Fundamentals of Energy Trading & Hedging
CPE Credits: Marketing 1, Management Advisory Services 3, Economics 2, Production 2, Specialized Knowledge & Applications 8: Total = 16
Day 1
Understanding Risk Management

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

Enterprise Risk in Energy
• Directional price risk
• Spread risk vs. price risk
• Force Majeure & physical supply risk
• Credit risk
• Operational Risk
• Risk in an Enterprise transformed, not eliminated

Identifying Risk Positions

• Physical vs. financial risk exposure
• Being long/short energy without a physical position
• Indexation and its implications to risk exposure

Structure of Trading

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

Pricing Energy in the Forward Market

Knowledge of how to construct and use forward price curves is central to understanding how the core derivative products — futures, options and swaps — function. This section focuses on the concept of forward pricing, price curves and ends with a discussion of basis risk and how this affects different strategies.

Defining the Forward Price Curve

• Based on dealable prices
• Not a price forecast

Pricing Energy in the Forward Market
• The theory of arbitrage-free forward pricing
• Why forward prices in energy don’t conform to theory
• Forward pricing disciplines for storable energy products
• Synthetic forwards

The Structure of Forward Price Curves
• Physical supply risk and backwardation in energy price curves
• Seasonality and the price curve for natural gas and refined products
• Price curves for power and coal
• Synthetic storage and storage arbitrage
• Valuing inter-period exchanges of physical energy

Price Curve Applications
• Pricing transactions
• Valuing existing positions
• Role of the price curve in developing hedge tactics
• Role of the price curve in analyzing capital energy investments

Using Swaps to Manage Risk

This section explores swaps as a financial tool in energy risk management including its relationship to the price curve. It explains how swaps serve to separate price risk from physical risk and the array of benefits that generates. Popular strategies are discussed along with more tailored solutions to risk management situations. 

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

Basis and Transportation

• Defining location basis
• Basis as synthetic transportation

The Basis Swaps 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

Fixed Transmission Rights (FTR’s)

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

Using Basis Swaps to Transform Risk

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

Hedging with Futures

Futures are one of the key building blocks of derivative products. This section introduces participants to exchange traded futures and its mechanisms such as margining, paper trading, physical settlement and the use of EFPs and EFSs. It also explores the newer areas of on-line trading, examining the varied product offered through these new trading platforms

The Futures Contract

• Exchange-traded contracts
• Comparison — futures vs. swaps
• Standardized terms
• The NYMEX Natural Gas Contract

The Mechanics of Margins

• Original margin
• Variation margin
• Cash liquidity risk

Exchange Traded Contracts

• The NYMEX Natural Gas Contract
• Contract Specifications: Physical vs. Financial settlement
• NYMEX options and strips

Credit and Cash Liquidity Risks

• Mechanics of margins
• Original vs. variation margin
• Variation margin
• Cash liquidity risk

Hedging Using Futures

• Standard (physical) delivery under NYMEX
• Infrequency of physical delivery
• Paper hedging a risk position using futures contracts
• NYMEX look-alike swaps
• Comparing futures and swap hedge strategies

Exchange of Futures for Physicals (EFP)

• Execution risk
• Using EFP Settlement
• EFP vs. basis swaps
• Exchange of Futures for Swaps

On-Line Traded Products

• NYMEX Clearport
• Penultimate swap futures
• Basis swap futures
• Swing swap futures

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