PAGE 1

Valuation Challenges for Real World

Energy Assets

Dr John Putney
RWE Supply and Trading



RWE Supply & Trading 7/20/2014 PAGE 2
Contents
> Typical energy assets gas swing, gas storage, power plants
> Valuing energy assets in traded markets
> Classic valuation models intrinsic and stochastic
> Where classic models fall short
> An alternative approach - methodology and infrastructure
> Building a realistic price process for evolving forward curves
RWE Supply & Trading 7/20/2014 PAGE 3
Gas Swing/Take-or-Pay Contracts
> Holder has rights to purchase gas each day subject to (e.g.)
Volume off-take limits daily, yearly and possibly sub-yearly
Contract price index to tradable or illiquid products, possibly with
volume dependent discounts
Inter-year constraints make-up, carry-forward
Sellers options to interrupt supply at short notice
Physical volume risks delivery shortfall, field depletion
> Historically, contracts have been
long-term agreements linked to the
operational life of a gas field

RWE Supply & Trading 7/20/2014 PAGE 4
Gas Storage
> Option to inject or withdraw specified volumes of gas each day:
Total volume in store must stay between min and max limits
Injection/withdrawal costs may be commodity price dependent
Injection/withdrawal rates may be dependent on volume in store
Number of injection-withdrawal cycles in the storage period may
be limited
> Storage agreement can relate to
physical facility or virtual contract
RWE Supply & Trading 7/20/2014 PAGE 5
Power Plant and Tolling Deals
> Options to dispatch a power plant buy fuel and carbon, sell power
> Dispatch decision changes plant operating regime and incurs fixed costs
Start-up and cycle costs may be commodity price dependent
> Dispatch decision taken frequently (daily half-hourly) but may need to
respect plant engineering
Ramp rates, min on/off times, start warmth
> Plant operation may be subject to emission constraints
UK opted-out plant has unit sulphur and stack running hours limits
> Supply logistics mean fuel delivery to coal stations is not just-in-time
Port to station delivery constraints and coal stocking options

RWE Supply & Trading 7/20/2014 PAGE 6
Energy Asset Options
Complex
Portfolio
of
Options
Time
Value
How much in
theory?
How much can be
captured in the
real world?
Constraine
d Exercise
Contingent
Options
Need to optimise
exercise decisions
when valuing
Forward price
process is
important
RWE Supply & Trading 7/20/2014 PAGE 7
Price Processes Governing Forward Curve Evolution
> Dynamics of curve movements
How different points along the curve can shift relative to each other
> Distribution of individual prices/returns
Presence of fat tails
> Mechanism by which successive prices/returns evolve
Existence of memory effects
> Cross Commodity relationships
Correlation/co-integration

Delivery Date
RWE Supply & Trading 7/20/2014 PAGE 8
Energy Assets in Traded Markets
Exposures to
multiple
commodities
Exercise (exposures)
at granularities finer
than market trades
Delivery
volumes
greater than
market trades
Exposures
beyond
liquid tenors
Price risks
arising from
volume risks
How to build a realistic
price process?
How to hedge effectively with standard tradable
products in the presence of real world market frictions?
RWE Supply & Trading 7/20/2014 PAGE 9
Energy Asset Valuation - Business Requirements
> Valuations of initial transactions e.g.
Acquisition of physical gas storage or power plant
Gas off-take and plant tolling contracts
Virtual deals and auction bids
> Daily reporting of P&L, position and risks
> Active management of assets
Exercise/hedging decision support tools for traders

RWE Supply & Trading 7/20/2014 PAGE 10
Intrinsic Valuation Models
> Optimise operation of asset against static forward curves
Typical methods are DP, LP and MIP
> Rich modelling of physical complexity
E.g. coal station with fuel logistics, plant dynamics and emission limits
> Capability to optimise portfolios containing long and short assets
E.g. swing and storage contracts with SOS constraint
> LP and MIP are easily extendable to accommodate non-standard features
> Models only provides intrinsic value and static position
But time value and delta may be estimated by rolling intrinsic simulations
RWE Supply & Trading 7/20/2014 PAGE 11
Stochastic Valuation Models
> Optimise operation of asset to maximise expected value under an assumed
spot/forward price process
> Generally restricted to a single asset with limited physical features
> Standard approach is SDP on a trinomial forest
Limited to single factor price process and no more than 2/3 commodities
Typically minutes to value storage with level dependent rates, but hours if
a cycle constraint is added
> Least Squares Monte Carlo is slower but can accommodate any multi-factor
price process and many commodities
E.g. gas swing with contract price indexed to a basket of oil products
> Models determine time value and delta
But the validity of this time value needs to be understood and addressed


RWE Supply & Trading 7/20/2014 PAGE 12
Time Value in the Real World
> The key question is how much time value can be captured by operating an
asset and hedging exposures in underlying commodity markets
And what value is at risk
> The classic stochastic models do not fully address this question because
They make assumptions about price processes that may be wrong
Price process parameters cannot even be observed (how to calibrate)
No account is taken of the risks and costs of real-world market frictions
Standard products, clip sizes, volume limits, depth dependent bid-offer
> Crucially, the concept of a universal fair time value does not really exist
It depends on the risk preferences of the counterparties

RWE Supply & Trading 7/20/2014 PAGE 13
Valuation against an Optimal Hedge Strategy
> The value we extract from an asset depends on how we operate and hedge it:
The model and parameters we use to determine exercise and exposure
Our hedging strategy frequency and how we optimise the trade-off
between hedge costs and risks in the presence of market frictions
> We can execute this process against an evolving forward curve scenario at
each market trading date we take the prevailing forward curve and
Run a chosen model to optimise the asset and determine exposures
Put incremental hedges in place in line with our hedging strategy
> We keep track of the asset and hedge P&L to determine the value captured
from the asset under the evolving curve scenario
> We are free to optimise the asset against a fine granularity forward curve but
can only hedge at standard product granularity and must pay bid-offer
RWE Supply & Trading 7/20/2014 PAGE 14
Storage Value Capture
Storage and Hedge P&L without Transaction Costs
-10
-5
0
5
10
15
20
25
30
Time
M
t
M
Storage Hedge Realised Total
Total Storage and Hedge P&L
0
2
4
6
8
10
12
14
16
18
Time
M
t
M
Without Transaction Costs With Transaction Costs
> 1 year storage
> LSMC hedge model
> Historic back test
> Initial valuation and hedge
placed 1 week before start of
storage period
> Hedge costs not insignificant
> P&L without transaction
costs relatively flat
RWE Supply & Trading 7/20/2014 PAGE 15
Generation and Use of Evolving Curve Scenarios
> Back tests against historic forward curves
Select best model (rolling intrinsic or rolling stochastic), model parameters
and hedging strategy
Sense check verification of valuation results
> Multiple simulations of curve evolution from a model
Distribution of value captured
Reserve for hedge effectiveness and value adjustment for model
> Stress tests built by mapping historic returns onto current forward curve
Verification of value distribution and reserve for model risk
> Valuations can be obtained with and without transaction costs
RWE Supply & Trading 7/20/2014 PAGE 16
Example Storage Valuation Results
> 1 year storage
> SDP hedge model
-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5
x 10
6
0
20
40
60
80
100
120
140
Total P&L inc Transaction Costs
F
r
e
q
u
e
n
c
y
Simulation and Scenarios Results
5th Percentile
10th Percentile
Simulation and Stress Test Results
> Comfort that stress
test results lie
away from tails of
distribution
RWE Supply & Trading 7/20/2014 PAGE 17
Valuation Infrastructure
> The above valuation methodology does not replace classic valuation models
but executes them many times at the heart of a simulated hedging strategy
> A flexible IT framework is required that allows analysts to construct and
evaluate hedging strategies from pluggable components
Valuation models from pricing libraries
Standard product trade generators and pricers
Hedge cost minimisation algorithms
Forward curve scenario generators
> P&L calculations can be taken care of by the core framework
> Valuations can be computationally intensive, but can be distributed across
multiple cores of servers and desk top PCs
RWE Supply & Trading 7/20/2014 PAGE 18
Modelling Forward Curve Evolution
> Curves start at next trading day
> As curve evolves delivery dates roll to
maturity
Tenor of fixed delivery reduces
> But volatility of non-storable commodities
tends to increase with tenor
Volatility Term Structure
0%
20%
40%
60%
80%
100%
120%
140%
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
Tenor (y)
RWE Supply & Trading 7/20/2014 PAGE 19
Model Calibration using Historic Price Returns
> Isolate volatility term effects by calibrating against fixed-tenor price returns
De-seasonalise prices or bucket fixed-delivery returns onto fixed tenor
> Use daily contract returns for a few prompt days then month contract returns
> HJM-style model may be built by using PCA to map onto stochastic factors

where the dz
k
(t) are i.i.d. normal variates
> But time series of fixed tenor returns do not really support such a model
Strong linear and non-linear auto-correlations with volatility clustering;
non-Gaussian distributions, particularly fat tails; complex spot/forward
price dynamics

( )
( )
( )
( ) ( ) t T , t dz
T , t F
T , t dF
r
K
1 k
k k
= = =

=
RWE Supply & Trading 7/20/2014 PAGE 20
OGARCH Curve Model
Multi-Variate
Return Time
Series
Uncorrelated
Component
Series
Independent
Component
Series
Conditional
Mean and
Volatility
Equations
ICA
ARMA, GARCH, OLS,
Max Likelihood,
Stability Constraints
Residual
Distribution
(Normal,
Student t, NIG)
PCA Dimension
Reduction
Sample residual distributions, invert
transformations, apply simulated returns to
evolve curve and roll to maturity
Integrate
spot model
?
RWE Supply & Trading 7/20/2014 PAGE 21
Dimension Reduction for Gas Curve Model
> PCA reproduces volatility better
than correlation and only achieves
linear independence
> ICA components satisfy a stronger
form of independence but are more
difficult to model
Correlation with M+18 - 4 Factor Model (Volatility Understated by 2%)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 0.5 1 1.5 2 2.5
Tenor (y)
Hist
PCA
Correlation with M+18 - 8 Factor Model (Volatility Understated by 1%)
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
0 0.5 1 1.5 2 2.5
Tenor (y)
Hist
PCA
Average Correlation between Component Returns^N
0%
5%
10%
15%
20%
25%
30%
35%
40%
1 2 3 4 5
N
PCA
ICA
RWE Supply & Trading 7/20/2014 PAGE 22
ARMA/GARCH: Auto-Correlation and Distribution Capture
> ARMA/GARCH can reduce auto-
correlation in returns and their
squares
> ARMA/GARCH with a NIG residual
distribution can replicate fat tails to
a large extent
Auto-Correlation of Samples
-1%
1%
3%
5%
7%
9%
11%
1 2 3 4
Component
Historic Returns
Model Residuals
Auto-Correlation of Samples^2
-3%
2%
7%
12%
17%
22%
1 2 3 4
Component
Historic Returns
Model Residuals
Kurtosis
0
2
4
6
8
10
12
14
1 2 3 4
Component
Historic
Model
RWE Supply & Trading 7/20/2014 PAGE 23
Modelling Multi-Commodity Curve Evolution
> OGARCH can be applied to model evolution of multiple commodity curves
> But a pure-returns based model only sees short-term curve dynamics and
cannot capture long-term association between commodity prices
Unrealistic commodity spreads can develop, whereas in reality macro-
economic and infrastructure relationships would tend to prevent this
> An alternative is the Vector Error Correction Model (VECM):



> Here X
t
is a vector of fixed-tenor log prices at time t, I
k
contain AR
coefficients, and O captures long-run, co-integrated relationships

> The model can be calibrated using Johansen method to establish stationary
combinations of prices, OLS to fit coefficients, and maximum likelihood to
determine a distribution to simulate the stochastic residual in c
t


1 - t t t t
t
K t
1 - K
1 k
k t k t
X X X , X X X = + + + =

=

RWE Supply & Trading 7/20/2014 PAGE 24
OGARCH vs VECM for Oil Time Spread
OGARCH
-
3
6
.
5
-
3
3
-
2
9
.
5
-
2
6
-
2
2
.
5
-
1
9
-
1
5
.
5
-
1
2
-
8
.
5
-
5
-
1
.
5 2
5
.
5 9
1
2
.
5
1
6
1
9
.
5
2
3
2
6
.
5
3
0
3
3
.
5
3
7
VECM
-
3
6
.
5
-
3
3
-
2
9
.
5
-
2
6
-
2
2
.
5
-
1
9
-
1
5
.
5
-
1
2
-
8
.
5
-
5
-
1
.
5 2
5
.
5 9
1
2
.
5
1
6
1
9
.
5
2
3
2
6
.
5
3
0
3
3
.
5
3
7
Spread Distributions
History
Simulated
RWE Supply & Trading 7/20/2014 PAGE 25
Demonstrating Validity of Price Process Models
> Calibration goodness of fit measures
> Animations of forward curve evolution
> Price and return distributions for commodity legs and spreads
Including time spreads
> Moment analysis
> Skill scores
> Managing and explaining extreme price behaviour

Many challenging problems still to be overcome!