Delta Energy Center

1
Delta Energy Center

• Teseo Bergoglio Santiago Martignone
• Jose Nogueira Pete
  Schirmer

Finc 556 Final project May 9, 2001
2
Delta Energy Center

• On December 18, 1998, the joint partnership of
  Calpine Corp. and Bechtel Enterprises filed an
  application for approval from the Energy
  Commission to construct and operate the Delta
  Energy Center (DEC).
• DEC will begin operations June 21, 2001.

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Delta Energy Center

• The project is an 880 megawatt, natural
  gas-fired, combined cycle electric generation
  facility.
• Operating at full load, DEC can burn 145 million
  cubic feet of natural gas daily.
• A new 5.3-mile natural gas pipeline will connect
  to PGE's Antioch natural gas terminal.

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Delta Energy Center

• The firm will establish a one-week reserve of
  natural gas before starting operations in June.
• 145 million c.f./day 145 billion BTUs/day.
• One-week reserve requires 1 trillion BTUs.

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DEC Business Position

• Natural position is short 1 trillion BTUs.
• Position equivalent to 100 futures contracts for
  10,000 million BTUs each.
• Jun01 price 4.645/MMBTUs
• 1 contract 46,450
• Total exposure 4,645,000
• The company has decided to limit its losses to
  139,350 (3.0 risk).

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Natural Gas Futures

• Natural gas futures and options are traded on the
  New York Mercantile Exchange (NYMEX).
• 1 future contract is for 10,000 million British
  Thermal Units (BTUs).
• The Jun01 contract matures May 30, with first
  delivery June 1 and last delivery June 30.
• Delivery is through Sabine Pipe Line Co.s Henry
  Hub in Louisiana.

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DEC Risk Summary

• Total exposure (-F) of 4.6 million (100
  contracts for 10,000 million BTUs).
• DEC has decided to limit its loss to 139,350
  (3.0 of total).
• Desired probability of losing more than 139,350
  5 (1 out of 20) or (1.65 standard deviations).

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VAR Inputs

• Futures price 4.645/MMBtus
• 30-day tier-2 commercial paper 4.5
• Risk premium 1.5 (based on SP500 gas index beta
  of 0.22 and assumed market risk premium of 7)
• Monthly price volatility 12.5436 over last 30
  days

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Value at Risk
10
Reduce Position Using Futures

• In order to limit losses exceeding 139,350 to a
  5 probability, DEC can only retain 13.468 of
  the total short exposure.
• DEC should purchase 87 natural gas futures
  contracts for Jun01.

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Hedging with Options

• We need not use just futures contracts to hedge
  our position.
• We may wish to use traded or synthetic options.
• Choice of strategy depends on our view of futures
  and volatilities vs. the markets.
• So look at commodity characteristics, then
  compare views

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Commodity Characteristics

• Prices have been volatile in the last year
  quadrupled to 10 per MMBTUs in Dec. 2000 and
  fell to 5 in Mar. 2001.
• Undersupply, under-storage (inventories record
  lows) and 39 below last year.
• Recent energy crisis and hot weather have boosted
  demand.

13
Market View

• Analysts expect prices to remain highly volatile
  relative to historical levels over the coming
  months.
• ATM calls and puts have implied volatilities of
  56, versus recent history of roughly 45.
• Phillips CEO expects rising demand for oil and
  gas (May 7th 2001).
• Expected future spot gt S0.

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Our View

• California energy crisis will drive gas prices
  up, and a hotter-than-expected month will boost
  demand.
• On the other hand, the economic downturn will
  depress demand.
• S1Our lt S1Mkt
• Therefore, futures prices are expensive.

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Our View

• Although volatility has been high, it tends to
  return to its mean.
• The market is pricing too much volatility into
  options.
• Therefore, options prices are expensive relative
  to their insurance value.

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Strategies for ManagingShort Positions
Our view
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Hedge with Futures
View Forward price fair and option prices fair
18
Hedge with Futures

• This does not eliminate potential losses greater
  than 139,350.
• It limits the probability of such losses to no
  more than 5.
• This probability is contingent on the accuracy of
  our VAR model assumptions.

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Short Straddle
View Forward price fair and option prices rich
20
Short Straddle

• The 5 probability of losses greater than
  139,350 is split between the two tails.
• There is roughly a 2.5 chance that future spot
  prices will be so low (high) that losses exceed
  our limit.
• This purpose is trading and income, rather than
  insurance, which comes from selling expensive
  options.

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Synthetic Long Put
View Forward price rich and option prices fair
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Synthetic Long PutITM
View Forward price rich and option prices rich
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Synthetic Long Puts

• Both fix our downside risk at 139,350 or less.
  No risk of additional losses.
• The drawback is that were paying too much for
  this insurance, because of the high volatility
  being priced into the options premia.

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Bear Spread
View Forward price rich and options prices rich
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Bear Spread

• The apparent arbitrage opportunity here is
  probably due to thinly traded options.
• The market will eliminate such opportunities.
• With the market overpricing options, DEC balances
  a long position in calls with a short position in
  puts.
• DEC isnt buying volatility, so no big gains or
  losses with big price swings.

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Dynamic Hedging

• Synthetic options can be created with dynamic
  hedging.
• Dynamic hedging costs lower than options costs
  when market variation is less than initially
  priced.
• Use when we disagree with implicit option market
  pricing of risk.

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Dynamic Hedge and Volatility

• The implied volatility in ATM calls and puts is
  around 56 per year, or 16.17 per month.
• We used the 30-day historical volatility, which
  is 12.5436 per month.
• If our expectation is correct, DECs dynamic
  hedging costs will be less than the cost of the
  traded call options.

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Initial Dynamic Hedge Position

• F0 4.645
• X 4.645
• r 0.0382
• T 0.933 (28/30 days)
• volatility 12.5436 per month
• N(d1) 0.63863
• Futures ? e-rTN(d1) 61.6263

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Initial Dynamic Hedge Position

• Synthetic call ?F B
• DEC can create a dynamic hedge position by
  entering 62 futures contracts and lending 100 x
  CATM 155,000.
• As the futures price changes and time to maturity
  decreases, DEC will have to adjust its hedge
  position.

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Recommended Strategy

• Three strategies are best aligned with our market
  view (forwards and options rich).
• Dynamic hedge is imperfect, may be
  administratively difficult.
• Synthetic long put (itm) still requires purchase
  of expensive calls.
• Bear spread gives odd results.

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Recommended Strategy

• Of the three, bear spread is recommended, even
  though we dont really expect arbitrage
  opportunities.
• This gives us some profits if prices are lower
  relative to futures (as expected).
• Buying expensive calls offset by selling
  expensive puts.