INFLATION – UNCERTAINTY
Bjornar Eide
Strategic Risk Consulting (SRC)
Energy companies are faced with many risks, but perhaps
one of the least talked about exposures is the risk of
inflation a...
Budgeted net interest
on the public debt was
approximately $240
billion in fiscal years
2007 and 2008. This
represented
ap...
The debt is projected to
nearly double to $20
trillion by 2015, but is
expected to increase to
nearly 100% of GDP by
2020 ...
 Demand-pull inflation is caused by increases in aggregate
demand due to increased private and government spending,
etc.
...
a) A chief measure of price inflation is the inflation rate, the
annualized percentage change in a general price index (no...
i. Identify contract with known escalation clauses
tied to CPI or CPI related components.
ii. Separate between labor and n...
Source Labor/Non
Labor
Duration Dollars Delta
Insurance Labor 3.4 Years $950 MM 0.85
Benefits Labor 5.2 Years $1,240 MM 1....
Market Place for
Inflation Products
(Hedging instruments)
TIPS
Treasury Inflation-Protected Securities (or TIPS) are the
i...
Market Place for
Inflation Products
(Hedging instruments)
“Current market
liquidity has limited
the availability of
non-li...
Spread between TIPS and Inflation
Swaps
(Mark up)
TIPS, Inflation Swaps and Non-
Linear Alternatives
Pros Cons
TIPS Principal is adjusted by
CPI creating hedge
effectivenes...
Dollars Exposed Duration Hedged - Inflation
Instruments
Dollar Off-sett
Ratio
Residual Risk
(10 Day Var)
$ 450 MM < 1 Year...
Strategy Residual Risk
VaR (10 Day)
S&P Liquidity
20% Shock
Holding Cost
Strategy
Naked $126 MM $0 $0
50 % TIPS $63 MM $0 ...
How to aggregate the overall market
risk picture to include the inflation
component
ERM
Diversified
RIsk
Fixed Income
Infl...
• CPI - Labor escalation clauses
• CPI - Non-Labor escalation clauses
Identify
• Linear exposed dollars to CPI
• Non-Linea...
BIBLIOGRAPHY
 Bjornar Eide was the Director of Risk Management for Sempra Energy Utilities from
September 2005 to January...
Inflation Houston 2010
Inflation Houston 2010
Inflation Houston 2010
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Inflation Houston 2010

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Overview of US inflation situation presented at the annual ACI conference in Houston

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Inflation Houston 2010

  1. 1. INFLATION – UNCERTAINTY Bjornar Eide Strategic Risk Consulting (SRC)
  2. 2. Energy companies are faced with many risks, but perhaps one of the least talked about exposures is the risk of inflation and how it relates to the general energy pricing picture. This presentation will focus on how identification, monitoring and management processes can enhance the control of inflation exposure. a) Definition of inflation exposure b) Identify dollars exposed to inflation within their operating structure c) Understand the market place for inflation d) How to use hedging instruments such as TIPS, Inflation Swaps and non-linear alternatives e) Utilize risk measures in the overall communication of inflation exposure f) Incorporate inflation risk metrics in the overall risk reporting process
  3. 3. Budgeted net interest on the public debt was approximately $240 billion in fiscal years 2007 and 2008. This represented approximately 9.5% of government spending. Interest was the fourth largest single budgeted disbursement category, after defense
  4. 4. The debt is projected to nearly double to $20 trillion by 2015, but is expected to increase to nearly 100% of GDP by 2020 and remain at that level thereafter
  5. 5.  Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.  Cost-push Inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs.  Built-in inflation is induced by adaptive expectations, and is often linked to the “price wage/spiral”. It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle„. Inflation Situation (The Keynesian view) “What is the current balance between federal spending, the US dollar and unemployment?”
  6. 6. a) A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index over time (CPI/CPURNSA), Personal Consumption Expenditures Price Index (PCEPI) and the GDP Deflator. a) The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities and financial assets. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price Inflation is a rise in the price of assets, as opposed to goods and services. “Inflation is referred to as a rise in the general level of prices of goods and services in an economy over a period of time”. Source : Wikipedia Encyclopedia “Is our exposure a result of desired indexation ?”
  7. 7. i. Identify contract with known escalation clauses tied to CPI or CPI related components. ii. Separate between labor and non-labor cost / revenue components. iii. For expense / revenue components not tied to escalation clauses or/and FX, fixed income or commodity related components but still subject to periodic renegotiations, compute the correlation coefficient to the monthly CPURNSA index. iv. Cash flow map dollars identified by linear and non linear characteristics to the CPURNSA index. Identification of dollars exposed (Hedging Item – CPURNSA, the dependent variable) “Do our accounting system, data warehouse or other data depositories allow for a break-down of cost / revenue escalation components?”
  8. 8. Source Labor/Non Labor Duration Dollars Delta Insurance Labor 3.4 Years $950 MM 0.85 Benefits Labor 5.2 Years $1,240 MM 1.00 Contract XX Non-Labor 6.4 Years $ 750 MM 1.00 Contract XX Non-Labor 4.3 Years $ 250 MM 0.45 Contract XX Non-Labor 2.5 Years $ 345 MM 0.56 Contract XX Non-Labor 5.4 Years $ 450 MM 1.00 Sample of how to identify dollars exposed and contributing factors “The cash flow map should break down the monthly linear / non-linear exposure against the CPURNSA index.”
  9. 9. Market Place for Inflation Products (Hedging instruments) TIPS Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5- year, 10-year and 30-year maturities. The U.S. Treasury replaced the 20-year maturity with the new 30-year maturity in February 2010. “Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality”
  10. 10. Market Place for Inflation Products (Hedging instruments) “Current market liquidity has limited the availability of non-linear alternatives such as options on swaps or TIPS”
  11. 11. Spread between TIPS and Inflation Swaps (Mark up)
  12. 12. TIPS, Inflation Swaps and Non- Linear Alternatives Pros Cons TIPS Principal is adjusted by CPI creating hedge effectiveness. Bond can not mature less than face value. Initial cost and holding cost based on initial margining / maintenance margin under ISDA agreements. Initial cost + holding cost of bond needs to be financed in full. Mark up against alternatives (TIPS) of 40- 50 bps + liquidity requirements SWAPS “Current market liquidity has limited the availability of non-linear alternatives such as options on swaps or TIPS”
  13. 13. Dollars Exposed Duration Hedged - Inflation Instruments Dollar Off-sett Ratio Residual Risk (10 Day Var) $ 450 MM < 1 Year $250 MM 56% $1.3 MM $ 650 MM 1 -3 Years $250 MM 38% $2.6 MM $ 1,000 MM 3- 5 Years $500 MM 50% $3.9 MM $ 1,500 MM 5-10 Years $ 500 MM 33% $8.9 MM $ 7,500 MM 10-30 Years $ 1,000 MM 13% $77.7 MM Sample of how to use inflation products to off-set inflation items
  14. 14. Strategy Residual Risk VaR (10 Day) S&P Liquidity 20% Shock Holding Cost Strategy Naked $126 MM $0 $0 50 % TIPS $63 MM $0 $10 MM 75 % TIPS $32 MM $0 $ 15 MM 25% TIPS + 25% SWAPS $63 MM $24 MM $ 6.2 MM 75 % SWAPS $32 MM $73 MM $3.7 MM Sample of how to use inflation products to off-set inflation items Duration – 5 years, Based on a $2billion NPV exposure “S&P Liquidity Requirements under margin accounts must be scaled for initial margin (20%) and maintenance margin (accrued P&L)”
  15. 15. How to aggregate the overall market risk picture to include the inflation component ERM Diversified RIsk Fixed Income Inflation FX Equity / Asset Holdings Commodity The overall market risk picture is a function of understanding the behavior of inflation relative to other pricing components
  16. 16. • CPI - Labor escalation clauses • CPI - Non-Labor escalation clauses Identify • Linear exposed dollars to CPI • Non-Linear exposed dollars to CPI Quantify • Risk Appetite (Limits) • Liquidity UtilizationMonitor • Durational inflation curve • Timing and type of hedges Manage SUMMARY
  17. 17. BIBLIOGRAPHY  Bjornar Eide was the Director of Risk Management for Sempra Energy Utilities from September 2005 to January 2010. Bjornar oversaw the risk governance structure for San Diego Gas & Electric and Southern California Gas Company. He was a member of the Risk Management Committee for each of the utilities, which is responsible for managing each of the utility’s exposure to market, credit, liquidity and operational risk. Bjornar has over 15 years of experience from energy markets, serving in a variety of capacities in an international environment. Prior to joining Sempra Energy Utilities, he worked as an independent strategic risk consultant for a variety of clients in Europe and the US focusing on strategic risk management related issues and the design of risk assessment capability. As a Director of Risk Management for NRG (from 2000 – 2002) he built up the risk management department and during his four year tenure with Statoil A/S as a portfolio manager, he actively managed positions that involved petroleum products, crude, natural gas & electricity including the build-up of the power marketing department. Eide holds an MBA in Finance from San Francisco State University and a BA in Business Administration from California Lutheran University.

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