Essentials of Energy Risk Management
This course is appropriate for all energy professionals wishing to obtain a practical (non-technical) understanding of the basic energy derivative and risk management concepts (e.g. forward pricing) and structures (e.g. synthetic storage) commonly used in today’s energy business. The risk management of the energy business is different from hedging in other business sectors. The physical dimensions of energy create differences in everything from forward pricing, to hedge strategies and option valuation. This program emphasizes these unique aspects of energy risk. Emphasis is placed on understanding how instruments, including forwards, swaps and options, can be combined explicitly with physical positions to serve as a hedge. Also explored is how more insidious risks, embedded within common energy assets and contracts, can also represent option or other derivative positions. An understanding of this interrelationship between financial risks and the physical dimensions of energy is a central theme of the program. There are no prerequisites for this program, nor is any advanced preparation required.
CPE Credits: Accounting & Auditing 2; Consulting Services 1; Management 1; Specialized Knowledge & Applications 12.
Day 1
Management of Enterprise Risk

Risks within an Energy Enterprise

• Directional price risk
• Spread risk vs. price risk
• Force Majeure & physical supply risk
• Credit and cash liquidity risks
• Operational Risk

Interdependence of Risk

• No risk elimination - only risk trade offs
• Choosing among risk positions
• Risk and capital allocation
• Portfolio management of enterprise risks and capital

Why Companies Hedge

• Earnings stability vs. price certainty
• Accessing capital
• Comparing volatilities of crude oil, natural gas, coal and power

Identifying Risk Positions

• Physical vs. financial risk exposure
• Indexation and its implications to risk exposure

Structure of Trading

• Factors influencing the bid-offer spread
• The dealing process
• Role of the market makers and broker

Pricing Energy in the Forward Market

Knowledge of forward pricing concepts for energy products and its relationship to forward price curves is central to understanding derivatives and trading, including forwards, futures, swaps and options. This section focuses on the concept of forward pricing and price curves, and how they come into play in developing hedge strategies, position valuation and other business applications.

Energy Pricing and the Forward Price Curve

• Defining the Forward Price Curve
• The theory of forward pricing
• Why forward prices in energy do not conform to theory
• Forward pricing disciplines for storable energy products
• Synthetic forwards

The Structure of Forward Prices

• Physical supply risk and backwardation in energy price curves
• Seasonality and the price curve for natural gas and refined products
• Price curves for natural gas and power
• Synthetic storage and storage arbitrage
• The economics of lending energy

Price Curve Applications

• Pricing transactions
• Valuing existing positions
• Role of the price curve in developing hedge tactics
• The role of the price curve in analyzing capital investments in energy

Using Swaps to Manage Risk

This section explores financially settled hedge instruments like swaps and futures in energy risk management. It explains how swaps serve to separate price risk from physical risk and the array of benefits this generates. Popular strategies are discussed along with more tailored solutions to risk management situations. Applications of swaps beyond energy price risk are also explored including weather, shipping and default risk hedging.

The Fixed/Floating Swap

• Swap mechanics
• Advantages to companies
• Separating physical risk from price risk
• Force majeure issues

Using a Swap to Hedge Price Risk

• Interpreting a dealer quote on a swap
• Constructing a hedge using swap
• Creating and interpreting swap diagrams
• Calculating a hedger’s all-in cost with a swap

Swap Pricing

• Defining a fair-value exchange pricing for a swap
• Relationship between swap prices and the price curve
• Embedding financing in a swap structure

Extending the Swap Concept

• Gas Daily/Swing swaps
• Weather hedging/Cooling Degree Day (CDD) swaps
• Hedging LNG and crude oil ocean shipping rates
• Storage swaps
• Volatility swaps
• Credit default swaps
• Contract for differences

Day 2
Basis Trading and Transportation

Basis and Transportation

• Defining location basis
• Basis as synthetic transportation

The Basis Swap as a Risk Management Tool

• Basis as a risk to a hedger
• The structure of the basis swap
• Pricing basis transactions
• Understanding bid-offer quotes in the basis market

Using the Basis Swap to Hedge Location Risks

• Managing natural gas basis risk
• Hedging transport/transmission costs with a basis swap
• Managing price risk using basis swaps
• Using a basis swap to eliminate basis risk
• Using a basis swap to optimize risk/return

Benchmark Pricing of Physical Natural Gas

• Pricing from the benchmark price curve
• Embedded options: Swing
• Credit and capital adequacy
• Combining value components to price delivered gas forward

Using Basis Swaps to Transform Risk

• Using basis swaps to optimize risk/return
• Using basis swaps to synthetically transport energy
• Spark spread swaps

Fixed Transmission Rights (FTR's)

• Locational Marginal Pricing
• FTR as a basis swap
• Firm transmission through an FTR

Energy Options

Following a review of the fundamentals of option structures and pricing, the program takes participants into the world of option structures being used today. It explores opportunities that can be developed using creative combinations of option and swap structures. Participants will also explore the economic values associated with options, a critical tool for their future understanding of risk management structures.

The Broad Concept of Optionality Required in the Energy Business

• Options as asymmetrical payouts
• ‘Real’ optionality embedded in energy assets and contracts

Fundamentals of Options

• Call and put structures and payouts
• Option terminology
• Intrinsic and time (extrinsic) value
• Identifying embedded options by recognizing payouts

Opting Pricing Basics

• Concept of an option premium
• Influence of the price curve
• Time value and time decay
• How energy options differ from options on financial products
• Understanding volatility

Timing of Exercise

• European vs. American options
• Variations in American-style options in energy
• Embedded financial storage in certain American options

Buying Options to Hedge Physical Risk Positions

• Hedging a buyer with a call
• Hedging a seller with a put
• Options as insurance
• Option vs. fixed-price hedging strategies
• Physical vs. financial settlement
• Risk-reward trade off

Recognizing Embedded Optionality

• Using option payout diagrams to identify hidden options
• Identifying options embedded in supply contracts
• Identifying optionality in energy assets

Reducing Energy Costs by Selling Options

• Covered vs. naked options
• Cost structure after selling options

Packaged Option Structures

• Linking option strips to create caps and floors
• Call strips as synthetic generation
• Combining puts and calls to create costless collars
• Comparing collar hedging strategies to fixed price and option hedging

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