API).
Aka tar sands. Major reserves in Canada,
Russia, Venezuela, US and Indonesia. The
global resources may be four times as large
as the worlds proven reserves of conven-
tional oils. However, today only 5% of
these resources appear to be economically
viable.
Oil shales. Oils that remain in a typically
clayey sedimentary source rock. This rock
needs to be mined, pulverized and pro-
cessed to release oil. The process produces
large volumes of solid waste and CO
2
and
requires enormous quantities of water. Lo-
cated throughout the world; large resource
in the U.S.
Synthetic oils. Oil converted from coal or
gas.
Non-conventional gas. Gas in coal de-
posits (coalbed methane), shales with low
permeability (tight sands), or in solution
in aquifers and zones of geopressure [The
IEA classies unconventional gas as: tight
gas; coalbed methane; shale gas]. Have
low recovery rates.
Polar zones. Large resources in Artic.
Technical progress may lead to more reserves
or accelerated extraction in a oil well.
Location of major oil proven reserves (in
Gbbl):
1. Middle East (743)
2. Former USSR (123)
3. Africa (114)
4. North America (60)
5. South America (104), mostly Venezuela.
1.1.2 Upstream oil and gas operations
[43, ++, inc]
Upstream activities are exploration and pro-
duction; Downstream activities are rening
and distribution. An integrated oil company is
involved in both, whereas an independent com-
pany is involved only in upstream.
To be commercially productive, a petroleum
reservoir must have adequate permeability and
porosity. Porosity is the measure of the open-
ings in a rock in which petroleum can ex-
ist. Permeability measures the connectability
of the pores, which determines the ability of
the petroleum to ow through the rock. If a
reservoir has low permeability, there are pro-
cedures to increase it, such as, fracturing and
acidizing.
Mineral rights refer to the ownership of any
mineral beneath the surface. These can be sep-
arate from ownership of surface rights. When
the owner enters into a lease with an oil com-
pany, mineral interests are created for both
sides:
Royalty interest (RI). The owner receives
a fraction (typically 1/8) of the produc-
tion, free of any operating costs. He is re-
sponsible for his share of production taxes
2
and postproduction costs (transportation,
etc). The RI is also referred to as nonop-
erating or nonworking interest.
Working interest (WI). It is responsible
for the exploration, development, and op-
eration of a property. The company pays
100% of the operating costs and keeps all
revenues after deducting the royalty inter-
est (typically 7/8).
When there are multiple companies, the
working interest can be [does not make
any sense]:
Undivided. Ex: company A sells
50% of its WI on the entire property
to company B.
Divided. Ex: company A sells 100%
of its WI on 50% of the property to
company B.
In the US mineral interests are typically ac-
quired via leasing. Most leases contain the
following provisions: lease bonus, royalty pay-
ments (as dened in RI above), primary term
(time to begin drilling), shut-in payments (if a
capable well is not producing, the lessee may
hold the lease by making shut-in payments to
the lessor), oset clause (requires drilling an
oset well if a neighbor nds a common oil
reservoir).
1.1.3 Accounting for International
Petroleum Operations [43]
The scal system is the set of payments that
the oil company must make to the foreign coun-
try that owns the mineral rights. Major types
of scal systems (distinction not really clear in
practice):
Concessionary systems. Typical in the
US, UK, Norway, and others. Payments
are royalties and taxes.
Contractual systems. Add more pay-
ments. Subtypes:
Production sharing contracts (most
popular). Prot oil (revenues - roy-
alties - production taxes - costs) is
shared between the parties.
Service contracts. The government
allows the contractor to recover costs
and earn a fee. Popular in South
America.
When two or more international parties are
involved in a joint operation they must execute
a joint operating agreement detailing how costs
and revenues are to be shared. This can be one
of the contracts above or can be a separate
agreement.
1.2 Crude Oil and Rening
1.2.1 Nature of oil and gas [24, ch1,
++]
Petroleum = Petro (rock) + oleum (oil). Aka
crude oil. Hydrocarbons include crude oil
(mixture of HC molecules with 5 to 60 carbon
atoms) and natural gas (molecules with 1 to 4
carbon atoms).
English units. Crude oil is measured in bar-
rels (b or bbl). 1 kb = 1 Mbbl = 1 000 bbl,
1 MMbbl = 1 000 000 bbl (M is from the latin
mille), 1 Gb = 1 Gbbl = 10
9
bbl. Natural
gas is measured in cubic feet (cf). A standard
cubic feet (scf) is a cubic feet at 60
F and 14.65
psi.
The density of crude oil is measured with
the American Petroleum Institute (API) scale
(API decreases with specic gravity; water has
10
API):
Light oils are 35 to 45. Most valuable, rich
in gasoline. Tend to be sweet (less than
1% sulfur). [Examples: Louisiana Sweet,
WTI, Brent.]
(Medium?) [Examples: West Texas Sour,
Arab Light.]
Heavy oils are below 25. Less valuable,
contain considerable asphalt. Tend to be
3
sour (above 1% sulfur). [Examples: Arab
Heavy, Venezuelan]
Benchmark crude oils:
West Texas Intermediate (WTI), 38 to 40
C and atmospheric
pressure (standard temperature and pressure,
STP).
1
See composition in section 1.2.1.
Liqueed natural gas (LNG) is produced by
cooling methane to 161.5
F = 15.6
C.
9
Reserves are classied as 1P, 2P, or 3P, like
oil. Proved (1P) gas reserves worldwide are
6 300 tcf, implying a reserves/production ratio
of 66 years.
An oil and gas reservoir may initially pro-
duce high volumes of oil relative to gas, but as
the oil production and reservoir pressure de-
cline, the gas/oil ratio of the produced hydro-
carbons may increase.
Coal bed methane is methane contained
within coal seams. This is an unconventional
source: though easy to nd because coal oc-
curs close to the surface, it is relatively di-
cult to produce. Nevertheless, in the US it is a
signicant portion of domestic gas production
volumes.
1.4.3 Transport and Storage [9, +]
The cost of transporting 1 energy unit of nat-
ural gas via onshore pipeline is 3 to 5 times
higher than oil. This ratio increases to 20 or
more for longer distances.
Liquied Natural Gas (LNG) is a trans-
portation alternative. Though less than 10%
of gas is transported as LNG, it is growing
rapidly [section 1.4.9 says it is not growing
due to shale gas]. Methane gas is cooled to
161.5
C (260
i=1
i
(t, T)dz
i
(t)
These risk factors can determined by principal
components analysis (PCA). Typically, there
are n = 3 risk factors, which act to shift, tilt,
and bend the curve.
42
Since S(t) = F(t, t), we can derive a process
for the spot price from the process for the for-
ward price. [See the paper for equations.] One
important result is that the simple model in
(4) with (t, T) = e
(Tt)
implies the mean-
reverting spot price in (3), albeit with a time
dependent drift term. If = 0, we obtain the
Black (1976) model.
Seasonality for gas and electricity can be in-
corporated by
dF(t, T)/F(t, T) =
S
(t)
n
i=1
i
(T t)dz
i
(t)
where
S
(t) is the time dependent spot volatil-
ity.
[See the paper for option pricing formulas.]
5.5 Estimating Price Volatility
5.5.1 Volatility Estimation in Energy
Markets [11, ch3, ++]
GBM is not a good model for energy prices
because:
Energy commodities are inputs to produc-
tion processes and/or consumption goods;
they are not investments assets. For ex-
ample, electricity prices may be negative,
which is not allowed in GBM.
Seasonality.
Jumps.
Mean reversion. Prices may depart from
the cost of production in the short term
due to abnormal market conditions, but in
the long term, the supply will be adjusted
and the prices will revert to the cost of
production.
However, a simple mean-reversion process
like Vasiceks (1977) may not perform well
because:
The speed of mean reversion may be
dierent below and above the mean.
In many markets, especially electric-
ity, departures to the upside are more
likely than to the downside.
A price spike is frequently neutral-
ized by a following spike of opposite
sign.
Prices of energy commodities behave dif-
ferently during dierent periods of their
lives. Eg, the volatility of forward con-
tracts increases as they get closer to their
maturity.
If the underlying price follows a GBM (re-
turns are iid), volatility can be estimated from
historical data as follows:
1. Calculate [daily] logarithmic price returns
[continuously compounded returns]: S
t
=
S
t1
e
r
r = ln(S
t
/S
t1
). Note that
r
0,T
:= ln(S
T
/S
0
) = r
1
+r
2
+. . . +r
T
.
2. Calculate standard deviation of daily se-
ries,
d
.
3. Annualize:
2
y
= 250
2
d
y
=
250
d
If the underlying price follows a mean-
reverting Ornstein-Uhlenbeck process, dS =
(
t
, with
t
N(0, 1). Alternatives for
the variance:
1. ARCH(q):
2
t
= a
0
+a
1
u
2
t1
+. . . +a
q
u
2
tq
2. GARCH(p,q):
2
t
= a
0
+
p
i=1
b
i
2
ti
+
q
i=1
a
i
u
2
ti
43
5.5.2 Volatilities [34, ch8, - -, inc]
The volatility of a price process is always as-
sumed to represent the annualized standard
deviation of returns.
We can back out a rudimentary term struc-
ture of implied volatilities from several options
on the same underlying. Suppose we have two
options on the same 3-month futures:
1. Option 1 expires in 1 month, has implied
volatility
0,1
.
2. Option 2 expires in 2 months, has implied
volatility
0,2
.
We can then estimate
1,2
from
2
0,2
= (
2
0,1
+
2
1,2
)/2
Referring to the same 3 models of section
5.3.2:
Single-factor lognormal price model
(GBM). Volatility is the same for spot
and all forward prices. Spot and all
forward prices are perfectly correlated
with each other. None of this is consistent
with real energy prices.
Single-factor log-of-price mean-reverting
model. The volatility of the forward price
goes to zero as the maturity date goes to
innity. Correlations remain perfect be-
cause it is still a single-factor model.
Two-factor mean-reverting model.
(Pilipovic model). Correlations be-
tween spot and forward prices are less
than one.
6 Risk Evaluation and Man-
agement (15%)
6.1 Value-at-Risk and Stress Testing
6.1.1 Value-at-risk [11, ch10, +, inc]
The basic VaR model assumes that market
variable returns are normally distributed (or
follow a random walk):
r
t
=
t
+
t
t
,
t
iidN(0, 1)
where r
t
is a log return.
Volatility estimation:
Simple Moving Average:
=
_
1
N
N
i=1
(r
i
)
2
Exponentially Weighted Moving Average:
=
_
1
N
i=1
i1
N
i=1
i1
(r
i
)
2
The decay factor is typically 0.9 < <
1.0. Older returns get exponentially less
weight. Note that
N
i=1
i1
=
1
1
, as in
the RiskMetrics formula (but not good for
close to 1!!!).
The corresponding formulas can be used to es-
timate covariances.
VaR methodologies:
1. Variance-Covariance or Delta VaR. As-
sumes that returns are normally dis-
tributed. Derivatives are represented in
terms of a Delta equivalent position in the
underlying asset, ie, the weights in the
portfolio are modied to w
i
=
V
i
S
i
w
i
(for a
basic instrument that is not a derivative,
V
i
S
i
= 1). The variance of the portfolio is
the usual
2
p
= w
w. Hence,
V aR = z
$
p
z is the critical level for a given con-
dence level. For example, z(95%) =
1.65, z(99%) = 2.326.
Examples:
100 M$ spot crude oil position. Stan-
dard deviation of daily returns of
crude oil price is 2.5%. The 1-day
44
VaR with a condence level of 95%
is
V aR = 1.65 0.025 100 M$
For a portfolio with 2 underlying
market variables,
V aR
2
p
= V aR
2
1
+V aR
2
2
+2V aR
1
V aR
2
2. Delta-Gamma VaR. The change in value
of derivatives are approximated with more
terms: , =
2
V/S
2
, and also =
V/t. The portfolio distribution is no
longer normal [see paper for formula], so
the VaR calculation becomes more com-
plicated. The main point of this approach
is to compute the change in value of an op-
tion without having to use the full option
pricing model. This can be integrated in
the Monte Carlo method to speed up the
simulations.
These methods up to here do not provide
the accuracy required for energy markets.
3. Monte Carlo simulation. Jumps, stochas-
tic volatility, or knowledge of future events
(eg, changes in the operation of a market)
can be easily incorporated.
4. Historical simulation. Good alternative if
returns are not well described by the nor-
mal distribution or other tractable alter-
natives, as is likely for energy markets.
VaR estimates should be backtested: check
how often the actual returns exceed the VaR
forecast.
6.1.2 Incorporating stress tests into
market risk modeling [1, +]
Stress tests are exercises to determine the
losses that might occur under unlikely but
plausible circumstances, i.e., under rare or ex-
treme events. Stress tests respond to VaR ex-
cessive dependency on history or unrealistic
statistical assumptions.
Types of stress tests:
1. Uses scenarios from recent history.
2. Uses predened scenarios that have
proven to be useful in practice. Eg, fall
in stock index of x standard deviations.
3. Mechanical-search stress tests.[?]
Problems with stress tests:
Choice of scenarios is subjective.
Results are dicult to interpret and to act
on because there is no probability for the
event concerned.
VaR and Stress Tests are often presented
as two separate measures of risk. How-
ever, the two methods can be integrated
by assigning (subjective) probabilities to
the stress scenarios.
Stress tests often ignore the correlation
between the stressed prices and other
prices.
6.2 Credit and Counterparty Risk
6.2.1 Credit risk management [7, ch6.3,
-, inc]
Credit risk is the risk that a counterparty can-
not full his contractual obligations. Credit
risk exposure results from:
Settlement risk: the possibility that a
counterparty cannot pay the obtained
benets, e.g. the delivered energy
amount.
Example: at some point before the matu-
rity of a forward contract, the risk is the
present value of the terminal payo, as-
suming that S
T
is the current spot price.
Replacement risk: the possibility that a
new replacement contract will have to be
entered into, under potentially worse mar-
ket conditions.
Credit risk can be quantied through:
Risk-at-Default. [= EAD x LGD ?]
45
Expected loss.
Potential exposure: maximum credit loss
to a given counterparty with a given con-
dence level. Obtained by generating mar-
ket prices scenarios. Useful for setting
credit limits.
Credit VaR.
Credit risk can be reduced through:
Margining agreements. Most powerful
method. [Works like in exchange-traded
products.]
Transfer an OTC transaction into an regu-
lar exchange-traded futures contract. The
European Energy Exchange allows this.
Additional collateralization.
Countertrade.
Price adjustment [?].
6.2.2 Dening counterparty credit risk
[18, ch2, ++, inc]
Counterparty risk is the risk that a counter-
party in an OTC derivatives transaction will
default prior to expiration of a trade and will
not therefore make the current and future pay-
ments required by the contract. Since the fu-
ture value of the derivative contract is uncer-
tain, each counterparty has risk to the other.
Traditionally, credit risk has been associated
only with lending risk. This is the risk that
we dont get our money back. It applies to
loans, bonds, mortgages, credit cards, and so
on. Only one party takes lending risk and even
the amount is fairly predictable.
Metrics for credit exposure:
Exposure is the maximum between zero
and the current Mark-to-Market(MtM) of
the position.
Expected MtM is the expected value of a
transaction for some future time.
Expected Exposure is the average of pos-
itive MtM values at some future time.
Note that E[MtM] < E[E].
Potential Future Exposure is the worse ex-
posure distribution for a given condence
level (similar to a VaR).
Eective Expected Exposure is a nonde-
creasing time series of E[E].
6.2.3 Mitigating counterparty credit
risk [18, ch3, ++, inc]
Termination gives the possibility that an in-
stitution can terminate a trade prior to their
counterparty going bankrupt. It may exist as
an option or be conditional on certain condi-
tions being met (e.g., ratings downgrade).
Close-out allows the unilateral termination
of all contracts with the insolvent counterparty
without waiting for the bankruptcy process to
be nalized. It is often combined with netting
into a single contract.
Netting is the ability to oset amounts due
at termination of individual contracts between
the same counterparties when determining the
nal obligation. Netting comes into force in
the event of a bankruptcy. Can be contracted
bilaterally or multilaterally. Long options with
upfront premiums do not give any benet from
netting because their MtM will never be nega-
tive. However, they may still be worth putting
under a netting agreement to oset negative
MtM of other instrument within the same net-
ting set in the future.
Collateral is an asset supporting a risk in a
legally enforceable way. Typical assets: cash
(most common), bonds, equity.
6.3 Enterprise Risk Management
..
46
6.4 Case Studies in Risk Manage-
ment
6.4.1 The collapse of Amaranth Advi-
sors [10, ++, inc]
Amaranth Advisors was a large-sized hedge
fund that failed in September 2006 due to
losses in natural gas futures and options.
They made a general bet that winter natural
gas prices would rise, while nonwinter natural
gas prices would increase to a lesser degree,
referred to as the long winter, short non-winter
spread trade.
Their trades had high levels of market and
liquidity risk, and also funding risk. Their
VaR numbers underestimated the risk. Some
of their traders were in a dierent city than
risk managers.
6.4.2 The Case for Enron [37, +, inc]
Enrons Board of Directors failed to monitor
... ensure ... or halt abuse. Sometimes the
Board chose to ignore problems, other times
it knowingly allowed Enron to engage in high
... risk practices.
At Enron, risk management neither provided
accurate information nor ensured accountabil-
ity.
7 Current Issues in Energy
(10%)
7.0.3 The Worlds Greatest Coal Arbi-
trage: Chinas Coal Import Be-
havior and Implications for the
Global Coal Market [32, -]
[They do not use arbitrage in the usual sense.
The paper simply says that Chinese consumers
buy coal from the cheapest source: domestic or
international.]
Coal is produced in the North of China and
moved to the consumption centers in the South
by rail and sea. Transport is expensive, repre-
senting 5060% of the nal price. During 2009,
it was cheaper to import coal from Indonesia,
Australia, and Russia. Hence, Chinese imports
accounted for 15% of all globally traded coal
in 2009, despite China still being the largest
coal producer. International coal prices have
since recovered and the import window began
to close by summer 2010.
This highlights the fact that, since China has
a massive domestic coal market, Chinas will-
ingness to import when international prices are
lower than domestic prices will move these two
prices closer to parity.
7.0.4 Oil Scarcity, Growth and Global
Imbalances [26, +, inc]
Oil is considered scarce when its supply falls
short of a specied level of demand, over a long
period. Oil scarcity is reected in the market
price, relative to the price of other goods.
Scarcity arises from continued tension be-
tween rapid growth in oil demand in emerg-
ing economies and the downshift in oil supply
trend growth.
Real oil prices have not trended persistently
up or down in 18752010. Instead, prices have
experienced slow-moving uctuations around
long-term averages. This suggests that periods
of oil scarcity have been long lasting but have
come to an end, and that investment, technol-
ogy, and discovery are eventually responsive to
price signals.
Energy consumption will depend largely on
GDP growth. However, the relation diers
across countries: linear for emerging markets,
but atter for high-income countries.
The paper concludes that gradual and mod-
erate increases in oil scarcity may not present
a major constraint on global growth in the
medium to long term.
47
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