Black Mondays, Black Thursdays, 9-11, and Hedge Fund Failures:
How "Black Swan" Events Impact Your Energy Supply Portfolio

As we move into peak hurricane season and summer energy demand levels persist in many regions of the US, it's a good time to pause and reflect on how unanticipated events can affect your energy supply portfolio. While energy managers are accustomed to responding to unanticipated events of the weather variety, the havoc Hurricane Katrina wreaked on energy markets and the recent travails of a number of hedge funds attributed to "unprecedented market events" and departures from "normal" market behavior suggest that business at large may need to look more closely at the potential effects of highly improbable events. Certainly, these events can dramatically alter risk exposure when it comes to your energy portfolio.

Rare events that carry big impact are examined in a recently published book, The Black Swan, (Random House, New York, 2007) by Nassim Taleb. His discussion of how these uncharacteristic occurrences can change everything - in an instant and in dramatic fashion - is enlightening and relevant to the concerns of institutional energy users.

According to Taleb, "Black Swan" market events are characterized by: 1) nothing in the past pointing to their possibility (hence, extremely low probability), 2) extreme impact, and 3) being explicable only after the fact. The name stems from the widespread preconception that all swans were white, that is, until black swans were discovered in Australia.

Extreme events to be considered in managing your energy supply portfolio include the conceiveable: low probability, high impact events, such as hurricanes, other severe weather, energy facility or pipeline closures, major political events, and other force majeure events. It also extends to the inconceivable: unanticipated or unimagined Black Swan events, like market failures (Amaranth or Long-term Capital Management) the 1987 stock market collapse (Black Monday), 9-11, the 1929 stock market crash (Black Thursday), and recent hedge fund failures.

In the face of such events, the defensive options are:

• Minimizing the portion of your energy portfolio allocated to index price contracts such that it represents a value you can withstand during extreme price swings
• Increasing the portion allocated to fixed price contract
• In some limited, additional markets (where activity and the nature of the market support development of underlying statistical analysis), adding derivative products to your portfolio, but with significant additional premium and administrative (FAS 133) costs

But how do you assess the potential impact of extreme events?

Wholesale electricity and natural gas prices (as measured by prompt month or 12-month strip values) are highly correlated (97% over the past 5 years). Their behavior has been characterized by, 1) a 15% per year upward trend over the last 10 years or more; and, 2) significant volatility. Most retail natural gas and electricity market supply prices are highly correlated with these "wholesale" prices, and the prevailing outlook for the future according to many experts is for continued tightness between supply and demand. As a result, upward pressure on prices and significant volatility when markets are perturbed can be expected to continue.

One approach to evaluating the possible extremes of price volatility is to look at specific historical extreme events, for example:

• NYMEX Henry Hub Gas Price April 2000 to April 2001: $2.82 to $10.04 per mmBTU (3.56 x)
• NYMEX Gas Price Jan 2005 to Dec 2005: $6.05 to $12.30 per mmBTU (2.03 x)
• NYMEX PJM Electricity Price Jan 2005 to Dec 2005: $52.38 to $103.35 per MWh (1.97 x)

Another approach to characterizing or quantifying the risk of extreme behavior is to use simple statistical analysis of historical behavior. Based on historical data, the current (as of August 24, 2007) probability that prices will be above $11.98 is 5%, a frequent extreme value used in value-at-risk analysis.

Another method frequently used in value at risk analysis to gauge extremes of price behavior is simulation (Monte Carlo method), based on a more detailed characterization of historical behavior. One simulation that EnergyWindow performed yielded a 5% probability prices would increase to $13.50 per mmBTU or higher from an initial value of $8.50 over the next three years.

Weighing the impact on those portions of your portfolio that float with markets is possible with simple approximate value-at-risk analysis. Simply calculate the percentage of your portfolio that is floating or indexed, and then multiply it by the possible range of price drivers, using one or more of the approaches above.

But remember, it is not only indexed price contracts in deregulated energy markets that create exposure. Other portions of your spend can create exposure, too:

• Most default local utility gas supply prices in North American utility territories vary monthly, quarterly, or annually and are highly correlated with wholesale prices.
• Default electric supply prices in most deregulated electric markets vary as frequently as monthly to as infrequently as annually and are also driven strongly by wholesale market prices.
• Electric supply prices in regulated markets can vary substantively over periods less than a year, to a lesser extent for those few utilities that have long term (multi-year) supply contracts and price caps and to a greater extent for the many utilities that have relatively automatic fuel adjustment clauses (often triggered if input prices vary more than a few per cent from base case input rates) or recourse to interim rate increased more frequent than annually if special or extreme circumstance warrant.

Let's use the example of a $50 million energy supply portfolio with $6 million in gas supply costs indexed or on default prices and $5 million in electric supply costs indexed or on default prices. The impact of extreme wholesale prices swings for the scenarios and analyses described above ranges from $6.5 million to $15.4 million.

Of course, fixed price contracts carry risks, too. Many of the risks affecting fixed price contracts and indexed contracts are the same. The principal risk uniquely associated with fixed contracts is the possibility that the buyer will have to cover the costs of unused energy. But, the probability of the need to close facilities or to reduce production substantively and without warning, combined with the probability that at the same time, prices will be lower is quite small - even in Black Swan terms - given the historical upward trend and projected outlook.

Finally, the other frequently touted disadvantage of fixed price contracts is a presumed price premium compared to indexed prices. However, EnergyWindow has explicit comparable data, based on actual online auction results and numerous anecdotal examples that suggest that the premium may be small, non-existent, or even negative.

In summary, an effective energy supply portfolio management strategy should consider:

• The risk of high impact, low probability – even unimaginable – events
• Limitation of the portion of your portfolio on floating or indexed prices, for which you can withstand the impact of extreme events
• The fact that prices in regulated markets are largely uncontrollable, but not constant, and can move significantly (due to fuel adjustments and interim rate increases) as a result of extreme events
• The real risk of fixed price contracts due to the requirement to cover the cost differences for unused energy
• How risky it is for anyone to speculate and “out-guess” the market with any degree of confidence, in hopes of buying at the lowest point.

Editor's Note: This article is excerpted from the new EnergyWindow white paper on hedging against "Black Swan" events. You can read about this subject in greater depth by downloading it at http://www.energywindow.com/pdfs/HowBlackSwanEventsImpactPortfolio.pdf

Quick Buyer's Tip

Buy now - save later! Many energy buyers wait until the end of their current contract to shop for subsequent periods, but this practice often leads to disappointing results. Not only does the narrowing timeframe force a faster decision than may be desirable, but waiting until the last minute frequently means watching the wholesale market run up further than it would had you decided to act early. Some end users are finding it wise to shop a year or more prior to the end of their contract - but not blindly. They are also watching the trends to assess when conditions appear favorable, relative to historical price behavior, and acting on opportunities when they are.

New White Paper Available

If you enjoyed this issue’s lead story on the effect unanticipated, high-impact events can have on your energy portfolio, you’ll want to learn more by downloading the full white paper from EnergyWindow’s website. This highly relevant new paper by Dr. Jack Mason delves deeper into strategies for protecting your portfolio from the unthinkable, and presents a wealth of insight and statistical analysis to support the discussion and illustrate scenarios. You’ll find this and other white papers that address timely topics for business energy buyers at http://www.energywindow.com/whitepapers.shtml

Visit Us at the EEI Fall National Accounts Conference

EnergyWindow will be exhibiting in Indianapolis at the EEI Fall National Accounts Conference. Stop by booth #200 and pay us a visit. We’d be happy to discuss your company’s energy supply concerns and provide you with a free analysis of how much you may be able to save, based on your facilities' loads and locations.

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