Options: Coal, nuclear spark German and French power volatility

Settlement prices on the German power options market have soared over the past month for the underlying front-year contract expiring at or in excess of €35.00/MWh – something that has not happened since the Calendar Year ’14 contract expired at €36.93/MWh.

Additionally, activity on the German power options market has picked up from sluggish levels over the summer in response to greater movement in the underlying product. Traders pointed out the market had previously been caught in a narrow range.

The call, or buy, settlement price for a Calendar Year ‘18 strike price of €35.00/MWh was €1.800/MWh on 8 September at the EEX exchange for the German product, as opposed to the joint German-Austrian options product. The contracts will expire on 14 December 2017.

The call settlement price rose at the same time as the underlying power contract reached a record high of €35.025/MWh at the brokered over-the-counter market on 8 September. The front year power contract has gained 8.8% since 11 August due to a highly bullish coal market and concerns over French nuclear supply.

By comparison the call price had been only €1.019/MWh on 1 September and €0.543/MWh on 11 August. Over the same period, open interest – the number of contracts outstanding on a future – for the Calendar ‘18 option has increased by 24% from 2,272 for 11 August to 2,823 for 8 September.

There remains potential for further volatility in the options market through unexpected coal prices movements, for example Rotterdam coal futures crashing back down through $80/tonne – as occurred on 7 September – according to one trader.

While strong increases in coal prices have driven up options settlement values, traders have identified cyclical price movements. “There has been a stable pattern in coal with prices hitting a new high and then dropping over the past six to nine weeks,” said one trader.

Volatility drives activity on the options market, which provides instruments for hedging the risk of unforeseeable price movements (see box-out).

For example, the French nuclear situation has been identified by one trader as a bigger driver of uncertainty in German power futures than the coal market.

French options

Supply concerns in France were fed by issues surrounding the country’s nuclear fleet. French nuclear regulator ASN has required utility EDF to audit nuclear components.

News that EDF found anomalies in paperwork sparked a series of calls for Calendar ’18 French options on 23 August as buyers sought to protect themselves from an upwards swing in the underlying power contract.

The settlement price for the French Calendar Year ’18 option with a strike price of €42.00/MWh soared to €1.448/MWh on 23 August from €0.997/MWh the previous day. Volumes of trade registered at that settlement price hit 219,000MWh; they had been zero on 22 August.

Since 23 August open interest on the French front year options product has increased by 10% to 250 while the settlement price hit €2.041/MWh on 8 September.

Options traders will look to announcements from EDF and ASN, as well as long-term weather forecasts to guide forthcoming hedges.

“A tight winter period has been identified with potential insufficient capacity,” said one market participant. jon.stibbs@icis.com

What are my options?

Options contracts allow energy market participants to hedge the risk of volatility on the underlying power market, insulating long or short positions from sharp price movements over a period of time. They can also be used as tools to speculate based on assumptions of those price movements.

The most common form in the European markets are known, appropriately, as European options. These contracts give the right but not the obligation to buy or sell a product at an agreed price at the set expiry date of the option.

Options generally expire before the underlying contract and, in terms of European power, options liquidity is focused on the most liquid markets such as Germany.

Participants tend to be utilities, banks, trading houses and hedge funds.

The buyer of the contract is known as the holder, while the seller is the writer.

There are two forms of options, which apply if a product is the particular side of a strike price at expiry:

• Call options: give the holder the right to buy which would require the writer to sell

• Put options: give the holder the right to sell, which would require the writer to buy

Decisions whether to enter into an option tend to be based on:

• The current price of the contract, which is called the underlying, in relation to the strike price

• The amount of time until expiry

• The implied volatility, which is a measure of volatility used in option pricing models, such as the Black-Scholes formula