Chapter 7 Energy Risk Management – Essentials of Financial Risk Management

CHAPTER 7

Energy Risk Management

Introduction

As with all other aspects of financial risk management, managing risk associated with energy markets is both an art and a science. Standard quantitative techniques and risk management practices are certainly applied, but the finer nuances of energy markets—from spikes in real-time electricity markets to price spreads between various grades of heavy fuel oil—make energy risk management a particularly interesting and at times challenging endeavor.

Energy use has been closely tied to economic growth since the industrial revolution when burning coal as a fuel to produce steam became common in England, eventually spreading across the globe. Although coal is still widely used in electricity production and steelmaking, other fossil fuels such as natural gas and oil, nuclear power, and renewables are now all important sources of energy. Each of these energy sources has unique characteristics that contribute to the particularly challenging nature of energy risk management.

Although no single precise measurement of total energy expenditures exists, estimates for the earlier part of this decade range from US$5 to US$6 trillion or close to 10 percent of global GDP.1 This is an astounding amount of money, and managing risks in these markets is critical to the success of individual companies and the economy as a whole.

Not all companies are equally exposed to energy markets, and varying degrees of sophistication within an energy risk management program is expected and appropriate. The degree of exposure can be classified into three broad categories:

  • Primary: companies whose primary line of business is in the energy industry—oil and gas exploration companies, oil refiners, and energy marketers. The financial success of these companies is highly dependent on energy prices, and therefore they are likely to have robust and sophisticated risk management programs to specifically identify and manage exposure to energy risks.
  • Secondary: companies that are not directly in the energy industry, but that have significant exposures to energy markets. Examples include energy-intensive manufacturing companies, mining companies, and airlines. These companies tend to also have robust risk management programs to manage energy risk, but often as a component of their broader financial risk management systems and practices, as opposed to a standalone risk management program.
  • Tertiary: companies with minimal direct exposure to energy markets. Technology, retail, and restaurants are examples of businesses in this category. These companies often do not put much thought into directly managing their energy risks. While other risk factors tend to have a larger impact on their financial success, energy costs can still be a meaningful input cost and should not be ignored.

Energy Price Risk

The most direct exposure to energy markets faced by many firms is to the level of energy commodities: for example, oil, gas, and electricity. Energy markets tend to be volatile and in certain circumstances can exhibit extreme volatility. The primary reasons for this volatility are the physical nature of energy commodities, limited transportation capacity to deliver energy from its source of production to point of consumptions, and the limited ability to store energy in many forms, which result in supply/demand imbalances. One of the most extreme examples of volatility in energy markets occurs in real-time electricity markets. In deregulated electricity markets such as New York, a System Operator receives offers from power generators to sell electricity and will dispatch power plants, and imports from neighboring markets, in an attempt to match supply to demand in a reliable and low-cost manner. When the system is nearing its maximum capacity, typically on hot summer days when air conditioning load is high, the unexpected loss of a power plant due to operational issues can result in a shortage of supply causing massive price spikes in the market price of electricity which updates every 5 minutes. Generally these price spikes are very short-lived as new supply will come online and price-sensitive demand will reduce their usage helping to quickly bring the market back into equilibrium (Figure 7.1).

Figure 7.1 NYC real-time power prices, July 20, 2017

On July 20th, 2017, prices for the New York City zone printed 5-minute intervals as low as $24.29 and as high as 1,438.41/MWh; a range that would be unthinkable in most markets. Granted, this is an extreme example and very few companies are directly exposed to this particular risk, but it does serve to demonstrate key risks which are paralleled to lesser degrees in natural gas, oil, and other energy markets.

Over longer periods of time, energy markets can be subject to boom-and-bust cycles, often in line with broader economic cycles. As economic activity picks up, demand for energy often increases more quickly than supply can be added, leading to increasing prices. The higher energy prices lead to greater investment in exploration and resource development, but the time it takes to bring incremental supply to market means that often this supply hits the market as the economy is losing steam and even entering a recession. The combination of decreased demand and increased supply can lead to drastic decreases in energy prices. It is important for a risk manager to understand the connection between economic cycles and energy prices, and of course how the financial performance of their firm is connected to both energy prices and economic cycles.

In addition to understanding the factors that influence prices of each energy source, there are some particular nuances of energy markets that can create significant differences within fuel types, which we explore in the following sections.

Basis Risk

Basis risk is a familiar concept in many financial markets and can refer to the deviations between a spot price and a futures contract price, or more generically between a financial hedge and the underlying exposure. In energy markets, there are additional dimensions that must be monitored: locational basis and quality basis.

Locational basis refers to differences in the price of the same commodity in different places. For example, natural gas in Boston is (almost) chemically identical to natural gas in Louisiana or Korea, but the price of this gas may be very different at the same time. This arises from the fact that natural gas cannot be transported freely and instantaneously around the world like a currency transfer or an interest rate can be in digital form. This same feature of energy markets arises in varying degrees in all physical commodities, particularly in those which are difficult and costly to transport, or where sufficient infrastructure does not exist to bring production from its source to where it is consumed. Oil production in the western Canadian oil sands has increased significantly over the last decade; however, pipeline capacity to bring this production to refineries or export terminals has not kept pace. At times, this leads to a significant discount for oil sands production. This is very different from financial commodities such as currencies: US$1 may cost €1.1 in New York and at the same time will trade at practically the same level in Tokyo, London, and Singapore. Many deregulated electricity markets have locational marginal pricing where hundreds or thousands of locations within a single state or multi-state market will have different prices. These prices are comprised of three components: an energy component that is uniform across the entire market, a loss component to reflect the energy physically lost through the transmission of electricity, and a congestion component that reflects the fact that limited transmission capacity will mean the next available lowest cost source of supply cannot always be used to meet demand at all locations and a more expensive source of supply may need to be used. At times of peak demand when many transmission lines are nearing the maximum capabilities, significant congestion can occur causing major differences in prices at locations that may be very close together geographically but on opposite sides of the transmission constraint.

Quality or product basis refers to different quality characteristics within an energy type that can lead to pricing differences. Coal is a prime example, as depending on where it is mined, it can vary across a number of quality characteristics: heat content, sulfur content, mercury levels, and even its hardness to name just a few. Depending on how these characteristics vary, the price of two otherwise indistinguishable coals may be very different. Higher heat content means a lower volume of coal must be consumed to produce the same amount of electricity and is therefore likely to trade at a higher price. Sulfur content in coal when burned is released as an air pollutant, which makes it an undesirable characteristic. Coals with lower levels of sulfur will tend to trade at a premium to higher-sulfur coals. Metallurgical coal, or “met coal” is used in steelmaking, whereas thermal coal is used for electricity production. The unique characteristics required for steelmaking, such as high heat content and low levels of impurities, means that at times met coal can be much more expensive than thermal coal.

Oil can also exhibit similar product quality dynamics: heavy, sour crudes tend to trade at a discount to light, sweet crude; however, this depends significantly on the relative supply of each type and the availability of refining capacity capable of handling each type. Once oil has been refined, quality differences can still result in price differentials: heavy fuel oil for sale in New York Harbor that contains 1 percent sulfur typically trades at a premium to 2.2 percent, which in turn trades at a premium to 3 percent. As financial hedges are not liquid for every product type and quality, it is important for the risk manager to understand how these basis differentials can change over time, what factors influence these differentials, and how to most effectively use available financial hedges to mitigate exposure to related but not perfectly correlated products.

Case Study

American natural gas markets

For a deeper dive into locational basis risk, we can explore American natural gas markets, where in certain regions during periods of high demand the pipeline infrastructure is insufficient to meet the needs of consumers. This can result in price spike in the daily gas markets, and significant price separation between production areas and key market areas. For example, the U.S. Northeast region consumes a large quantity of natural gas on cold winter days for power generation, industrial uses, as well as significant volumes for residential and commercial heating needs. Prices in the Northeast can decouple from those in the rest of the continent, spiking higher in constrained areas where pipeline infrastructure cannot deliver enough natural gas to meet demand. The higher prices incent price-sensitive consumers to reduce their demand: natural gas fired power plants will be replaced by generators that use other fuels, or plants capable of burning oil will switch to this alternative fuel, and some industrial consumers will temporarily halt some optional processes. The ability for consumers to reduce consumption or switch to alternative fuels is in itself a very valuable form of operational risk management that can replicate some of the effects of buying financial hedging products. North American natural gas futures contracts that trade on exchanges such as the Intercontinental Exchange (ICE) or the New York Mercantile Exchange (NYMEX) are settled at Henry Hub, a pricing hub in Louisiana located near the major production basin in the Gulf of Mexico. If natural gas transportation infrastructure was sized such that production could always reach every consumption area, prices would be much more uniform across the continent, and natural gas could be hedged simply with Henry Hub futures. Unfortunately, pipeline capacity is limited and the resulting constraints cause price separation between Henry Hub and the key demand centers which can make Henry Hub futures ineffective hedges if you are located downstream of the constraints. Luckily there are other products, basis swaps (or futures), that can be used to hedge the locational differential. A purchaser of a natural gas basis swap pays a fixed price and receives a floating price equal to the difference between price at the location referenced in the contract and Henry Hub, as illustrated in Figure 7.2. When prices rise in the market area relative to Henry Hub, the swap purchaser receives the difference which offsets the higher price paid for the physical natural gas they are consuming. A gas consumer in New England may enter a swap for January where they pay a fixed price of $5/MMBtu and in return will receive the difference between the monthly index price for Algonquin Citygates and the price at Henry Hub. If Algonquin settles at $9/MMBtu and Henry Hub at $3/MMBtu, the swap buyer will receive a net payment of $1/MMBtu.

Figure 7.2 Basis swap

Seasonality

Unlike financial products like stocks and bonds, which effectively trade the same regardless of the weather outside, certain energy commodities can exhibit significant seasonality, with prices and volatility spiking at times of high demand. This is shown in the New York electricity and Northeast natural gas examples cited earlier in this chapter. A key operational risk management tool for some companies is to reduce consumption when prices are higher; however, this real option is not available to all market participants. For example, a natural gas local distribution company (LDC) must supply gas to its customers, generally at a fixed price, regardless of what price they have to pay for the gas. What makes this risk particularly dangerous is that the amount of gas these companies must supply is highly correlated with prices: higher volumes on days when market prices are highest. LDCs, and other companies facing similar risks, use a portfolio approach to mitigate exposure to these risks including physical and financial contracts, as well as investment in infrastructure. LDCs often contract for firm pipeline capacity which allows them to import natural gas from areas of supply where prices tend to be lower, allowing them to avoid paying the higher prices in the market area. They often enter into physical supply agreements with producers or marketing companies at a fixed price, eliminating exposure to volatile market prices. Other physical contracts may be indexed to trading hubs, which leaves exposure to market prices that can be mitigated through the use of financial derivatives. Some physical contracts contain swing options, allowing the purchaser flexibility in the volume purchased for a given day or month, allowing the company to better align its purchased volume to what it must supply to its customers. Physical storage is another very valuable risk management tool, where a company can inject natural gas into a storage facility at times of low pricing and withdraw it when prices are high, helping minimize purchases at times of peak pricing.

Each of these risk management tools has a cost, whether through an option premium paid to a marketer or fixed demand charges paid for pipeline or storage capacity. Many companies have some ability to pass hedging costs through to their customers, but a decision must be made as to how much risk should be mitigated and how much is acceptable for the company or its customers to bear. Managing broad exposure to large market movements may make sense as it can be done using standard products with high liquidity and low costs, but entering into highly customized bespoke contracts with financial institutions to manage risk that may not be material to the overall business may not provide a level of risk reduction commensurate with the costs incurred. This decision is a key part of any company’s risk management process and will need to consider all the internal and external objectives and pressures unique to each firm.

Geopolitical Risk

Although we have explored several instances of market dynamics related to localized environments and infrastructure constraints, energy markets are also influenced by global trends and events. Much of global oil production occurs in regions that have been prone to armed conflict or general geopolitical instability including Iran, Iraq, Saudi Arabia, and Libya. Conflict, the threat of war, terrorism, sanctions, or regime change can either directly reduce oil production or raise the possibility of future supply disruptions, leading to increases in prices and volatility. The wars in Iraq, the Arab Spring movement, and sanctions imposed on Iran are all examples of geopolitical risk. The increase in liquefied natural gas (LNG) trade has had the effect of turning natural gas into more of a fungible global commodity; however, not to the extent of oil or coal. The increase in LNG exports from more stable countries such as the United States and Australia also helps dampen geopolitical risk in the natural gas markets.

Legislative and Regulatory Risk

Due to its critical role in the economy, and even national security, the energy industry is often subject to a high degree of regulation and is exposed to regulatory and legislative risk. This may be at a local, state or provincial, national, or even international level. One example is in natural gas pipeline development in the United States, where in a constrained region like New England, the addition of a major interstate pipeline would have a significant impact of pricing. Although the Federal Energy Regulatory Commission (FERC) has overall jurisdiction over approving interstate pipelines, states can block pipeline development by refusing to grant water permits, and local governments can refuse to allow siting of infrastructure such as compressor stations. At the federal level, pipelines may or may not receive approval from FERC, a decision which can drastically impact forward market pricing in these regions.

Environmental legislation can also have a major impact on energy markets, particularly over longer time periods. This may take the form of local air pollution rules which limit the use of certain fuels, or from global agreement like the Paris Agreement which seeks to reduce greenhouse gas emissions globally to limit further global warming. A number of tools can be used to reduce greenhouse gas emissions; for example, jurisdictions may ban through legislation the use of carbon-intensive fuels like coal, they may provide tax credits or other incentives for the production of renewable energy, or they may require electricity providers to source a certain percentage of their supply from renewable sources through the implementation of Renewable Portfolio Standards. Each of these tools will impact energy markets in unique ways, and it is important for the risk manager to monitor enacted and proposed legislation and regulation to understand the potential impact to their business directly or more broadly to energy markets to which they are exposed.

Application of Hedging Tools

Similar to other financial risks, futures, swaps, and options can be used to hedge energy price risk. Futures contracts are available on many energy contracts; however, much of the liquidity is concentrated in only a few key contracts. Although many other contracts exist, the vast majority of financial oil derivatives trade on two contracts: West Texas Intermediate (light, sweet crude delivered to Cushing, Oklahoma) which serves as a benchmark for crude in North America and Brent Crude, a North Sea product which serves as a benchmark for global prices. Many consumers of oil may not be directly exposed to changes in either of these benchmarks, but rather they consume refined products: heavy fuel oil, gasoline, diesel, or heating to name a few. Futures contracts are also available on these refined products; however, the liquidity tends to be limited, especially for longer-dated delivery. Some basic quantitative analysis such as regression analysis can help identify which energy indices are most correlated to a company’s earnings or other key financial metrics. It is important to be mindful of the competitive landscape and whether or not energy price changes can be passed on to customers. This type of situation was explored in more detail in Chapter 2 with the Southwest Airlines Case Study.

Returning to our definition of risk, the possibility that good or bad things may happen, will lead us to our next decision: whether to protect against only one direction of price movement while leaving the company exposed to opposite price movements, or to hedge exposure to price movements in both directions. Simply, should we eliminate exposure to “bad things” while allowing the company to benefit from the “good things” or eliminate exposure to both the bad and good things? If minimizing exposure to both upside and downside risk, financial products that lock-in a price, such as swaps, forwards, or futures contracts are a natural choice. For buyers of these contracts, an increase in the market price of the reference asset will result in gains which offset the rising cost of the physical energy commodity, while a decrease in the price of the reference asset will result in losses. Regardless of the direction of market movements, entering these contracts has the result of locking in the price paid. There are relatively liquid financial markets for many energy commodities; however, these contracts tend to reflect only the most common qualities and only for a limited number of delivery locations. These risks were discussed in greater detail earlier in the chapter, and market participants must be mindful of how their energy costs may not be perfectly correlated to the available financial products.

If a decision is made to hedge only one side of the risk, options are a natural choice. For example, an energy consumer who buys a call option will be protected from rising prices by receiving a payoff from the option as prices rise, but as prices fall the option expires with no obligation for either party to make a payment, so the buyer is able to benefit from the lower market prices in the physical market. Options of course require an upfront payment to the seller, namely the option premium. Option prices are higher for more volatile underlying assets, and energy commodities tend to be more volatile than many other financial assets, making using options to hedge a very expensive proposition at times. In addition, options are more complicated, therefore requiring more sophistication in the risk management department, and tend to be much less liquid than futures contracts.

Physical contracts can also be a very effective risk management tool in the energy industry. By entering into an agreement with an energy supplier to purchase electricity, gas, oil, or any other fuel, the buyer is removing much of the basis risk discussed earlier. The exact product is known, the delivery location is known, and depending on the nature of the contract even the price may be known. These contracts can be structured to allow for volume flexibility eliminating some of the volumetric risk faced by energy consumers. For many smaller consumers of energy, these are the only contracts needed. They buy their electricity from the regulated local utility under a set tariff, and their natural gas comes from the LDC, again under a regulated tariff. These tariffs, however, typically only eliminate price risk over short periods of time: the tariffs will be updated on a periodic basis (typically annually, but at times more frequently) as the cost of service incurred by the utility changes. As fuel costs are typically the largest and most volatile single component of this cost, entering into financial hedges to offset changes in these tariffs may be required for companies wishing to manage energy price risk over longer time periods.

Trends

Users of electricity and natural gas need to be mindful of long-term trends that influence broader market price levels. These trends can be driven by many factors such as an increased focus on climate change or technological innovation which makes hydrocarbon reserves economically accessible.

Energy markets are highly dynamic, and it is important for risk managers to be mindful of new and emerging trends, both regional and global, which may have a significant impact on prices and volatility. Energy production is the primary contributor to global greenhouse gas (GHG) emissions, and the increased focus on climate change is causing major changes to the way in which energy is produced and consumed. Renewable energy sources such as wind, solar, and hydro are increasing in importance with production costs for solar photovoltaic electricity in particular experiencing huge decreases in cost. Intermittent sources of generation, which unlike traditional fossil fuel based generation (ignoring maintenance outages) cannot always be counted on when needed and sometimes produce surplus electricity when it cannot all be consumed. One way to solve this issue is through the use of energy storage. Battery technology has been an area of research and development, and a few large grid-scale storage projects have been placed in service recently, but although falling, the costs are still relatively high. As prices continue to fall, more batteries will be deployed which will allow integration of additional intermittent renewable generation.

Another key trend over the last decade has been the use of hydraulic fracturing and horizontal drilling to access previously uneconomic oil and natural gas reserves. These technologies have been widely adopted in the United States, resulting in a reversal in the long-term decline in oil and gas production, and significantly reducing American reliance on imported hydrocarbons. The increased natural gas production has resulted in depressed pricing and a reduction in volatility. This has resulted in somewhat of a renaissance for U.S. manufacturing and petrochemical industries as well helping continue the shift from coal-fired electricity to natural gas. It has also resulted in some consumers of natural gas incurring large losses on their hedging programs leading to a complete re-thinking of their hedging activities as exemplified in the Florida Utilities Case Study in Chapter 10.

Risk Management Process

It is important to develop a solid understanding of how your firm is exposed to energy markets either directly through energy purchases and sales or indirectly through the knock-on impact on production inputs or shipping costs. Once exposures have been identified, a determination must be made as to whether or not these exposures can be hedged: what physical or financial contracts or operational decisions are available that can mitigate these exposures? Next, a decision must be made as to how much, if any, of this exposure should be hedged depending on the particular situation of the firm in the context of its financial profile and competitive position in its industry. Then develop an execution plan and enter the hedges. The final step in ongoing monitoring and reporting of risks and the overall hedging program, a step that is ongoing and will result in an iterative process as new and changing risks are identified, new hedges become available, or the financial profile and objectives of a firm evolve over time.

Concluding Thoughts

From traditional manufacturing firms to technology companies with massive data centers or cryptocurrency miners, energy will continue to be a critical component of the global economy. Each energy type presents unique challenges, from natural gas pipeline constraints causing locational basis risk to political unrest in the Middle East increasing volatility in the oil markets. Many standard financial derivatives are available for use in energy risk management, but physical contracting practices and operational hedges are also invaluable tools for risk managers. Understanding the nuances of highly dynamic energy markets will allow firms to create robust risk management plans and make informed and prudent hedging decisions to support financial objectives.

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1Leonardo Energy. November, 2016. “World Energy Expenditures.” http://www.leonardo-energy.org/resources/798