(from Derivatives
Strategy, August 1997)
Question:
The energy
market is poised to explode. What do you see in your crystal ball
over the next five years?
Answer:
Yes, the energy
business is going to explode: right in someone's face. When I
look into my crystal ball, I see an impending energy crisis. Not
like the oil embargo of the 70's, but more like the S&L debacle
of the 80's. This will happen because of the difficulty involved
in pricing, measuring, and managing the risk of energy contracts,
coupled with the government's obligation to keep utilities afloat.
Anyone who
knows the energy market knows energy derivatives are impossible
to value. Hardly any historical data exists. What little there
is indicates prices are anything but lognormal. Energy derivatives
are also the most complex instruments traded. Contracts with variable
quantities at fixed prices, others with fixed quantities at variable
prices, still others with delivery of fixed amounts, but with
delivery taking place any time the buyer wants, are largely unique
to energy. And since demand for energy is not just a function
of price, but also of how much energy one needs to run a business
or to be comfortable at home, valuation assuming rational exercise
is an irrational assumption. Plus, consumers of energy cannot
"borrow or lend at the risk free rate," as we blithely assume
in the world of liquid assets: if you're getting cheap electricity
in your house, you can't "arb" the electric company by selling
some of it to someone else. This inherent illiquidity combined
with complex relationships among oil, gas, coal, hydro, nuclear
and electricity, not to mention predicting the weather many years
out, makes valuation of energy derivatives a daunting task. You'll
need to be part engineer, part statistician and part farmer's
almanac, with an 800 line to the psychic friend's network!
So if we can't
figure out how to price energy derivatives, how can we measure
VAR? We can't. Big blowups are bound to happen at places that
don't understand the risks. When someplace defaults on a "payment",
electricity won't be delivered, leading to brownouts and blackouts.
The government won't allow a community's energy supplier to go
under, and will have no choice but to become the energy supplier
of last resort. When that happens, we can all kiss the balanced
budget goodbye.
