Category Archives: exposure

“A lot of weather we’ve been having lately.”

The winter of 2011-2012 was the fourth warmest on record in the U.S., according to the National Oceanic Atmospheric Administration (NOAA). One consequence of this has been a sharp drop in demand for natural gas use to heat buildings, and that is a hit to the bottom line of many gas distribution utilities with revenues tied to the quantity of gas consumed. For example, the Delta Natural Gas Company, a Kentucky utility, reported in its second quarter 10Q that:

Heating degree days were 78% and 84% of normal thirty year average temperatures for the three and nine months ended March 31, 2012, respectively, as compared with 102% and 105% of normal temperatures in the 2011 periods. … For the three months ended March 31, 2012, consolidated gross margins decreased $890,000 (7%) due to decreased regulated and non-regulated gross margins of $707,000 (7%) and $183,000 (6%), respectively. Regulated gross margins decreased due to a 26% decline in volumes sold as a result of warmer weather, as compared to the same period in the prior year. … Non-regulated gross margins decreased due to a 26% decline in volumes sold due to a decline in our non-regulated customers’ gas requirement, partially offset by a decline in the cost of gas and the sale of natural gas liquids.

Some of this quantity risk might be hedgeable using weather derivatives. And hedging this risk can decrease the volatility in corporate cash flow, increasing both the company’s debt capacity and its dividend ratio and ultimately raising shareholder value.

A research paper by Francisco Pérez-González of Stanford University and Hayong Yun of the University of Notre Dame, forthcoming in the Journal of Finance, uses this setting to explore the question of whether financial innovation is useful to the real economy. They take the case of the innovation of weather derivatives in 1997 as a kind of natural experiment and explore the cash flow volatility situation for natural gas and electric utilities before and after the introduction of this risk management tool. Altogether, they examine stock market and financial statement data on 203 companies over the years 1960 to 2007. Their data show that the utilities most likely to use weather derivatives are those with the greatest cash flow sensitivity to weather, and that those that do make use of the derivatives significantly decrease the volatility of their cash flows. This increases the debt and dividend ratios of these utilities, and ultimately their share prices, too.

Delta’s Refinery Gambit: It’s Not About Volatility

Delta Airlines’ deal to buy the Trainer Refinery owned by Phillips66 was formally announced yesterday. The 8K filing is available here and includes the press release and slide show. Until yesterday the deal was being talked about as a way to hedge the fluctuating price of jet fuel oil. But the announcement makes clear that the objective is something different entirely: battling the rising jet fuel crack spread in the Northeast U.S. where Delta has critical hubs at LaGuardia and JFK.

This is one of the key charts from Delta’s slideshow highlighting the rising crack spread Delta has paid over the last three years.

The possibility of further closures of East Coast refineries threatened to drive the local spread even higher, Delta claimed. Delta believes that by investing in the refinery, including $100 million in investments to shift even more of its production to jet fuel, it will be able to source its fuel cheaper and able to bargain better for the balance of its needs.

The title of Delta’s presentation reads “Addressing Rising Jet Fuel Risk”, and it does contain talk about how “jet fuel crack spreads cannot be cost-effectively hedged”, among other language evocative of risk management and hedging. But it would be a mistake to try and understand this as a hedge in the traditional sense. Delta isn’t trying to limit volatility: at least not volatility around a mean. It’s trying to put direct pressure on the mean level of the jet fuel spread. That’s a different thing entirely.

This is an attempt to gain a strategic advantage in the airline industry. Will it payoff? Apparently yes, according to Delta’s projections. Even if the Brent-WTI spread reverses and becomes negative and many East Coast refineries reopen for business, that will likely take longer than one year, as much time as Delta believes is needed to payback the investment. Time will tell.

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Update: Liam Denning at the WSJ provides some useful statistics:

The Justice Department considers a market with a Herfindahl-Hirschman Index score above 2,500 to be “highly concentrated.” In 2010, the East Coast refining market’s score hit 3,255, against a nationwide one of 680, according to the Federal Trade Commission. If Pennsylvania’s Trainer facility had stayed idle rather than be bought by Delta, the score would likely have surpassed 4,000, according to the American Antitrust Institute.

Reading the Term Structure of Futures Prices

Over the last few years, natural gas prices in the U.S. have been pounded by a variety of factors. Front and center are the continuing breakthroughs in horizontal drilling and hydraulic fracturing. On top of this, the winter of 2011-2012 was the fourth warmest on record, according to the National Oceanic Atmospheric Administration (NOAA), and those temperatures slashed demand. From a peak of over $13/mmBtu in July 2008, the price fell to almost $2/mmBtu in March 2012.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

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Climate apples and oranges

Monday’s post discussed a proposal by Vikram Pandit, the CEO of Citigroup, calling for a comparison of the results produced by risk models across different banks when evaluating a standardized “hypothetical” portfolio of assets. Exercises like this are standard fare in many research fields where modeling encompasses a broad array of complicated issues, and there can be wide disparity in both structural and parameter choices.

Let’s look at the economics of controlling greenhouse gas emissions. A number of major research institutions have developed economic models to assess the costs of mitigation, including one of the MIT centers where I work. The results from these models play a useful role in public discussion about what should be done.

But these models are inherently very complicated. Greenhouse gases are produced in many different sectors of the economy, in particular in the energy sector which is, in turn, an input to many other sectors, so an economy wide model is required. The greenhouse gas problem operates at long time scales, so technological evolution over many decades is key. Finally, greenhouse gases are a global public goods problem, so a global economic model is required. Building a model to meet these demands is a heroic effort, demanding many judgment calls on major issues.

Understanding the different assumptions and structural choices and how they impact the results is useful, and can shape how the results are read. During the Bush administration, the U.S. government, which underwrites much of the research in this area, ran a comparison exercise on these economic models similar to what Vikram Pandit is proposing for bank risk models. They took 3 of the leading models, and had them generate a suite of diagnostic results when analyzing a common set of policies. They then published an analysis of the different results and the underlying modeling choices that generated the differences. This was done as a part of the Climate Change Science Program and the full results can be found here.

To illustrate the variation across models, here’s just one of the diagnostics, the forecasted change in the price of natural gas. The three models produced strikingly different results. One model produces a forecast that increases more than 800% by the end of the century under modest emissions constraints, while another forecasts increases less than 200%.

Seeing such widely variant results is an eye opener. Novices in any research area often take modeling results for granted. Seasoned researchers are more attuned to the weaknesses and uncertainties and range of different opinions across the scientific community. Comparison exercises, like the one done by the U.S. Climate Change Science Program, or like the one Citibank’s Vikram Pandit is proposing, shine light on differences that the public needs to be better attuned to.

Of course, knowing that there are differences isn’t the end of the process, and doesn’t solve all of the problems. But it’s a useful contribution.

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.

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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?

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The Risk Management of Economic Angst

I’ve just returned from Europe where I spent part of the summer talking to companies in different European nations. Everywhere I went, the signals are flashing yellow. In Europe, the recovery seems to be coming to a standstill.

A poisonous mix of sluggish output, sovereign debt crisis, fragile banks and lack of political will has created a perverse cycle of lower growth, less than expected tax revenues (despite VAT and income tax hikes), obstinate fiscal deficits, growing public debt, more turmoil in financial markets, stressed banks that refuse to ease lending, further austerity and spending cuts, which further undercut business and consumer confidence, as well as disposable income, which lead to yet lower economic growth and so on. It is as if much of the Eurozone and the UK are dangerously balanced on the edge of another recession…without even having been able to recover to the levels of output seen before it all started in 2008.

Recent data tells a sad story. Industrial production in the 17-nation euro area fell 0.7 percent in June compared to May. GDP has slowed to a meager 0.2 per cent in the second quarter from 0.8 per cent in the previous three months. Even mighty Germany is decelerating fast, with last quarter GDP slowing to a shocking 0.1 percent, and the latest IFO Business Climate Index shows that German businesses have turned much less optimistic.

No question that the coming year will be challenging for European businesses. Many companies have been closely monitoring how the situation is evolving, and are diligently working on contingency plans that deal with possible sinister Eco-Fin scenarios.

The following figure shows the risk matrix used by a European manufacturing company (call it MadeInEU) back at the beginning of 2010 (a few months after the beginning of the Greek debt tragedy). The risk matrix plots the different drivers of risk that matter to MadeInEU. The horizontal axis measures the likelihood of a particular driver of risk happening; the vertical axis measures how a driver influences operations, EBITDA and Cash flows. A heuristic combination of probability and impact helps managers rank the drivers of risk by their relative importance.

The same risk matrix redrawn at the end of June showed a different picture. The most important changes that caught management attention were the significant upgrades in three drivers: (1) Macroeconomy; (2) Access to Capital; (3) Financial Risks (mainly related to the outlook for the Euro).

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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.

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The perils of serving two masters

Carolyn Cui and Liam Pleven at the Wall Street Journal have a nice piece today on the competition between gold ETFs and gold mining companies for the investment dollars of gold bugs.

Share prices of gold-producing companies have lagged the huge run-up in the price of gold, as well as the broad stock market, for years. Investors, instead, have poured billions of dollars into exchange-traded funds backed by actual bullion, believing that would provide purer exposure to gold prices and avoid unrelated stock-market risk.

But the companies are fighting back:

In April, the Denver company introduced a “gold-price-linked dividend,” promising an increase of 20 cents a share in its annual payout for every $100-an-ounce rise in gold prices. Newmont receives about $300 million in additional cash after taxes for every $100 increase in gold prices, Mr. O’Brien said. Based on current gold prices, the company is expected to declare a 25 cent quarterly dividend in July, a 25% rise from April’s.

The promised payouts, although still small compared with traditional big dividend payers such as utilities or health-care providers, are aimed at setting gold stocks apart from bullion or gold ETFs.

I say the mining companies should stop trying to battle the tide and instead declare good riddance.

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When a hedge becomes a risk: The recent rally in corn prices.

Commodities markets have been quite agitated in May. The tremors felt on May 5 have not dissipated and recent data on the US economy, the risks of inflation in China’s and the protracted debt crisis in the EU left many traders wary. Prices of precious metals, industrial metals and oil have all dropped. So far, grains, led by corn, have held their value pretty well.

Corn is now being planted to be harvested in August. Weather is the main factor affecting the progress of planting and yields (#bushels per acre), and consequently a key driver of prices for new corn. Estimates indicate that the planting season is behind schedule, and that flooding of the Mississippi has destroyed some fields. Lower expected yields and acreage put further strains on an already historically tight ratio of stocks-to-usage – a measure of supply and demand.

Presumably these facts should have a greater impact on the incoming crop season (new corn). Yet, the recent sharp rally in corn prices occurred in nearby contracts (July futures) rather than in December futures contracts. Why is old corn more bullish than new corn?

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