1. Teseo Bergoglio Santiago Martignone Jose Nogueira Pete Schirmer
Delta Energy Center
Teseo Bergoglio Santiago Martignone
Jose Nogueira Pete Schirmer
Finc 556 Final project May 9, 2001

2. Bergoglio Martignone Nogueira Schirmer
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
Bergoglio Martignone Nogueira Schirmer

3. Bergoglio Martignone Nogueira Schirmer
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 PG&E's Antioch natural gas terminal.
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Bergoglio Martignone Nogueira Schirmer

4. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

5. Bergoglio Martignone Nogueira Schirmer
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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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer

6. Bergoglio Martignone Nogueira Schirmer
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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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer

7. Bergoglio Martignone Nogueira Schirmer
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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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer

8. Bergoglio Martignone Nogueira Schirmer
VAR Inputs
Futures price: $4.645/MMBtus
30-day tier-2 commercial paper: 4.5%
Risk premium 1.5% (based on S&P500 gas index beta of 0.22 and assumed market risk premium of 7%)
Monthly price volatility: % over last 30 days
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Bergoglio Martignone Nogueira Schirmer

9. Bergoglio Martignone Nogueira Schirmer
Value at Risk
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Bergoglio Martignone Nogueira Schirmer

10. Reduce Position Using Futures
In order to limit losses exceeding $139,350 to a 5% probability, DEC can only retain % of the total short exposure.
DEC should purchase 87 natural gas futures contracts for Jun01.
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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer

11. Bergoglio Martignone Nogueira Schirmer
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 market’s.
So look at commodity characteristics, then compare views…
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Bergoglio Martignone Nogueira Schirmer

12. Commodity Characteristics
Prices have been volatile in the last year; quadrupled to $10 per MMBTUs in Dec and fell to $5 in Mar
Undersupply, under-storage (inventories record lows) and 39% below last year.
Recent energy crisis and hot weather have boosted demand.
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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer

13. Bergoglio Martignone Nogueira Schirmer
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 > S0.
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Bergoglio Martignone Nogueira Schirmer

14. Bergoglio Martignone Nogueira Schirmer
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 < S1Mkt
Therefore, futures prices are expensive.
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Bergoglio Martignone Nogueira Schirmer

15. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

16. Strategies for Managing Short Positions
Volatility
Views Up
(option prices cheap)
Stable
(option prices fair)
Down
(option prices rich) Di r e c t i o n
(forward cheap)
? Or Stable
(forward fair)
Hedge
Short straddle
(forward rich)
Synthetic long put
Synthetic long put (itm) Dynamic hedge Bear spread
Our view
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17. Bergoglio Martignone Nogueira Schirmer
Hedge with Futures
View: Forward price fair and option prices fair
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Bergoglio Martignone Nogueira Schirmer

18. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

19. Bergoglio Martignone Nogueira Schirmer
Short Straddle
View: Forward price fair and option prices rich
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Bergoglio Martignone Nogueira Schirmer

20. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

21. Bergoglio Martignone Nogueira Schirmer
Synthetic Long Put
View: Forward price rich and option prices fair
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Bergoglio Martignone Nogueira Schirmer

22. Bergoglio Martignone Nogueira Schirmer
Synthetic Long PutITM
View: Forward price rich and option prices rich
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Bergoglio Martignone Nogueira Schirmer

23. Bergoglio Martignone Nogueira Schirmer
Synthetic Long Puts
Both fix our downside risk at $139,350 or less. No risk of additional losses.
The drawback is that we’re paying too much for this insurance, because of the high volatility being priced into the options premia.
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Bergoglio Martignone Nogueira Schirmer

24. Bergoglio Martignone Nogueira Schirmer
Bear Spread
View: Forward price rich and options prices rich
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Bergoglio Martignone Nogueira Schirmer

25. Bergoglio Martignone Nogueira Schirmer
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 isn’t buying volatility, so no big gains or losses with big price swings.
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Bergoglio Martignone Nogueira Schirmer

26. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

27. 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 % per month.
If our expectation is correct, DEC’s dynamic hedging costs will be less than the cost of the traded call options.
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Bergoglio Martignone Nogueira Schirmer

28. Initial Dynamic Hedge Position
F0 = 4.645
X = 4.645
r =
T = (28/30 days)
volatility = % per month
N(d1) =
Futures Δ = e-rTN(d1) = %
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Bergoglio Martignone Nogueira Schirmer

29. Initial Dynamic Hedge Position
Synthetic call = ΔF – 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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Bergoglio Martignone Nogueira Schirmer

30. Bergoglio Martignone Nogueira Schirmer
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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Bergoglio Martignone Nogueira Schirmer

31. Bergoglio Martignone Nogueira Schirmer
Recommended Strategy
Of the three, bear spread is recommended, even though we don’t 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.
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Delta Energy Center
Bergoglio Martignone Nogueira Schirmer