Erp Practice Exam 2

Energy Risk Professional (ERP® ) Examination Practice Exam 2

Energy Risk Professional Examination (ERP®) Practice Exam 2

TABLE OF CONTENTS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

ERP Practice Exam 2 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 2 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 2 Answer Sheet/Answers Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

ERP Practice Exam 2 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

© 2011 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

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INTRODUCTION

1. Plan a date and time to take the practice exam. Set dates appropriately to give sufficient study/review

The ERP Exam is a practice-oriented examination. Its ques-

time for the practice exam prior to the actual exam.

tions are derived from a combination of theory, as set forth in the core readings, and “real-world” work experience.

2. Simulate the test environment as closely as possible.

Candidates are expected to understand energy risk man-

•

Take the practice exam in a quiet place.

agement concepts and approaches and how they would

•

Have only the practice exam, candidate answer

apply to an energy risk manager’s day-to-day activities.

sheet, calculator, and writing instruments (pencils,

The ERP Examination is also a comprehensive examination, testing an energy risk professional on a number of risk

erasers) available. •

Minimize possible distractions from other people,

management concepts and approaches. It is very rare that

cell phones, televisions, etc.; put away any study

an energy risk manager will be faced with an issue that can

material before beginning the practice exam.

immediately be slotted into just one category. In the real

•

Allocate 2 minutes per question for the practice

world, an energy risk manager must be able to identify any

exam and set an alarm to alert you when a total of

number of risk-related issues and be able to deal with them

120 minutes have passed (or 2-60 minute sessions

effectively.

with a break in between to simulate the actual exam

The ERP Practice Exam 2 has been developed to aid

conditions). Complete the entire exam but note the

candidates in their preparation for the ERP Examination in November 2011. This practice exam is based on a sample

questions answered after the 120-minute mark. •

Follow the ERP calculator policy. Candidates are only

of actual questions from the 2009 ERP Examination and

allowed to bring certain types of calculators into the

is suggestive of the questions that will be in the 2011 ERP

exam room. The only calculators authorized for use

Examination.

on the ERP Exam in 2011 are listed below, there will

The ERP Practice Exam 2 contains 60 multiple choice

be no exceptions to this policy. You will not be allowed

questions. Note that the 2011 ERP Examination will consist

into the exam room with a personal calculator other

of a morning and afternoon session, each containing 90

than the following: Texas Instruments BA II Plus

multiple choice questions. The practice exam is designed to

(including the BA II Plus Professional), Hewlett Packard

be shorter to allow candidates to calibrate their prepared-

12C (including the HP 12C Platinum), Hewlett Packard

ness for the exam without being overwhelming.

10B II, Hewlett Packard 10B II+ and Hewlett Packard 20B.

The ERP Practice Exam 2 does not necessarily cover all topics to be tested in the 2011 ERP Examination. For a complete list of topics and core readings, candidates

3. After completing the ERP Practice Exam 2 •

Calculate your score by comparing your answer

should refer to the 2011 ERP Examination Study Guide.

sheet with the practice exam answer key. Only

Core readings were selected in consultation with the Energy

include questions completed within the first 120

Oversight Committee (EOC) to assist candidates in their

minutes in your score.

review of the subjects covered by the exam. Questions for

•

Use the practice exam Answers and Explanations to

the ERP Examination are derived from these core readings

better understand the correct and incorrect answers

in their entirety. As such, it is strongly suggested that candi-

and to identify topics that require additional review.

dates review all core readings listed in the 2011 ERP Study

Consult referenced core readings to prepare for

Guide in-depth prior to sitting for the exam.

the exam. •

Remember: pass/fail status for the actual exam is

Suggested Use of Practice Exams

based on the distribution of scores from all candi-

To maximize the effectiveness of the practice exams, candi-

dates, so use your scores only to gauge your own

dates are encouraged to follow these recommendations:

progress and level of preparedness.


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Energy Risk ® Professional(ERP ) Examination Practice Exam 2 Answer Sheet


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Energy Risk ® Professional(ERP ) Examination Practice Exam 2 Questions


1.

2.

Which of the following is true regarding crude oil reservoirs? a.

Crude oil will naturally migrate upwards towards the Earth’s surface unless it encounters an impermeable material.

b.

Crude oil will naturally migrate downwards towards the Earth’s crust unless it encounters an impermeable material.

c.

Crude oil rarely migrates far from the place where it was formed.

d.

Only the salt residue of an ancient seabed will effectively contain crude oil in commercially recoverable amounts.

You wish to use a bull spread strategy for heating oil using call option contracts and you purchase one contract. You decide to use option strikes at USD 1.91 and USD 1.97. Using the table below, what would the total net premium expense be, assuming no commissions or other transaction costs? Exercise Price

Call Premium

Put Premium

USD 1.85 USD 1.91 USD 1.97

USD 0.227 USD 0.195 USD 0.169

USD 0.158 USD 0.186 USD 0.220

December 2009 Heating Oil Futures Contract = USD 1.91 per gallon

c.

USD 0.026 USD 195 USD 1,092

d.

USD 1,950

a. b.

3.

A natural gas producer sells a swing swap (10,000 MMBtu per day) at USD 5.50 for the last five days in January to an end-user. Calculate the cash settlement at the end of the swap based on the Gas Daily Index below: Date Jan 27

High Price USD 5.70

Low Price USD 5.60

Gas Daily Index USD 5.65

Jan 28

USD 5.60

USD 5.50

USD 5.55

Jan 29 Jan 30

USD 5.80 USD 5.90

USD 5.60 USD 5.60

USD 5.70 USD 5.75

Jan 31

USD 6.20

USD 6.00

USD 6.10

a.

USD 12,500 payment from the producer to the end-user.

b. c.

USD 12,500 payment from the end-user to the producer. USD 17,000 payment from the producer to the end-user.

d.

USD 17,000 payment from the end-user to the producer.


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4.

According to the International Accounting Standards (IAS) Rule 39, for a derivative hedge to be effective, the correlation between changes in the price of derivative hedge and changes in the price of the underlying physical asset should be in the range of?

b.

80% to 125% 85% to 115%

c.

80% to 120%

d.

75% to 125%

a.

5.

Ethanol is a gasoline substitute made from biomass. E85 is a blend of vehicle fuel containing 85% ethanol and 15% gasoline. Thanks to government policies mandating its use, what country is the world’s largest consumer of E85? a. b. c. d.

6.

China United States

When compared globally, proven reserves of coal are estimated to contain __________ energy as contained by the world’s proven reserves of petroleum? a. b. c. d.

7.

Brazil Canada

Half as much Roughly the same amount of Twice as much Three times as much

An analyst from PB Energy Trading is implementing a VaR methodology and needs to choose between a Monte Carlo based model and a variance-covariance based model. Compared to the analytical method, what is the main advantage of Monte Carlo simulation? a.

Ability to handle energy portfolios containing large number of risk factors.

b.

Low price of computing large numbers of risk factors.

c.

Simplicity and ease of handling large energy portfolios. Ability to estimate VaR for energy portfolios that contain nonlinear assets.

d.

8.

Pierre is about to enter into a long-term energy contract with an unfamiliar counterparty and is concerned about their creditworthiness. Which of the following techniques will be the most effective in reducing Pierre’s credit risk?

6

a.

Margining agreement

b. c.

Additional collateralization Countertrade

d.

Price adjustment



9.

Charlene is the supply manager for Opechee Petroleum Refinery. Opechee needs to acquire 100,000 barrels of crude oil for delivery in December. In October the December futures contract is trading at USD 85 per barrel. Charlene decides to implement a cap strategy and buys 100 December call options with a strike of USD 85 per barrel and a premium of USD 850 per option. If the December futures price hits USD 90 per barrel what is the effective cost per barrel of crude after accounting for the option contract? a.

USD 84.15

b.

USD 85.00 USD 85.85 USD 89.15

c. d.

10.

In recent years, new LNG projects in West Africa that capture associated gas from oil fields currently in production have been launched. What has been the primary motivation behind the sudden development of these LNG projects in West Africa? a. b. c d.

11.

12.

To provide an alternative fuel source for motor vehicles in the region Government policy in the region to eliminate gas flaring from oil wells Fears that the oil fields will soon run dry Heavy foreign investment in LNG, particularly from China

Which of the following best describes royalties on an LNG project? a.

Payments made on a percentage of the sales revenues.

b. c.

Payments based on a percentage of the profits. Payments based on profits minus local tax payments.

d.

Payment based on varying unit costs.

Consider a manufacturing plant that consumes a large amount of electricity each month. Monthly on-peak forwards are currently available at USD 75/MWh for a 100MW contract. If the plant manager purchases a monthly on-peak power forward contract, how many megawatt hours will the plant receive, assuming there are 20 business days per month? a. b. c. d.

2,000 MWh 16,000 MWh 32,000 MWh 48,000 MWh


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13.

An option has a premium of USD 5.00 and a strike price of USD 28.00. If the price of the underlying is USD 31.00, what is the time value of the option?

14.

a.

USD 5.00

b. c.

USD 3.00 USD 2.00

d.

USD 0.00

Time series analysis is necessary for

2

.

2

Constant drift-term calibration Option modeling

average volatility calculation spot price modeling

c.

Comparing long-term price behavior to model-implied behavior

calibrating model parameters

d.

Calibrating model parameters

comparing long-term price behavior to model-implied behavior

b.

Which of the following statements regarding Value-at-Risk (VaR) is true? a. b. c. d.

16.

, while distribution analysis is important in

1 a.

15.

1

VaR assumes the portfolio does not change over time. VaR can be represented by multiple numbers of risk measurements. VaR accounts for the absolute worst-case scenario. VaR models are best used to predict future market behavior.

There are four power plants which can be dispatched to a power grid, their operating costs and capacities as shown in the table below. The system operator will use a merit order curve to minimize the cost of running the system. Based on this information, how many megawatts can be dispatched by the system operator while keeping the equilibrium price below USD 35/MWh?

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Plant

Cost/MWh

Capacity (MW)

A

USD 20

500

B C

USD 40 USD 30

100 150

D

USD 44

300

a.

500 MWs

b. c.

650 MWs 700 MWs

d.

750 MWs



17.

Victor is offered the four qualities of crude oil below. Assuming no basis differences, for which of the following should he be willing to pay the most?

18.

a.

API = 38 and Sulfur = 0.3%

b. c.

API = 38 and Sulfur = 1.2% API = 23 and Sulfur = 0.3%

d.


Consider a natural gas futures contract trading at USD 2.00 with an initial margin requirement of USD 3,000 which supports a decrease in the price of the futures contract to USD 1.70. What is the additional margin requirement if the futures price falls to USD 1.60?

19.

a.

USD 1,000

b. c.

USD 2,000 USD 3,000

d.

USD 4,000

How will the Smart Grid help to lower the operating costs of electric utility companies? a. b. c. d.

20.

By By By All

reducing the usage of peaker facilities reducing the need to build high-capacity transmission lines reducing fuel costs of the above

Crude oils from West Africa are often sold based on a formula indexed to Brent crude plus a premium or discount depending on the quality of the crude. Which of the following risks could be mitigated if a West African producer executes a futures contract on Brent?

c.

Basis risk and supply risk Basis risk and directional risk Supply risk

d.

Market price risk

a. b.

21.

Which of the following statements correctly describes a weakness in using single factor mean-reverting models for option valuation? a. b. c. d.

Black-equivalent volatility approaches zero with increasing time to expiration Black-equivalent volatility grows with increasing time to expiration Black-equivalent volatility decreases with increasing time to expiration Black-equivalent volatility changes in proportion to spot price volatility


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22.

Bob Burns would like to understand the term floor as it relates to energy commodity trading strategies. Which of the following positions has the characteristics of a floor?

23.

24.

a.

Short call option

b. c.

Long call option Short put option

d.

Long put option

Which of the following is the key driver of volatility in the natural gas market in the United Kingdom? a.

Demand

b. c.

Infrastructure Storage

d.

Supply

Suppose it is January and the spot price of Brent crude on the ICE exchange is USD 106. The annual risk-free interest rate is 6%, and monthly storage cost is USD 0.50 per barrel. If the crude can be stored for three months but cannot be sold out of storage before the three month storage term ends, what breakeven forward price per barrel supports a storage strategy?

c.

USD 107.51 USD 108.03 USD 109.11

d.

USD 109.78

a. b.

25.

26.

Which of the following statements correctly describes cogeneration? a.

The generation of electricity using two forms of fossil fuel.

b. c.

The generation of electricity using a combination of two distinct types of generating units, with combined output. A generating unit that produces both electricity and heat.

d.

A generating unit that has more than one owner resulting in shared electricity output.

Several notable firms have been driven out of business because a single individual was in charge of both the execution and reconciliation of derivatives trades. This is an example of a failure in which risk control category? a. b. c. d.

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Management control Segregation of duties Risk Reporting Risk assessment



27.

Refineries X, Y, and Z have complexity factors of 2, 5, and 10, respectively. Using industry accepted guidelines or thresholds, which of the following correctly classifies each refinery as “simple,” “complex,” or “very complex.”

b.

X – simple, Y – simple, Z – complex X – very complex, Y – complex, Z – simple

c.

X – simple, Y – complex, Z – very complex

d.

X – simple, Y – very complex, Z – very complex

a.

28.

LNG pricing has historically been dependent on which of the following? a. b. c. d.

29.

Processes set by the seller of the LNG. Price fixing by local governments.

A natural gas distributor is buying LNG from a gas trader using a bi-lateral contract that includes a force majeure clause. Which of the following is an implied outcome of the force majeure clause? a. b. c. d.

30.

Specific conditions in the customers’ markets. Lack of a structured pricing arrangement.

Derivatives contracts can be cancelled and not honored. The gas trader can sell the gas to another counterparty offering a higher price. The gas trader is free to not perform its obligation if the cost for sourcing the LNG is too high. There is a possibility that positions may actually disappear.

Markus has been studying nuclear power generation using the following technologies: Boiling Water Reactors (BWRs), Pressurized Water Reactors (PWRs) and Pebble-Be d Modular Reactors (PBMRs). Which of the following statements regarding these methods of nuclear power generation is correct? a. b.

PBMRs are the latest technology being advocated because it increases the output in terms of megawatt hours for the same capital cost. PWRs feeds steam directly from the reactor into the turbines thereby introducing low levels of radiation to the turbines, condensers and associated piping.

c. d.

The high temperatures possible with a PWR design make it more thermally efficient than a BWR. One problem with a PBMR is that it operates at high temperatures, which raises safety issues.


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31.

Match the following characteristics of a distribution with the correct description: 1. 2. 3.

Skew

a. c.

1–A, 2–B, 3–C 1–B, 2–A, 3–C 1–C, 2–B, 3–A

d.

1–C, 2–A, 3–B

b.

32.

Kurtosis Standard Deviation

A. B.

Captures the width of a distribution Reflects symmetry or imbalance of the distribution to the left or right of

C.

the mean Characterizes the tails of the distribution

Thomas is trading electricity power options and has 90 days of price data. Which factor should he apply to the standard deviation of his data set to estimate annual volatility? a.

√ 90

b.

1/ √ 90 √ 250 √ 365

c. d.

33.


Crude oil will naturally migrate upwards towards the Earth’s surface unless it encounters an impermeable

b.

material. Crude oil will naturally migrate downwards towards the Earth’s crust unless it encounters an impermeable

c.

material. Crude oil rarely migrates far from the place where it was formed.

d.

34.


Consider a trade in which a futures contract on natural gas was purchased and a futures contract on crude oil was simultaneously sold at a lower price. Assuming the price of the futures on natural gas remains above the price of the futures on crude oil, but the spread between the two prices narrows you would expect that the trade will ________. a. b. c. d.

12

Make money Lose money Make money only if both prices rise Lose money only if both prices fall



35.

Ten days ago Rebecca, a gasoline option trader sold 50 put contracts on gasoline futures, with a strike price USD 0.012 cents/gallon and current delta of 0.7. Which of the following positions does Rebecca need to add to her portfolio to neutralize her position?

b.

Long 35 Futures contracts Long 60 Futures contracts

c.

Short 35 Futures contract

d.

Short 60 Futures contracts

a.

36.

Which of the following describes gas basis? a. b. c. d.

37. 37.

b. c. d.

Perform the calculation again since spark spreads cannot yield negative values Switch to a lower-cost fuel that will allow the plant to run profitably Modernize the generation equipment at the plant to make it more efficient Stop power production until electricity rates rise to a point where he can sell power profitably

One common method of reducing credit risk between parties is the use of a countertrade. Which of the following statements about a countertrade is correct? a.

A countertrade increases settlement risk and reduces replacement risk.

b.

A countertrade reduces settlement risk and reduces replacement risk. A countertrade increases settlement risk and locks in replacement risk. A countertrade reduces settlement risk and locks in replacement risk.

c. d.

39.

The tax rate for gas inventory The convenience yield for gas ownership

Jean-Claude is the operator of a 100MW power plant. He has just performed a spark spread calculation and has gotten a negative result. What is the most practical economic course of action for Jean-Claude to take? a.

38.

The underlying cost of the commodity The price difference between locations

Which of the following alternative energy sources can be classified as either passive or active? a. b. c. d.

Biofuels Hydroelectric Solar Wind


13


40.

To ensure that the quality of imported LNG supplied to end users falls within prescribed parameters, which of the following actions should be taken? I.

Dilute the vaporized LNG with air or nitrogen.

II. Enrich the vaporized vaporized LNG with higher heating value components such as ethane, ethane, propane, and butane. III. Establish a Wobbe Wobbe index range range and a heating heating value range range for the LNG.

c.

I II I and III

d.

All of the above

a. b.

41.

To calculate the historical volatility for use in a Geometric Brownian Motion (GBM) process you need to do which of the following? I. II. III. IV. IV.

Determine the commodity’s long run mean price Calculate the standard standard deviation of the prices about the long-term mean Calculate the standard deviation deviation of the logarithmic price returns returns Annualize the standard standard deviation by the appropriate appropriate factor factor

a.

I and II I, II, and IV III and IV III only

b. c. d.

42.

In the crude oil market, what are paper barrels? a. b. c. d.

43.

Future contracts bought without the expectation of actual delivery of the product A new, environmentally-friendly container for crude oil

Rank the following countries in order of highest to lowest percentage of electricity produced from nuclear power (beginning with the highest percentage): a. b. c. d.

14

Statistical projections of a refinery’s profit and loss Projections on how much oil an unproven reservoir may hold

France, Japan, USA, Russia, Japan, USA, France, Russia USA, Japan, Russia, France USA, Russia, France, Japan



44.

Which of the following statements regarding Value-at-Risk (VaR) (VaR) is false? a. b. c. d.

45.

46.

VaR VaR models estimate the absolute worst-case scenario. VaR VaR models should not be used to predict future market behavior. behavior.

Alessandro Montano, ERP, is analyzing the recent sale of a pipeline owned by his company. Which of the following valuation methods should Alessandro use to record a financial gain or loss for the sale? a.

Economic value

b. c.

Comparable sales Replacement cost

d.

Book value

Which of the following factors has the greatest influence on day-to-day variations in demand for electricity in a given location? a. b. c. d.

47. 47.

VaR models assume portfolios do not change over time. VaR models provide a single measure of risk.

Economic factors Fuel costs Generation constraints Weather

We assume that the heat rate of a natural gas peaking unit is 10,000 Btu/kWh. The price of electricity is USD 25.00 per MWh, and the price of natural gas is USD 2.00. What is the “spark spread” for this plant in USD per kWh? a.

USD 0.005

b.

USD 0.02 USD 0.03 USD 0.4

c. d.

48.

The principle of parallelism implies what type of relationship between spot and future prices? a. b. c. d.

A low level of correlation between spot and futures prices A high level of correlation between spot and futures prices A volatile correlation between spot and futures prices No correlation between spot and futures prices


15


49.

The cost of crude oil typically accounts for 70-80% of the total operating expenses associated with refined products. As a result procurement managers seek to purchase types or blends of crude oil that will offer the highest profit margin when used to create refined petroleum products. Which of the following is a method commonly used by refineries to evaluate crude oil? a.

Break-even analysis

b.

Proximate analysis

c.

Ultimate analysis Fischer-Tropsch analysis

d.

50.

Given a flat volatility term structure for the entire WTI forward price curve at 35%, the Black-equivalent volatility of a look-back cash-settled average price option with a 3-month averaging period would 1 over the last three months of the option’s life because 2 . 1

2

a.

Increase

b.

Decrease

volatility of the underlying forward price tends to grow as option expiration time decreases volatility of the underlying forward price tends to drop as option expiration time decreases

c.

Increase

d.

Decrease

as we begin collecting the daily forward price settlements to ultimately determine the average price at option settlement, the uncertainty around the value of the average price settlement value drops as we begin collecting the daily forward price settlements to ultimately determine the average price at option settlement, the uncertainty around the value of the average price settlement value drops

51.

Your company is calculating Value-at-Risk (VaR) using an historical simulation method, with a 97.5% confidence level and two day holding period. In order to assess the validity of the method used to measure price risk, back-testing is also put in place. Assuming there are 260 business days in a year, which of the following loss scenarios (e.g. number of times portfolio losses exceed VaR) would you consider an acceptable threshold?

16

a.

Once every two months

b c.

2.5 times each month 2 times each month

d.

130 times in six months



52.

Blockhead Cement Company has historically consumed an average of 30MWh of electric power per day and typically purchases power at prevailing spot market prices. In an effort to hedge price exposure the company’s risk management team has decided to use electricity swaps. They are planning to test the strategy in the month of August by engaging in a fixed-for-floating electricity swap with a local power provider for 30MWh of power at USD 120/MWh. What will Blockhead’s net cash flow be if the cost of power for August is USD 105,681 and the floating leg of the swap is set at USD 108,240?

c.

Pay USD 102,321 Receive USD 102,321 Pay USD 109,041

d.

Receive USD 109,041

a. b.

53.

A generating plant has a nameplate rating of 650 megawatts and is expected to be offline for 720 hours for a scheduled outage during the year. A typical year is comprised of 8,760 hours. Actual generation during the year was 4,270,500 megawatt hours. What is the plant’s load factor?

c.

81.7% 75.0% 72.76%

d.

76.0%

a. b.

54.

The risk manager of a power generation company is reviewing the parameters under which analytical VaR is calculated and the nature of the company’s price exposures. She believes that the hypothesis of one day holding period is not realistic, and is willing to instead require a 5-day holding period. Traders complain that in this case the calculated VaR will be much higher and they will not be able to respect the company VaR limit of ten million. She proposes to review the VaR limit in a manner consistent with the new holding period; consequently, the new VaR limit will be approximately: a.

50 Million

b.

22 Million 12 Million 10 Million

c. d.

55

Prior to drilling a well, an assessment is made as to the reserves a reservoir may contain based on data derived from a current or prior well production or geophysical data. Which of the following makes the technical process for estimating reserves complex? a. b. c. d.

The subjective nature of the process. The quantitative methodologies used. The publication of reserve estimates is often biased. The reserves are not considered assets.


17


56.

Consider the statements below regarding delivery costs as a percentage of the cost of electricity charged to the end-use customer. Which of the following statements is false? a.

Distribution accounts for about 30 to 50 percent of the total delivery cost.

b. c.

Generation accounts for about 35 to 50 percent of the total delivery cost. Transmission accounts for about 5 to 15 percent of the total delivery cost.

d.

Delivery operations vary wildly from plant-to-plant, thus no generalizations about the percentage of costs can be made.

57.

A landman is used to determine the legal rights of a company to drill for petroleum and natural gas, and to facilitate mandatory legal requirements. Of the landman's responsibilities, which of the following is NOT one of his/her roles? a. b. c. d.

58.

18

Conduct seismological tests to locate minerals. Locate mineral owners. Verify mineral ownership via title searches. Negotiate leasing terms necessary for drilling.

A refiner is negotiating the sale of 10,000 tons of jet fuel to an airline. By giving a discount on the current market price, the refiner has secured the possibility to sell and deliver, if the refiner wants, an additional volume of 10% at the same agreed price. Such price is finally set at USD 450/ton. At the time of delivery, the prevailing market price is USD 400/ton, and the refiner decides to deliver also the additional 10% volume. The refiner’s position can be described as: a.

Purchase of a call option for free, and exercise (strike) price at USD 400/ton.

b. c.

Purchase of a put option for free, and exercise (strike) price at USD 450/ton. Purchase of a put option with premium equal to the discount, and exercise (strike) price at USD 450/ton.

d.

Purchase of a call option with premium equal to the discount, and exercise (strike) price at USD 450/ton.



59.

The round-the-clock forward contract for single day delivery on February 10 and February 11 currently trades at USD 60 and USD 50, respectively. The three-day forward contract for round-the-clock del ivery for the period starting February 10 and ending February 12 also trades at USD 50. Assuming a zero-percent discount rate, what is the round-the-clock forward price for a single day of delivery occurring on February 12? a.

USD 40

b.

USD 45

c.

USD 50 USD 55

d.

60

You run a lucrative kerosene business and wish to hedge your exposure to kerosene price changes on a contract that is close to delivery. By implementing this hedge using heating oil derivatives you are exposed to changes in _______ basis. a.

Location

b.

Storage Product Intermarket

c. d.


19

Energy Risk ® Professional(ERP ) Examination Practice Exam 2 Answers


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21

Energy Risk ® Professional(ERP ) Examination Practice Exam 2 Explanations


1.



b.


c.


d.


Correct Answer: a Reading Reference: The Petroleum Industry: A Nontechnical Guide , Conaway; Chapter 2. Explanation: Because of subsurface pressure, crude oil will naturally migrate towards the surface, unless it is contained by a layer of impermeable material (a “trap”) to form a reservoir, thus a is the correct answer.

2.

You wish to use a bull spread strategy for heating oil using call option contracts and you purchase one contract. You decide to use option strikes at USD 1.91 and USD 1.97. Using the table below, what would the total net premium expense be, assuming no commissions or other transaction costs? Exercise Price USD 1.85 USD 1.91

Call Premium USD 0.227 USD 0.195

Put Premium USD 0.158 USD 0.186

USD 1.97

USD 0.169

USD 0.220

December 2009 Heating Oil Futures Contract = USD 1.91 per gallon a. b. c. d.

USD 0.026 USD 195 USD 1,092 USD 1,950

Correct Answer: c Reading Reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition , Errera and Brown: Chapter 7, p. 114 Explanation: Answer C is correct as per the following formula; prices are per gallon, so the answer is 42,000 gallons × (USD 0.195 − USD 0.169) = USD 1,092.


23


3.

A natural gas producer sells a swing swap (10,000 MMBtu per day) at USD 5.50 for the last five days in January to an end-user. Calculate the cash settlement at the end of the swap based on the Gas Daily Index below: Date Jan 27

High Price USD 5.70

Low Price USD 5.60

Gas Daily Index USD 5.65

Jan 28

USD 5.60

USD 5.50

USD 5.55

Jan 29 Jan 30 Jan 31

USD 5.80 USD 5.90 USD 6.20

USD 5.60 USD 5.60 USD 6.00

USD 5.70 USD 5.75 USD 6.10

a.

USD 12,500 payment from the producer to the end-user.

b. c.

USD 12,500 payment from the end-user to the producer. USD 17,000 payment from the producer to the end-user.

d.

USD 17,000 payment from the end-user to the producer.

Correct Answer: a Reading Reference: Trading Natural Gas: A Nontechnical Guide , Sturm; Chapter 4, Page 38-42 Explanation: Answer a is correct, if the average gas daily index for the five days is USD 5.75 and is USD 0.25 above the contract price, the producer would effectively be receiving a price of USD 5.50 and paying a price of USD 5.75, a net payment of USD 0.25 an MMbtu. Multiplying the USD 0.25 MMbtu payment by the total contract quantity of gas of 50,000 MMbtu results in a payment of USD 12,500 from the producer to the end-user. The producer should be able to sell its physical gas in the market at a price near the USD 5.75 Gas Daily Index average and result in a net receipt of USD 5.50 an MMbtu if the hedge was 100% effective.

4.

According to the International Accounting Standards (IAS) Rule 39, for a derivative hedge to be effective, the correlation between changes in the price of derivative hedge and changes in the price of the underlying physical asset should be in the range of?

b.

80% to 125% 85% to 115%

c.

80% to 120%

d.

75% to 125%

a.

Correct Answer: a Reading Reference: Tom James. Energy Markets: Price Risk Management and Trading, Chapter 17: Accounting for Energy Derivatives Trades, p. 352-3. Explanation: Answer a is correct; as per definition the range should be between 80% to 125%, according to IAS 39.

24



5.

Ethanol is a gasoline substitute made from biomass. E85 is a blend of vehicle fuel containing 85% ethanol and 15% gasoline. Thanks to government policies mandating its use, what country is the world’s largest consumer of E85?

b.

Brazil Canada

c.

China

d.

United States

a.

Correct Answer: a Reading Reference: Fisher Investments on Energy , Chapter 6, page 159. Explanation: In an effort to become energy independent, Brazil’s government has pursued a policy to fuel their nation’s motor vehicles with E85, using ethanol refined from Brazil’s ample supplies of sugar cane.

6.

When compared globally, proven reserves of coal are estimated to contain __________ energy as contained by the world’s proven reserves of petroleum? a. b. c. d.

Half as much Roughly the same amount of Twice as much Three times as much

Correct Answer: d Reading Reference: Producing Liquid Fuels from Coal: Prospects and Policy Issues , Bartis; Chapter 2, page 5, 12. Explanation: According to the World Energy Council, when compared to global petroleum reserves, global coal reserves contain roughly three times as much energy, making d the correct answer.


25


7.

An analyst from PB Energy Trading is implementing a VaR methodology and needs to choose between a Monte Carlo based model and a variance-covariance based model. Compared to the analytical method, what is the main advantage of Monte Carlo simulation?

b.

Ability to handle energy portfolios containing large number of risk factors. Low price of computing large numbers of risk factors.

c.

Simplicity and ease of handling large energy portfolios.

d.

Ability to estimate VaR for energy portfolios that contain nonlinear assets.

a.

Correct Answer: d Reading Reference: Leppard; Chapter 10, p. 200-205 Explanation: Answer d is correct. The advantages of Monte Carlo simulations include the ability to model evolution of risk factors over the holding period. Furthermore, there is no need to approximate portfolio values in this method—they are computed exactly. Hence, the method can be used for estimating VaR in the most nonlinear portfolio, which is a valuable characteristic for energy portfolios with assets.

8.

Pierre is about to enter into a long-term energy contract with an unfamiliar counterparty and is concerned about their creditworthiness. Which of the following techniques will be the most effective in reducing Pierre’s credit risk? a. b. c. d.

Margining agreement Additional collateralization Countertrade Price adjustment

Correct Answer: a Reading Reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Burger, Chapter 6.3, p. 268 Explanation: Answer a is the best selection, since it transfers cash to the “upside” counterparty from the “downside” counterparty. Cash in hand is the best solution. While answers b, c and d would mitigate risk, they are not the best solution in this scenario. For example, “additional collateralization” is not the same as cash, and there may be monetization costs to convert it to cash.

26



9.

Charlene is the supply manager for Opechee Petroleum Refinery. Opechee needs to acquire 100,000 barrels of crude oil for delivery in December. In October the December futures contract is trading at USD 85 per barrel. Charlene decides to implement a cap strategy and buys 100 December call options with a strike of USD 85 per barrel and a premium of USD 850 per option. If the December futures price hits USD 90 per barrel what is the effective cost per barrel of crude after accounting for the option contract? a.

USD 84.15

b.

USD 85.00 USD 85.85 USD 89.15

c. d.

Correct Answer: c Reading Reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition , Errera, Chapter 7, p. 123 Explanation: The correct answer is c since, Charlene longs the call options, and since at expiry date the crude price is USD 90 per barrel, which is larger than the strike price of call options, she will execute the call options and buy crude at USD 85 per barrel. She also paid premium for the call options, so the total amount she paid is: USD 85 per barrel * 100,000 barrels + 100 call options * USD 850 per option = USD 8,585,000. Then the average cost per barrel is USD 8,585,000 /100,000 barrels = USD 85.85 per barrel.

10.

In recent years, new LNG projects in West Africa that capture associated gas from oil fields currently in production have been launched. What has been the primary motivation behind the sudden development of these LNG projects in West Africa? a.

To provide an alternative fuel source for motor vehicles in the region

b. c

Government policy in the region to eliminate gas flaring from oil wells Fears that the oil fields will soon run dry

d.

Heavy foreign investment in LNG, particularly from China

Correct Answer: b Reading Reference: LNG: A Nontechnical Guide , Tusiani and Shearer; Ch. 11, page 301-302. Explanation: Associated fields produce both oil and natural gas. For years companies in the oil fields of West Africa routinely flared off the natural gas that emerged from the oil wells as a waste product. In recent years, over environmental concerns, governments in the region mandated that this natural gas be captured to eliminate gas flaring, spurring the development of LNG projects and making b the correct answer.


27


11.

Which of the following best describes royalties on an LNG project? a. b. c. d.

Payments made on a percentage of the sales revenues. Payments based on a percentage of the profits. Payments based on profits minus local tax payments. Payment based on varying unit costs.

Correct Answer: a Reading Reference: LNG: A Nontechnical Guide , Tusiani and Shearer: Chapter 11, p. 303 Explanation: Answer a is correct. Typically speaking, in the upstream, royalties are a common device by which governments can secure a share of a project's revenue. High royalties can be onerous to an LNG project, since they involve a payment to the sovereign made directly out of the sales revenues irrespective of the project’s actual earnings. These royalties can be on oil and/or gas; in the case of an LNG project, any liquids produced are often subject to the same royalties as oil production. Royalties are usually expressed as a percentage of initial revenue. For current LNG projects, they generally fall in a range of 5%–20%. Less commonly, they can be calculated as a fixed unit cost (USD /MMBtu).

12.

Consider a manufacturing plant that consumes a large amount of electricity each month. Monthly on-peak forwards are currently available at USD 75/MWh for a 100MW contract. If the plant manager purchases a monthly on-peak power forward contract, how many megawatt hours will the plant receive, assuming there are 20 business days per month? a. b. c. d.

2,000 MWh 16,000 MWh 32,000 MWh 48,000 MWh

Correct Answer: c Reading Reference: Energy Modelling: Advances in the Management of Uncertainty , Kaminski: Chapter 2, p. 59 Explanation: Answer c is correct: 16 hours per day times 20 days, times 100 MWs = 32,000.

28



13.

An option has a premium of USD 5.00 and a strike price of USD 28.00. If the price of the underlying is USD 31.00, what is the time value of the option? a.

USD 5.00

b. c.

USD 3.00 USD 2.00

d.

USD 0.00

Correct Answer: c Reading Reference: Energy Markets: Price Risk Management: A Non-Technical Introduction to Energy Derivatives , James: Chapter 6, p. 137-8 Explanation: c is correct. It is the premium less the intrinsic value: intrinsic value = USD 31 – USD 28 = USD 3, so USD 5 – USD 3 = USD 2, therefore time value = USD 2.00.

14.

Time series analysis is necessary for

a. b. c. d.

1

, while distribution analysis is important in

1

2

Constant drift-term calibration Option modeling Comparing long-term price behavior to model-implied behavior Calibrating model parameters

average volatility calculation spot price modeling calibrating model parameters

2

.

comparing long-term price behavior to model-implied behavior

Correct Answer: d Reading Reference: Energy Risk , Pilipovic: Chapter 5, p. 72-3 Explanation: Time series analysis is specifically used in calibrating model parameters while distribution analysis is important in testing model-implied behavior against actual long-term price behavior. Hence, answer d is the correct answer. Drift term calibration is one of the results of time series analysis. However, other model parameters are also calibrated. Similarly, while average volatilities can be implied through distribution analysis, this can be only a part of the process of performing a distribution analysis. So while answer a is somewhat appropriate, it does not provide the best answer. Answers b and c are both incorrect, as the opposite of the statements is true.


29


15.

Which of the following statements regarding Value-at-Risk (VaR) is true? a. b. c. d.

VaR assumes the portfolio does not change over time. VaR can be represented by multiple numbers of risk measurements. VaR accounts for the absolute worst-case scenario. VaR models are best used to predict future market behavior.

Correct Answer: a Reading Reference: Energy Risk Management: A Non-technical Introduction to Energy Derivatives , Leppard: Chapter 8, p. 195 Explanation: Answer a is true VaR assumes the portfolio does not change over time. Answer b is false: VaR is a single number measure of risk. Answer c is false: VaR does not estimate the absolute worst-case scenario. Answer d is false: VaR uses some model of what constitutes normal market behavior. Since the future cannot be known (or there would be no need to VaR) the model must be based on statistical assumptions for how the market will behave.

16.

There are four power plants which can be dispatched to a power grid, their operating costs and capacities as shown in the table below. The system operator will use a merit order curve to minimize the cost of running the system. Based on this information, how many megawatts can be dispatched by the system operator while keeping the equilibrium price below USD 35/MWh? Plant

Cost/MWh

Capacity (MW)

A

USD 20

500

B C

USD 40 USD 30

100 150

D

USD 44

300

c.

500 MWs 650 MWs 700 MWs

d.

750 MWs

a. b.

Correct Answer: b Reading Reference: Electricity Markets: Pricing, Structures and Economics , Chris Harris, Chapter 6, page 197 Explanation: Answer b is correct. The merit order curve involves selecting the least expensive power first up to the required system capacity. The market equilibrium price is set by the most expensive power plant used to meet the system capacity. The merit order curve would dispatch the least expensive plants first. Plant A would be dispatched for up to 500 MW at USD 20 and then Plant C would be dispatched for up to an additional 150 MWs at USD 30. Any additional energy needs would require dispatching Plant B at USD 40/MW, which would set the price above USD 35. Therefore, up to 650 MWs could be dispatched to keep the price below USD 35/MWh.

30



17.

Victor is offered the four qualities of crude oil below. Assuming no basis differences, for which of the following should he be willing to pay the most? a.


b. c.

API = 38 and Sulfur = 1.2% API = 23 and Sulfur = 0.3%

d.


Correct Answer: a Reading Reference: Nontechnical Guide to Petroleum, Geology, Exploration, Drilling, and Production, 2nd Edition , Hyne: Chapter 1, p. 5 Explanation: Answer a is correct because a higher API is more valuable, while higher sulfur is less valuable. Answer a combines the higher API with the lowest sulfur content from the four choices available.

18.

Consider a natural gas futures contract trading at USD 2.00 with an initial margin requirement of USD 3,000 which supports a decrease in the price of the futures contract to USD 1.70. What is the additional margin requirement if the futures price falls to USD 1.60? a. b. c. d.

USD USD USD USD

1,000 2,000 3,000 4,000

Correct Answer: a Reading Reference: Trading Natural Gas: A Nontechnical Guide , Sturm; Chapter 4, p. 37-8 Explanation: Answer a is correct. A trader will receive notice of a margin call if the value of their position has deteriorated beyond the initial margin requirement. In the example above, the value of USD 1.70 * 10,000 = USD 17,000 requires an initial margin of USD 3,000 giving USD 17,000 + USD 3,000 = USD 20,000 worth of natural gas. Hence, when the futures contract price falls to USD 1.60, we have USD 1.60 * 10,000 + USD 3,000 = USD 19,000, which requires an additional payment of USD 1,000 to maintain the initial value of the position.


31


19.

How will the Smart Grid help to lower the operating costs of electric utility companies? a. b. c. d.

By reducing the usage of peaker facilities By reducing the need to build high-capacity transmission lines By reducing fuel costs All of the above

Correct Answer: d Reading Reference: The Smart Grid, An Introduction ; US Department of Energy, page 23 Explanation: By providing a detailed, on-going assessment of consumer power usage, the Smart Grid will allow utility companies to better anticipate demand and will lessen the need to run “peaker” generation plants. Since these plants require fuel bought on the spot market, overall fuel costs will also go down. The Smart Grid will allow electric utilities to fully utilize existing transmission lines, sending perhaps 300% more electricity through existing lines, lessening the need to build new transmission corridors; therefore d—all of the above—is the correct answer.

20.

Crude oils from West Africa are often sold based on a formula indexed to Brent crude plus a premium or discount depending on the quality of the crude. Which of the following risks could be mitigated if a West African producer executes a futures contract on Brent?

c.

Basis risk and supply risk Basis risk and directional risk Supply risk

d.

Market price risk

a. b.

Correct Answer: d Reading Reference: Surviving Energy Prices, Beutel: Chapter 3, p. 19-21 (and much of the entire chapter) Explanation: Answer d is correct. Futures can only be used to reduce the impact of price volatility with no impact on supply risk. The producer is exposed to directional risk and basis risk but can only reduce market price risk using futures contracts.

32



21.

Which of the following statements correctly describes a weakness in using single factor mean-reverting models for option valuation? a.

Black-equivalent volatility approaches zero with increasing time to expiration

b. c.

Black-equivalent volatility grows with increasing time to expiration Black-equivalent volatility decreases with increasing time to expiration

d.

Black-equivalent volatility changes in proportion to spot price volatility

Correct Answer: a Reading Reference: Energy Risk , Pilipovic: Chapter 5, p. 105-09 Explanation: The correct answer is a. One stated drawback of a single-factor, mean-reverting model is that it forces the implied Black-equivalent average of the price distribution to approach zero over a long period of time, requiring caution when using a single-factor mean-reverting model when valuing longer-term options.

22.

Bob Burns would like to understand the term floor as it relates to energy commodity trading strategies. Which of the following positions has the characteristics of a floor? a. b. c. d.

Short call option Long call option Short put option Long put option

Correct Answer: d Reading Reference: Energy Options Strategies, Errera, Chapter 7, p.123 Explanation: Answer d is correct because a “floor” or put option protects against energy prices falling to undesirable levels—the profit from a long call increases as spot/forward prices decrease, offsetting loses from physical positions.

23.

Which of the following is the key driver of volatility in the natural gas market in the United Kingdom? a.

Demand

b.

Infrastructure Storage Supply

c. d.

Correct Answer: a Reading Reference: The Handbook of Commodity Investing , Fabozzi (ed.); Chapter 36, p 842-43 Explanation: Demand elasticity, particularly from domestic users, is the key driver of volatility in the UK.


33


24.

Suppose it is January and the spot price of Brent crude on the ICE exchange is USD 106. The annual risk-free interest rate is 6%, and monthly storage cost is USD 0.50 per barrel. If the crude can be stored for three months but cannot be sold out of storage before the three month storage term ends, what breakeven forward price per barrel supports a storage strategy? a.

USD 107.51

b.

USD 108.03

c.

USD 109.11 USD 109.78

d.

Correct Answer: c Reading Reference: Fundamentals of Derivatives Markets, McDonald, Chapter 6, p.182 Explanation: Answer c is correct because, it incorporates the future value of the commodity (.0053 = future value factor of 1.0151 x current spot price of USD 106 = USD 107.60) and the future value of 3 months storage (USD 1.5075). All other answers are incorrect and not based on any calculation.

25.

Which of the following statements correctly describes cogeneration?

c.

The generation of electricity using two forms of fossil fuel. The generation of electricity using a combination of two distinct types of generating units, with combined output. A generating unit that produces both electricity and heat.

d.

A generating unit that has more than one owner resulting in shared electricity output.

a. b.

Correct Answer: c Reading Reference: Making Competition Work in Electricity , Hunt, Chapter 2, pages 18-20 Explanation: Answer c is correct, in cogeneration, both electricity and heat (for use in various business processes) is produced.

26.

Several notable firms have been driven out of business because a single individual was in charge of both the execution and reconciliation of derivatives trades. This is an example of a failure in which risk control category? a. b. c. d.

Management control Segregation of duties Risk Reporting Risk assessment

Correct Answer: b

34



Reading Reference: Energy Markets: Price Risk Management and Trading, Tom James; Chapter 10, page 183-84 Explanation: Proper risk control dictates that the same individual not be in charge of the execution of trades (front office duties) and reconciliation of trades and generation of reports (back office duties); if one person has both front and back office duties, it is possible for them to hide bad trades and not properly inform senior management about outstanding positions, making b, segregation of duties, the correct answer.

27.

Refineries X, Y, and Z have complexity factors of 2, 5, and 10, respectively. Using industry accepted guidelines or thresholds, which of the following correctly classifies each refinery as “simple,” “complex,” or “very complex.” a. b. c. d.

X – simple, Y – simple, Z – complex X – very complex, Y – complex, Z – simple X – simple, Y – complex, Z – very complex X – simple, Y – very complex, Z – very complex

Correct Answer: a Reading Reference: Petroleum Refining in Nontechnical Language, 3rd Edition , Leffler: Chapter 20, p. 194 Explanation: Answer a is correct. Refineries are classed by complexity type using the categories: “simple” (2 < complexity < = 5); “complex” (8 < complexity < 12); and “very complex” (complexity > 15).

28.

LNG pricing has historically been dependent on which of the following? a. b. c. d.

Specific conditions in the customers’ markets. Lack of a structured pricing arrangement. Processes set by the seller of the LNG. Price fixing by local governments.

Correct Answer: a Reading Reference: LNG: A Nontechnical Guide , Tusiani and Shearer: Chapter 3, p. 74 Explanation: Answer a is correct. Pricing of LNG has until recently depended on the specific conditions of the customers’ markets. In markets that have utility buyers and essentially no pipeline gas supplies, such as Japan and Korea, prices have been mainly set by reference to crude oil as a proxy price for LNG. In turn, these supply arrangements were subject to approval by the governmental authorities that permitted the utilities to recover their fuel cost (but no associated profit) from their captive customers.


35


29.

A natural gas distributor is buying LNG from a gas trader using a bi-lateral contract that includes a force majeure clause. Which of the following is an implied outcome of the force majeure clause? a.

Derivatives contracts can be cancelled and not honored.

b. c.

The gas trader can sell the gas to another counterparty offering a higher price. The gas trader is free to not perform its obligation if the cost for sourcing the LNG is too high.

d.

There is a possibility that positions may actually disappear.

Correct Answer: d Reading Reference: Energy Risk Management: A Non-technical Introduction to Energy Derivatives , Leppard: Chapter 8, p. 206 Explanation: Answer d is correct. A contract for physical delivery cannot have impacts on derivatives contracts, and those normally do not include force majeure clauses, hence a is wrong. Force majeure included cases, not market related, which are out of the control of the counterparties, hence b and c are wrong. Force majeure corresponds to positions disappearing, a risk arising from extreme weather, other natural or man-made events, so only answer d is correct.

30.

Markus has been studying nuclear power generation using the following technologies: Boiling Water Reactors (BWRs), Pressurized Water Reactors (PWRs) and Pebble-Be d Modular Reactors (PBMRs). Which of the following statements regarding these methods of nuclear power generation is correct? a.

PBMRs are the latest technology being advocated because it increases the output in terms of megawatt

b.

hours for the same capital cost. PWRs feeds steam directly from the reactor into the turbines thereby introducing low levels of radiation

c.

to the turbines, condensers and associated piping. The high temperatures possible with a PWR design make it more thermally efficient than a BWR.

d.

One problem with a PBMR is that it operates at high temperatures, which raises safety issues.

Correct Answer: c Reading Reference: Roy L. Nersesian. Energy for the 21st Century: A Comprehensive Guide to Conventional and Alternative Sources (Armonk, NY: M.E. Sharpe, 2007): Chapter 8, p. 283. Explanation: Answer c is correct; PWRs are more thermally efficient than BWRs because PWRs operate at higher temperatures. Answer a is incorrect because PBMRs are actually best suited for smaller applications. Answer b is incorrect because it is BWRs that inject low levels of radiation into equipment. Finally, answer d is incorrect because excessive heat within PBMRs will shut down reactions.

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31.

Match the following characteristics of a distribution with the correct description: 1. 2.

Kurtosis Standard Deviation

3.

Skew

a. c.

1–A, 2–B, 3–C 1–B, 2–A, 3–C 1–C, 2–B, 3–A

d.

1–C, 2–A, 3–B

b.

A. B.

Captures the width of a distribution Reflects symmetry or imbalance of the distribution to the left or right of

C.

the mean Characterizes the tails of the distribution

Correct Answer: d Reading Reference: Energy Risk , Pilipovic: Chapter 4, p. 75-76. Explanation: Each moment of a distribution captures various characteristics of the variable behavior. Standard deviation measures the width of a distribution, skew is an estimate of whether the variable ‘favors’ values to the left or the right of the mean or is perfectly symmetric, and kurtosis captures the behavior of the variable when it takes on very large or very small values—hence the ‘tails’ of the distribution. Therefore, the correct answer is d.

32.

Thomas is trading electricity power options and has 90 days of price data. Which factor should he apply to the standard deviation of his data set to estimate annual volatility? a.

√ 90

b.

1/ √ 90

c.

√ 250

d.

√ 365

Correct Answer: d Reading Reference: Energy Derivatives: Pricing and Risk Management , Clewlow and Strickland chapter 3.2.1 page 40 Explanation: For most products that are only traded on weekdays, like natural gas, one normally scales the historical volatility by the number of trading days. The exact number of trading days varies by market and by product, but 250 is commonly used as an average figure. Choice d is correct however because, unlike natural gas, power is traded every day so the factor needed to annualize the volatility is the square root of 365. Choices a and b use the square root of 90 (the days in Thomas’ data set), not the total number of trading days.


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33.



b.


c.


d.


Correct Answer: a Reading Reference: The Petroleum Industry: A Nontechnical Guide , Conaway; Chapter 2. Explanation: Because of subsurface pressure, crude oil will naturally migrate towards the surface, unless it is contained by a layer of impermeable material (a “trap”) to form a reservoir, thus a is the correct answer. Crude oil can migrate for miles, up to 50, from its place of formation making c incorrect; and while salt domes from ancient seas do provide effective traps, other types of geologic structures can and do effectively contain large reservoirs of oil, making d incorrect.

34.

Consider a trade in which a futures contract on natural gas was purchased and a futures contract on crude oil was simultaneously sold at a lower price. Assuming the price of the futures on natural gas remains above the price of the futures on crude oil, but the spread between the two prices narrows you would expect that the trade will ________. a.

Make money

b. c.

Lose money Make money only if both prices rise

d.

Lose money only if both prices fall

Correct Answer: b Reading Reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition , Errera: Chapter 4, p. 60 Explanation: Answer b is correct. If the spread between two contracts narrows, a loss will occur if the lower-priced contract has been sold and the higher-priced contract purchased.

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35.

Ten days ago Rebecca, a gasoline option trader sold 50 put contracts on gasoline futures, with a strike price USD 0.012 cents/gallon and current delta of 0.7. Which of the following positions does Rebecca need to add to her portfolio to neutralize her position?

b.

Long 35 Futures contracts Long 60 Futures contracts

c.

Short 35 Futures contract

d.

Short 60 Futures contracts

a.

Correct Answer: c Reading Reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Burger: Chapter 2, p. 57-8 Explanation: Rebecca is short put options, so she has to be short the underlying. The quantity to sell is calculated by the delta, hence 0.7 Future for every put, so 35 Future contracts in total. Answer c is the correct one.

36.

Which of the following describes gas basis? a. b. c. d.

The underlying cost of the commodity The price difference between locations The tax rate for gas inventory The convenience yield for gas ownership

Correct Answer: b Reading Reference: Energy Risk , Pilipovic: Chapter 2, p. 32 Explanation: Answer b is correct. Decentralization introduces geographic “basis risk,” which is unique to energies. In financial markets, today’s dollar is worth a dollar anywhere in the country. In energy markets, price depends on location. A megawatt of electricity is priced according to delivery point; the same holds true for natural gas. Location is a fundamental driver of price. Pilipovic defines “basis risk” as: The difference in prices between identical products but in two different markets.


39


37.

Jean-Claude is the operator of a 100MW power plant. He has just performed a spark spread calculation and has gotten a negative result. What is the most practical economic course of action for Jean-Claude to take? a.

Perform the calculation again since spark spreads cannot yield negative values

b. c.

Switch to a lower-cost fuel that will allow the plant to run profitably Modernize the generation equipment at the plant to make it more efficient

d.

Stop power production until electricity rates rise to a point where he can sell power profitably

Correct Answer: d Reading Reference: Energy Trading and Investing, Edwards; Chapter 4.3, page 274 Explanation: Jean-Claude is most likely to simply shut the plant off until the electric rates rise to a point where he can sell his power profitably, making answer d correct. Spark spread calculations can yield negative values; and while answers b and c would change the inputs for the spark spread calculation, which may then give a positive value, neither may be a practical course of action nor can either action be done as quickly as can the decision to shut the power plant down temporarily.

38.

One common method of reducing credit risk between parties is the use of a countertrade. Which of the following statements about a countertrade is correct?

c.

A countertrade increases settlement risk and reduces replacement risk. A countertrade reduces settlement risk and reduces replacement risk. A countertrade increases settlement risk and locks in replacement risk.

d.

A countertrade reduces settlement risk and locks in replacement risk.

a. b.

Correct Answer: d Reading Reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Burger: Chapter 6, p. 268 Explanation: Countertrade: If there is a netting agreement, the conclusion of a countertrade with the same counterparty reduces the settlement risk of sold forward contracts and locks the actual replacement risk. Since the countertrade is concluded at the actual market price and the replacement risk cannot be reduced.

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39.

Which of the following alternative energy sources can be classified as either passive or active? a. b. c. d.

Biofuels Hydroelectric Solar Wind

Correct Answer: c Reading Reference: Fisher Investments on Energy : Chapter 6, p. 152 Explanation: Solar energy systems come in two types: active, which uses mechanical systems to collect and distribute solar energy; and passive which absorbs and distributes solar heat without the use of machinery (i.e. through heat-absorbing materials or careful design of buildings to maximize the potential for solar heating).

40.

To ensure that the quality of imported LNG supplied to end users falls within prescribed parameters, which of the following actions should be taken? I.

Dilute the vaporized LNG with air or nitrogen.

II. Enrich the vaporized LNG with higher heating value components such as ethane, propane, and butane. III. Establish a Wobbe index range and a heating value range for the LNG. a. b. c. d.

I II I and III All of the above

Correct Answer: d Reading Reference: LNG: A Nontechnical Guide , Tusiani and Shearer, Ch. 7, pp. 180-182. Explanation: Gas interchangeability may require dilution or enrichment to ensure calorific value requirements. The Wobbe index is a measure of gas quality and burner performance and may also be prescribed by pipeline tariffs. Therefore all three items are steps that may be necessary to ensure the quality of the LNG delivered to end users, making d the correct choice.


41


41.

To calculate the historical volatility for use in a Geometric Brownian Motion (GBM) process you need to do which of the following? I.

Determine the commodity’s long run mean price

II. Calculate the standard deviation of the prices about the long-term mean III. Calculate the standard deviation of the logarithmic price returns IV. Annualize the standard deviation by the appropriate factor a. b. c. d.

I and II I, II, and IV III and IV III only

Correct Answer: c Reading Reference: Energy Derivatives: Pricing and Risk Management , Clewlow and Strickland: Chapter 3.2.1, p. 40 Explanation: For historical volatility that will be used in a GBM process, you need to calculate the standard deviation of the logarithmic price returns and then to scale it by the appropriate factor to annualize the volatility.

42.

In the crude oil market, what are paper barrels? a. b. c. d.

Statistical projections of a refinery’s profit and loss Projections on how much oil an unproven reservoir may hold Future contracts bought without the expectation of actual delivery of the product A new, environmentally-friendly container for crude oil

Correct Answer: c Reading Reference: The Role of WTI As A Crude Oil Benchmark , Purvin & Gertz, page 24. Explanation: Answer c is correct. Paper barrels are crude oil futures contracts purchased for hedging or speculative purposes; the buyer does not have intention on taking delivery and will eventually cancel out the contract with an opposite transaction.

43.

Rank the following countries in order of highest to lowest percentage of electricity produced from nuclear power (beginning with the highest percentage): a. b. c. d.

France, Japan, USA, Russia, Japan, USA, France, Russia USA, Japan, Russia, France USA, Russia, France, Japan

Correct Answer: a

42



Reading Reference: Energy for the 21st Century , Nersesian; Chapter 8, p. 284-285 Explanation: Answer a is correct. Europe has the highest percentage of electricity produced by nuclear power, followed by North America, FSU (Russia and Ukraine), and Asia. Countries with the highest percentage of electricity generated by nuclear power are France (78 percent), Japan (26 percent), and the United States (20 percent). Russia’s nuclear generation amounts to about 17% of its electricity needs.

44.

Which of the following statements regarding Value-at-Risk (VaR) is false? a. b. c. d.

VaR models assume portfolios do not change over time. VaR models provide a single measure of risk. VaR models estimate the absolute worst-case scenario. VaR models should not be used to predict future market behavior.

Correct Answer: c Reading Reference: Energy Risk Management: A Non-technical Introduction to Energy Derivatives , Leppard: Chapter 8, p. 195 Explanation: c is correct; as per definition.

45.

Alessandro Montano, ERP, is analyzing the recent sale of a pipeline owned by his company. Which of the following valuation methods should Alessandro use to record a financial gain or loss for the sale? a.

Economic value

b. c.

Comparable sales Replacement cost

d.

Book value

Correct Answer: d Reading Reference: Oil and Gas Pipelines: In Nontechnical Language, Miesner and Leffler: Chapter 10, p. 228 Explanation: Answer d is correct. Book value is used by sellers to allow them to understand if they need to record a financial gain or loss for the sale. It is not particularly useful for purchasers, since book value has little relevance to what the asset is currently worth. Sometimes it is used to reallocate ownership between joint venture partners if the venture was set to provide for this approach.


43


46.

Which of the following factors has the greatest influence on day-to-day variations in demand for electricity in a given location? a.

Economic factors

b. c.

Fuel costs Generation constraints

d.

Weather

Correct Answer: d Reading Reference: Energy Trading and Investing, Edwards; Chapter 4.1, page 250 Explanation: Weather is considered the single largest factor in affecting day-to-day variations in demand for electricity—for example, people using more air conditioners on an unexpectedly hot day, making d the correct answer. Note that answers b and c would be factors affecting supply, not demand.

47.

We assume that the heat rate of a natural gas peaking unit is 10,000 Btu/kWh. The price of electricity is USD 25.00 per MWh, and the price of natural gas is USD 2.00. What is the “spark spread” for this plant in USD per kWh? a. b. c. d.

USD USD USD USD

0.005 0.02 0.03 0.4

Correct Answer: a Reading Reference: Managing Energy Price Risk , Kaminski (Kaminski, et al): Chapter 3, p. 120 Explanation: Answer a is correct: Output price – USD 25/MWh = USD 25/1,000 kWh = USD 0.025/kWh. Input price – 10,000 Btu/kWh x USD 2.00/MMBtu = 10,000 Btu/kWh x USD 2.00/1,000,000 Btu = USD 2.00/100kWh = USD 0.02/kWh. The spark spread is therefore USD 0.005/kWh.

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48.

The principle of parallelism implies what type of relationship between spot and future prices? a. b. c. d.

A low level of correlation between spot and futures prices A high level of correlation between spot and futures prices A volatile correlation between spot and futures prices No correlation between spot and futures prices

Correct Answer: b Reading Reference: Fundamentals of Trading Energy Futures & Options, Errera: Chapter 3 p. 32 Explanation: Answer b is correct. Parallelism occurs because the same factors that impact cash prices tend also to impact the price of the commodity for future delivery.

49.

The cost of crude oil typically accounts for 70-80% of the total operating expenses associated with refined products. As a result procurement managers seek to purchase types or blends of crude oil that will offer the highest profit margin when used to create refined petroleum products. Which of the following is a method commonly used by refineries to evaluate crude oil? a. b. c. d.

Break-even analysis Proximate analysis Ultimate analysis Fischer-Tropsch analysis

Correct Answer: a Reading Reference: Petroleum Refining: Technology and Economics , Gary, et al: Chapter 14, p. 302-03 Explanation: Answer a is correct. Break-even analysis involves determining the difference in value of increments of crude oils when compared to a reference crude oil—a type or blend previously processed by the refinery whose characteristics and costs are known.


45


50.

Given a flat volatility term structure for the entire WTI forward price curve at 35%, the Black-equivalent volatility of a look-back cash-settled average price option with a 3-month averaging period would 1 over the last three months of the option’s life because 2 .

a.

1 Increase

2 volatility of the underlying forward price tends to grow as option expiration time decreases

b.

Decrease

c.

Increase

volatility of the underlying forward price tends to drop as option expiration time decreases as we begin collecting the daily forward price settlements to ultimately determine the average price at option settlement, the uncertainty around the value of the average price settlement value drops

d.

Decrease

as we begin collecting the daily forward price settlements to ultimately determine the average price at option settlement, the uncertainty around the value of the average price settlement value drops

Correct Answer: d Reading Reference: Energy Risk , Pilipovic: Chapter 11, p. 314-317 Explanation: d is correct. In case of an Asian option, once we begin taking in the forward price settles that ultimately will define the final average price for option settle, the volatility of that average price starts dropping significantly. Hence, the correct answer is answer d.

51.

Your company is calculating Value-at-Risk (VaR) using an historical simulation method, with a 97.5% confidence level and two day holding period. In order to assess the validity of the method used to measure price risk, back-testing is also put in place. Assuming there are 260 business days in a year, which of the following loss scenarios (e.g. number of times portfolio losses exceed VaR) would you consider an acceptable threshold?

c.

Once every two months 2.5 times each month 2 times each month

d.

130 times in six months

a. b

Correct Answer: a Reading Reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Burger: Chapter 6.2, p. 253, 264 Explanation: a is the correct answer. In 2.5 % of the cases the real losses have to exceed the VaR, as it is calculated with 97.5% confidence level. This corresponds to 6.5 days in a year, hence about once every two months. Answer a is correct and all the others are wrong.

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52.

Blockhead Cement Company has historically consumed an average of 30MWh of electric power per day and typically purchases power at prevailing spot market prices. In an effort to hedge price exposure the company’s risk management team has decided to use electricity swaps. They are planning to test the strategy in the month of August by engaging in a fixed-for-floating electricity swap with a local power provider for 30MWh of power at USD 120/MWh. What will Blockhead’s net cash flow be if the cost of power for August is USD 105,681 and the floating leg of the swap is set at USD 108,240?

c.

Pay USD 102,321 Receive USD 102,321 Pay USD 109,041

d.

Receive USD 109,041

a. b.

Correct Answer: c Reading Reference: Steve Leppard. Energy Risk Management: A Non-technical Introduction to Energy Derivatives (London: Risk Books, 2005). Chapter 4, p. 50 Explanation: Answer c is correct. An electricity swap is an example of a commodity swap where the hedger/buyer makes fixed payments in exchange for floating income based on the spot prices. To compute the cash flow of the cement factory, we name the following variables: Actual Cost of Power = USD 105,681 Floating leg payment = USD 108,240 Fixed payment = 31 days x 30MWh/day x USD 120/MWh = USD 111,600 Being an electricity consumer, the factory pays the spot market the actual cost of power and the swap provider separately. It also earns the floating leg payment of the swap. The formula therefore is: Cash Flow = Floating leg payment – Fixed Payment – Actual Cost of power = USD 108,240 – USD 111,600 – USD 105,681 = - USD 109,041

53.

A generating plant has a nameplate rating of 650 megawatts and is expected to be offline for 720 hours for a scheduled outage during the year. A typical year is comprised of 8,760 hours. Actual generation during the year was 4,270,500 megawatt hours. What is the plant’s load factor?

b.

81.7% 75.0%

c.

72.76%

d.

76.0%

a.

Correct Answer: a Reading Reference: Electricity Markets: Pricing, Structures and Economics , Harris: Chapter 2, p. 28 Explanation: Answer b is correct per the formula below. 4,270,500MWh = 81.7% 650MWh x (8,760hr – 720hr)


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54.

The risk manager of a power generation company is reviewing the parameters under which analytical VaR is calculated and the nature of the company’s price exposures. She believes that the hypothesis of one day holding period is not realistic, and is willing to instead require a 5-day holding period. Traders complain that in this case the calculated VaR will be much higher and they will not be able to respect the company VaR limit of ten million. She proposes to review the VaR limit in a manner consistent with the new holding period; consequently, the new VaR limit will be approximately:

c.

50 Million 22 Million 12 Million

d.

10 Million

a. b.

Correct Answer: b Reading Reference: Managing Energy Risk: An Integrated View on Power and Other Energy Markets, Burger: Chapter 6.2, p. 257 Explanation: b is the correct answer. A Value-at-Risk calculated with the analytical model can be easily recalculated under any holding period by using the square root rule, i.e. by multiplying the one day VaR by the square root of the new holding period. As in the question it is assumed that the new holding period is 5 days, the new VaR will be approximately 2.2 times the one day VaR, i.e. about 22 Million. Consequently answer b is the correct one.

55

Prior to drilling a well, an assessment is made as to the reserves a reservoir may contain based on data derived from a current or prior well production or geophysical data. Which of the following makes the technical process for estimating reserves complex? a. b. c. d.

The subjective nature of the process. The quantitative methodologies used. The publication of reserve estimates is often biased. The reserves are not considered assets.

Correct Answer: a Reading Reference: Oil, Gas Exploration, and Production , Institut Francais: Chapter 3, p. 100 Explanation: a is correct. Many uncertainties occur in the various stages of exploring and appraising an oil or gas field. The approaches produce a probability that a particular prospect does indeed contain hydrocarbons. This is a probability because the estimates of the uncertainties involved are themselves formulated by experts in the light of their own experience, based on their own hypotheses. The probability estimates are therefore described as subjective, or as a priori probabilities.

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56.

Consider the statements below regarding delivery costs as a percentage of the cost of electricity charged to the end-use customer. Which of the following statements is false? a.

Distribution accounts for about 30 to 50 percent of the total delivery cost.

b. c.

Generation accounts for about 35 to 50 percent of the total delivery cost. Transmission accounts for about 5 to 15 percent of the total delivery cost.

d.

Delivery operations vary wildly from plant-to-plant, thus no generalizations about the percentage of costs can be made.

Correct Answer: d Reading Reference: Making Competition Work in Electricity , Hunt: Chapter 2, p. 17, 20-1 Explanation: d is false, thus correct. Generally speaking, since electricity (the end product) is standardized, generalizations of cost breakdowns, like the ones listed above, can be made.

57.

A landman is used to determine the legal rights of a company to drill for petroleum and natural gas, and to facilitate mandatory legal requirements. Of the landman's responsibilities, which of the following is NOT one of his/her roles? a. b. c. d.

Conduct seismological tests to locate minerals. Locate mineral owners. Verify mineral ownership via title searches. Negotiate leasing terms necessary for drilling.

Correct Answer: a Reading Reference: Fundamentals of Oil & Gas Accounting , Wright & Gallun; Chapter 1 Explanation: It is the job of a landman to identify and locate mineral rights owner of fee land. This is done by searching through the county or parish courthouse records. Commercial land ownership maps that are frequently updated are used to determine the status of a leases, the names of lessees and the identity of surface right and mineral rights owners. A title opinion can be obtained from an attorney who determines the mineral rights owner and attempts to persuade the owner to sign a lease. It is the company's responsibility to partake in exploration geophysics. The landman's responsibilities are strictly legal.


49


58.

A refiner is negotiating the sale of 10,000 tons of jet fuel to an airline. By giving a discount on the current market price, the refiner has secured the possibility to sell and deliver, if the refiner wants, an additional volume of 10% at the same agreed price. Such price is finally set at USD 450/ton. At the time of delivery, the prevailing market price is USD 400/ton, and the refiner decides to deliver also the additional 10% volume. The refiner’s position can be described as: a.

Purchase of a call option for free, and exercise (strike) price at USD 400/ton.

b.

Purchase of a put option for free, and exercise (strike) price at USD 450/ton. Purchase of a put option with premium equal to the discount, and exercise (strike) price at USD 450/ton. Purchase of a call option with premium equal to the discount, and exercise (strike) price at USD 450/ton.

c. d.

Correct Answer: c Reading Reference: Managing Energy Price Risk , Kaminski, Chapter 2 Explanation:Answer c is correct. The refiner will exercise this option when market prices are lower than USD 450/ton, because it will sell to the airline at USD 450/ton a good which has lower value in the market, consequently its position similar to the purchase of a put.

59.

The round-the-clock forward contract for single day delivery on February 10 and February 11 currently trades at USD 60 and USD 50, respectively. The three-day forward contract for round-the-clock delivery for the period starting February 10 and ending February 12 also trades at USD 50. Assuming a zero-percent discount rate, what is the round-the-clock forward price for a single day of delivery occurring on February 12? a. b. c. d.

USD 40 USD 45 USD 50 USD 55

Correct Answer: a Reading Reference: Energy Risk , Pilipovic: Chapter 7, p. 179-182 Explanation: The relationship between the three-day forward price contract for 7 x 24 delivery and the daily forward price contracts, assuming a zero-percent discount curve is given by: 3 • 24 • F Feb10-Feb12 = 24 • FFeb10 + 24 • FFeb11 + 24 • FFeb12 Plugging in the values provided by the problem statement and simplifying the above equation, we have: 3 • USD 50 = USD 60 + USD 50 + F Feb10 The price for the third day of the delivery then must be USD 40.00, answer a.

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60

You run a lucrative kerosene business and wish to hedge your exposure to kerosene price changes on a contract that is close to delivery. By implementing this hedge using heating oil derivatives you are exposed to changes in _______ basis.

b.

Location Storage

c.

Product

d.

Intermarket

a.

Correct Answer: c Reading Reference: Fundamentals of Trading Energy Futures & Options, 2nd Edition , Errera: Chapter 3 p. 49 Explanation: Answer c is correct. The difference between the futures price and the price of a similar cash commodity is called product basis.


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Erp Practice Exam 2

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