1. Common Energy Derivatives and Their Use to Manage Risk
Presenter:
Jeff Jewell, DTE Energy

2. Agenda Common Derivative Structures Common Energy Products
Common Risk Management Strategies

3. Common Energy Derivatives Physical vs. Financial Contracts
Physical transaction
A contract in which the actual (physical) commodity is transferred between parties to the contract. (i.e., Party A sells and delivers gas to Party B)
Financial transaction
A contract in which no commodity is transferred between parties and parties only exchange cash payments in amount equal to the financial benefit of holding the contract (i.e., Party A pays Party B the change in the contract value from inception to expiration)

4. Common Energy Derivatives
Futures
Exchange traded
Essentially financial
Forwards
Over the counter (OTC)
Physicals
Swaps
OTC
Financials
Options
Exchange traded or OTC
Physical or financial

5. Common Energy Markets New York Mercantile Exchange (NYMEX)
Intercontinental Exchange
Independent System Operator (ISO)
Over-the-Counter
Broker

6. Common Energy Derivatives Exchange Traded Futures and Options
A legal agreement between a buyer or seller and the clearinghouse of a futures exchange
Futures contracts generally have the following characteristics:
They obligate the purchaser (seller) to accept (make) delivery of a standardized quantity of a commodity or financial instrument at a specified date or during a specified period, or they provide for cash settlement rather than delivery
They are defined by standard delivery points and volumes
They effectively can be canceled before the delivery date by entering into an offsetting contract
All changes in value of open contracts are settled on a regular basis, usually daily.
They carry no credit risk

7. Common Energy Derivatives Exchange Traded Futures and Options
New York Mercantile Exchange (NYMEX)
PJM Monthly Peak (JM)
The Exchange provides financially settled monthly futures contracts for on-peak and off-peak electricity transactions based on the daily floating price for each peak day of the month at the PJM western hub (swap-like)
Trading Unit: 2.5 MWs, equivalent to 40 megawatts (Mw) per peak day (between 19 and 23 days) depending on the month. Depending on the number of peak days in the month, the number of megawatt hours will vary (between 760 Mwh and 920 Mwh).
Trading Months: The current year plus the next five calendar years.
Termination of Trading: One business day before the last peak day of the month.
Settlement: Financial, based on the arithmetic average of the PJM western hub real-time locational marginal price (LMP) for the peak hours of each day.
Similar Off-peak Product available (JP)

8. Common Energy Derivatives Exchange Traded Futures and Options
New York Mercantile Exchange (NYMEX)
Natural Gas (NG) Futures Contract
Trading Unit: 10,000 million British thermal units (mmBtu).
Trading Months: The current year and the next five years
Last Trading Day: Trading terminates three business days prior to the first calendar day of the delivery month.
Delivery: The Sabine Pipe Line Co. Henry Hub in Louisiana
Crude Option (LO)
Trading Unit: Option: One NYMEX Division light sweet crude oil futures contract. Future: 1,000 US barrels (12,000 gallons)
Trading Months: Crude oil options are listed seven years forward
Last Trading Day: Option trading ends three business days before the underlying futures contract. Futures: Trading terminates three business days prior to the 25th of the month preceding the delivery month
Delivery: West Texas Intermediate

9. Common Energy Derivatives OTC – Forwards (Physicals)
Symmetrical exposure
Over-the-counter contract to purchase or sell a specific quantity of a financial instrument, a commodity or a foreign currency
Pre-determined specified price
Settlement at a specified future date
Can be settled by actual delivery of the item in the contract, or net cash settlement
Credit Risk
Exchange of Collateral, Letters of Credit, Parental Guarantee

10. Common Energy Derivatives OTC - Forwards
Forward Sale of Power at $70
Delivers 100 MW
Utility
Marketer
Pays $70/MW

11. Common Energy Derivatives OTC - Swaps
Over-the-counter contracts to exchange cash flows as of a series of specified dates (swap)
Based on agreed upon notional amount
Pre-agreed fixed rate; pre-agreed variable index
Symmetrical exposure
Credit Risk
Exchange of Collateral, Letters of Credit, Parental Guarantee
Examples:
Basis Swap (Natural Gas)
Fixed vs. Float Swap

12. Common Energy Derivatives OTC - Swaps
Fixed vs. Float swap
Pay: $6/mmbtu
Receive: Gas Daily Index $/mmbtu
Pay Fixed ($6)
Utility
Financial
Institution
Receives Float
(Gas Daily
Index Price)

13. Common Energy Derivatives OTC - Options
A financial instrument which represents a contract sold by one party (option writer) to another party (option holder).
The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a financial or physical asset at an agreed-upon price (strike price) during a certain period of time or on a specific date (exercise date).
Option Premium: price the option holder pays for the right to buy or sell the financial or physical at a specified price in the future
Accounting for Premium is over the life of the option, not the delivery period.

14. Common Energy Products/Contracts - Gas
Natural Gas
Transportation
Full Requirements contracts
Trigger contracts
Park and loans
Storage contracts
Swing contracts
Basis contract
Take or pay contract

15. Common Energy Products/Contracts - Power
Electricity
Capacity
Financial Transmission Rights (FTR)
Auction Revenue Rights (ARR)
Transmission & Distribution
Spark spreads
Tolling agreements
Full requirements contracts
Renewable Energy Credits
Energy Products
There are several different commodities that are traded in the Energy Industry. In general, they are power and the fuel required to produce electricity or heat homes (i.e. oil, gas, coal, etc).
The two most heavily traded commodities are power and gas, and due to their unique infrastructures have several associated products that can be traded in the market.
Power:
Electricity – actual electricity that is generated and delivered counterparty
Capacity – electricity that may be generated and delivered at the option of the purchaser of the capacity
Transmission & Distribution – provides the purchaser with the capability to deliver electricity to from point-to-point within a region (transmission) or to retail end-users (distribution).
Gas
Gas – actual gas that is delivered to the counterparty
Storage – the capability to store a fixed volume of gas in a third-parties storage facility.
Transportation – provides the purchaser with the capability to deliver gas from location-to-location across the country.

16. Common Energy Derivatives and Their Use to Manage Risk
How are these Products/Contracts Used?
“Lock-in” prices
To fix the purchase or sales price of an energy commodity at a future point in time
Protect against unfavorable price movements
Example:
Collar (put and call)
Swap
Basis is the differential between the market price of a commodity and the market price of the same commodity, due to differences in the delivery point, time of delivery, or contract settlement. Basis Risk is the risk that the fluctuations in the differentials will adversely affect the company.
Credit Risk is the risk that the counterparty (or customer) to the contract will not pay the amount owed for delivery of a commodity. Energy markets are particularly susceptible to this risk due to the nature of physical delivery and size of the corresponding payments.
The risk that an energy trader is unable to deliver the agreed upon commodity to a counterparty is called Operational Risk. Operational risk is typically the result of failure in the commodity production or delivery infrastructure. If a fuel supplier or a power producer cannot deliver the commodity to the counterparty as agreed the seller can be responsible for liquidated damages.

17. Common Energy Derivatives and Their Use to Manage Risk
Option Collar - A Zero Cost Collar strategy combines the sale of a Call Option and the purchase of a Put Option
The Option premium collected by the sale of the Call Option with a higher strike price (capped sale price) will fund the purchase of a Put Option with a lower strike price (capped purchase price).

18. Sources of derivative value movement
Changes in spot market rates – scratches surface
Changes in forward market rates over the entire duration (tenor) of the instrument – present value of these changes affects current value
Unusual terms (combined derivatives; leverage factors)
Additional market factors (volatilities, correlations, spreads)
Changes in creditworthiness (e.g., non-performance risk) of either or both counterparties, often mitigated by credit support agreements (collateral) and master netting arrangements to offset derivative assets and liabilities between the same two counterparties

19. Common Energy Derivatives and Their Use to Manage Risk
Reduce earning volatility
Investors/Capital Markets may desire predicable future earnings
May be achieved by locking-in both the purchase and sales price of a product, regardless of future price movements
Manage other risks
Basis risk (locational)
Credit risk
Operational risk (physical delivery, plant outages)

20. Questions?