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The potential cost of delay can be measured
by a concept known as Value-at-Risk (VAR). VAR is a risk management tool that can be
used by energy traders, financial
institutions, or anyone possessing an asset
of changing value. The technique is used to
mathematically predict how much value could
be lost over a period of time if a decision
is delayed. In other words, "how badly could
things get if I do nothing."
Let's consider an example of a Purchasing
Manager (we'll call him Sam - short for
Strategic Asset Manager) who has carefully
identified and obtained approval for his
company's 2008 natural gas budget of
$1,620,000. Sam has just received bids for
his annual natural gas needs, has quickly
identified a winning bid, and has
pre-approved all contract terms and
conditions. Sam, however, discovers a
problem. The
Plant Manager who normally concurs with such
agreements is on vacation and won't be back
for seven days. Sam is torn between
disturbing his boss who is relaxing on a
beach for the first time in 5 years, or
waiting for his return? Let's see if we can
help Sam make an informed decision. As Sam's
consultant we have access to historical
energy price returns that we will need to
compute his VAR. The only other information
we need to know is how confident does Sam
want to be with his prediction. For this
example we'll assume Sam wants to know his
VAR with 95% confidence. The calculation of
VAR is:
VAR = Mark-to-market value x Confidence
Factor x Annualized Volatility x Square root
of (holding period / days
in a year).
Given and/or assumed information:
Mark-to-market value of current offer = $8/Dth x 200,000 Dth = $1,600,000 VAR = $1,600,000 x 1.645 x 0.22 x SQRT(5 / 252) = $81,563 Analysis: The VAR calculation means that Sam can say with 95% confidence that the cost of his company's annual gas needs will NOT increase by more than $81,563 from the present offer within the next 5 trading days. Another way to express this would be to say, there is a 5% chance they could have to pay as much as $1,681,563 ($1,600,000 + $81,563) if they wait for the Plant Manager's return. With an annual budget of $1,620,000, Sam would be smart to make the call, politely inform his boss of the risk and obtain permission to execute the contract. I suspect that Sam's boss would not be annoyed by the call, but rather impressed with the quality of Sam's analysis, and the decision to buy now would be an easy one to make. Notes: 1. Each monthly natural gas Future's contract has its own volatility. A volume-weighted average would be modeled based on a customer's unique load profile. The 22% annual volatility value is an approximation for current market conditions. 2. The Confidence Factor of 1.645 is obtained from "Z" table statistics for a normal distribution curve with a 95% confidence level. 3. There are several generally accepted methods for calculating Value-at-Risk (variance-covariance, Monte Carlo simulation, and historical price returns). This example uses the historical price return method. 4. Volatility is the standard deviation of the daily price returns for the 12-month strip of natural gas futures contracts. Independent
Energy Consultants are licensed natural
gas and electricity brokers and aggregators.
Please contact us if you would like to learn
how we can help you mitigate the risks with
your natural gas and electricity purchases.
Depending on your size and needs we are able
to issue paper RFPs, Internet Reverse
Auctions or a Post and Respond bid process.
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