond.

For those hanging on to the assets, Porter said they must develop their trading strategies around those assets, looking 10 years or more into the future.

As they look into the future, he said asset managers should consider several factors, including how the asset will be used as the market rules and dynamics change, how products like ancillary services need to evolve in response to those changes, and how new environmental regulations will unfold.

“What happened last year woke up a lot of boards, but the industry continues to change so fast,” Porter said. “To manage the risks involved, you need to have the information, know what your needs are, and understand how that changes daily.”

The info deck

But as Dragana Pilipovic of SAVA Risk Management explained in her book, Energy Risk: Valuing and Managing Energy Derivatives, electricity trading remains a market caught somewhere between infancy and adolescence, which presents those involved a relatively thin deck of information from which to draw.

“Unfortunately, energy`s relative youth presents a classic paradox: How can one price new products without having price histories and readily available market prices for benchmarks?” Pilipovic said. “There is not enough spot and forward price information flowing through the market to establish a universally agreed-upon understanding of fundamental price drivers or the quantitative pricing methodologies. The lack of liquidity frustrates the process of price discovery.”

Pilipovic described liquidity as the “lifeblood of risk management.” And the ability to keep the blood pumping through this young market seems further challenged by its decentralized structure.

By comparison, the financial markets remain centralized in terms of location, capital, expertise, and contract structure. For example, local, regional and national banks and financial institutions primarily look to Wall Street, Chicago, and other major trading centers to hedge their portfolios, with a dollar worth a dollar anywhere in the country.

However, the energy market`s decentralization, Pilipovic said creates a unique geographic “basis risk.” Because electricity prices depend on delivery points, location remains a fundamental driver of price.

“While many producers and end users may actively use futures contracts in New York and Kansas City, these contracts represent prices at specific delivery points that may behave very differently from the local market being hedged,” she said.

Even the job descriptions and diverse experience levels of those involved with risk management send mixed signals to the market. From large end users and small municipals to Duke Energy and Southern Company, power traders maintain energy purchasing officers and wholesale analysts on one end of the spectrum, and full trading and risk management staffs at the extreme. Those filling these roles come from trading, risk management, corporate treasury, and engineering backgrounds.

Finally, those who use financial derivatives find that simple forwards, swaps, caps, floors, and swaptions meet most of their needs, but the energy commodity requires far more customization, which leads to the type of sophisticated risk management and modeling strategies discussed in the next section.

“These market inefficiencies will be resolved with time, of course, as grow- ing market understanding takes place,” Pilipovic said. “But until then, the market will reflect a wide degree of inconsistency.”

Adding cards

As energy trading matures and liquidity and competitiveness increase, immediate access to accurate and comprehensive pricing and transaction data becomes imperative. Several indices designed to clear the muddy waters of price transparency now exist, with one of the most comprehensive additions announced recently by PricewaterhouseCoopers.

Although traders and risk managers access prices on regulated futures exchanges like NYMEX and the Chicago Board of Trade (CBOT), most market activity occurs over the counter (OTC). Joining forces with Amerex, Natsource and Prebon Yamane, which broker about two-thirds of all OTC transactions in the U.S., PricewaterhouseCoopers now offers the Next Day PowerTrax Index. An index for natural gas trades is also planned.

J.C. Whorton of PricewaterhouseCoopers, and Mike Moore, a principal with Amerex in Houston, said the information contained in this type of index enhances a trader`s ability to make strategic and investment decisions and appropriately evaluate risks.

“Every time a broker closes a deal, it`s like taking a snapshot of the market,” Moore said. “You must have access to historical data to predict the future.”

Amid the columns and numbers, energy traders find the basis for more accurate daily mark-to-market and settling swaps. Other key uses include: value power purchases and sales; plot forward prices; determine weekly, monthly, quarterly, and annual average prices; validate compliance with FASB 133; and support other regulatory filings.

Brokers like Natsource and HESI, a software and risk management consulting firm, also increasingly offer a variety of services or new cards for the info deck. Examples include database maintenance, market simulation systems, weather hedging services, and research support for developing risk management strategies.

“In the past, wholesale power traded in isolation,” said Jack Cogen, Natsource president. “Today, risk management means taking all products-coal, gas, electricity, emissions, etc.-and placing them under one umbrella. None of these move in isolation, and if you think of them as a spread, you get more out of it.”

New tricks

Electricity`s tie to weather conditions and seasonal demand-easily demonstrated by the growing popularity of weather derivatives-makes it far more volatile than any other commodity, stock or bond. Because of this, any option pricing model based on a frictionless environment, such as the Black-Scholes model, typically no longer applies.

Recognizing this, some trading floors are shedding the old methods and using a few new tricks. Still, traditions die hard, with only a handful truly exploring option evaluation methods other than Black-Scholes, a formula used to calculate the fair value of an option.

All models use simplifying assumptions, which, at times, fail to address key market features like volatility. For example, Black-Scholes assumes stock prices retain constant volatilities, so the randomness exhibited by stock prices should always have the same magnitude. But in the electricity market, out-of-money options that, according to the Black-Scholes model, should have zero value often trade for more than $1/Mwh.

“Huge sums of money have been lost or wasted because stochasitic process does not provide truly accurate information,” said Steven M. Rideout, managing director of Integrated Energy Services, a risk management consulting firm. “This old technology relies on probability distributions and volatility measurements, assuming the future will look like the past.”

Rideout said stochastic process doesn`t predict whether the market will go higher or lower, with price movement remaining its only concern. With this information, traders buy or sell options based on the price ranges given in the probability distribution, and this process must be repeated for each isolated cash flow.

In response to the limitations of these old methods, Rideout said Integrated Energy Services turned to a risk management tool called P-28, a new, physics-based technology. The science underlying P-28 is described in a book by Dr. Valery A. Kholodnyi, Beliefs-Preferences Gauge Symmetry Group and Replication of Contingent Claims in a General Market Environment.

When pricing options, Rideout said P-28 doesn`t isolate the cash flow but uses all relevant market data, including the prices for all available liquid options and liquid underlying securities for all available delivery months and locations.

The option prices with different strike prices surrounding any single cash flow are tied together by a specific group of symmetries. These symmetries-known as put-call symmetry or the no-arbitrage tenet-are basic parts of stochastic process. However, when using these symmetries, stochastic process (Black-Scholes) destroys another, more universal set of symmetries fundamental to P-28, he said.

“Describing how it works is similar to explaining quantum mechanics and Einstein`s unified field theories. In fact, Einstein used gauge symmetry, and Maxwell used it to define his classical electromagnetic equation,” Rideout said.

“But it`s not an academic model that deals only with hypothetical numbers far removed from the real world. As markets develop and offer more liquid vehicles, these new technologies will continue to improve as pricing models.”

By combining quantitative finance, microeconomics, physics and math, P-28 and other sophisticated models seem in many respects to be the electricity industry`s next best bet. However because it`s still early in the game, it remains to be seen whether the risk management tools of today will prove an ace in the hole or a deck full of jokers.

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