INFLATION – UNCERTAINTY

Bjornar EideStrategic Risk Consulting (SRC)

Energy companies are faced with many risks, but perhaps one of the least talked about exposures is the risk of inflation and how it relates to the general energy pricing picture. This presentation will focus on how identification, monitoring and management processes can enhance the control of inflation exposure.

a) Definition of inflation exposure

b) Identify dollars exposed to inflation within their operating structure

c) Understand the market place for inflation

d) How to use hedging instruments such as TIPS, Inflation Swaps and non-linear alternatives

e) Utilize risk measures in the overall communication of inflation exposure

f) Incorporate inflation risk metrics in the overall risk reporting process

Budgeted net interest

on the public debt was

approximately $240

billion in fiscal years

2007 and 2008. This

represented

approximately 9.5% of

government spending.

Interest was the fourth

largest single budgeted

disbursement category,

after defense

The debt is projected to

nearly double to $20

trillion by 2015, but is

expected to increase to

nearly 100% of GDP by

2020 and remain at that

level thereafter

Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.

Cost-push Inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs.

Built-in inflation is induced by adaptive expectations, and is often linked to the “price wage/spiral”. It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle„.

Inflation Situation(The Keynesian view)

“What is the current balance between federal spending, the US dollar and unemployment?”

a) A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index over time (CPI/CPURNSA), Personal Consumption Expenditures Price Index (PCEPI) and the GDP Deflator.

a) The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities and financial assets. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price Inflation is a rise in the price of assets, as opposed to goods and services.

“Inflation is referred to as a rise in the general level of prices of goods and services in an economy over a period of time”.

Source : Wikipedia Encyclopedia

“Is our exposure a

result of desired indexation ?”

i. Identify contract with known escalation clauses tied to CPI or CPI related components.

ii. Separate between labor and non-labor cost / revenue components.

iii. For expense / revenue components not tied to escalation clauses or/and FX, fixed income or commodity related components but still subject to periodic renegotiations, compute the correlation coefficient to the monthly CPURNSA index.

iv. Cash flow map dollars identified by linear and non linear characteristics to the CPURNSA index.

Identification of dollars exposed

(Hedging Item – CPURNSA, the dependent variable)

“Do our accounting system, data warehouse or other data depositories allow for a break-down of cost / revenue escalation components?”

Source Labor/Non Labor

Duration Dollars Delta

Insurance Labor 3.4 Years $950 MM 0.85

Benefits Labor 5.2 Years $1,240 MM 1.00

Contract XX Non-Labor 6.4 Years $ 750 MM 1.00

Contract XX Non-Labor 4.3 Years $ 250 MM 0.45

Contract XX Non-Labor 2.5 Years $ 345 MM 0.56

Contract XX Non-Labor 5.4 Years $ 450 MM 1.00

Sample of how to identify dollars exposed and contributing factors

“The cash flow map should break down the monthly linear / non-linear exposure against the CPURNSA index.”

Market Place for Inflation Products(Hedging instruments)

TIPS

Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 30-year maturities. The U.S. Treasury replaced the 20-year maturity with the new 30-year maturity in February 2010.

“Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality”

Market Place for Inflation Products(Hedging instruments)

“Current market liquidity has limited the availability of non-linear alternatives such as options on swaps or TIPS”

Spread between TIPS and Inflation Swaps

(Mark up)

TIPS, Inflation Swaps and Non-Linear Alternatives

Pros Cons

TIPS Principal is adjusted by CPI creating hedge effectiveness. Bond can not mature less than face value.

Initial cost and holding cost based on initial margining / maintenance margin under ISDA agreements.

Initial cost + holding cost of bond needs to be financed in full.

Mark up against alternatives (TIPS) of 40-50 bps + liquidity requirements

SWAPS

“Current market liquidity has limited the availability of non-linear alternatives such as options on swaps or TIPS”

Dollars Exposed Duration Hedged - InflationInstruments

Dollar Off-sett Ratio

Residual Risk (10 Day Var)

$ 450 MM < 1 Year $250 MM 56% $1.3 MM

$ 650 MM 1 -3 Years $250 MM 38% $2.6 MM

$ 1,000 MM 3- 5 Years $500 MM 50% $3.9 MM

$ 1,500 MM 5-10 Years $ 500 MM 33% $8.9 MM

$ 7,500 MM 10-30 Years $ 1,000 MM 13% $77.7 MM

Sample of how to use inflation products to off-set inflation items

Strategy Residual Risk

VaR (10 Day)

S&P Liquidity

20% Shock

Holding Cost

Strategy

Naked $126 MM $0 $0

50 % TIPS $63 MM $0 $10 MM

75 % TIPS $32 MM $0 $ 15 MM

25% TIPS +25% SWAPS

$63 MM $24 MM $ 6.2 MM

75 % SWAPS $32 MM $73 MM $3.7 MM

Sample of how to use inflation products to off-set inflation items

Duration – 5 years, Based on a $2billion NPV exposure“S&P Liquidity Requirements under margin accounts must be scaled for initial margin (20%) and maintenance margin (accrued P&L)”

How to aggregate the overall market risk picture to include the inflation

component

ERM Diversified

RIskFixed Income

Inflation

FX

Equity / Asset Holdings

Commodity

The overall market risk picture is a function of understanding the behavior of inflation relative to other pricing components

• CPI - Labor escalation clauses

• CPI - Non-Labor escalation clauses Identify

• Linear exposed dollars to CPI

• Non-Linear exposed dollars to CPIQuantify

• Risk Appetite (Limits)

• Liquidity Utilization Monitor

• Durational inflation curve

• Timing and type of hedgesManage

SUMMARY

BIBLIOGRAPHY

Bjornar Eide was the Director of Risk Management for Sempra Energy Utilities from September 2005 to January 2010. Bjornar oversaw the risk governance structure for San Diego Gas & Electric and Southern California Gas Company. He was a member of the Risk Management Committee for each of the utilities, which is responsible for managing each of the utility’s exposure to market, credit, liquidity and operational risk. Bjornar has over 15 years of experience from energy markets, serving in a variety of capacities in an international environment. Prior to joining Sempra Energy Utilities, he worked as an independent strategic risk consultant for a variety of clients in Europe and the US focusing on strategic risk management related issues and the design of risk assessment capability. As a Director of Risk Management for NRG (from 2000 – 2002) he built up the risk management department and during his four year tenure with Statoil A/S as a portfolio manager, he actively managed positions that involved petroleum products, crude, natural gas & electricity including the build-up of the power marketing department. Eide holds an MBA in Finance from San Francisco State University and a BA in Business Administration from California Lutheran University.