Category Archives: commodities

Phantom Costs to the Swap Dealer Designation and OTC Reform

The CFTC is working to finalize the rule defining swap dealers and major swap participants. Under the Dodd-Frank financial reform, the rules governing operation of the OTC derivative market operate in large part through codes of conduct imposed on these entities. As reported most recently by Silla Brush at Bloomberg, a number of companies are hoping that the rules will be redrafted so that they escape designation and the responsibilities that go along with it. To bolster their lobbying effort, these companies commissioned a report by the economics consulting company NERA to estimate the costs of applying the law to them. The Bloomberg story quotes me as saying that “the study exaggerates the costs of the rule.” Here’s a little more meat behind what I meant.

NERA calculates the cost of posting margin as follows. According to the 26 companies that sponsored its report, the average company would have had to post $235 million in margin. NERA estimates the margin account would have earned interest at a rate of 3.49%, pre-tax. According to NERA, the Weighted Average Cost of Capital (WACC) for the energy companies who sponsored its report at 13.08%, pre-tax. That is, in order to raise the capital needed to fund an extra $1 in the margin account costs the average company 13.08%, but that account only earns 3.49%. The difference is 9.59%. The idea is that a company is losing the difference, or 9.59%, on every $1 is has to post in margin. Multiplying 9.59% by $235 million per firm yields an annual cash flow shortfall of $23 million per firm, NERA’s estimated Annual Carrying Cost of Margin.

One big error in the calculation is the use of the 13.08% WACC figure as an estimate of what it would cost to fund the margin account. This is comparable to the error of discounting a specific project’s cash flow using the company’s WACC, ignoring the fact that the risk of the project may be very different from the average risk of the firm. Every introductory corporate finance textbook warns the reader against this mistake. The average WACC reflects the average riskiness of all of the different assets of the firm. It makes no sense to compare the average WACC against the expected return of a specific asset or project and claim that that is a rate of return shortfall. A manager who did that, would consistently see a shortfall in relatively safe projects and a premium in relatively risky projects, regardless of the actual NPV of each project. The NPV is determined by comparing the project’s expected return against the project’s own cost of capital, not against the firm’s average cost of capital. Only in the specific case that the project’s risk equals the firm’s average project risk, is the WACC coincidentally the right cost of capital. That is clearly not the case for the margin account. It is invested in relatively safe assets. In contrast, the NERA companies’ average WACC reflects investments in power plants, oil wells, and derivative trading operations, all of which can be expected to be much riskier. That is why NERA’s calculation is an exaggeration. It isn’t just off by a rounding error. The key number it uses has absolutely nothing to do with what NERA purports to measure.

Is that a fat tail I see?

One side effect of the financial crisis is a much wider familiarity with the wonky lexicon of risk management, which is generally a good thing. But it has its drawbacks. Once a person has learned to spot a black swan, it seems there are black swans everywhere. Of course, the very ubiquity means one isn’t really talking about black swans. Overuse of the term threatens to rob it of its special meaning.

Javier Blass reports in the Financial Times that

One buzzword – “tail risk” – is dominating oil markets and could have big implications for prices for 2012. If this year was marked by relative stability in crude prices, with oil trading in a narrow band between $100 and $120 a barrel in spite of turmoil in the Middle East, next year may be very different. Oil traders and investors are bracing themselves for a rougher ride. In the trading rooms of London, New York and Geneva the talk is of tail risks, low probability events that have an outsize impact on prices. The problem, says Daniel Jaeggi, head of trading at Mercuria, the Geneva-based oil trading house, is that these tails are “currently inordinately fat”. On the one hand are intensifying fears over the eurozone crisis, a bearish factor. On the other, the continuing political turmoil in the Middle East could be bullish. “This means that the [price] outcomes could be substantially altered from the base case if anyone of a number of low probability events materialises,” he says.

So, the probability of prices far above and below the base case is higher than usual. That’s risk alright, but it’s not necessarily a fat tail. It could just be a plain vanilla increase in variance. If the percent change in price is a normally distributed random variable, and the variance goes up, that gives a higher probability of prices far above and below the base case. A fat tail is something more. The normal distribution does not have fat tails, no matter how high the variance.

Maybe the tails are fat. Or maybe it’s just a plain vanilla increase in risk. Not everyone is as punctilious as a pedant on such fine points.

The cost and value of variability in electricity generation

The Bloomberg terminal offers an LCOE function provided by its New Energy Finance unit. The function calculates the levelized cost of electricity for a number of generation technologies. The LCOE is the discounted lifetime cost of a generating one unit of electricity from a particular plant type taking into account all capital and operating costs. Shown here are the results for solar thermal, offshore win, solar PV, biomass and municipal waste incineration, geothermal, wind onshore, coal fired, natural gas combined cycle, and landfill gas:

But just because you can crunch the formula doesn’t mean the results are meaningful. Average cost is interesting, but it ignores two things that are critical to properly evaluating different generation technologies. Continue reading

A Silver-Linked Dividend Without the Silver Lining

Hecla Mining Co. is copying Newmont’s strategy. It announced last month that its dividend will be linked to the price of silver:

All dividends, including those in the third quarter, would increase or decrease by $0.01 per share for each $5.00 per ounce incremental increase or decrease in the average realized silver price in the preceding quarter.

Here’s the resulting payout diagram:

Data from January 1999 to October 2010 show that, with the brief exception of the summer of 2008, silver prices have never been above $25. Prices above $30 are a phenomenon of the last twelve months. Expecting silver prices to go up in the future, Hecla is giving investors extra leverage…if its prediction comes true.

Continue reading

A gold-linked dividend in the modern gold rush

Earlier this year, the Newmont Mining Corporation announced that future dividend payouts would be linked to the price of gold. For every $100 increase in the average price received on its sales of gold, the annual dividend would be increased by 20¢ a share. From the Newmont deck:

What does the promise of a gold-linked dividend provide above and beyond what investors in Newmont already had?

Continue reading

The Cosmetics of Collateral Transformation

Responding to the new regulatory reforms such as the Dodd-Frank Act in the US, banks are now marketing “collateral transformation” services. A good source for various materials on this issue is Tracey Alloway’s coverage in FT Alphaville.

What are these services? How are they connected to the reforms? Should we be worried?

Collateral transformation is a fancy name for a particular type of loan, as shown in the top three boxes of the figure below. A company/fund trading a standardized derivatives contract cleared by a central counterparty (CCP) must post a margin. Initial margins are posted with cash and government securities; variation margins are posted with cash. Holding cash for the purpose of posting margins exacts an opportunity cost, for it earns less than if invested in less liquid securities. The bank steps in and offers to lend the company/fund the cash for collateral at the CCP, and the company/fund provides less liquid securities it holds in the balance sheet to the bank as collateral. In addition to providing the company/fund with liquidity, the bank structures the arrangement to easily mesh with the mechanics of trading, settlement and so on, so as to minimize the administrative costs to the institutions that are its customers. See this brochure and this article.

Continue reading

Is E.ON’s trading unit profitable?

E.ON, is a large European electricity and natural gas company. It manages its trading operations as a separate profit center. The traders are both responsible for optimizing E.ON’s own generation and other assets–sourcing inputs cheaply and maximizing the value of outputs–and also for running a proprietary trading book.

E.ON just announced its second quarter results and was very candid about the fact that the outlook for the trading unit this year is not good. Indeed, it’s forecasting a loss in trading for the full 2011 fiscal year.

So let’s look back at last year, FY2010, when the trading unit recorded a profit. The Annual Report details each unit’s return on capital employed (ROCE). Here’s what it shows:

The chart shows the reported ROCE for each of the separate units as well as the ROCE for the group as a whole. Not shown is the ROCE for the corporate center. But EON doesn’t report an ROCE for the trading unit. Why not?

Continue reading

Markets for Power & the Efficient Operation of Nuclear Reactors

Lucas Davis and Catherine Wolfram at UC Berkeley’s Energy Institute at Haas have an excellent new working paper analyzing the impact of the deregulation of wholesale electricity markets on the efficiency with which nuclear power plants are operated. They examine as well the impact of consolidation in ownership of reactors:

We find that deregulation and consolidation are associated with a 10 percent increase in operating efficiency, achieved primarily by reducing the frequency and duration of reactor outages. At average wholesale prices the value of this increased efficiency is approximately $2.5 billion annually and implies an annual decrease of almost 40 million metric tons of carbon dioxide emissions.

They also look at one measure of the safety of operations–the number of scrams, or emergency shutdowns–and find that divestiture of a reactor from a regulated utility into an idependent power producer implies a 30% decrease in scrams. That’s based on a full regression, but here’s the raw data:

Continue reading

TEPCO’s black swan

The four reactors at Fukushima Daiichi damaged in the March 11 earthquake and tsunami belong to the Tokyo Electric Power Co. (TEPCO). Not surprisingly, TEPCO’s financial situation has become perilous. In announcing its annual results, the company recorded a direct loss of more than ¥1 trillion ($12 billion). This does not include several significant additional costs. Several of TEPCO’s other nuclear reactors remain down in part due to the regulatory and political reaction to the accident. The company will need to purchase replacement power both for the four lost reactors, and for the add-on shut down reactors. Most importantly, the ¥1 trillion does not include the liability for the various types of damage caused by the accident. Estimates for the size of this liability range from 2-11 times the ¥1 trillion loss already booked. Following the accident, TEPCO’s stock quickly lost ¾ of its market value, or more than  ¥2.7 trillion ($32 billion). It is widely believed that the liabilities from the accident make TEPCO insolvent, but for a government decision to support the company financially.

Continue reading

The unorthodox model of risk pricing behind the UK EMR #5: creating value out of thin air

The UK’s Electricity Market Reform White Paper claims to have quantified how offering low-C generators a hedge creates value:

In our central scenario, the FiT CfD reduces the cost of decarbonisation to 2030 by £2.5 billion compared to using the Premium Feed-in Tariff (PFiT) to deliver the same investment. ( § 2.3, p. 37)

Given that my previous post says there can be no net value at all, I find this claim startling and it should be informative to investigate exactly how this number is arrived at.

Bottom line: (i) they calculate the benefit of a hedge captured by the low-C generator, but, (ii) they completely ignore the cost to the taxpayer or ratepayer from providing that hedge.

Ignoring (ii), the cost to taxpayer or ratepayer, is obviously the big problem, and we could stop there. But let’s take the bait and go ahead to examine (i), how they calculate the benefit of hedge captured by the low-C generator.

The White Paper purports to have assessed how providing the hedge (in the form of a Contracts for Differences, or CfD) lowers the cost of capital for different types of projects. Here is Figure 7 from the White Paper with the results:

Continue reading

%d bloggers like this: