Category Archives: volatility

Dumbing down

John Kay’s column in the Financial Times yesterday uses the episode with the Swiss franc as a reminder about model risk.

Crude oil basis risk is receding… for now.

Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.

However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.

Historical Spreads 2

This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.

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Reading the Term Structure

Natural gas prices have been rising recently. But I always like to look at the whole term structure of futures prices to get a better sense of what is really going on. My colleagues at CRA, Billy Muttiah and James Dunning, prepared this chart which overlays snapshots of the term structure at the start of the last several months. It tells a simple story.

Natural Gas Futures Prices - 12-05-2012

What’s going on is mostly a story about the long-run. Only a small amount of recent spot price changes are due to short-run factors and changes in the spot vs. futures price. Prices at all maturities have been going up. And the shifts are roughly parallel throughout the term structure.

A quick look like this doesn’t clarify whether it is long-run demand shocks, long-run supply shocks or any number of other combination of factors. But it does focus attention in the right place.

No pain, no gain?

The Missing Risk Premium takes aim at a central premise of modern finance theory: extra return requires extra risk. The premise is so central that few of us involved in modern academic finance can even imagine a world without it. Eric Falkenstein insists that we do. This book is his challenge to us.

Falkenstein’s thesis is a radical one: extra risk does not yield extra return. Continue reading

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.


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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Duality and Uncertainty: Lessons from the carbon market

The Great Recession has hit the European carbon market hard. With output down, the demand for allowances is down, and so is the price. As recently as the start of this year, emissions allowances were trading at €14/t CO2. But last week the price was below €7. This is gloomy news for those who want the carbon price to incentivize innovation in low carbon technology. For example, David Hone, Climate Change Advisor for Shell, is one of many who have been advocating that the Union set aside a number of allowances in order to support the price. Earlier this week that proposal moved a step closer to becoming a reality with a favorable vote by the European Parliament’s Environment Committee. The price of carbon subsequently jumped up by 30% on Tuesday on the news.

I bring up this news because I think it highlights a weakness in the economic debate about the best means to the end of pricing emissions. The argument revolves around whether or not the government should set the price of emissions, and let companies choose the quantity of emissions, or whether the government should set the quantity of emissions it will allow, and let the market set the price. The former is a carbon tax, the latter is a cap-and-trade system. In a world of certainty, where the cost of abatement by companies is well known, the two are equivalent. When the government sets the price (tax level), it knows the quantity of emissions that companies will choose. Alternatively, when the government sets the cap, it knows the price that will emerge in the market. That’s duality.

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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

The EIA on financial markets and crude oil prices

The US Energy Information Administration (EIA) has gone live with a new set of pages on “What Drives Crude Oil Prices.”  Of course, supply and demand factors are front and center. But what’s new is the inclusion of pages on the role of Financial Markets. True to its role as an information provider, the EIA is only reporting the facts, not hawking a line. There’s no startlingly new information on these pages. It is mostly a compilation of data otherwise available from the CME group on futures trades, from the CFTC’s Commitment of Traders report and other sources. But, the effort to put these together and within the larger picture of supply and demand forces is a worthy one, and an important step for the EIA.

These pages are one output of the EIA’s Energy and Financial Markets Initiative that Richard Newell instituted when he became Administrator.

My favorite product of the Initiative is one of the first ones. The EIA now publishes confidence bounds on price forecasts. These are produced using implied volatilities from exchange traded options. The full analysis of volatility, including confidence bounds is here. This is an important step forward in raising the level of public discussion.

The EIA is a very valuable source of data on US and international energy markets. There is nothing comparable anywhere else in the world, which is a shame. Unfortunately, it’s a fact of life that information costs money, and budget cutbacks are affecting the EIA, too. So it is unclear how much of the EIA’s new Initiative will last. I have my fingers crossed.

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