did amaranth advisors llc attempt to corner the march 2007 nymex at henry hub?

8/14/2019 Did Amaranth Advisors LLC Attempt to Corner the March 2007 NYMEX at Henry Hub?

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Developing a Power Purchase/Fuel Supply Portfolio:Energy Strategies for Cities and Other Public Agencies

May 18, 2006Robert McCullough

ManagerMcCullough Research1

Welcome to the Muddle

One year ago, President Bush signed the Energy Policy Act of 2005 into law. At the time,Senator John McCain commented: This bill left no lobbyist behind.

Indeed, a close reading of EPAct05 reveals that Congress paid scant attention to U.S.energy statistics while drafting the solutions found in the bill As we now grapple with its

legacy of legislative ineptitude, I believe we must go back to energy basics before we cantruly help our consumers.

Where Does Energy Come From?

The U.S. imports a little over half of its crude oil consumption. This roughly equates tothe fuel used for the nations car and light truck fleet. Since the 1970s, relatively little oilis used in electric generation, although 18% of the generation mix is dual fuel capable.

The primary fuel for electric generation is coal, but beginning in the 1970s, natural gashas been the fuel of choice for new electric generation. Todays electricity restructuring

policies continue to emphasize gas.

1 McCullough Research, 3816 S.E. Woodstock Boulevard, Portland OR 97202; 503-777-4616;[email protected]
mailto:[email protected]://www.mresearch.com/http://www.mresearch.com/mailto:[email protected]


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Coal

34%

Petroleum

3%

Natural Gas

23%

Dual Fueled

18%

Other

4%

Nuclear

10%

Hydro

8%

However, a change is underway. New coal units now cost significantly less thancombined cycle gas units. Given current prices, we can expect most new plants to befueled by coal. I will discuss the implications of this fuel change for the structure of theindustry, and for public power.

Where Do the Prices Come From?

On a British Thermal Unit (BTU) basis, prices for crude oil and natural gas are closelylinked. The following chart shows comparable spot prices since 2000:

Natural Gas and Oil Spot Prices

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$2.00

$4.00$6.00

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$/MMBT

Natural Gas Oil BTU


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This relationship does not occur by chance. Oil and natural gas are close substitutes.Electric generation, heating, and chemical feedstock uses can substitute one fuel foranother on relatively short notice. The deviations between oil and gas prices have tendedto correlate with periods of market manipulation. (An aside: we do not know the degreeto which Enron and El Paso Gas manipulations in 2001 or TXU manipulations in 2003

changed natural gas prices.)

There are sophisticated forward markets for oil and gas. The New York MercantileExchange (NYMEX) operates relatively deep forward exchanges in both resources:

Natural Gas and Oil Forwards on NYMEX

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$2.00

$4.00

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$14.00

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$/MMBT

Natural Gas OIL BTU

In principle, the existence of these markets should provide us with a good picture offuture prices, but history does not show it. We do not have a good theory about whyforward exchanges do such a poor job predicting the future. Fortunately we can hedgeour exposure to fuel price movements at the forward exchanges and let the counterpartyassume the risk that things may turn out differently.

On May 18, 2000, a few days before the onset of the Western Market Crisis of 2000-2001, the future of natural gas looked like this:


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NYMEX Henry Hub Forwards and Actual Henry Hub Prices as of May 18, 2000

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$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

$9.00

$10.00

Jun-00

Aug-00

Oct-00

Dec-0

0

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1

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2

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Apr-03

$/MMBT

NYMEXHenry Hub Spot (Actual) Henry Hub

Since we know that extensive manipulation of natural gas futures occurred in 2001 on theNYMEX Henry Hub, , we now have some sense about why the actual future did notcooperate with the expectations of the traders at NYMEX.

The amount of the future explained by NYMEX forwards (natural gas, 2000-2005) is lessthan half the precision of forecasts of the NYMEX forward prices from looking at todaysspot price.

Economists call this phenomenon tail wagging. The dog is literally wagged by the tail forwards are changed by spot in many markets. Harvard Universitys William Hoganand I debated this extensively at FERC. The debate was finally decided in my favor in

Chapter V of the commissions Final Staff Report on the Western Market Crisis in2003.

The lesson for those of us desperately polishing the crystal ball of energy forecasts tomake good future resource decisions is simple. Forward markets in energy tend to believethat the future will look much like today no more and no less.

For example, the future as of May 5, 2006 looks like this:


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May 5, 2006 NYMEX Forwards for Gas and Oil

$-

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

Jun-06

Sep-06

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$/MMBT

Oil Gas

We can see that this is not a very intelligent forecast upon which to base a decision to buyeither forward gas or oil.

What Are the Alternatives to Imported Oil?

While the pundits miss the economic logic behind oil prices again and again, the basicfacts are easy to understand. OPEC will continue to push up the price of oil until there isa clear price response on behalf of the United States. This is standard duopoly theory.2While it is in vogue to predict Chinas economic future, the fact is that we have increasedthe efficiencies of our car and light truck fleet so extensively that we are not veryresponsive to oil price increases:

2 Duopoly refers to a situation where a single buyer faces a single seller. In such situations, a processknown as Cournot equilibrium takes place where the supplier raises the price, the consumer reducesdemand, and the supplier adjusts theprice accordingly. The result is not efficient the supplier will raise prices to levels considerably abovemarginal cost to take advantage of the consumers inability to find substitutes. If the consumer hascompetitively priced substitutes, the Cournot equilibrium will approach a competitive price. If not, priceswill be higher, and the product supplied will be artificially reduced.


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Oil Imports and Prices

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50,000

100,000

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350,000

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Jan-06

ThousandBarrelsPer

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$8.00

$10.00

$12.00

$/Barr

Imports Price

As you can see by this graph, U.S. oil imports have not responded at all to recent priceincreases. This signals OPEC that the prices are sustainable and that it should maintainproduction at current levels. An irony of our energy policy is that a sudden shift tohybrid cars will increase our lack of price response to oil and provide an incentive toincrease OPEC prices.

The correct way to reduce prices in a duopoly is by convincing the supplier that you arevery responsive to prices. A CNN special about millions of Americans walking to workmight help, but a better approach is to actually develop a substitute.

When Henry Ford started producing the Model T, he planned to fuel the cars with ethanol

corn whisky and even started developing his own ethanol industry.

His timing was bad, however. Lawrence of Arabia backed the winning side in the civilwar being waged in Saudi Arabia, and as a reward the west received a legacy of cheap oilproduced by U.S. and British companies. If Henry had backed the Hashemites (hint:Saudi Arabia is not called Hashemite Arabia) Ford Motor Company might well be sellingethanol today.

Unfortunately, even though U.S. ethanol production is dramatically increasing, federalpolicy is actually counterproductive. The major subsidy for ethanol is not paid to eitherethanol producers or consumers but to the oil companies that add ethanol to gasoline to

boost octane.


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Monthly Ethanol Production

0

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400,000,000

May-98

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Gallon

In 2005, ethanol displaced 3% of exports. We can confidently expect ethanol to displace4.5% of exports in 2006.3 Production can be increased easily since ethanol production islimited only by the supply of corn. Ethanol consumed 9.15% of corn production in 2005.

At current corn and natural gas prices, ethanol can expand to 10% of U.S. fuelrequirements for cars and light trucks for $50/barrel. The cost increases to $60/barrelafter ethanol has occupied the fuel additive niche in the fuel supply.4

The bottom line is that the U.S. can replace foreign oil imports at $60 per gallon. Thisimplies that natural gas has an upper limit at $9.50/mmbtu.

Resource Choices

The ongoing debate about resource choice which tends to focus on natural gas reflects adecision based on inexpensive natural gas prices and market conditions often arbitrarily

mandated that reward dispatchable resources.

The correct solution to the debate depends on ownership and fuel choice. At current fuelprices, coal is highly competitive with natural gas and is likely to remain so for theimmediate future.

The Energy Information Administration derives future plant costs on an ongoing basis.Based on current fuel costs and EIA cost estimates, coal will dominate gas for all unitswhich can expect to operate 30% per year:

3 Unlike other renewable resources, ethanol is a proven technology. An increase in 50% of productioncapacity is scheduled for 2006.4 While gasoline is rich in energy, it is not an efficient fuel for motor vehicles. In order to raise the octanerating (the ability to compress the fuel to run efficiently), gasoline requires an additive. Traditionally, theindustry has depended on MTBE, a fuel with severe environmental risks. Ethanols energy content is 80%of gasoline, meaning that the first 10% use of ethanol is relatively efficient. After that it requires 6 units ofethanol to replace 5 units of gasoline.


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Resource Choices for Expected Annual Operation

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100.0

0%

$/kW

Scrubbed Coal New Integrated Coal-Gasification Combined Cycle (IGCC)

IGCC with Carbon Sequestration Conv Gas/Oil Comb Cycle

Adv Gas/Oil Comb Cycle (CC) ADV CC with CarbonSequestration

Conv Combustion Turbine Adv Combustion Turbine

The situation is even more extreme if the capital costs for public agencies are used:

Resource Choices for Expected Annual Operation

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$50.00

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85.00%

90.00%

95.00%

100.00%

$/kW

Scrubbed Coal New Integrated Coal-Gasification Combined Cycle (IGCC)

IGCC with Carbon Sequestration Conv Gas/Oil Comb Cycle

Adv Gas/Oil Comb Cycle (CC) ADV CC with CarbonSequestration

Conv Combustion Turbine Adv Combustion Turbine

We may conclude that this situation may pose political problems, but the economicconclusion is inescapable: at current gas prices, natural gas-based generation will only beused for peaking.

RTO Bypass

Despite the spotty operating data supplied by the nations regional transmissionorganizations, market evidence indicates that the RTOs tend to price out at approximately20% higher than comparable free market prices.


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Recent state level bids in New Jersey and Maryland provide substantial evidence thatpurchasing energy at RTOs is more expensive. Several explanations suggest themselves,although, to be fair, each is hotly contested by the advocates of administered markets:

1. Administrative overhead: RTOs are costly bureaucracies. Their deep staffing

requirements and high operational costs are the logical outcomes of the lack of checksand balances. Usually, RTO expenses are charged to a wide class of end users who arerarely represented on RTO boards; therefore, it is not surprising that a measure offeatherbedding has become common.

2. Complex, often unintelligible rules: RTO regulations can and do run intohundred of thousands of pages of dense formulas, special exceptions, and uniqueterminology. Such complexity is an effective barrier to entry. In most cases, entrantsfind it necessary to implement new computer infrastructure to communicate with theRTO.

3. Arbitrary market structures: RTOs may have implemented market structures thatare prone to inefficiency and market manipulation. Although the California ISO is theinstitution most often cited in this regard, others are just as likely to implement structuresthat have little economic logic. In Texas, for example, market prices are calculated withan algorithm which fails frequently, requiring a rule of thumb market price decision.

4. Conflicts of interest: RTO governance is dominated by the parties most likely tohave an interest in the outcome of a policy discussion. This has led to some shifts inpolicy that would not normally be explained by theory or common sense.5

5. Inadequate regulation: RTOs frequently operate without effective checks andbalances. While FERC claims jurisdiction, its regulation has been most obvious by itsabsence. FERC has had difficulties judging whether RTOs are making efficient decisionsbecause the commission cannot see the entire picture.

Over time, the differential between free market prices and RTO administered prices islikely to create a demand for RTO bypass. Public power will probably gain a significantstrategic advantage in the years ahead.

The Bottom Line and Energy Strategies

When in a muddle, it is difficult to recognize a fundamental shift in market realities. Thelast fifteen years of inexpensive natural gas provided a market advantage to simplenatural gas units. Now high capital cost, low fuel cost coal units are gaining ascendancy.

5 For example, in late December 2002, ERCOT adopted relaxed balancing the same rule that FERCidentified as a cause of the real time emergencies at the California ISO. Within three months ERCOT wasfacing possible blackouts and the rule was dropped abruptly. The firm that profited most by the powercrises in Texas in February and March 2003 chaired ERCOTs board of directors at the time.


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Entities with advantages in financing will be able to employ emerging technologies withhigh capital costs and low fuel costs. This will put the economic advantage back in thecourt of public power.

My crystal ball indicates that market bids will not be the answer because the unwieldy

mechanics of operating RTOs make purchasing expensive and risky. We will come toprefer direct ownership in the case of California and RTO bypass. Yes, it will taketime to work back to basics and reform our federal energy policies, but I have fullconfidence in the ability of public power to fulfill its mission.

did amaranth advisors llc attempt to corner the march 2007 nymex at henry hub?

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