Notes Energy and Finance certificate

Introduction to the derivatives

A derivative is a financial instrument of which the value is determined by an underlying asset. Two kinds: forwards (forward, futures, swaps), and contingent (option). Derivatives have been created to hedge systemic risks (which cannot be diversified via a large portfolio or covered by an insurance company). Forward: two parties agree on a price. Payment at maturity can be over-the-counter (OTC) market, counterparty risk, low liquidity, short maturity, and restricted access. . Price of the forward is valued by the spot price at inception, risk-rate over the period and the period T, if there is dividend D paid at time t. Forward price is set by spot price, cost, interest rate and expected demand. Futures exist to limit the counterparty risk and increase the liquidity: same basis than the forward but organized with a clearing house (intermediary). A person who enters the future market needs to deposit an initial margin and has to keep it over the maintenance margin via a new deposit. Position are marked day to day -> can leads to important cash-outs. Swaps contract force two parties to exchange cash flows at multiple times. A call is a contract that gives the right (not obligation) to someone to buy an asset at a time at a fixed price against a prime. A put gives the right to sell.

Physical constraints
During the transformation from primary into secondary energy there are losses (following entropy laws, and energy conservation) as follows: -

Conversion: 25% Transport: 5% End-use: 35%

A light bulb has an efficiency of 2% (= useable energy / primary energy). 0,1kg of fossil fuel heat 1kWh: oil is a concentrated form of energy. 10mg of fission of nuclear uranium provides 1kWh. 1mg of fusion provides the same. Oil is easy to handle via flexible transportation chain, coal (solid) hard to handle but flexible chain, gas hard to handle plus inflexible chain (1000 times less energy /m3 than oil). Primary energy consumption: - Oil 34%

Coal 30% Gas 24% Electricity 12% (nuclear and hydro)

There is a correlation between income and energy consumption. In the world, people consume 1,7toe (total is 12,6Gtoe). There are three scenario regarding the evolution of the demand: - A1: 24,5Gtoe in 2050 - B: 19,8Gtoe - C: 14,2Gtoe Proven oil reserve in 2010: 190Gt (19% in Saudi Arabia). Peak oil in 2020 (later if new discoveries, better efficiency, new heavy oil, tar sands). World electricity generation: 19 201 TWh (2007). Price of every kind of primary energy increases recently, as the production and exploration investment skyrocketed. Oil market was defined in 70s by controlled market (dominated by OPEC): security of supplies guaranteed, long term contracts. In 80s: market freedom; sharp price rise, increased volatility, spot forward and future markets. In 90s: financial markets: regulated price (moderate) geopolitical orders, benchmark price via formulas (swap, options). Product sales: 600$/t (light crude price > heavy crude price). Transportation costs: 20$/t. Tow different price: FOB (free on board) cargo is available at loading location (buyer pays transportation and insurance costs) and CIF (cost insurance freight) seller pays transportation and insurance costs and cargo is available at offloading location. Refining costs: 30$/t Netback value: 550$/t (=600-20-30). Main phase of an oil/gas field: - Exploration: evaluation, exploration (seismic exploration), delineation. 5-10 years, 10-20% of technical costs. - Development (between discovery and production): 3-8 years, 40-60% technical costs. Wells, export facilities, production facilities, storage, FPSO. - Production: 15-50 years, 30-50% costs (OPEX) - Abandonment: 1-5 years, 5-15% costs (rehabilitation) Breakeven price rises a lot with unconventional methods: - OPEC middle east: 20$/bbl - Conventional: 25$/bbl - (Ultra-) Deep water: 30-50$/bbl - Enhanced recovery: 40-80$/bbl - Heavy oil: 60-80$/bbl - Artic: 80-100$/bbl

- Oil sands: >100$/bbl So with a 85Mbbl/day scenario: price will be around 60-80$/bbl.

Peak oil, reserves

Original oil in place (OOIP) = volume*porosity*saturation Reserve = OOIP*recovery rate Reserve in place > technically recoverable > economically recoverable > proven reserves. Peak of reserves: finite quantity Peak of production: economically recoverable Peak of supply: local consumption and disruption of transportation Peak of demand: substitutes (The stone age ended, not because we ran out of stones). A peak of easy and cheap oil will occur, and non-OPEC conventional oil is peaking (at 100 mb/day), maybe driven by climate change policy.

The demand side: long-term rule of fossil fuel energy

Coal is the fastest growing energy (+65% to 2035) oil is the leading one. Coal, oil; gas and biomass represent more than 80% of source of energy. To meet the 450 IEA scenario coal has to be reduced (reduction in absolute term, whereas oil growth rate has to be reduced) replaced by nuclear and renewables. The 450 ppm of CO2 in the atmosphere would lead to an increase of 2C by 2100, current policies will lead to a 6-7C increase. Non-OECD countries drive the demand; OECD states are receding; strong demand in BRICS countries pushed price up (+30% of oil price, +35% of raw material price). Industry demand grows fastest than transport and other due to efficiency gains in the latter two. Due to long lead-times in energy development the increasing share of renewable energy wont even change the energy mix by 2050, according to current policies. Even in a post-Fukushima scenario there isnt evidence of a nuclear phase-out, but coal drops sharply in the new policy scenario.

The demand side: the drivers

The GDP is one of the major energy drivers: energy intensive. We see a shift from OECD to non-OECD countries, as the world population and the power (in India) count, but the wealth stays in OECD. The road to recovery from the financial crisis has been highly energy intensive.

The supply-side: constraints of geology

The oil price will stay high because of marginal cost increase through unconventional methods (cf last section). In a 85bbl/day scenario prices are set by heavy oil, artic and

oil sands. Furthermore, to replace decline in production and reserve and increasing demand, another 6-8 times Saudi Arabia has to be found. And it is a very capitalistic segment, as large investments are needed. 37 T$ in 2010 = 17T$ for power, 10T$ for oil, 10T$ for gas and 1T$ for coal. -> Fossil fuel remains dominant, energy demand and CO2 emissions grow by 45% to 2030 and they are huge threats to the security of energy supply.

The supply-side: constraints of geopolitics

National Oil Companies (NOC) hold the bulk of oil world reserves (OPEC = 70%) at low extraction cost. OPEC also holds 50% of the conventional gas reserves. So the non-OECD countries control and will control conventional resources. Cost of piracy: 7-12 billion$/year Many bottlenecks on oil routes (Suezetc). No international governance (US and China strategy are exclusive).

The constraints of carbon: Copenhagen, Cancun,

Developed countries account for 20% of population, 60% of GDP and 50% and greenhouse gas emission (GHG), and it takes 35% less of GHG to produce in developed than in emerging countries. 2010: GHG emission: 50 GtCO2eq; 2050: 80GtCO2eq.Emission in OECD stay flat (successful climate change policy or recession?), 75% of the increase are in China, India and Middle East. A stabilization of GHG concentration in the atmosphere can lead to serious damages (health, climate, infrastructure): 140 million people exposed, and estimated 35 000 billion$. A reduction of 27GtCO2eq/year is economically viable if under 40/ton. Electricity (demand and clearer production) account for 2/3 of the emission reduction efforts: the economy must be carbon-driven.

The world before and after Fukushima.

The problem with coal: a coal-fired MWh = 1ton of CO2. Clean coal electricity production is a viable solution while addressing the climate change issues. Smart grid may be a solution because as the efficiency in electricity is around 33%, a MWh of electricity wasted is 3 MWh of primary energy wasted. Plus the electricity demand is about to double in 2030. Smart grid = grid + digital and technological to manage demand and renewable intermittency and integrate load supply nuclear. Phasing-out nuclear is impossible.

Fundamental for oil market

The life cycle of an oil field is: build-up, plateau, decline, enhanced recovery, decline and abandonment. OPEX is around 40% of total expenditure.

For now discoveries are over production, but the difference is shrinking. We see a large increase in CAPEX expenditure, but no correlated with oil production: unconventional oil, efficiency enhancement. Costs are broken as follows: finding costs (acquisition of acreage, exploration, purchase of reserve), development costs (construction, transport facilities). Both added equals technical costs (entire costs excluding marketing). These technical costs are a major criterion for the valuation of a company stocks or assets. Market cap are 4 to 10 less big for oil services company (Schlumberger) than for energy company (ExxonMobil). The reserves are: - 1P: proven (90% recoverable) - 2P: probable (50% recoverable) - 3P: possible (10% recoverable) So we can define the reserve life = 1P/annual production. This is also a good criterion for the valuation of an oil company. There are two different players in the oil industry: - IOC: born further WW1, super-majors, command E&P techno, and financial power. 15-30% ROCE, can carry lot of debt, open to public investments. - NOC: born further 1st oil shock, government-owned, title to reserve, tax and country revenue producer. Driven by international oil price. The two biggest consumer of oil are US (19Mbarrel/day), China (9Mbarrel/day). The production is very dependent (for 60%) of 300 giant fields (out of 70 000). In other terms, 60% of the production comes from 300 fields (0,4%). They have been in operation for over 50 years. We expect a production of non-crude oil to explode (crude remaining stable). The number of future contracts increases at the end of each trading day: producers (processors, merchants) are globally short; money managers are globally long on these futures. The demand for oil is relatively inelastic as 22% come from passengers.

Fundamentals of the gas market

The main problem with gas is its bulkiness (1030 barrel of gas = 1 barrel of oil), and its transportation, which is hard and inflexible (thus very costly). High reserves are in Russia (45 trillions cubic meters), Iran (30) and Qatar (25), but potential reserves for 125 in US and Canada. The total proven reserves are estimated at 180 tcm more than enough to meet the global demand in 2035. Resources (not only proven) are about 400tcm (=130 years of production). Unconventional gas resources (shale gas, coalbed methane) are discovered (estimated to reach 900tcm and 380tcm economically recoverable)! -> Comfortably meet demand to 2035 and beyond. The demand is 3100bcm/y in 2010 and 4750bcm/y in a post Fukushima scenario (primarily

for electricity and heat). But its utilization is very sensitive to relative price of gas versus other sources: carbon-concerned economy will likely boost gas consumption. This unconventional gas will play a leading role. Now the 10 biggest gas fields account for 33% of gas production and have been in operation for 40 years. In US, no discovery of well, but new production comes from unconventional gas (gas shale) since 2007. In Europe the demand is climate-sensitive, leading to a need for swing supply. In China the demand grows 7x in 10 years. Russia has the biggest proven reserves (45tcm) but will it be able to meet rising demand in domestic market and export obligations. Gas supply in Europe depends on Russias relationship with Ukraine and Belarus. International gas trade is to increase significantly. The share of LNG continues to grow; will it make the gas market global? Today market is very regulated (70% of long-term contracts), based on security, as there isnt any global market: buyer wants supply security, seller wants price security (because of large CAPEX he made) = take or pay contract (oblige to buy a certain minimal quantity to a competitive price). Price was connected with oil price with a variety of indices (British gas formula). This deregulation tends to a gas-to-gas competition via the emergence of trading hubs, which have TOP contracts with gas companies and sell to a spot price (need a storage facility for cash and carry strategy). Gas price is set by the net-back principle, which calculates the price to be competitive with alternate energy. Coal is the floor, heavy oil the ceiling. In the US, discoveries of gas shale disconnected gas and oil prices. These market prices are becoming more competitive than long-term contracts sustainable spreads?? Not sure, we might be going to see the end of LT contracts.

Commodity markets
Commodities are generic products with little specification from the ground or underground, homogenous price, large targeted market, 70% of world trade volumes. Two classes: - Soft: agricultural, industrial products - Hard: metals, energy products, other. Commodity market exists to manage risk through forward (price and volume risks), because of the high volatility of commodity products (crude oil 15-60%, natural gas 60120%), as they may travel a lot. Some of the chain rings can make offset hedging with their parties (no need for absolute price as they buy something of which the price is volatile too). Basically producers want to hedge to protect themselves against a price decrease (absolute hedging), intermediaries want to protect against the difference between the price they buy and the one they sell, (offset hedging) and consumers want to protect against a price increase (absolute hedging). Backwardation: price of the future decrease with time (positive roll-yield) Contango: the cost of carry. The market is in contango when later future prices are higher than sooner ones. Ex: 1-month future 70$/bbl, 2-month future 71$/bbl: it is

worth to wait and sell in 2 months (if cost of carry is not too important) = negative rollyield. Structure of the commodities market: physical and financial markets. Physical deliveries play an important role as they enable a convergence of physical and financial prices (1% of transactions lead to an actual delivery but it is enough to ensure convergence). Physical market: between producers and consumers brokers provide liquidity ensuring matching between offers and demands. Investment banks carry the management risks; trading houses carry the transport and sales risks. In the financial market, hedge funds and financial institutions play too via an organized market and future contracts (clearing house). There exists a mechanical leverage between physical and financial market as one barrel physically traded results in 5 barrels financially traded: each actor hedging his risks. Statistics show that financial market is 25 times physical one. Two types of financial markets: - OTC: tailored contracts, credit risk, no clearing house - Organized: standardized contracts, no credit risk, clearing house The clearinghouse reduces the settlement risk by netting offsetting transactions between multiple counterparties, by requiring a margin deposit, and by monitoring the credit. It needs to be well capitalized to ensure the isolation of failure of a participant. Mechanism of hedging contract. Usually commodities are traded on an average monthly price. - Straightforward hedging: when the product is directly linked to the underlying asset, using the same market. - Proxy hedging: on poor liquidity market, although the hedge is not perfect it enables optimization. Buying a Swap: buyer is hedging against increasing price by exchanging a floating price with a fixed one. There is no premium paid, but the buyer does not benefic from a price decrease. The swap is contracted with the bank, so the consumer pays the supplier the reference price (not the swap fixed price) with money given by the bank against the swap fixed price. Volatility (implied) is the first parameter of an option price (the higher the volatility the higher the premium): smile curve. You can play the volatility with options: long one = long call and put; short volatility (butterfly curve) = long calls with different strikes. Commodities market is very attractive to investors as there are liquidity abundance, perfect hedge, good fundamental pitch, good asset class.

The European gas market

The European gas market is a hub enabling all kind of participant to exchange under an organized market (regulations), providing liquidity, most operations are quasivirtual. National balancing points are hub with no physical deliveries (UK gas). Title transfer facility: Dutch gas

Long term contracts are set up to secure nation provisions, gas price is set up by oil price and derived products for time lag. 85% of gas contracts are oil-indexed. Forward price are indexed and published (ex: argus natural gas). On the OTC market, NBP accounts for 60% of tradings. Basis swaps are used to hedge price differential between producer and market for a distributor for instance. It pays a fixed price and received the differential between the two spot prices.

Thermal coal market

90% of coal is used for power generation, 41% of world power generation (14% of final energy). Only volumes are traded despite rapid growth: 14%, as major volumes are consumed locally, and the information is poor. There are three main market coal references. 6500Mt of coal produced every year, only 700Mt physically traded, so coal market is increasingly liquid (3x paper than physical trade). There is a huge growth in coal derivative market: with 3 main future contracts (Newcastle, Richard bay, and Rotterdam): 10% growth. 54% growth on swaps with a growing proportion of cleared contracts in the OTC market.

The European electricity market

Electricity is traded in blocks (=power*duration): morning, peak hours, night, Exchange market enables to sell or buy hourly products in order to adjust the load curve. Usually national exchanges but they are leading to a growing integration (all electricity used at the highest price): market harmonization, price convergence. The market size is growing, especially in Germany (short terms contracts) and Scandinavia (9% growth). Hedging strategies are different through Europe though. Spain likes to sell at the last minute (50% is contracted the year of generation). Germany sells it 2 years in advance (for 70%); idem for Scandinavian countries. In practices utilities hedge their generation margin: (electricity price gas or coal price) / gas or coal efficiency.

The oil market

Three types of oil products: - Cleaner: from light crude oil; gas, naphtha (gasoline) - Clean: gasoil, heating oil. - Dirty: from heavy crude oil; fuel, bitumen. Because each crude oil has a name and proper characteristics: density, sulfur content, viscosity, and distillation point. The price and value of course depend on those. Currently three references exist in crude oil exchange Brent (Europe) WTI (US) and Dubai (Asia). Price publishers do also fix prices (ex: Platts in Europe). Paper and physical markets are linked.

Proxy hedging does not allow a perfect coverage as price between the product and the proxy can diverge on the short run.

The European carbon market

International carbon market is set up by the Kyoto protocol, and other local (Australia) and voluntary (USA) markets. The main objective is a 5,2% decrease in carbon emissions. Two ways: - Cap-and-trade scheme: via emissions allowances - Carbon credits (carbon offsets). The EU ETS produces a carbon price based on reduction efforts. It is cap-and-trade market where quotas can be exchanged: 100 fine for every CO2t not surrendered. In this market, transactions are increasingly cleared. The main hedging strategy is the zero cost collar (buying a put, selling a call).

Finance energy project

Financing an infrastructure can be do by: - Out of cash - Out of corporate balance sheet - Out of future cash flows from assets of the projects: this is project finance (really complex). - Exporting finance - Asset finance Project finance is a very useful technic to calculate risks and dispatch them among shareholders. Corporate finance: financing a project within the boundaries and money from the company (through a bank): the risk is on the company not on the project (if it fails the company has to pay the loan back). Project finance: it relies on future cash flows: all the risks on the project (technic, management, assessment of the assets). Project is really identifying risks, allocating them, to ensure parts involved set up adequate incentives to their respective managements. Nevertheless how do you know of the whole value chain will be motivated? This is the reason why todays renewable energy projects are hard to finance as we cant ensure a sustainable supply at a relatively fixed price, some parties arent stable yet. Moreover project finance a project that does not exist yet Trade finance: long-term contract; finance a project with other ones. Sponsors use project finance as they can leverage different projects, they improve risk allocation (reducing corporate finance borders). Project finance volumes increase (decrease in 2009, but recovery at the same level than 2008 in 2010) at about 210b$. Accelerated by a decrease in debt financing (more stringent financing condition post-crisis.) Risk allocation: three objectives to ensure: - Ability of each parts regarding their objectives

Are incentivized enough? Have they obligation to meet?

EPC: engineering, procurement and construction is a map of the project showing each parts and their relations (contracted relations). For each risk you must ensure that it is covered or take by counterparty and ensure it is incentivized (penalty for failing, reward for objectives meeting). Risks (cf slides) - Construction/Completion: design, construction, techno, weather, third party (pollution risks), leading to delays, cost overruns, underperformance. Solutions: experienced sponsors, standard techno, strong EPC contract (fixed price) financial model stress, and additional budget provision. - Market risk: off taker risks, not able to sell. Solutions: take-or-pay contracts, credit contracts, market and price analysis, hedging strategy. Operation risk is the materialization of expected cash flows over time, cash flows that are connected to the market but also to the project reliability and maintenance. Strong for offshore wind power generation. - Political risks: country risk, strategic change, and nationalization, off shore cash flows. Solutions: long-term risk sharing agreement, sovereign protection, exports agencies, etc. To hedge construction and operational risks borrowers must contract two types of insurance policy, one for each. Environmental and social responsibility issues: the equator principles, which provide environmental laws, World Bank guidelines. Due diligence are made to analyze all those risks.

Wind offshore project

The wind offshore market: 6GW capacity (200GW on-shore capacity), and a 36GW target for 2020 in Europe as a 3% of the expected power generation. Today the offshore wind power accounts for 1to 5% of the power generation and targeted at 5 to 15% in 2020. Because it is a very costly power generation: 180/MWh (while 50 for on shore wind power, 45 for natural gas, and 95 for biomass), but expected to decrease. They need massive investment, relying mostly and increasingly on project finance. The development of offshore wind needs the convergence of utilities and industrial companies. The investments are higher than onshore, but compensated but a steadier wind and larger scale of development. Costs come from: - Turbines (50%) - Foundations (20%) - Electric connections and grid (15%) - Others (15%) Total is about 3 millions/megawatt (1 m/MW for onshore).

Foundations are the key elements of development because of variety of fields, depth, geotechnical, and ports Moreover they usually need a jacket to resist to waves and tides, and globally salty water. Marine electrical cables, AC/DC conversion for long distance, but the critical path is installation ships. Project analysis relies on four key topics: construction, economics, sponsorship and operation (cf slides). Offshore market tenors are lower than usual project finance ones, because no one wants to challenge the project (no actual history and track record). Cash sweeps: contract or clause that force a % of generated cash flow to be used for debt repayment. It reduces management power, but reduces banks (or lenders) risks, as revenues are ensured, if these ones really materialized effectively.

The LNG sector

Biggest project finance projects are in LNG sector. LNG is natural gas liquefied (less than -160), can be easily transported because it is 600 X less bulk than natural gas. It is used because it can secure energy supplies in countries, which havent pipelines, it is cheaper to transport, it is efficient to address the worlds growing demand of natural gas. However it is very capital intensive (main assets to be built), and government usually an interest from the upstream/liquefaction assets. The global LNG demand is expected to grow strongly. LNG is the most efficiency way to transport energy over a long distance (maybe the technical only way). Costs: - Upstream: 1500 5000$ - Liquefaction: 3000 10000$ Long-term contract are mandatory to support the raising of long term project financing. Banks have supported the development of LNG, in assuming the price risk. Must involve lower offshore capacities to capture the value of stranded gas fields.

Reserve based finance

Finance based on the value of the reserve and production form an oil (gas) field relies upon the revenue from underlying field to repay the debt. It is not relying on an artificial contract, but dealing with living corporate companies (similar to project finance by dealing with actual company). 4C: cash flow, collateral (asset), competence, character. After completion the repayment follows several factors: a fixed amortization, cover ration over the project life NPV and over the loan life NPV.

Energy contracts

A contract is an agreement giving obligations enforced by law: it needs an agreement, capacity of the parties, consideration (a price must be attached to the contract, or it is voidable), intention to contract and agreement must not be contrary to law. Upstream contract: energy contracts address all the risks that may arise throughout the life of an oil field (build-up, plateau, enhanced recovery decline). In all countries (except USA) subsoil belong to the State, and the ultimate owner. OIC are dealing with NOC direct lands, because they invest in national property. Abandon does happen because oil company to profit from English (for example) law and avoid dealing with the national (Kazakhstan for example) law. So they close the factory or production facility and simply leave the country.