American Gas Association Energy Market Regulation Conference Steve Levine Frank Graves October 9 2014 State of the markets Relatively calm period for US gas markets shaken somewhat by P olar Vortex last winter ID: 689304
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Slide1
LDC Procurement and Hedging
American Gas AssociationEnergy Market Regulation Conference
Steve LevineFrank Graves
October 9, 2014Slide2
State of the markets
Relatively calm period for U.S. gas markets shaken somewhat by Polar Vortex last winterPolar Vortex highlighted gas-electric interactions/competition for pipeline capacity
Polar Vortex may not repeat, but still potential for local mismatches between supply and deliverabilityImplications for LDC procurement and risk managementIs risk management dead or alive in today’s gas markets?Low prices and low volatility less risk management, or a good time to lengthen hedges?
Should gas LDCs revise practices towards value versus volume risk management?Is liquidity a new problem, requiring physical solutions?
IntroductionSlide3
Prices and Volatility Have Declined Since 2009Slide4
Implied volatilities and futures over time
Average 12-Month Forward Implied
Volatility and Futures
Implied Volatility as of May’12
Implied Volatility as of Oct’13
Both volatility and
seasonality have also declined
in the past couple of years
There
has been
a lagged, usually positive
correlation between future prices and
volatilitySlide5
Are Electric and Gas Futures Myopic?
Recent gas futures reflect a nearly flat real outlook for the rest of this decade, suggesting that demand-side pressures from coal plant retirements, LNG exports and industrial demand growth are dominated by expected supply-side optimism.
Henry Hub Futures (real $/MMBtu)
However, many fundamental forecasts (e.g., AEO2014
) show
price bumps around 2016-18 and 2020-23.Slide6
Coal Plant Retirement Impact on Gas Demand
Retirement of 59
– 77 GW
of coal capacity by 2016 could
result in 3.3-6.1 Bcf/d increase in gas demand, depending on share of gas in marginal fuel mix
. (More possible if 111(d) implemented)
Source: “Coal Plant Retirements and Market Impacts,” Metin Celebi, The Brattle Group, February 5, 2014.
Increased use of gas by the existing gas-fired generation fleet (376 GW) would result in 5-8% increase in fleet-wide capacity factor.Slide7
Most (35 Bcf
/d) proposed in the Gulf Coast1.6 Bcf/d East Coast, 2.5 Bcf/d West Coast, 2.5 Bcf/d project in Alaska
One plant under construction (Sabine Pass); another (Cameron LNG) has made its final investment decision8 (10.6 Bcf/d) with DOE approval for exports to non-FTA countriesSabine Pass (2.2 Bcf/d), Freeport (1.8 Bcf/d), Lake Charles (2.0
Bcf/d), Cameron (1.7 Bcf/d), Cove Point (0.8
Bcf/d), Jordan Cove (0.8 Bcf/d), Oregon LNG (1.3
Bcf
/d), and Carib Energy (0.1
Bcf
/d).
3 (5.7
Bcf
/d) with FERC approval
Sabine Pass (2.2
Bcf
/d), Freeport (1.8 Bcf/d), and Cameron (1.7 Bcf/d)
About 42 Bcf/d of Proposed U.S. LNG Export CapacitySlide8
Marcellus/Utica
Production Growth
By 2019
~+5 Bcf/d
1.25 Bcf/d to South/Gulf Coast
2.15 Bcf/d to South/Gulf Coast
1.18 Bcf/d to IN
0.44 Bcf/d to KY
1.0 Bcf/d
to MI
2.5 Bcf/d
to Midcontinent
0.18 Bcf/d
in PA
with access
to TGP and
TETCO
Pipeline Projects from the Marcellus
Shale offtake projects may not serve the areas that were most affected by the Polar VortexSlide9
Basis and Delivery Point Risks:Polar Vortex 2013/2014 Natural Gas Prices
PV showed that some gas procurement locations (
citygates
) carry more risks than others (basins) .
Black swan or recurring prospect?
Low liquidity plus local competition with electric peaking
Potential for unhedged expected volumes plus cold weather unplanned volumes
At very high local prices
Physical procurement considerations include:
H
ow much pipeline capacity from which basins?
Diversity of receipt points?
Market area storage capacity?
More interruptible demand?
How can gas buyers manage risks around these uncertainties?Slide10
Key risk management insights to establish with regulators and customer groups
Volume versus price risk managementProper definitions (hence expectations) of risk and risk management; distinction between risk and “regret”
Criteria and tools for setting goals and monitoring activities in risk reductionNo “one size fits all” for risk reduction; need customer engagement to determine appropriate risk management goalsMonte Carlo methods, VaR
, TEVar and other metrics of net open position
Standards for reviewing prudence of risk management effortsDistinction between risk management and least cost planning
Hazards of ex post reviews of hedge performance
Reviewing adherence to risk control protocols Slide11
Volume Hedging vs. Price Risk Management
Many gas LDCs tend to manage risk with storage and financial forwards/swaps for a fixed volume (35-75+%) of expected needsThis reduces risk, roughly in proportion to target volume hedged,
but actual amount of risk reduced or remaining is not measured or consideredNo explicit consideration of shifts in market forward prices or volatilityNor consideration of rare event price spikesNo basis for changing extent, type, or timing of hedge positionsUsually very mechanical
Or worse, accelerated or decelerated when market prices move down/up relative to past history (which is likely to increase
risk)Risk of imprudence if approach seems outdated, passive, or naïve after adverse events
Best defense is to develop forward-looking risk metrics of exposure of total future costs to current net open position
A
nd
to educate regulators and customer groups on how to evaluate risk management outcomes
.Slide12
Risk versus regret
Risk is ex ante exposure to future volatility (unexpected potential variability) – eliminated by forward purchases at fixed or capped prices.
Regret is ex post disappointment if a hedge turns out to be more costly than not hedging would have been.Not quite a fair complaint: insurance has value even if not used
Regret is a valid concern, but:Regret reduction is generally
antagonistic to risk reductionThe more
ex ante
certainty, (risk reduction) the greater
the chance of
ex post
disappointment (regret),
and
vice versa
Alternative hedging strategies can shift the weight between risk and regret exposure
– subject to customer preferences.
Cumulative Probability
Hedge
Price
100%
50%
Regret
Satisfied
Cost
Zone of
IndifferenceSlide13
Capturing risk information in market prices
Market volatility
can be estimated from historical patterns or inferred from the price of traded options (implied volatility)
Monte
Carlo simulation
then used to
generate future possible price distributions
consistent
with
current
forward
prices
and
their volatility
Volume uncertainty, basis risk, and rare extreme events can also be added to the mix of risk drivers
Conditional Probability Distributions
Spot Prices and Change in Forward CurvesSlide14
Specifying Goals for Risk Management
P95
Regret
Zone of
Indifference
Developing an effective hedging strategy requires four types of information based on consumer preferences:
R
isk
tolerance
for high cost ex
tremes (
how
high is too
high, too often?)
Regret avoidance (do you want the low end open?)
Zone of indifference (how wide or narrow should the middle section
be for confidence about expected costs)
Time frame (how far ahead do you want these assurances
?)Slide15
Comparing alternative hedging strategies
The range of potential delivery period costs are calculated by applying simulated market outcomes to the utility’s
net open position
under a given hedging strategy.
Volatility Term Structure
Forward Curve and Confidence Bands
+σ
=26%
-
σ
=-26%
Mean = $4
(under all
strategies)
―
All Spot
―
All DCA
―
All Options
Value at Risk (VaR)
DCA
+$0.9
Options
+$1.1
Spot
+$1.9
Regret
DCA
–$0.8
Options
–$1.4
Spot
–$1.5Slide16
Conclusions and Recommendations
Gas utilities should study their 2-4 year (mid-term) vulnerability to future Polar Vortex like events
Looking closely at regional deliverability, electric competition, depth and diversity of suppliers, and pace of near-term supply versus demand shifts.If liquidity a big factor, physical solutions may be better than financial ones, e.g. local storageShift risk management practices towards simulation of uncertainty in total future costs or typical bill due to uncertainty in net open position over timePuts the focus of performance review on whether the expected risk was controlled, not on the luck of hedges ending up in or out of the money.
Provides an economic basis for modifying hedging strategy over time in response to volatility increases/decreases
Likely to require educational workshops with staff and key
intervenor
groups to agree on risk goals, approaches, and strategySlide17
Presenters
M
r. Steve Levine
Phone
:
+1.617.864.7900
Principal
Email
:
Steve.Levine@brattle.com
Mr
.
Levine specializes
in energy and regulatory economics. He
has over 20 years of experience as a consultant providing advice, expert testimony, and litigation support on such matters as the competitiveness of natural gas markets, damage claims in energy contract pricing disputes, the conduct of gas market participants, gas pipeline business risk, and the reasonableness of utility contracting and risk management decisions. He also has expertise in financial modeling, pipeline ratemaking, and utility asset valuation
.
Mr. Frank Graves Phone:
+1.617.864.7900
Principal
Email:
Frank.Graves@brattle.com
Mr. Graves
has
advised
gas and electric utilities
for over 30 years on such matters as
system capacity
expansion, network modeling,
procurement and hedging, investment
and contract prudence, service design and pricing, financial performance evaluation, and asset and contract valuation
. He frequently testifies in regulatory venues in regard to prudence, ratemaking, and impacts of new or
proposed
regulatory policies on the market and individual companies, as well as in state and federal courts in regard to contract disputes and securities fraud.Slide18
About Brattle
The Brattle Group provides consulting and expert testimony in economics, finance, and regulation to corporations, law firms, and governments around the world. About half of our work is in energy and utility-related planning, regulatory and litigation support.
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