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

1. INFLATION – UNCERTAINTY
Bjornar Eide
Strategic Risk Consulting (SRC)

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. 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. 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.  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. 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 ?”

8. 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?”

9. 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.”

10. 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”

11. 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”

12. Spread between TIPS and Inflation
Swaps
(Mark up)

15. 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”

16. 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

17. 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)”

18. 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

19. • 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

20. 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.