Managing your profits using temperature and commodity price protection

Transcription

1 Managing your profits using temperature and commodity price protection

2 What affects my business? Your earnings volatility Temperature Commodity Prices Dec13 Feb anomaly European Climate Assessment & Dataset 2

3 What affects my business? Your earnings volatility Temperature Commodity Prices Warm? less demand, less sales Cold? unexpected demand + + Low? loss of value of fuel inventory High? cost of increased fuel supply You cannot manage the weather but you can manage the financial impact of weather

4 Managing temperature risk Exposure and application Utilities lose revenues when summers are cool and winters are warm Brewers lose beer sales in cool summers Warm winter or rainy summers hurt travel business Construction costs increase when sites shut down on extremely cold days in the winter Notional terms Product: Warm winter protection via HDD put London Heathrow Airport Strike (k) : 1700 HDDs total during Term Payout: MAX (0, (k-x))*notional Tick or notional (N): EUR Term: November to March Client: Case study UK household gas retail cooperative Temperature indices can also be used to structure swaps or calls Broad variety of indices available, including "Critical Day" count products HDD based swaps and options are traded on CME Problem: Solution: Result: Loss of revenues during winter eliminated normal cash surplus used to support co-op s other activities HDD put, which paid client if average temperature over a season was lower than 1std below normal 12 locations weighted to match load and service area Revenues were protected via recovery from the product in the following warm winter

5 HDDs HDDs Hedging temperature and gas prices Exposure and application Gas retailers face both temperature and commodity price risk: temperature drives demand and gas priced drive margins Since temperature is unpredictable, risk managers must guess when they put price hedging in place most hedge to a normal level of demand Even modest fluctuations around those normal volumes play havoc with gas price hedges Financial index products compete very effectively with other ways to manage this risk (active delta hedging, storage, flex in gas contracts) Structure Product: Index (X): Strike (k): Payout: Notional terms Tick or notional (N): Term: Temperature / gas swap London Heathrow Airport (LHR) Heating Degree Days (HDDs): daily, the difference between that day's average temperature and 18 C, if negative. Gas Index (Price) = NBP day-ahead price Set by client according to hedging strategy Daily Payout = (HDDActual HDDStrike) x (PriceActual PriceStrike) x Notional Volume Can be fixed or shaped by gas demand November to March Case study Swap payout mechanics SRCS Client Option payout mechanics No payout Payout to Client Client: Problem: Solution: UK household gas retail cooperative Delta hedging strategy was not effective in smoothing margins, and carried high transaction costs Gas / temperature swap to offset variability in underlying operating profits Client SRCS Payout to Client No payout Result: 12 locations weighted to match load and service area Operating profits were protected, giving business unit much more earnings stability

6 The essentials What can you do if you decide to buy protection vs. if you do not? Budgeting Planning Investing Happy stakeholders Costing A function of payout probability Typical RoL 2%-205 (premium vs. maximum payout) Parameters Where is your risk location? What's your risk period? What s your pain point? What kind of compensation do you need? Notionals? 6

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