Common Energy Derivatives and Their Use to Manage Risk

Presenter: Jeff Jewell, DTE Energy

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Agenda

► Common Derivative Structures► Common Energy Products► Common Risk Management Strategies

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Common Energy DerivativesPhysical vs. Financial Contracts

►Physical transaction► A contract in which the actual (physical) commodity is transferred

between parties to the contract. (i.e., Party A sells and delivers gas to Party B)

►Financial transaction► A contract in which no commodity is transferred between parties and

parties only exchange cash payments in amount equal to the financial benefit of holding the contract (i.e., Party A pays Party B the change in the contract value from inception to expiration)

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Common Energy Derivatives

► Futures► Exchange traded► Essentially financial

► Forwards► Over the counter (OTC)► Physicals

► Swaps► OTC► Financials

► Options► Exchange traded or OTC► Physical or financial

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Common Energy Markets

► New York Mercantile Exchange (NYMEX)► Intercontinental Exchange► Independent System Operator (ISO)► Over-the-Counter► Broker

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Common Energy Derivatives Exchange Traded Futures and Options► A legal agreement between a buyer or seller and the clearinghouse of

a futures exchange► Futures contracts generally have the following characteristics:

► They obligate the purchaser (seller) to accept (make) delivery of a standardized quantity of a commodity or financial instrument at a specified date or during a specified period, or they provide for cash settlement rather than delivery

► They are defined by standard delivery points and volumes► They effectively can be canceled before the delivery date by entering

into an offsetting contract► All changes in value of open contracts are settled on a regular basis,

usually daily. ► They carry no credit risk

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Common Energy Derivatives Exchange Traded Futures and Options► New York Mercantile Exchange (NYMEX)

► PJM Monthly Peak (JM)► The Exchange provides financially settled monthly futures contracts for on-peak

and off-peak electricity transactions based on the daily floating price for each peak day of the month at the PJM western hub (swap-like)

► Trading Unit: 2.5 MWs, equivalent to 40 megawatts (Mw) per peak day (between 19 and 23 days) depending on the month. Depending on the number of peak days in the month, the number of megawatt hours will vary (between 760 Mwh and 920 Mwh).

► Trading Months: The current year plus the next five calendar years.► Termination of Trading: One business day before the last peak day of the

month.► Settlement: Financial, based on the arithmetic average of the PJM western

hub real-time locational marginal price (LMP) for the peak hours of each day. ► Similar Off-peak Product available (JP)

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Common Energy Derivatives Exchange Traded Futures and Options► New York Mercantile Exchange (NYMEX)

► Natural Gas (NG) Futures Contract► Trading Unit: 10,000 million British thermal units (mmBtu).► Trading Months: The current year and the next five years► Last Trading Day: Trading terminates three business days prior to the first

calendar day of the delivery month.► Delivery: The Sabine Pipe Line Co. Henry Hub in Louisiana

► Crude Option (LO)► Trading Unit: Option: One NYMEX Division light sweet crude oil futures

contract. Future: 1,000 US barrels (12,000 gallons)► Trading Months: Crude oil options are listed seven years forward► Last Trading Day: Option trading ends three business days before the

underlying futures contract. Futures: Trading terminates three business days prior to the 25th of the month preceding the delivery month

► Delivery: West Texas Intermediate

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Common Energy DerivativesOTC – Forwards (Physicals)

► Symmetrical exposure► Over-the-counter contract to purchase or sell a specific quantity of a

financial instrument, a commodity or a foreign currency ► Pre-determined specified price► Settlement at a specified future date► Can be settled by actual delivery of the item in the contract, or net

cash settlement► Credit Risk

► Exchange of Collateral, Letters of Credit, Parental Guarantee

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Common Energy DerivativesOTC - Forwards

Forward Sale of Power at $70

Utility Marketer

Delivers 100 MW

Pays $70/MW

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Common Energy DerivativesOTC - Swaps

► Over-the-counter contracts to exchange cash flows as of a series of specified dates (swap)

► Based on agreed upon notional amount► Pre-agreed fixed rate; pre-agreed variable index► Symmetrical exposure► Credit Risk

► Exchange of Collateral, Letters of Credit, Parental Guarantee► Examples:

► Basis Swap (Natural Gas)► Fixed vs. Float Swap

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Common Energy DerivativesOTC - Swaps

Utility Financial Institution

Pay Fixed ($6)

Receives Float (Gas DailyIndex Price)

Fixed vs. Float swap► Pay: $6/mmbtu► Receive: Gas Daily Index $/mmbtu

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Common Energy DerivativesOTC - Options

►A financial instrument which represents a contract sold by one party (option writer) to another party (option holder).

►The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a financial or physical asset at an agreed-upon price (strike price) during a certain period of time or on a specific date (exercise date).

►Option Premium: price the option holder pays for the right to buy or sell the financial or physical at a specified price in the future

►Accounting for Premium is over the life of the option, not the delivery period.

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Common Energy Products/Contracts - Gas

► Natural Gas► Transportation ► Full Requirements contracts ► Trigger contracts► Park and loans ► Storage contracts ► Swing contracts► Basis contract ► Take or pay contract

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Common Energy Products/Contracts - Power

► Electricity► Capacity► Financial Transmission Rights (FTR)► Auction Revenue Rights (ARR)► Transmission & Distribution► Spark spreads► Tolling agreements ► Full requirements contracts► Renewable Energy Credits

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Common Energy Derivatives and Their Use to Manage Risk

How are these Products/Contracts Used?► “Lock-in” prices

► To fix the purchase or sales price of an energy commodity at a future point in time

► Protect against unfavorable price movements► Example:

► Collar (put and call)► Swap

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Common Energy Derivatives and Their Use to Manage Risk

► Option Collar - A Zero Cost Collar strategy combines the sale of a Call Option and the purchase of a Put Option

► The Option premium collected by the sale of the Call Option with a higher strike price (capped sale price) will fund the purchase of a Put Option with a lower strike price (capped purchase price).

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Sources of derivative value movement

► Changes in spot market rates – scratches surface► Changes in forward market rates over the entire duration

(tenor) of the instrument – present value of these changes affects current value

► Unusual terms (combined derivatives; leverage factors)► Additional market factors (volatilities, correlations, spreads)► Changes in creditworthiness (e.g., non-performance risk) of

either or both counterparties, often mitigated by credit support agreements (collateral) and master netting arrangements to offset derivative assets and liabilities between the same two counterparties

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Common Energy Derivatives and Their Use to Manage Risk

► Reduce earning volatility► Investors/Capital Markets may desire predicable future earnings► May be achieved by locking-in both the purchase and sales price

of a product, regardless of future price movements► Manage other risks

► Basis risk (locational)► Credit risk ► Operational risk (physical delivery, plant outages)

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Questions?