Unit- 6
Unit- 6
HEDGING STRATEGY
HEDGING STRATEGY
Energy price volatility ruled the 1990s. Crude oil prices soared as high as $40/bbl during Energy price volatility ruled the 1990s. Crude oil prices soared as high as $40/bbl during the Gulf War and dropped as low as single digits in 1998 and 1999. They were at 10 the Gulf War and dropped as low as single digits in 1998 and 1999. They were at 10 year highs as this book went to press. Natural gas prices experienced as much or even year highs as this book went to press. Natural gas prices experienced as much or even greater volatility as changes in temperatures increased and decreased the size of the greater volatility as changes in temperatures increased and decreased the size of the “gas bubble”. These wild swings in energy commodity prices wreaked havoc on the “gas bubble”. These wild swings in energy commodity prices wreaked havoc on the bottom lines of many energy producers, refiners, marketers, traders and end-users. bottom lines of many energy producers, refiners, marketers, traders and end-users.
One outgrowth of these market developments was sprouting of energy price risk One outgrowth of these market developments was sprouting of energy price risk management programs throughout the energy industry. For a few companies, the management programs throughout the energy industry. For a few companies, the experience was a highly visible financial disaster owing to the misuse – or experience was a highly visible financial disaster owing to the misuse – or misunderstanding – of the use of derivatives in so called “hedging” programs. For the misunderstanding – of the use of derivatives in so called “hedging” programs. For the vast majority of companies, success in energy price risk management was mixed. As a vast majority of companies, success in energy price risk management was mixed. As a result, comprehensive, and enterprise –wide risk management programs are still not result, comprehensive, and enterprise –wide risk management programs are still not widespread throughout the industry.
widespread throughout the industry.
From my experience analyzing energy risk management programs since 1979, From my experience analyzing energy risk management programs since 1979, there are several
there are several key reasons why key reasons why there are there are relatively few relatively few really really successful energysuccessful energy price risk management programs. First and most fundamental is the failure to properly price risk management programs. First and most fundamental is the failure to properly establish an important and sustaining rationale for the hedging program. In every establish an important and sustaining rationale for the hedging program. In every company, there will be wide ranging opinions as to whether the company should be company, there will be wide ranging opinions as to whether the company should be expected.
expected.
A second critical reason is the Failure to properly analyze and quantity the A second critical reason is the Failure to properly analyze and quantity the company’s portfolio risk exposure on a continuous basis. Clearly if the risk is company’s portfolio risk exposure on a continuous basis. Clearly if the risk is misdiagnosed, like a disease, it can not be properly treated or controlled.
misdiagnosed, like a disease, it can not be properly treated or controlled.
A third crucial reason is lack of a systematic strategy properly designed to A third crucial reason is lack of a systematic strategy properly designed to address the company’s portfolio risk. Few companies have what I consider to be a address the company’s portfolio risk. Few companies have what I consider to be a formal strategy, with decision rules. Many that does have rules based on physical rather formal strategy, with decision rules. Many that does have rules based on physical rather then financial events.
then financial events.
A fourth major reason is the lack of structure and discipline in the implementation A fourth major reason is the lack of structure and discipline in the implementation of the risk management process. Often expectations are not set or, again , very widely of the risk management process. Often expectations are not set or, again , very widely
among executives .
among executives . Evaluations of result, if Evaluations of result, if they take place at they take place at all, are ofteninconsistentall, are ofteninconsistent with risk reduction objectives.
with risk reduction objectives.
To hedge or not to hedge To hedge or not to hedge
For hedging to gain lasting acceptance in any company , it must be seen as a For hedging to gain lasting acceptance in any company , it must be seen as a means by which the company can better attain its corporate strategic or financial goals. means by which the company can better attain its corporate strategic or financial goals. Such goal may
Such goal may include meeting or include meeting or exceeding a budget, exceeding a budget, protecting against protecting against a drop ina drop in cash flow that could
cash flow that could threaten debt rating or threaten debt rating or payments , or batter payments , or batter enabling a company toenabling a company to have a competitive cost or price . In short, it must provide a viable alternative to simply have a competitive cost or price . In short, it must provide a viable alternative to simply accepting the market
accepting the market risk and its risk and its impact. impact. It is management’s It is management’s responsibility to set responsibility to set thethe proper objectives for risk management and the proper evaluation criteria.
proper objectives for risk management and the proper evaluation criteria. In my view, there are at least two valid hedging objectives:
In my view, there are at least two valid hedging objectives: •
• To achieve the highest risk adjusted return on capital employedTo achieve the highest risk adjusted return on capital employed •
• To reduce the risk of unacceptably low returns on capital employedTo reduce the risk of unacceptably low returns on capital employed
Over the years, I have heard many reasons why executives believe their their Over the years, I have heard many reasons why executives believe their their companies should not hedge some believe that their companies are being rewarded in companies should not hedge some believe that their companies are being rewarded in the stock market for taking energy market risk. Even for those companies that are the stock market for taking energy market risk. Even for those companies that are oriented toward accepting the market’s energy price exposure, I believe hedging is still oriented toward accepting the market’s energy price exposure, I believe hedging is still logical. Why? Because companies should take the risk that have the highest risk – logical. Why? Because companies should take the risk that have the highest risk – adjusted expected returns.
adjusted expected returns.
Why take risks on exposures that are expected to lose money? If an unhedged Why take risks on exposures that are expected to lose money? If an unhedged portfolio has market exposures with negative expected returns, those exposures should portfolio has market exposures with negative expected returns, those exposures should be hedged. By hedging those exposures, the company can afford to take additional risk be hedged. By hedging those exposures, the company can afford to take additional risk on exposures with positive expected returns. This is simply the most logical method to on exposures with positive expected returns. This is simply the most logical method to allocate risk capital. Wheather the outcome of such capital allocation is favorable or not allocate risk capital. Wheather the outcome of such capital allocation is favorable or not the company would at least be making more rationale risk management decision than the company would at least be making more rationale risk management decision than exposure with negative expected returns.
Backwardation Backwardation
Backwardation is a market condition where spot prices exceed forward prices. Backwardation is a market condition where spot prices exceed forward prices. Contango is the opposite condition, where forward prices exceed spot prices. The terms Contango is the opposite condition, where forward prices exceed spot prices. The terms are most commonly used in oil markets but are also applied in certain commodities and are most commonly used in oil markets but are also applied in certain commodities and energies markets. In oil markets, the prevailing condition may reflect immediate supply energies markets. In oil markets, the prevailing condition may reflect immediate supply and demand. If crude oil is contango, it may indicate immediately available supply. and demand. If crude oil is contango, it may indicate immediately available supply. Backwardation can indicate an immediate shortage. Anything that threatens the steady Backwardation can indicate an immediate shortage. Anything that threatens the steady flow of oil around the world, such as imminent war, tends to drive the oil market into flow of oil around the world, such as imminent war, tends to drive the oil market into backwardation.
backwardation.
A theory developed in respect to the price of a futures contract and the contract's time to A theory developed in respect to the price of a futures contract and the contract's time to expire. Backwardation says that as the contract approaches expiration, the futures expire. Backwardation says that as the contract approaches expiration, the futures contract will trade at a higher price compared to when the contract was further away contract will trade at a higher price compared to when the contract was further away from expiration. This is said to occur due to the convenience yield being higher than the from expiration. This is said to occur due to the convenience yield being higher than the prevailing risk free rate.
prevailing risk free rate.
When backwardation does occur in a futures market it has been suggested that an When backwardation does occur in a futures market it has been suggested that an individual in the short position would benefit the most by delivering as late as individual in the short position would benefit the most by delivering as late as possible.Backwardation in futures contracts was called "normal backwardation" by possible.Backwardation in futures contracts was called "normal backwardation" by economist John Maynard Keynes. This is because he believed that a price movement economist John Maynard Keynes. This is because he believed that a price movement like the one suggested by backwardation was not random but consistent with the like the one suggested by backwardation was not random but consistent with the prevailing market conditions.
prevailing market conditions. Backwardation is the opposite of contango.Backwardation is the opposite of contango.
Backwardation (sometimes incorrectly referred to as "backwardization") is a futures Backwardation (sometimes incorrectly referred to as "backwardization") is a futures market term: it means an
market term: it means an downward downward sloping forward curve (as in an inverted yieldsloping forward curve (as in an inverted yield curve): one says that the forward curve is "in backwardation" (or sometimes: curve): one says that the forward curve is "in backwardation" (or sometimes: "backwardated").
Formally, it is the situation where, and the amount by which, the price of a commodity Formally, it is the situation where, and the amount by which, the price of a commodity for future delivery is
for future delivery is lower lower than the spot price, or a far future delivery price lower than athan the spot price, or a far future delivery price lower than a nearer future delivery.
nearer future delivery.
The opposite market condition to backwardation is known as contango. The opposite market condition to backwardation is known as contango.
More generally, the term is sometimes applied to forward prices other than those of More generally, the term is sometimes applied to forward prices other than those of futures contracts, when analogous price patterns arise. For example, if it costs more to futures contracts, when analogous price patterns arise. For example, if it costs more to lease silver for 30 days than for 60 days, it might be said that the silver lease rates are lease silver for 30 days than for 60 days, it might be said that the silver lease rates are "in backwardation.
"in backwardation.
Notable examples of backwardation include, Notable examples of backwardation include,
1.Commodities: Copper circa 1990, apparently arising from market manipulation1.Commodities: Copper circa 1990, apparently arising from market manipulation by Yasuo Hamanaka of Sumitomo Corporation.
by Yasuo Hamanaka of Sumitomo Corporation.
2.FX: The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006:2.FX: The Australian dollar, priced in Japanese yen terms (AUD/JPY), in 2006: the backwardation occurs simply because Australian dollar bonds pay so much more the backwardation occurs simply because Australian dollar bonds pay so much more interest at every point in the yield curve than Japanese yen bonds do. Any high-yield interest at every point in the yield curve than Japanese yen bonds do. Any high-yield foreign currency contract will show backwardation in its pricing.
foreign currency contract will show backwardation in its pricing.
3.NYMEX traded natural gas currently (May 2007).3.NYMEX traded natural gas currently (May 2007). Trend
Trend
The general direction of a market or of the price of an asset. Trends can vary in length The general direction of a market or of the price of an asset. Trends can vary in length from short, to intermediate, to long term. If you can identify a trend, it can be highly from short, to intermediate, to long term. If you can identify a trend, it can be highly profitable, because you will be able to trade with the trend. As a general strategy, it is profitable, because you will be able to trade with the trend. As a general strategy, it is best to trade with trends, meaning that if the general trend of the market is headed up, best to trade with trends, meaning that if the general trend of the market is headed up, you should be very cautious about taking any positions that rely on the trend going in you should be very cautious about taking any positions that rely on the trend going in the opposite direction.
the opposite direction.
A trend can also apply to interest rates, yields, equities and any other market which is A trend can also apply to interest rates, yields, equities and any other market which is characterized by a long-term movement in price or volume.
Market trends Market trends Market trends
Market trends reflect the general direction of prices or rates in financial markets.reflect the general direction of prices or rates in financial markets.[1][1] Participants in a given market use price charts to observe these trends, and to identify Participants in a given market use price charts to observe these trends, and to identify investment and trading opportunities.
investment and trading opportunities.
That market prices do move in trends is one of the major premises of technical That market prices do move in trends is one of the major premises of technical analysis,
analysis,[2][2] though the description of market trends is common to Wall Street,though the description of market trends is common to Wall Street,[3][3] thethe economics profession, and the Federal Reserve.
economics profession, and the Federal Reserve. [4][4]
Market trends unfold in periods when bulls (buyers) consistently outnumber bears Market trends unfold in periods when bulls (buyers) consistently outnumber bears (sellers), or vice versa. A bull or bear market describes the trend and sentiment driving (sellers), or vice versa. A bull or bear market describes the trend and sentiment driving it, but can also refer to specific securities and sectors ("bullish on IBM", "bullish on it, but can also refer to specific securities and sectors ("bullish on IBM", "bullish on technology stocks," or "bearish on gold", etc.)
Bull market
Bull market
The Charging Bull in Bowling Green, New York is a symbol of the bull market. The Charging Bull in Bowling Green, New York is a symbol of the bull market.
A bull market tends to be associated with increasing investor confidence, motivating A bull market tends to be associated with increasing investor confidence, motivating investors to buy in anticipation of further capital gains. The longest and most famous investors to buy in anticipation of further capital gains. The longest and most famous bull market was in the 1990s when the U.S. and many other global financial markets bull market was in the 1990s when the U.S. and many other global financial markets grew at their fastest pace ever.
grew at their fastest pace ever.[5][5]
In describing financial market behavior, the largest group of market participants is In describing financial market behavior, the largest group of market participants is often referred to, metaphorically, as a
often referred to, metaphorically, as a herd herd . This is especially relevant to participants. This is especially relevant to participants in bull markets since bulls are herding animals. A bull market is also described as a in bull markets since bulls are herding animals. A bull market is also described as a
bull run
bull run . Dow Theory attempts to describe the character of these market. Dow Theory attempts to describe the character of these market movements.
movements.
The United States has been in a long-term bull market since about 1983, with brief The United States has been in a long-term bull market since about 1983, with brief upsets including the Panic of 1987 and the NASDAQ Crash in 2000.
upsets including the Panic of 1987 and the NASDAQ Crash in 2000.
Bear market
Bear market
A bear market tends to be accompanied by widespread pessimism. Investors A bear market tends to be accompanied by widespread pessimism. Investors anticipating further losses are motivated to sell, with negative sentiment feeding on anticipating further losses are motivated to sell, with negative sentiment feeding on itself in a vicious circle. The most famous bear market in history was 1930 to 1932, itself in a vicious circle. The most famous bear market in history was 1930 to 1932, marking the start of the Great Depression.
marking the start of the Great Depression.[6][6] A milder, low-level long-term bearA milder, low-level long-term bear market occurred from about 1967 to 1983, encompassing the stagflation economy, market occurred from about 1967 to 1983, encompassing the stagflation economy, energy crises in the 1970s, and high unemployment in the early 1980s.
Prices fluctuate constantly on the open market; a bear market is not a simple Prices fluctuate constantly on the open market; a bear market is not a simple decline, but a substantial drop in the prices of a range of issues over a defined decline, but a substantial drop in the prices of a range of issues over a defined period of time. By one common definition, a bear market is marked by a price period of time. By one common definition, a bear market is marked by a price decline of 20% or more in a key stock market index from a recent peak over a decline of 20% or more in a key stock market index from a recent peak over a 12-month period. However, no consensual definition of a bear market exists to clearly month period. However, no consensual definition of a bear market exists to clearly differentiate a primary market trend from a secondary market trend.
differentiate a primary market trend from a secondary market trend.
Investors frequently confuse bear markets with corrections. Corrections are much Investors frequently confuse bear markets with corrections. Corrections are much shorter lived, whereas bear markets occur over a longer period with typically a shorter lived, whereas bear markets occur over a longer period with typically a greater magnitude of loss from top to bottom.
greater magnitude of loss from top to bottom. A
A secondary trendsecondary trend is a temporary change in price within a primary trend. Theseis a temporary change in price within a primary trend. These usually last a few weeks to a few months. A temporary decrease during a bull usually last a few weeks to a few months. A temporary decrease during a bull market is called a
market is called a correctioncorrection; a temporary increase during a bear market is called a; a temporary increase during a bear market is called a bear market rally
bear market rally..
Whether a change is a correction or rally can be determined only with hindsight. Whether a change is a correction or rally can be determined only with hindsight. When trends begin to appear, market analysts debate whether it is a correction/rally When trends begin to appear, market analysts debate whether it is a correction/rally or a new bull/bear market, but it is difficult to tell. A correction sometimes or a new bull/bear market, but it is difficult to tell. A correction sometimes foreshadows a bear market.
foreshadows a bear market.
Correction Correction
A market correction is sometimes defined as a drop of at least 10%, but not more A market correction is sometimes defined as a drop of at least 10%, but not more than 20% (25% on intraday trading) over a short period of time. The major difference than 20% (25% on intraday trading) over a short period of time. The major difference between a bear market and a correction is magnitude and duration. Bear markets between a bear market and a correction is magnitude and duration. Bear markets last much longer, and the magnitude of loss is greater.
last much longer, and the magnitude of loss is greater.
Major disasters or negative geopolitical events can spark a correction. One example Major disasters or negative geopolitical events can spark a correction. One example is the performance of the stock markets just before and after the September 11, is the performance of the stock markets just before and after the September 11, 2001 attacks. On September 7, 2001, the Dow fell 234.99 points to 9,605.85, 2001 attacks. On September 7, 2001, the Dow fell 234.99 points to 9,605.85, thoroughly pushing the Dow into a correction. On September 17, 2001, the first day thoroughly pushing the Dow into a correction. On September 17, 2001, the first day
of trading after the attacks, the Dow Jones Industrial Average plunged 684.81 points of trading after the attacks, the Dow Jones Industrial Average plunged 684.81 points to 8,920.70. That loss officially pushed the Dow, not just even further into a to 8,920.70. That loss officially pushed the Dow, not just even further into a correction, but into a bear market. (Although unless investors had prior knowledge of correction, but into a bear market. (Although unless investors had prior knowledge of the events of September 11, 2001, it would be impossible for the attacks to have the events of September 11, 2001, it would be impossible for the attacks to have had an effect on the markets ahead of time.) How can this be called a, "correction" had an effect on the markets ahead of time.) How can this be called a, "correction" when on 9.7.01 the Dow fell 2-3% and on 9.17 by 7-8%? Both numbers, eight and when on 9.7.01 the Dow fell 2-3% and on 9.17 by 7-8%? Both numbers, eight and three are less than ten, therefor this is not a, "correction" by the definition stated three are less than ten, therefor this is not a, "correction" by the definition stated above.
above.
Because of depressed prices and valuation, market corrections can be a good Because of depressed prices and valuation, market corrections can be a good opportunity for value-strategy investors. If one buys stocks when everyone else is opportunity for value-strategy investors. If one buys stocks when everyone else is selling, the prices fall and therefore the P/E ratio goes down. In addition, one is able selling, the prices fall and therefore the P/E ratio goes down. In addition, one is able to purchase undervalued stocks with a highly probable upside potential.
to purchase undervalued stocks with a highly probable upside potential.
Bear market rally Bear market rally
A bear market rally is sometimes defined as an increase of at least 10%, but no A bear market rally is sometimes defined as an increase of at least 10%, but no more than 20%.
more than 20%.
Notable bear market rallies occurred in the Dow Jones index after the 1929 stock Notable bear market rallies occurred in the Dow Jones index after the 1929 stock market crash leading down to the market bottom in 1932, as well as throughout the market crash leading down to the market bottom in 1932, as well as throughout the late 1960s and early 1970s. The Japanese Nikkei stock average has been typified late 1960s and early 1970s. The Japanese Nikkei stock average has been typified by a number of bear market rallies since the late 1980s while experiencing an by a number of bear market rallies since the late 1980s while experiencing an overall downward trend.
overall downward trend. A
A secular market trendsecular market trend is a long-term trend that usually lasts 5 to 25 years, andis a long-term trend that usually lasts 5 to 25 years, and consists of sequential primary trends. In a
consists of sequential primary trends. In a secular bull marketsecular bull market the bear markets arethe bear markets are smaller than the bull markets. Typically, each bear market does not wipe out the smaller than the bull markets. Typically, each bear market does not wipe out the gains of the previous bull market, and the next bull market makes up the losses of gains of the previous bull market, and the next bull market makes up the losses of the bear market. Conversely, in a
the bear market. Conversely, in a secular bear marketsecular bear market, the bull markets are smaller, the bull markets are smaller than the bear markets and do not wipe out the losses of the previous bear market. than the bear markets and do not wipe out the losses of the previous bear market.
An example of a secular bear market was seen in gold over the period between An example of a secular bear market was seen in gold over the period between January 1980 to June 1999, over which the nominal gold price fell from a high of January 1980 to June 1999, over which the nominal gold price fell from a high of $850/oz to a low of $253/oz,
$850/oz to a low of $253/oz,[7][7] which formed part of the Great Commoditieswhich formed part of the Great Commodities Depression. Conversely, the S&P 500 experienced a secular bull market over a Depression. Conversely, the S&P 500 experienced a secular bull market over a similar time period.
similar time period.[8][8]
An example of a secular bull market would be the US Stock market between August An example of a secular bull market would be the US Stock market between August 1982 and June 2007. The DJIA, S&P500 and Wilshire 5000 indexes all made new 1982 and June 2007. The DJIA, S&P500 and Wilshire 5000 indexes all made new record highs in 2007 with only a single cyclical bear market low in October 2002 record highs in 2007 with only a single cyclical bear market low in October 2002 after the cyclical bull market high made in March 2000.
after the cyclical bull market high made in March 2000.
These secular bull and bear market trends are also termed "super cycles". "Grand These secular bull and bear market trends are also termed "super cycles". "Grand supercycles" of 50 to 300 years have also been proposed by Nikolai Kondratiev and supercycles" of 50 to 300 years have also been proposed by Nikolai Kondratiev and Ralph Nelson Elliott.
Ralph Nelson Elliott.
Price risk identification Price risk identification
The best way I have found to identify a company's portfolio risk to commodity prices The best way I have found to identify a company's portfolio risk to commodity prices is to create a model of their earnings. The objective of building the model is to is to create a model of their earnings. The objective of building the model is to determine how the company's earnings change if "market prices" of related determine how the company's earnings change if "market prices" of related com-modities change. Though any number of market prices can be used in building the modities change. Though any number of market prices can be used in building the earnings' model, I often use NYMEX futures contract prices. The futures price curve earnings' model, I often use NYMEX futures contract prices. The futures price curve could be viewed as an unreliable input since it keeps changing all the time. However, could be viewed as an unreliable input since it keeps changing all the time. However, the benefit of this approach is that one can "lock-in" projected earnings if they are high the benefit of this approach is that one can "lock-in" projected earnings if they are high enough, or if the downside is perceived to be great. In a sense, the "prediction" can enough, or if the downside is perceived to be great. In a sense, the "prediction" can become a self-fulfilling prophecy through hedging, no matter how the price curve become a self-fulfilling prophecy through hedging, no matter how the price curve changes after the hedge is established.
changes after the hedge is established.
Earnings models Earnings models
Earnings can be forecast by linking NYMEX futures prices to a company's sales Earnings can be forecast by linking NYMEX futures prices to a company's sales prices and costs. The equations can be developed through multiple regression analysis. prices and costs. The equations can be developed through multiple regression analysis.
By inserting the current forward strip, an earnings forecast for forward months can be By inserting the current forward strip, an earnings forecast for forward months can be generated. As NYMEX prices change, new earnings forecasts can be automatically generated. As NYMEX prices change, new earnings forecasts can be automatically generated.
generated. Stress tests Stress tests
A stress test is a means for assessing the impact of an extreme price movement on A stress test is a means for assessing the impact of an extreme price movement on future earnings. For example, with an earnings model, crude futures prices could be future earnings. For example, with an earnings model, crude futures prices could be increased or decreased by $l/bbl to determine the effect such a change would have on increased or decreased by $l/bbl to determine the effect such a change would have on future earnings.
WHAT IS MONTE CARLO SIMULATION? WHAT IS MONTE CARLO SIMULATION?
The drawback of stress testing is that the probability of the scenario being tested is not taken The drawback of stress testing is that the probability of the scenario being tested is not taken into account. To assess the likely distribution of earnings for any given month, a probability into account. To assess the likely distribution of earnings for any given month, a probability distribution for futures prices is needed. Further, the relationships among futures prices must be distribution for futures prices is needed. Further, the relationships among futures prices must be maintained for the resulting distribution to be realistic. One analytical method to develop a
maintained for the resulting distribution to be realistic. One analytical method to develop a distribution of earnings is "Monte Carlo simulation." A Monte Carlo simulation is a method by distribution of earnings is "Monte Carlo simulation." A Monte Carlo simulation is a method by which price scenarios are randomly selected from their distribution according to their frequency in which price scenarios are randomly selected from their distribution according to their frequency in the distribution. The output of the simulation is a distribution showing the frequency of different the distribution. The output of the simulation is a distribution showing the frequency of different earnings estimates
earnings estimates The standard deviation of an The standard deviation of an earnings distribution is a generally earnings distribution is a generally acceptedaccepted measure of portfolio risk. A new standard deviation can be computed when hedge positions are measure of portfolio risk. A new standard deviation can be computed when hedge positions are included in the portfolio by running the Monte Carlo simulation. If the new standard deviation is included in the portfolio by running the Monte Carlo simulation. If the new standard deviation is lower, the hedge has reduced portfolio risk, and vice versa.
lower, the hedge has reduced portfolio risk, and vice versa. What do we mean by "simulation?"
What do we mean by "simulation?" When we use the wordWhen we use the word simulation simulation , we refer to any, we refer to any
analytical method meant to imitate a real-life system, especially when other analyses are too analytical method meant to imitate a real-life system, especially when other analyses are too mathematically complex or too difficult to reproduce. Without the aid of simulation, a spreadsheet mathematically complex or too difficult to reproduce. Without the aid of simulation, a spreadsheet model will only reveal a single outcome, generally the most likely or average scenario. model will only reveal a single outcome, generally the most likely or average scenario. Spreadsheet risk analysis uses both a spreadsheet model and simulation to automatically analyze Spreadsheet risk analysis uses both a spreadsheet model and simulation to automatically analyze the effect of varying inputs on outputs of the modeled system.
the effect of varying inputs on outputs of the modeled system.
One type of spreadsheet simulation is
One type of spreadsheet simulation is Monte Carlo simulationMonte Carlo simulation, which randomly, which randomly generates values for uncertain variables over and over to simulate a model.
generates values for uncertain variables over and over to simulate a model.
How did Monte Carlo simulation get its name? How did Monte Carlo simulation get its name?
Carlo simulation was named for Monte Carlo, Monaco, where the primary attractions are casinos Carlo simulation was named for Monte Carlo, Monaco, where the primary attractions are casinos containing games of chance. Games of chance such as roulette wheels, dice, and slot machines, containing games of chance. Games of chance such as roulette wheels, dice, and slot machines, exhibit random behavior.
exhibit random behavior.
The random behavior in games of chance is similar to how Monte Carlo simulation selects variable The random behavior in games of chance is similar to how Monte Carlo simulation selects variable
values at random to simulate a model. When you roll a die, you know that either a 1, 2, 3, 4, 5, or 6 values at random to simulate a model. When you roll a die, you know that either a 1, 2, 3, 4, 5, or 6 will come up, but you don't know which for any particular roll. It's the same with the variables that will come up, but you don't know which for any particular roll. It's the same with the variables that have a known range of values but an uncertain value for any particular time or event (e.g. interest have a known range of values but an uncertain value for any particular time or event (e.g. interest rates, staffing needs, stock prices, inventory, phone calls per minute).
rates, staffing needs, stock prices, inventory, phone calls per minute). What do you do with uncertain variables in your spreadsheet? What do you do with uncertain variables in your spreadsheet?
For each uncertain variable (one that has a range of possible values), you define the possible For each uncertain variable (one that has a range of possible values), you define the possible values with a probability distribution. The type of distribution you select is based on the conditions values with a probability distribution. The type of distribution you select is based on the conditions surrounding that variable. Distribution types include:
surrounding that variable. Distribution types include:
..
To add this sort of function to an Excel spreadsheet, you would need to know the equation that To add this sort of function to an Excel spreadsheet, you would need to know the equation that represents this distribution. With Crystal Ball, these equations are automatically calculated for you. represents this distribution. With Crystal Ball, these equations are automatically calculated for you. Crystal Ball can even fit a distribution to any historical data that you might have.
Crystal Ball can even fit a distribution to any historical data that you might have. What happens during a simulation?
What happens during a simulation?
A simulation calculates multiple scenarios of a model by repeatedly sampling values from the A simulation calculates multiple scenarios of a model by repeatedly sampling values from the probability distributions for the uncertain variables and using those values for the cell. Crystal Ball probability distributions for the uncertain variables and using those values for the cell. Crystal Ball simulations can consist of as many trials (or scenarios) as you want hundreds or even thousands simulations can consist of as many trials (or scenarios) as you want hundreds or even thousands -in just a few seconds.
in just a few seconds.
During a single trial, Crystal Ball randomly selects a value from the defined possibilities (the range During a single trial, Crystal Ball randomly selects a value from the defined possibilities (the range and shape of the distribution) for each uncertain variable and then recalculates the spreadsheet and shape of the distribution) for each uncertain variable and then recalculates the spreadsheet
Portfolio Risk Theory
Portfolio Risk Theory
Before addressing the questions of what to hedge, when to hedge or how much to Before addressing the questions of what to hedge, when to hedge or how much to hedge , the company needs to know the nature the magnitude of its price risk . The hedge , the company needs to know the nature the magnitude of its price risk . The lessons learned about its price risk are often as valuable in making other business lessons learned about its price risk are often as valuable in making other business decisions as they are in making the determination of whether to hedge- e.g. refinery decisions as they are in making the determination of whether to hedge- e.g. refinery optimization and inventory management.
optimization and inventory management.
The application of portfolio theory to business and not just stock portfolios, began The application of portfolio theory to business and not just stock portfolios, began to take hold in the latter part of the 1990s. Many financial firms , and even some to take hold in the latter part of the 1990s. Many financial firms , and even some industrial firms , embraced the concept of managing the “ enterprise” or “global” risk of industrial firms , embraced the concept of managing the “ enterprise” or “global” risk of their business portfolio.
their business portfolio. A business portfolio
A business portfolio is a group of assets-such as a company's oil reserves,is a group of assets-such as a company's oil reserves, refineries, or inventories. A financial portfolio
refineries, or inventories. A financial portfolio may be a group of oil futures contracts,may be a group of oil futures contracts, swaps, and/or derivatives. Each has its own set of risk/return characteristics, depending swaps, and/or derivatives. Each has its own set of risk/return characteristics, depending on what a portfolio includes. When a financial portfolio is combined with the firm's on what a portfolio includes. When a financial portfolio is combined with the firm's business portfolio, the combination (or total portfolio) will have new risk-return business portfolio, the combination (or total portfolio) will have new risk-return characteristics, or market exposure, than either one separately. Diversification of risk characteristics, or market exposure, than either one separately. Diversification of risk enables the total portfolio to have lower risk than either the business portfolio or enables the total portfolio to have lower risk than either the business portfolio or financial portfolio has separately. Controlling the risk of the financial portfolio separately financial portfolio has separately. Controlling the risk of the financial portfolio separately is inconsistent with managing the risk of the total portfolio.
is inconsistent with managing the risk of the total portfolio.
It is this portfolio framework that one must apply in the construction of hedges. It is this portfolio framework that one must apply in the construction of hedges. Otherwise, determining the proper portfolio is just guesswork that may lead to a result Otherwise, determining the proper portfolio is just guesswork that may lead to a result the opposite of what is expected.
the opposite of what is expected.
The Financial Accounting Standards Board (FASB) has defined commodity price risk The Financial Accounting Standards Board (FASB) has defined commodity price risk as the sensitivity of a firm's income to changes in prices
as the sensitivity of a firm's income to changes in prices .. Many large oil companies areMany large oil companies are exposed to changes in literally thousands of prices, 1 and so the problem of price risk exposed to changes in literally thousands of prices, 1 and so the problem of price risk identification and quantification is analytically challenging.
identification and quantification is analytically challenging.
As a result, many firms do not conduct a comprehensive, portfolio risk assessment As a result, many firms do not conduct a comprehensive, portfolio risk assessment to identify their risk exposure. The most common mistake is that someone identifies one to identify their risk exposure. The most common mistake is that someone identifies one risk within the portfolio and the company hedges that risk.
However, a risk analysis that addresses only part of a company's portfolio (i.e., However, a risk analysis that addresses only part of a company's portfolio (i.e., aa partial risk analysis) is inherently flawed. Correlations among all risk factors need to be partial risk analysis) is inherently flawed. Correlations among all risk factors need to be quantified. The result of considering only part of a company's portfolio risk exposure can quantified. The result of considering only part of a company's portfolio risk exposure can in fact lead to a hedging strategy that actually increases, rather than reduces, risk.
in fact lead to a hedging strategy that actually increases, rather than reduces, risk. If you were to craft the perfect investment, you would probably want its attributes to If you were to craft the perfect investment, you would probably want its attributes to include high returns coupled with little risk. The reality, of course, is that this kind of include high returns coupled with little risk. The reality, of course, is that this kind of investment is next to impossible to find. Not surprisingly, people spend a lot of time investment is next to impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the "perfect investment". But developing methods and strategies that come close to the "perfect investment". But none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the management of your portfolio.
management of your portfolio.
The Theory The Theory
One of the most important and influential economic theories dealing with finance and One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title investment, MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the 1952
"Portfolio Selection" in the 1952 Journal of Finance Journal of Finance . MPT says that it is not enough to. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.
also known as not putting all of your eggs in one basket.
For most investors, the risk they take when they buy a stock is that the return will be For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls "risk".
stock has its own standard deviation from the mean, which MPT calls "risk".
The risk in a portfolio of diverse individual stocks will be less than the risk inherent in The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays are not directly related). Consider a portfolio that holds two risky stocks: one that pays
both assets will always pay off, regardless of whether it rains or shines. Adding one both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio.
risky asset to another can reduce the overall risk of an all-weather portfolio.
In other words, Markowitz showed that investment is not just about picking stocks, but In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest about choosing the right combination of stocks among which to distribute one's nest eggs.
eggs.
Two Kinds of Risk Two Kinds of Risk
Modern portfolio theory states that the risk for individual stock returns has two Modern portfolio theory states that the risk for individual stock returns has two components:
components:
Systematic Risk
Systematic Risk - These are market risks that cannot be diversified away. Interest rates,- These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
recessions and wars are examples of systematic risks.
Unsystematic Risk
Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks- Also known as "specific risk", this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock's return that is not correlated with Figure 1). It represents the component of a stock's return that is not correlated with general market moves.
general market moves.
For a well-diversified portfolio, the risk - or average deviation from the mean - of each For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference or covariance stock contributes little to portfolio risk. Instead, it is the difference or covariance
-between individual stocks' levels of risk that determines overall portfolio risk. As a result, between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks.
Figure 1 Figure 1
The Efficient Frontier The Efficient Frontier
Now that we understand the benefits of diversification, the question of how to identify Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. Enter the efficient frontier.
the best level of diversification arises. Enter the efficient frontier.
For every level of return, there is one portfolio that offers the lowest possible risk, and For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These
for every level of risk, there is a portfolio that offers the highest return. These
combinations can be plotted on a graph, and the resulting line is the efficient frontier. combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the efficient frontier for just two stocks - a high risk/high return
Figure 2 shows the efficient frontier for just two stocks - a high risk/high return
technology stock (Google) and a low risk/low return consumer products stock (Coca technology stock (Google) and a low risk/low return consumer products stock (Coca Cola).
Figure 2 Figure 2
Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.
will take on determines the position of the portfolio on the line.
Modern portfolio theory takes this idea even further. It suggests that combining a stock Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. In other funded by borrowing, can actually increase returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the remaining stock
words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose.
otherwise choose.
What MPT Means for You What MPT Means for You
Modern portfolio theory has had a marked impact on how investors perceive risk, return Modern portfolio theory has had a marked impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification can and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts. reduce investment risk. In fact, modern money managers routinely follow its precepts.
That being said, MPT has some shortcomings in the real world. For starters, it often That being said, MPT has some shortcomings in the real world. For starters, it often
take on a perceived risky investment (futures, for example) in order to reduce overall take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques. Furthermore, MPT assumes that it is possible to
portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments; in times portfolio. But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are of market stress, seemingly independent investments do, in fact, act as though they are related.
related.
Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter. Government-backed bonds returns, but finding a truly risk-free asset is another matter. Government-backed bonds are presumed to be risk free, but, in reality, they are not. Securities such as gilts
are presumed to be risk free, but, in reality, they are not. Securities such as gilts
and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.
interest rate changes can both affect their value.
Then there is the question of the number of stocks required for diversification. How Then there is the question of the number of stocks required for diversification. How many is enough? Mutual funds can contain dozens and dozens of stocks. Investment many is enough? Mutual funds can contain dozens and dozens of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.
come very close to achieving optimal diversity after adding the twentieth stock.
Conclusion Conclusion
The gist of MPT is that the market is hard to beat and that the people who beat the The gist of MPT is that the market is hard to beat and that the people who beat the market are those who take above-average risk. It is also implied that these risk takers market are those who take above-average risk. It is also implied that these risk takers will get their comeuppance when markets turn down.
will get their comeuppance when markets turn down. Price Risk and Derivatives
Price Risk and Derivatives
Diversification and insurance are the major tools for managing exploration risk and Diversification and insurance are the major tools for managing exploration risk and protecting firms from property loss and liability. Firms manage volume risk—not having protecting firms from property loss and liability. Firms manage volume risk—not having adequate supplies—by maintaining inventories or acquiring productive assets. adequate supplies—by maintaining inventories or acquiring productive assets.
Derivatives are particularly appropriate for managing the price risk that arises as a result Derivatives are particularly appropriate for managing the price risk that arises as a result of highly volatile prices in the petroleum and natural gas industries.
of highly volatile prices in the petroleum and natural gas industries.
Petroleum and Natural Gas Price Risks and Risk Management Strategies Petroleum and Natural Gas Price Risks and Risk Management Strategies
Participant
Participants s Price Price RisksRisks
Risk Management Strategies Risk Management Strategies and Derivative Instruments and Derivative Instruments
Employed Employed Oil
Oil Producers Producers Low Low crude crude oil oil price price Sell Sell crude crude oil oil future future or or buy buy putput option
option Petroleum
Petroleum Refiners Refiners High High crude crude oil oil price price Buy Buy crude crude oil oil future future or or callcall option
option Low
Low product product price price Sell Sell product product future future or or swapswap contract,
contract, buy put option buy put option Thin
Thin profit profit margin margin Buy Buy crack crack spreadspread Storage
Storage Operators Operators High purchase High purchase price price or or lowlow sale price
sale price
Buy or sell calendar spread Buy or sell calendar spread Large Consumers
Large Consumers
Local Distribution Companies Local Distribution Companies (Natural Gas)
(Natural Gas)
Unstable prices, wholesale Unstable prices, wholesale prices higher than retail prices higher than retail
Buy future or call option, buy Buy future or call option, buy basis contract
basis contract Power
Power Plants Plants (Natural (Natural Gas) Gas) Thin Thin profit profit margin margin Buy Buy spark spark spreadspread Airlines
Airlines and and Shippers Shippers High High fuel fuel price price Buy Buy swap swap contractcontract Source: Energy Information Administration.
Source: Energy Information Administration.
The typical price risks faced by market participants and the standard derivative The typical price risks faced by market participants and the standard derivative contracts used to manage those risks are shown in
contracts used to manage those risks are shown in tabletable. Price risk in the petroleum. Price risk in the petroleum and natural gas industries is naturally associated with each participant’s stage of and natural gas industries is naturally associated with each participant’s stage of production. Some companies integrate their operations from exploration through final production. Some companies integrate their operations from exploration through final sales to eliminate the price risks that arise at the intermediate stages of processing. For sales to eliminate the price risks that arise at the intermediate stages of processing. For example, for an integrated producer, an increase in the cost of crude oil purchased at its example, for an integrated producer, an increase in the cost of crude oil purchased at its
companies usually do not have integrated operations. Independent producers want companies usually do not have integrated operations. Independent producers want protection from low crude oil prices, and they sell to refiners who want protection from protection from low crude oil prices, and they sell to refiners who want protection from high prices. Refiners want protection from low product prices, and they sell to storage high prices. Refiners want protection from low product prices, and they sell to storage facilities and customers who are concerned about high prices. At each stage, suppliers facilities and customers who are concerned about high prices. At each stage, suppliers and purchasers can split the risk in order to allay their concerns. They typically and purchasers can split the risk in order to allay their concerns. They typically supplement exchange-traded futures and options with over-the-counter (OTC) products supplement exchange-traded futures and options with over-the-counter (OTC) products to manage their price risks.
to manage their price risks.
Risk managers in the petroleum and natural gas industries commonly use derivatives to Risk managers in the petroleum and natural gas industries commonly use derivatives to achieve certainty about the prices they pay or receive. Depending on their achieve certainty about the prices they pay or receive. Depending on their circumstance, they may be concerned with the price paid
circumstance, they may be concerned with the price paid per se per se , with price spreads, with price spreads (differences between prices), with ceilings and floors, and/or with price changes over (differences between prices), with ceilings and floors, and/or with price changes over time. In addition, volumetric production payment contracts—a variant of a standard time. In addition, volumetric production payment contracts—a variant of a standard swap—may be used to reduce uncertainty about cash flows and credit. Some of the swap—may be used to reduce uncertainty about cash flows and credit. Some of the instruments particular to the oil and gas industries are described below.
instruments particular to the oil and gas industries are described below.
The principal difficulty in using exchange-traded products is they often do not exactly The principal difficulty in using exchange-traded products is they often do not exactly correspond to what the trader is attempting to hedge or to speculate in. For examples, correspond to what the trader is attempting to hedge or to speculate in. For examples, price movements in premium gasoline are not identical to those in unleaded gasoline. price movements in premium gasoline are not identical to those in unleaded gasoline. Similarly, the price of natural gas at Henry Hub is not identical to that at Chicago. The Similarly, the price of natural gas at Henry Hub is not identical to that at Chicago. The distinction between what exchange products can hedge and what the user wants to distinction between what exchange products can hedge and what the user wants to hedge is the source of
hedge is the source of basis risk basis risk . Basis risk is the risk that the price difference between. Basis risk is the risk that the price difference between the exchange contract and the commodity being hedged will widen (or narrow) the exchange contract and the commodity being hedged will widen (or narrow) unexpectedly. To a large extent, the OTC market exists to bridge the gap between unexpectedly. To a large extent, the OTC market exists to bridge the gap between exchange-traded products and the needs of individual traders, so that the two markets exchange-traded products and the needs of individual traders, so that the two markets in effect have a symbiotic relationship.
in effect have a symbiotic relationship. Basis Contracts
Basis Contracts
Price certainty in a unified market can be bought with forward sales, futures contracts, Price certainty in a unified market can be bought with forward sales, futures contracts, or swaps (contracts for differences). When one or both parties face a spot market price or swaps (contracts for differences). When one or both parties face a spot market price that differs from the price in reference market, however, other derivative contract that differs from the price in reference market, however, other derivative contract
instruments may be needed to manage the resulting basis risk. For example, a local instruments may be needed to manage the resulting basis risk. For example, a local distribution company (LDC) in Tennessee could enter into a swap contract with a distribution company (LDC) in Tennessee could enter into a swap contract with a natural gas producer, using the Henry Hub price as the reference price; however, the natural gas producer, using the Henry Hub price as the reference price; however, the LDC would lose price certainty if the local spot market price differed from the Henry Hub LDC would lose price certainty if the local spot market price differed from the Henry Hub price. In this example, when the Henry Hub price is higher than the Tennessee price by price. In this example, when the Henry Hub price is higher than the Tennessee price by more than it was at the initiation of the swap contract, the LDC gains, because its more than it was at the initiation of the swap contract, the LDC gains, because its payment from the producer will exceed the amount it pays to buy gas in its local market. payment from the producer will exceed the amount it pays to buy gas in its local market. Effectively, the LDC will pay less per thousand cubic feet than the fixed amount the LDC Effectively, the LDC will pay less per thousand cubic feet than the fixed amount the LDC pays the producer. Conversely, if the Tennessee price is lower, the producer’s payment pays the producer. Conversely, if the Tennessee price is lower, the producer’s payment will not cover the LDC’s gas bill in its local market.
will not cover the LDC’s gas bill in its local market. A variety of
A variety of basis contracts basis contracts are available in OTC markets to hedge locational, product,are available in OTC markets to hedge locational, product, and even temporal differences between exchange-traded standard contracts and the and even temporal differences between exchange-traded standard contracts and the particular circumstances of contract users. The simplest is a
particular circumstances of contract users. The simplest is a basis swap basis swap . In the example. In the example above, the OTC trader would pay the LDC the difference between the Tennessee price above, the OTC trader would pay the LDC the difference between the Tennessee price and the Henry Hub price (for the nominal amount of gas) in exchange for a fixed and the Henry Hub price (for the nominal amount of gas) in exchange for a fixed payment. The variety of contractual provisions is unlimited. For example, the flexible payment. The variety of contractual provisions is unlimited. For example, the flexible payment could be defined as a daily or monthly average (weighted or unweighted) price payment could be defined as a daily or monthly average (weighted or unweighted) price difference; it could be capped; or it could require the LDC to share the costs when the difference; it could be capped; or it could require the LDC to share the costs when the contract’s ceiling price is exceeded. What this OTC contract does is to close the gap contract’s ceiling price is exceeded. What this OTC contract does is to close the gap between the Henry Hub price and the price on the LDC’s local spot market, allowing the between the Henry Hub price and the price on the LDC’s local spot market, allowing the LDC to achieve price certainty.
LDC to achieve price certainty.
The traders supplying basis contracts can survive only if the basis difference they pay— The traders supplying basis contracts can survive only if the basis difference they pay— averaged over time and adjusted for both financing charges and the time value of averaged over time and adjusted for both financing charges and the time value of money—is less than the fixed payment from the LDC. Competition among OTC traders money—is less than the fixed payment from the LDC. Competition among OTC traders can only reduce the premium for supplying basis protection. Reducing the underlying can only reduce the premium for supplying basis protection. Reducing the underlying causes of volatile price differences would require more pipeline capacity, more storage causes of volatile price differences would require more pipeline capacity, more storage capacity, cost-based transmission pricing, and other physical and economic changes to capacity, cost-based transmission pricing, and other physical and economic changes to the delivery system itself.
