ERPExamPartIPhysicalEnergy

Markets

INTRODUCTIONTOENERGYCOMMODITIESANDRISKMANAGEMENTPARTI
EXAMWEIGHT|10%|8QUESTIONS

IntroductiontoPhysicalEnergyCommodityMarketsLinkingPhysicalandFinancial
EnergyMarkets
Forwardcontractsandcarry
MarketliquidityRiskManagementOverview
Theriskmanagementprocess
Basictypesofrisk

GlenSwindle.ValuationandRiskManagementinEnergyMarkets.(NewYork:
CambridgeUniversityPress,2014).

Chapter1Context
Describetheuniquecharacteristicsofenergythatdifferentiateitfromotherassetclasses.
Energymarketsserveapurposeotherthanspeculationofhedgefunds.Mosttradingactivities
involvebalancingvariationsinsupplyanddemandacrosstimeandbetweenlocations.
Volatility
Energypricesexhibithigherlevelsofvolatilitycomparedwithotherassetclasses.High
volatilityaffectscommercialactivitiesinnumerousways:
Impedingconvergenceontransactionpriceandcomplexstructures.
Affectingcapitalrequirementsandcollateraldemandsonmarketparticipants.
Dramaticallyshorteningtimescalesatwhichhedgingprogramsmustbeaffected
Specialnessenergycommoditiesfrequentlytradeatapremium.Supplyanddemand
variationsaremoreextremeinenergymarkets.
Definecalendarstrips(calstrip)andseasonalstripsandunderstandtheirpractical
application.
Acalstripisthepriceaverageofthefuturesorforwardpricesforagivencalendaryearand
shouldbethoughtofasapricefordeliveryofthecommodityofthenexttwelvemonths.For
commoditieswithseasonality,suchasnatgas,seasonalstripsconcentrateliquidity.InNat
gas,commonlytradedstripsarewinterstripsNovMarandsummerstripsAprOct.
Mostlargetransactionsinvolveexposuretomultipleyearsofcommoditypricessocalstrip
pricesaremorepertinent.

Explaintheimpactofvolatilityoncollateralpostings,creditexposures,andcapital
requirementsonenergycommoditytradingoperations.

Highvolatilityalsorequireshighercollateralpostingsandincreaseincreditexposureresulting
inhighercapitalrequirementsfortradingoperations.Thelargerthepotentialswingsinthe
marktomarkettradingoperations,themorecashorfunctionalequivalentssuchaslettersof
creditarerequiredfordailyoperations.

IdentifythebenchmarkNYMEXnaturalgasdeliverylocation,andexplainwhynaturalgas
forwardcurvesexhibitseasonalvariationsindemand.
HenryHub.Naturalgasforwardcurvesexhibitseasonalityduetodemand.Heatingdemandin
thewinterinnorthamericaresultsinfarhigherconsumptionthanduringtherestoftheyear.
Wintermonthsarespecialrelativetothesummer.
Definebasisandunderstandtheprimarydriversofbasisdifferentials.

Basisdifferentialsarisewhenthereislocationalspecialnessbetweentradinghubs.For
example,thedifferencebetweenTETM3andHenryhubisabasisbetweenlocations.TETM3
typicallytradesatapremiumtoHHduetotransportationcosts.

IdentifytheglobalandNorthAmericanbenchmarkcontractsacrossenergycommodities.
NYMEXWTI
ICEBrent
NYMEXNG

Understandtherelationshipbetweenlocationalspreads,benchmarks,hubs,andliquidity.

Intreasuries,themostrecentissuances(ontheruns)arethebenchmarkbonds.Forequities,
thethebroaderindicesarethebenchmarks.Inenergy,itisthosedescribedabove.
Benchmarksareusedtorapidlyhedgelargeriskpositions.
Energymarketstraderiskinahierarchicalfashion,withthebenchmarksattheapex.Less
liquidproducts,referredtoashubs,tradeataspreadtothebenchmark.
Theusualsequenceofeventsisthatthebenchmarkinstrumentsareusedtoreducetherisk
positiontoaspreadorbasisbetweenthetransactionandthebenchmark.Subsequent
hedges,generallyrequiringlongerperiodsoftime,arethenusedtotransferthehedgeto
positionsthatareclosertothetransaction,locationallyandtemporally.Incaseswherethe
transactioninvolvesdeliveryataparticularilliquidlocation,aresidualspreadexposuremaybe
inventoriedforthelifeofthetransaction.

Chapter2ForwardsandCarry
Summarizethevarietyofderivativeinstrumentsavailableforhedgingandrisktransfer
activities.

WTIandBrentFutures

WTISwaps
NaturalGasFutures
NaturalGasPenultimateSwaps
GasDailySwaps

Identifytheabbreviations/identifiersforcommoditiesfuturescontractsforeachcalendar
month.

FJanuary
GFebruary
HMarch
JApril
KMay
MJune
NJuly
QAugust
USept
VOct
XNov
ZDec

ExampleDecember2010=Z10
Comparethecharacteristicsofphysicallydeliveredvs.financiallysettledtransactions

AswapisafinanciallysettledOTCtrade,ifitisexchangetradeditiscalledalistedswap.A
forwardcontractisanOTCtraderequiringphysicaldelivery.Ifitisexchangetraded,thenitis
calledafuturescontract.

DefinelotandopeninterestandexplainthedynamicsofNYMEXWTIfuturescontract
expiration.

Lotisthenotionalquantityforonecontract.1000barrelsisonelotforoil
OpenInterestthenumberofoutstandingcontractsTheopenishighestandmostvolatilein
theclosestmonths.

ExplainthemechanicsofanExchangeforPhysical(EFP)transaction.

PhysicalsettlementisthroughnegotiatedtransactionsreferredtoasExchangeforPhysical
(EFP)transactions,inwhichspecificgradesanddeliverylocationsarepricedasaspreadto
thefuturessettlementprice.EFPsarecommonincommoditiesmarketsandallow
counterpartieswithlongandshortfuturescontractstoexchangetheirrespectiveoffsetting

futurespositionsforphysicaldeliveryofadesiredspecificationandlocationatanegotiated
spreadtothefuturespriceatthetimetheEFPisexecuted.

Defineanddistinguishcontango,backwardation,andconvenienceyield.

Whenforwardpricesaredecreasingwithtenor,thecurveisinbackwardation.Whenforward
pricesareincreasingwithtenor,thecurveisincontango.Backwardationisassociatedwith
supplystressandcontangoisassociatedwithsuppleexcess.Contangoprovidesanincentive
tostorethecommodityforfutureuseandincentivisesinventorybuildandbackwardation
incentivisesareductionininventory.
Aconvenienceyieldisthebenefitorpremiumassociatedwithholdinganunderlyingproductor
physicalgood,ratherthanthecontractorderivativeproduct.Anexamplewouldbepurchasing
physicalbalesofwheatratherthanfuturecontracts.Ifthereisasuddendrought,andthe
demandforwheatincreases,thedifferencebetweenthefirstpurchasepriceofthewheat
versusthepriceaftertheshockwouldbetheconvenienceyield.

Describetheeconomicsofaparkandloandealstructure.
Aparkandloanstructureinvolvesrepointhenaturaldirection,namely,buyinginthecheaper
monthsandstoringtotheexpensivemonthswhendemandishigher.

BywayofExample,inaparkandloantransaction,ratherthanmakinga
securedloantoanaturalgasstoragefacilityoperator,aFRFIpurchasesa
specificamountofnaturalgas(asagreedtowiththestoragefacilityoperator)
fromthirdpartiesandarrangestohavethegasinjectedintothestoragefacility
onagivendate(e.g.,April15).Shortlyafterenteringintothepurchase
agreement,butpriortothedateonwhichthegasistobeinjectedinthestorage
facility,theFRFIsellsthegastothirdpartiesforforwarddeliveryataspecified
date(e.g.,October15).Duringthestorageperiod(e.g.,April15October15),the
FRFIhasanownershipinterestinthecomingledgascontainedinthestorage
facility.TheFRFIdoesnotwithdrawthegas,orotherwisedealwithit(e.g.,by
sellingittoanotherpartyandsubsequentlyreplenishingit),untilthespecified
deliverydate.Thestoragefacilityoperator,however,isnotprecludedfromselling
thenaturalgastoathirdpartyduringthestorageperiod,butwouldhaveto
replaceitwithanequivalentamountofg asbythedateoftheforwardsale

Chapter3MacroPerspective
Understandtheseasonalityinherentinvariousenergycommoditymarketsandexplain
factorsthatimpactseasonality.

Distillatepeaksinthewinterbecauseofheatingseason.Gasconsumptionpeaksinthe
summerfordrivingseasonwithdemanddroppingatthestartoftheschoolyearinSept.
Demandseasonalityiswhatmakesrefineryflexibilityandstorageuseful.Refineriestunetheir
outputtoproducemoregasolinepriortothedrivingseasonandlikewiseforheatingoilas
winterapproaches.


Explainhowgasstoragefacilities,injection,andwithdrawalfactorintotheconceptof
seasonality.

Gasstoragefacilitiesareusedtobridgethegapbetweenthehighseasonalityindemandand
theslowlyvaryingnonseasonalproductionrate.Injectiontoinventoryoccursinthesummer
monthsandwithdrawaloccursinthewintermonths.Thishastheeffectofofresolvingthe
mismatchbetweensupplyanddemand.

Defineandinterpretthecrackspreadforvariousrefinedproducts.
Crackspreadsarethepricedifferencesbetweentherefinedproductsandthecostoftheinput
crudeoil.Acommonlyreferencedcrackspreadisthe3:2:1spread.2pGasoline+1pHeatingOil3pCrude.

Describehowderegulationandtechnologicalinnovationssuchashydraulicfracturing
(fracking)haveevolvedthenaturalgasmarkets.

Technologicalinnovationssuchasfrackinghaveresultedinadramaticchangeintheestimates
ofnaturalgasreservesinNorthAmericacausingtheUSAtotransitionfromanetimporterto
anetexporterofnaturalgas.ThishasalsodecoupledthedomesticU.S.naturalgasmarkets
fromglobalenergybenchmarks.

Understandthefundamentalmarketdynamicsofthemostcommonlytradednaturalgas
spreads.

ThemostcommonlytradednatgasspreadistheMarchAprilspread.Theforwardcurvecan
exhibitameaningfuldropbetweenthesetwocontractmonthsacrossalltenors.Thisspread
servestodefinethepremiumbetweentheendofwinterandthebeginningoftheinjection
season.TheMarchAprilspreadhassettledatornearparitywithonlyoneexceptionin2003
wheninventorylevelswelow.Tightinventorycanresultinnontrivialspreadsatsettlement.

DescribetherelationshipbetweenUSnaturalgaspricesrelativetoworldbenchmarkspot
prices.

USNatgaspricesaredecoupledfromglobalbenchmarkspotprices.However,European
markets,withliquidtradinghubsarecloserinspirittonorthamericanmarkets.

MichelCrouhy,DanGalai,andRobertMark.TheEssentialsofRiskManagement,2nd
Edition.(McGrawHillEducation,2014).Chapter1RiskManagement:AHelicopter
View
Appendix1.1TypologyofRiskExposures
Explaintheconceptofriskandcompareriskmanagementwithrisktaking.
Riskisessentiallyhowvariablecostsandrevenueswillbe.Whatisthelikelihoodthatabig
losswilloccurinthecourseofbusiness.Itistheunexpectedcosts.
Riskmanagementistheprocesstakentoidentifyandmeasurerisk,appreciateits
consequences,andthentotakeactionaccordinglysuchastransferringormitigatingtherisk.It

isabouthowfirmsactivelyselectthetypeandlevelofriskthatitisappropriateforthemto
assume.Risktakinggoeshandinhandwithriskmanagement.Riskmanagementdrivesthe
risktakingchoicesandgivesthecapacitytomakeforwardlookingchoicesaboutriskin
relationtoreward,andtoevaluateperformance.

Describetheriskmanagementprocessandidentifyproblemsandchallengeswhichcanarise
intheriskmanagementprocess.

SeePage85
Theriskanalystfirstidentifieskeyfactorsthatseemlikelytocausevolatilityinthereturnsfrom
thepositionorportfoliounderconsideration.Thenumberofriskfactorsvariesconsiderably
dependingontheproblemandthesophisticationoftheapproach.Theriskmanagermust
measuretheinfluenceoftheriskfactorsoneachother,thestatisticalmeasurewhichisthe
covariance.Disentanglingtheeffectsofmultipleriskfactorsandquantifyingtheinfluenceof
eachiscomplicatedascovariancealtersovertime.
Oncetheriskmanagermeasuresandestimatesriskexposures,findsinstrumentsandfacilities
toshiftortradetherisk,theythenassesstheeffectsoftheexposuresandcostsandbenefits
oftheinstruments.Fromthere,theriskmitigationstrategyistoavoid,transfer,mitigate,and
keep,thenevaluatetheperformanceandrepeat.

Evaluateandapplytoolsandproceduresusedtomeasureandmanagerisk,including
quantitativemeasures,qualitativeassessment,andenterpriseriskmanagement.

ValueatRisk(VaR)isastatisticalmeasurethatdefinesaparticularleveloflossintermsofits
chancesofoccurrence.VaRandeconomiccapitalevolvedtofacilitateintegrated
measurementandmanagementofvariousrisksandbusinesslines.TheVaRframeworkisa
wayofmeasuringandcomparingriskacrossmanydifferentmarkets.Itis,however,only
suitableformarketsoperatinginnormalconditionsoverashortperiodoftime.Thereisalso
trendtowardworstcasescenarioanalysis.
EnterpriseRiskManagementisadeliberateattempttobreakthroughthetendencyoffirmsto
operateinriskmanagementsilosandtoignoreenterprisewiderisks,andtoattempttotake
riskintoconsiderationinbusinessdecisionsmuchmoreexplicitlythanhasbeendoneinthe
past.TherearemanyERMtoolssuchas:
Conceptualtoolsthatfacilitateenterprisewideriskmeasurement(suchaseconomic
capitalandenterprisewidestresstesting)
Monitoringtoolsthatfacilitateenterprisewideriskidentification
Organizationaltoolssuchasseniorriskcommitteeswithamandatetolookatall
enterprisewiderisks

Describeanddifferentiatebetweenthekeyclassesofrisks,explainhoweachtypeofriskcan
arise,andassessthepotentialimpactofeachtypeofriskonanorganization.

MarketRiskistheriskthatchangesinfinancialmarketpricesandrateswillreducethevalue
ofasecurityoraportfolio.

Interestrateriskistheriskthatthevalueofafixedincomesecuritywillfallasaresult
ofanincreaseinmarketinterestrates.
Equitypriceriskisassociatedwithvolatilityinstockpricesandreferstothesensitivity
ofaninstrumentorportfoliovaluetochangeinthelevelofbroadstockmarketprices.
ForeignExchangeRiskarisesfromopenorimperfectlyhedgedpositionsinparticular
foreigncurrencydenominatedassetsandliabilitiesleadingtofluctuationsinprofitsor
valuesasmeasuredinalocalcurrency.
CommodityPriceRiskFormostcommodities,thenumberofmarketplayershaving
directexposuretotheparticularcommodityisquitelimited,henceaffectingtrading
liquiditywhichinturncangeneratehighlevelsofpricevolatility.

CreditRiskistheriskofaneconomiclossfromthefailureofacounterpartytofulfillits
contractualobligationsorfromtheincreasedriskofdefaultduringthetermofthetransaction.
DefaultRiskisthedebtor'sincapacityorrefusaltomeethis/herdebtobligations
usuallywithin60daysofduedate.
DowngradeRiskistheriskthattheperceivedcreditworthinessoftheborroweror
counterpartymightdeteriorate.
SettlementRiskistheriskduetotheexchangeofcashflowswhenatransactionis
settled.Failuretoperformonsettlementcanbecausedbyacounterpartydefault,
liquidityconstraints,oroperationalissues.Theriskisgreatestwhenpaymentsoccurin
differenttimezones,foreignexchangetransactionssuchascurrencyswapswhere
notionalamountsareexchangedindifferentcurrencies.

LiquidityRiskcomprisesbothfundingliquidityriskandtradingliquidityrisk.
Fundingliquidityriskrelatestoafirm'sabilitytoraisethenecessarycashtorolloverits
debttomeetcash,margin,andcollateralrequirementsofcounterpartiesandtosatisfy
capitalwithdrawals.
Tradingliquidityriskistheriskthataninstitutionwillnotbeabletoexecutea
transactionattheprevailingmarketpricebecausethereis,temporarily,noappetitefor
thedealontheothersideofthemarket.Ifthetransactioncannotbepostponed,its
executionmayleadtoasubstantiallossontheposition.

OperationalRiskreferstopotentiallossesresultingfromarangeofoperational
weaknessesincludinginadequatesystems,managementfailure,faultycontrols,fraud,and
humanerrors.Itcanalsoincludenaturalandmanmadecatastrophes.
Humanfactorriskrelatestothelossesthatmayresultfromhumanerrorssuchas
pushingthewrongbuttononacomputer,inadvertentlydestroyingafile,orenteringthe
wrongvaluefortheparameterinputofamodel.Thisalsoincludesemployeefraud
Technologyriskcomputersystemsfailure

LegalandRegulatoryRiskiscloselyrelatedtooperationalriskandreputationrisk.An
exampleisacounterpartylacksthelegalorregulatoryauthoritytoengageinarisky
transaction.Thereisriskofbeingsued.
BusinessRiskreferstotheclassicrisksofthebusinessworld,suchasuncertaintyaboutthe
demandforproducts,thepriceofthoseproducts,andthecostofproducinganddelivering
thoseproducts.Itismanagedthroughstrategicdecisions.

StrategicRiskistheriskofsignificantinvestmentsforwhichthereisahighuncertainty
aboutsuccessandprofitability.Itcanalsoberelatedtoachangeofstrategyofacompany.
ReputationRisktwomainclassesofreputationrisk:
Thebeliefthatanenterprisecanandwillfulfillitspromisestocounterpartiesand
creditors
Thebeliefthattheenterpriseisafairdealerandfollowsethicalpractices
SystemicRiskconcernsthepotentialforthefailureofoneinstitutiontocreateachain
reactioneffectonotherinstitutionsandthreatenthestabilityoffinancialmarkets.

CRUDEOILMARKETSANDREFINEDPRODUCTSPARTIEXAMWEIGHT|35%|
28QUESTIONS

Exploration,Production,andProjectDevelopment
Proved,possibleandprobablereserves
BarrelofOilEquivalent
Contractualandconcessionarysystems
Productionsharingagreements
Leaseprovisionsincludingroyaltypayments
Economicvaluationofoil/gasprojects
Upstreameconomicsincluding:wellheadprice,breakevenpriceandtaxallocations
Partnershiparrangementsandtheallocationofworkinginterests
RealOptionsvaluationanalysis
PetroleumRefining
Refinerycomplexity
Refiningmarginsandpriceformation
Crackspread
Specificationsandrequirements
Finishedproductsandpricing
RenewableIdentificationNumbers(RINs)
GlobalBenchmarksandPriceFormation
Gradesofcrudeoil
Brent,WTI,DubaiOman
Oiltradingrelatedtobenchmarkpricing
CrudeOilTransportationandStorage
Pipeline,seaborne,andraileconomics
WorldscaleandIncoterms
CreatingandregulatingasafetycultureUnconventionalOil
Unconventionalresourcesdefined
Conventionalvs.unconventionalprojecteconomics

AndrewInkpenandMichaelH.Moffett.TheGlobalOilandGasIndustry:Management,
StrategyandFinance.(Tulsa,Oklahoma:PennWellBooks,2011).


Chapter3Access,Leasing,andExploration
Definethecoreactivitiesintheupstreamoilandgasvaluechain.
Finding,developing,andproducingcrudeoilandnaturalgasarethecoreactivitiesinthe
upstreamoilandgasvaluechain

Summarizetheprocessofaccessingnewreservesandoutlinethestepsinvolvedin
developingapetroleumproject.

Identificationofoilandgasfieldtargets
Gaininglegalaccesstoexplorationanddevelopmenttargets
Generationandanalysisofappraisaldata
Analysisofexplorationdiscoveries
Commercialagreementssuchasprojectfinanceandnegotiatingcontractsfor
productionoutput
Finalinvestmentdecision(FID),whenacompanycommitstorecoveringoiland/orgas
Fielddevelopment
Fieldproduction

ExplorationandProductionfirms(E&P)acquirenewreservesthroughnegotiation,acquisition,
orpartnership.Theyalsoacquirethemthroughexplorationandgeology.

Equityoiloilthatcanbebookedasreserves.

Understandsubsurfaceoilandgasgeologicalstructuresandhowtheyaffectproject
development.

Seepage137and138fordiagrams

Crudeoilandnaturalgasareformedinasourcerock,whichistypically7000to18000feet
belowsurface.Theoilandgasthenriseasaresultofbuoyancytoareservoirrockformation.
Theoilandgasmoleculesthenmigrateupwarduntilreachingacaprockformation,which
trapstheoilandgas,formingareservoir,inwhichthegasformsacapabovetheoil.The
mostcommontrapformationsarecalleddomesoranticlines.

Theeasiestandcheapestoilextractionisfromseepageswhichareclosetothesurface.Most
oftheearlyoilproductioncamefromthesetypesofformations.Today,geologistsusesurface
topologyandseismologytodiscoverdeeperoilreserves.Thedeeperthereservethemore
costlytheventure.

Identifytheownerofsubsurfacemineralandresourcerightsbasedonjurisdictionandmarket
assumptions.

Therighttoexploreanddevelop,involvingmineralrightsorsubsurfacerights,istypicallyheld
bythestate.ThisisthecaseinmostoftheworldexceptUSAandCanadawhereanindividual
orcorporationmayowntherights.


Compareandcontrastthefiscalregimesofinternationalpetroleumagreements.

Legalstructurescoveringboththeresponsibilitiesofthedeveloper(lessee)andthemineral
rightsowner(lessor)arecalledfiscalregimesforinternationalpetroleumagreements(IPAs).

Concessions(Royalty/Taxsystem)
Theoilcompanydevelopingthepropertytakestitletotheoilatthewellhead
Lesseeusuallyprovidesallexploration,development,andproductioncapital
Lesseepaysthelessoraroyalty(%ofprice)forthelifeoftheproject
Lesseepaysthehostgovernmentcorporateincometaxesandpossiblyspecialoil
taxesoverthelifeoftheproject
Productionsharingagreements(PSA)
Theoilcompanydevelopingthepropertysharestitletotheoilatthewellhead
Lesseesplitsexploration,development,andproductioncapitalwithhostcountry
Lesseetypicallypayslittleornoroyalty
Lesseeislimitedinamountofcapitalandoperatingcostdeemeddeductibleperyear
Lesseepaysthehostgovernmentcorporateincometaxesandpossiblyspecialoil
taxesoverthelifeoftheproject
Riskservicecontracts
Theoilcompanydevelopingthepropertyisonlyacontractor,andtakesnotitletothe
oilorgasproduced
Lesseeprovideslittleornocapitaltowardsexploration,development,andproduction
Lesseepaysthehostgovernmentcorporateincometaxesandpossiblyspecialoil
taxes

Describethetypicalcomponentsofaleaseagreementandmethodstoestablishroyalty
payments.

PrimaryTerms defineaspecificperiod,frombeginningtoend,overwhichthelesseewill
haverightofaccess.Itmayincludethepossibilityofleasetermextension.
GrantedUsetermscoverspecificuseandpurposesrightsofthelessee.Thesetermswillbe
specificindefiningthepropertyandexactrightsthelesseehasforthetermofthelease,
including:minimumdrillingrequirements,nonperformancepenalties,typesofexploration
techniquesallowed,anddrillingmethodsanddistinctions.
BonusandRoyaltiesdefineupfrontpaymentsorbonuspaymentsassociatedwithresults.
TheroyaltyclausewilldefinethepercentageorshareofproductionproceedsthattheLessee
willpaytotheLessor.Althoughthereisnostandardroyaltyrate,mostleaseagreements
historicallyvariedbetween12.5%and25%.Royaltyratesmaydifferbetweenoilandgas.
Thelessormayhavetherighttoreceiveroyaltiesinmonetarytermsortheoilandgasitself
(inkind).Theremayalsobeaminimumannualroyalty,regardlessofdiscoveryor
development,andthepossibilityofahigherroyaltyratepostpayout.
DelayRentaltermsincludeconditionsbywhichthelesseemaydelaydrillingorotherusesof
thepropertyinlieuofadelayrentalpayment,aftercompletingrequiredminimumexploration
ordrillingrequirements.