Download A Look Forward— Understanding Forward Curves in Energy

SPECIAL REPORT: RISK
A Look Forward—
Understanding Forward
Curves in Energy Markets
May 2012
Risk Data Services
WWW.PLATTS.COM
A Look Forward — Understanding Forward Curves in Energy Markets
EXECUTIVE SUMMARY
The 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. 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 prices.
The contract for June deliveries recently settled at $2.3125, July
deliveries settled at $2.519, August deliveries settled at $2.6445,
and so forth. If we listed 12 months of futures prices in a table
and then graphed thoseprices, it would look like this:
Publishers vs. Exchanges
A 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 reliability.
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 distributors.
Forward curve data may differ between data sources. The
differences are commonly related to market insights available
to a particular data source. 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 overthe-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 (i.e. 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 Month
Delivery Month
June-12
2. 31 2 5
July-12
2. 51 9
August-12
2. 64 4 5
September-12
2. 61 9
October-12
2. 64 2 5
November-12
2. 93 6 9
December-12
3. 32 1
January-13
3. 40 6 5
February-13
3. 42 3 6
Delivery Month
CME
Platts
March-13
3. 39 5 5
June-12
-0 . 0 3
-0 . 0 425
April-13
3. 35 0 6
July-12
0.0675
0.06
May-13
3. 38 7 3
August-12
0.12
0 . 1 25
September-12
0.065
0 . 0 575
October-12
0
0
November-12
0.0675
0 . 0 481
December-12
0.0675
0 . 1 059
January-13
0.0675
0 . 0 554
February-13
0.0675
0 . 0 602
March-13
0.0675
0 . 0 554
April-13
0.0575
0 . 0 318
May-13
0.0575
0 . 0 293
June-13
0.0575
0 . 0 293
Socal Gas
Source: Platts, 5/2012
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3.4
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2.6
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-1
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This collection of prices is referred to as the “forward curve,”
so-named because of the shape it takes on a graph. Any
commodity with a forward market may be said to have a
Sources: NYMEX & Platts, 5/2012
The 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.
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A Look Forward — Understanding Forward Curves in Energy Markets
Exchange Data Limitations
Improved Curve Validation
Settlement 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
balance.
Accessing market data from a respected publisher, such as Platts,
strengthens the curve validation process. More robust results can be
achieved through the validation of internally developed curves against
independent market data aggregated from multiple sources.
BUSINESS 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. 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 stakeholders.
USAGE CASES
The 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. 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 restatement in future periods.
Another 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. 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 (i.e. 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 risk.
A third usage case is risk management and reporting. 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 limitsmonitoring 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 reporting.
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A Look Forward — Understanding Forward Curves in Energy Markets
LIMITATIONS AND METHODOLOGIES
Forward 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. Understanding the curve providers’ methodologies and
the limitations of those methodologies is a key step in choosing
the optimal forward curve source. The following table provides a
summary of typical forward curve providers, their methodologies,
and limitations.
Provider Type
Typical Methodology
Methodological Limitation
Publishers
• Combined multiple sources of market
data toproduce forward curves (e.g.
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 reporting
Exchanges
• Quoted market prices for traded markets
• Margin-based settlements for nontraded markets
• Does not typically capture OTC transactions
• May trade strips instead of individual months
• Does not capture illiquid points
Brokers
• Aggregated price indications from
dealer markets
• Indications do not always indicate market trades
• May indicate strips instead of individual months
• Does not capture illiquid points
Data distributors
• Exchange-based data feeds
• Data vendor aggregation
• Quantitative models
• May not have control over data vendor methodologies
• May not disclose which curves and tenors are market-based and
which are model-based
System vendors
• Data usually integrated as part of
trading/risk management software
• Exchange-based data feeds
• Data vendor aggregation
• Quantitative models
• May not have control over data vendor methodologies
• May not disclose which curves and tenors are marketbased and
which are model-based
• May lack long term analytical capabilities
Consensus curve
publishers
• High trust in data as member participates
in aggregation
• Usually available on a monthly basis and only reflects activities by
reporting entities as opposed to the broader market
Internally
developed
curves
• Trader assessments
• Quantitative models
• Traders may reflect book bias
• Models may not be consistent with industry practice
• Models may be mis-calibrated
• May not match market quote
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A Look Forward — Understanding Forward Curves in Energy Markets
Transparency is Key
When selecting a forward curve data provider, transparency into the
providers’ methodologies and modeling techniques is key. The better
providers will publish their methodologies on-line for access by anyone
with an internet connection.
There is an important distinction between curves based on
market assessments (e.g. publisher curves) and those based
on settlement prices (e.g. exchange curves). Market-assessed
curves often involve multiple quotations in multiple markets,
including both exchange trades and over-the-counter trades.
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
balance. Understanding this distinction is important as failure
to understand which exchange-based curves are traded versus
“settled” may lead to false assertions related to Topic 820
reliability levels.
Modeled curves should not be used if reliable market data exists.
However, modeled curves may be the only option if market
data does not exist (e.g. illiquid points and tenors). In those
circumstances, the forward curve’s quality is highly dependent on
the quality of market-based inputs, modeling assumptions, and
modeling methodology. Failure to calibrate or back-test those
models in a timely manner will negatively impact the modeled
curves’ accuracy. Securing independently-modeled curves for
comparison and validation is therefore an important control
against model error.
Whatever the curve source, transparency into its markets and
methodologies is absolutely vital. Companies need to know: which
curves are based on actual market trades;, which curves are based
on settles; which settlement prices are exchange-derived for
margining purposes when actual trades do not occur; which curves
incorporate OTC trades or market assessments; which portions of
particular curves are liquid and which are not; and which curves
are modeled, how they are modeled, and how often they are
recalibrated to observed markets for similar assets.
would enable the company to apply sufficient granularity to
its asset valuations, VAR calculations, and independent curve
validation processes.
Selection of a forward curve provider or providers should be
accompanied by effective communication to enable stakeholders
to understand and agree with the selection. Traders need to
know the selection accurately reflects the market. Risk Control
needs to know the selection meets risk management needs and
is compliant with or can be incorporated into risk policies. Banks,
auditors, investors, and regulators need to know the company
reliably selects “mark-to-market” over “mark-to-make-believe”
on a daily basis. Management needs to understand the selection
in terms of the trade-off between cost and utility so that
subsequent provider decisions are based on operational needs as
opposed to cost-only decisions.
RECOMMENDED APPROACH
The most effective approach to forward curve selection is to
understand your company’s usage cases, match those usage
cases to the abilities and products offered by forward curve
providers, and communicate the selection and subsequent curverelated processes to stakeholders. A number of common
practices should be applied during such an approach:
• Purchase reliable and daily mark-to-market data from a reputable
source using industry-standard and transparent methodologies;
• Risk-rank and categorize curves by factors such aggregate
notional value, usage case, and firm-wide risk to help inform
forward curve selection decisions;
• Incorporate a robust but efficient curve validation methodology
into the existing risk management framework;
• Update risk policies to include forward curve selection,
development, usage, and validation methodologies in order to
specify which scenarios are appropriate for different market
data sources; and
• Communicate to necessary stakeholders that higher-risk
curves require robust analysis based on independent
validation against the best available market data sources,
even if that analysis comes at a cost.
SELECTION AND COMMUNICATION
Once a company has defined a usage case (or cases), it can select
a forward provider whose methodologies address the company’s
needs and limitations that do not detract from the usefulness of
the curves. It is possible that a company may choose multiple
providers for multiple purposes. For instance, a company may
select exchange-based curve data for fair value calculations
and a publisher for asset valuations and risk management. The
exchange-based data would allow the company to comply with
Topic 820 reliability level requirements while the publisher data
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BENEFITS OF EFFECTIVE FORWARD
CURVE SELECTION
to improve the reliability of its risk and analytical tools. This
reliability may come through an enhanced curve validation
process, reduced reliance on internal models, or consistency
with industry-observed practices and pricing.
Selecting the right forward curves for derivative valuation is a
requirement for financial statement preparation. However, the
selection of a forward curve provider or data source may yield
additional benefits if done correctly. Aside from accurate valuation
of derivatives and assets, the primary benefit of an effective curve
selection process is improved clarity, reliability, and efficiency in
operational and capital management processes.
For instance, a clear understanding of forward curve usage
cases and provider methodologies gives companies insights into
the valuation components of complex transactions and assets.
Companies which are able to institutionalize these insights
through process, training, and policy are then able to increase the
quality of their internal and external reporting.
As another example, an enterprise-wide understanding of
forward curve sources and limitations will allow a company
The net effect of these benefits is a lower risk of financial
reporting issues and misstatements. A clear knowledge of the
forward curve source allows companies to provide Reliability
Level assertions without fear of a future retraction. An effective
validation process reduces the risk of model mis-calibration and
derivative valuation error, thereby reducing the possibility of
subsequent restatement. Enhanced reporting quality not only
reduces the risk of financial statement error and restatement,
but it increases management’s confidence in the long-term
forecasts and strategic assessments which rely on forward curve
assessments. By clarifying the reliability of forward-looking
statements, management can better pursue strategies and
manage the market risks associated with them.
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