(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.
