A Look Forward— Understanding Forward Curves …

1 REPORT: RISKA look Forward Understanding ForwardCurves in Energy Markets May 2012 Risk Data ServicesPLATTS SPECIAL REPORT: RISK | 2A look Forward Understanding Forward Curves in Energy MarketsEXECUTIVE SUMMARYThe term Forward curve is a basic concept used freely by participants in energy markets. Despite the basic nature of the term itself, there is a wide divergence between companies in the definition and use of Forward Curves . This paper explores several types of Forward Curves used by market participants, differences between market-based Curves and settlement-derived Curves , and tools available to energy companies for modeling Forward prices. Forward Curves The term Forward curve refers to a series of sequential prices either for future delivery of an asset or expected future settlements of an index.

2 If we consider the NYMEX natural gas markets we note market participants could enter into contracts to purchase natural gas deliveries in future months for fixed contract for June deliveries recently settled at $ , July deliveries settled at $ , August deliveries settled at $ , and so forth. If we listed 12 months of futures prices in a table and then graphed thoseprices, it would look like this: Forward curve. The availability and reliability of that Forward curve is heavily dependent on the market s liquidity at each Forward month. Market data may come from multiple sources, including regulated exchanges, broker statements, trader indications, or third-party data publishers and curve data may differ between data sources. The differences are commonly related to market insights available to a particular data source.

3 For example, an exchange may only quote a market in multiple-month strips while a third party data publisher may quote each month within those strips based on over-the-counter data not available to the exchange. In the following example, Socal Gas basis swaps were recently quoted by both an exchange and by a market data publisher. The obvious difference is that the data publisher had availability to monthly quotes whereas the exchange quoted the first five months as a single strip. Differences in the remaining months are attributable to market liquidity and available data ( the exchange bases its settlement prices on a few contracts which trade infrequently while the data publisher bases its quotations on daily over-the-counter transactions occurring between multiple market participants):Delivery MonthDelivery : platts , 5/2012 Socal GasDelivery : NYMEX & platts , 5 - 12 Jul - 12 Aug - 12 Sep - 12 Oct - 12 Nov - 12 Dec - 12 Jan - 13 Feb - 13 Mar - 13 Apr - 13 May - 13 This collection of prices is referred to as the Forward curve, so-named because of the shape it takes on a graph.

4 Any commodity with a Forward market may be said to have a Publishers vs. ExchangesA key concept this paper explores is the difference between market assessed Forward Curves produced by reputable energy market data publishers and data available from exchanges. Publishers, such as platts , pull data from multiple sources to produce Forward curve data that provides greater market coverage and improves choice between data sources is often a difficult one, with implications for position reporting, risk measurement, limits monitoring, fair value calculation, and financial statement reporting. platts SPECIAL REPORT: RISK | 3A look Forward Understanding Forward Curves in Energy MarketsImproved Curve ValidationAccessing market data from a respected publisher, such as platts , strengthens the curve validation process.

5 More robust results can be achieved through the validation of internally developed Curves against independent market data aggregated from multiple Data LimitationsSettlement data from an exchange are limited to transactions executed across the exchange s platform. Settlement prices are based on single markets and are constrained by the liquidity in those markets if a market doesn t trade, the exchange will still settle its open interest using a formula-based approach in order to keep margin accounts in CHALLENGES There are many choices available to industry market participants seeking Forward curve data sources. The most common sources are exchanges, brokers, data publishers, data distributors, ETRM system vendors, and internally-developed models.

6 The first step towards selection of an appropriate Forward curve source is to understand your company s intended Forward curve usage case. The next step is to understand the limitations and methodologies inherent in each Forward curve source. The final step is to match your company s needs to the most appropriate Forward curve source and communicating the choice to key CASESThe predominant usage case for Forward Curves is financial statement preparation. Companies use Forward Curves as inputs to derivative models to calculate the fair value of financial instruments carried on the balance sheet. For SEC filers, this activity is governed by GAAP, specifically ASC Topic 820 (formerly, SFAS-157). Amongst other things, Topic 820 states companies should use market-based price inputs and should disclose the reliability of those inputs.

7 Input reliability is classified as either level 1 (unadjusted quotes from active markets), level 2 (quotes from inactive markets or markets for similar instruments), or level 3 (price inputs based on management assumptions). The reliability level requirements often mean companies must use the most active market quotes, even in instances where those markets are quoted as strips as opposed to individual months. Accidentally using lower-level price inputs or misrepresenting the reliability of price inputs may put the company at risk of re-statement in future common usage case is asset valuation for either planning purposes or dynamic hedging. Since these valuations are not for financial statement preparation purposes, companies may use something other than exchange-based Curves .

8 This is especially helpful in cases where the operating characteristics of a particular asset are more granular than available market quotes. For instance, a company may have rights to a natural gas storage facility between November and March. If the company applied quarterly strip prices observed on exchanges, it would incorrectly price the asset s value in November and December ( the strip prices Oct-Dec, not Nov-Dec) and would fail to capture monthly spreads within a given quarter. Using shaped Curves would provide the company with a better estimate of the asset s value, even though the intra-quarter prices do not meet GAAP definitions for input price reliability. With a better estimate of the asset s value, the company would be in a better position to manage the asset s net third usage case is risk management and reporting.

9 These practices vary widely amongst energy market participants, as do Forward curve applications to this end. Some companies may wish to have Value-at-Risk measurements and limits-monitoring processes match observable market data regardless of granularity. Other companies may wish to apply liquidity and seasonality adjustments if they believe those practices provide a more nuanced view of firm risk. The former may suggest an exchange-based curve source and the latter may suggest a curve source taking into consideration non-exchange data. In either case, companies should use a curve validation process by which they compare independent Forward curve data to the Forward Curves which they use for financial reporting, risk measurement,and risk SPECIAL REPORT: RISK | 4A look Forward Understanding Forward Curves in Energy MarketsLIMITATIONS AND METHODOLOGIESF orward curve providers vary in their approach to curve development, and these approaches should be aligned to a company s specific usage case as the company determines which to use.

10 Understanding the curve providers methodologies and Provider TypeTypical MethodologyMethodological LimitationPublishers Combined multiple sources of market data toproduce Forward Curves ( exchanges, brokers, commercial and back office groups of market participants) Internal quantitative methodologiesto model illiquid points Independent of market participants Usually broad coverage not limited to trades on their system Methodology used to model certain transactions may not be readily available or transparent Timeliness of data delivery may be a challenge for companies requiring end of day risk reportingExchanges Quoted market prices for traded markets Margin-based settlements for non-traded markets Does not typically capture OTC transactions May trade strips instead of individual months Does not capture illiquid pointsBrokers Aggregated price indications from dealer markets Indications do not always indicate market trades May indicate strips instead of individual months Does not