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This is a short summary of existing ERP practice questions (from the GARP ERP practice exam)
that I found the most difficult and some of my own notes that I used to study for the ERP exam
in 2010. In total, they are 78 questions. As in the Concept Checkers for the ERP exam, the
format is question-answer to help you find the answer faster if you are pressed for time.
I may offer a realistic practice exam and/or a practice webinar sometime soon in the future
before the next ERP exam. If you are interested, please let me know via email.
All the best for your ERP exam preparation!
Alex Janis
www.energyriskprofessional.com
alex.janis@energyriskprofessional.com
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Correct answer:
d.
Reason: The capital cost of developing an oil or gasfield may amount to several billion dollars. It
is crucial that the key parameters are identified and evaluated so that the project can be
properly defined and its viability assessed, because some of these parameters strongly
influence the costs. Onshore, the nature of the terrain is the main determinant of costs.
Offshore it is the water depth, which may be conventional (to 300 m), deep (to 1500 m) or
ultra-deep (over 1500 m). A basic engineering survey represents about 2% of the technical
costs of an off-shore drilling project, while transporting equipment and bulk material
represents about 7.5% of the total cost. Reservoir parameters determine the number of wells
required, and whether water or gas injection will be needed during the lifetime of the field.
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$60.00
$60.90
$62.10
$62.90
Correct answer:
b.
Reason: The effective price paid (in dollars per barrel) is the final spot price less the gain on the
futures, or 62.00 1.10 = 60.90.
This can also be calculated as the initial futures price plus the final basis, 60.00 + 0.90 = 60.90.
If Merg waited until expiration of the futures contract and took delivery, then the price paid
would be $60.00, as gains on the futures perfectly offset the change in the spot.
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Price hedging.
______
[] risk in the natural gas market can be hedged with a [].
a.
b.
c.
d.
Correct answer:
d.
Reason: If a forward contract is used to make or take delivery of the underlying commodity,
then it has eliminated market risk by locking in the price of the physical commodity. A long
forward contract can effectively be closed out by selling a contract for the same physical
specification, location, volume and month before physical delivery commences; the mark-tomarket value of a forward contract tells us the value of doing so at the current market level.
Crude prices.
______
Given the following, simplified table of U.S. Gulf Coast refining margins at a given time, which is
NOT true:
Light Crude
Medium Crude
Heavy Crude
Simple
0.10
(0.35)
(3.16)
Refining Margins$/bbl
Complex
Very Complex
0.30
0.35
0.65
1.52
3.60
4.60
a. Simple refineries break even more or less on light crude, but lose money handling heavier
crudes.
b. Medium crudes are profitable in complex refineries but not in simple ones.
c. Complex refineries are highly profitable running heavy crude, but they may have difficulty
competing for space against very complex refineries running the same crude.
d. Heavy crude is too expensive and may have to come down in price to compete with medium
and light crudes.
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Correct answer:
d.
Reason: All of the above are true except for number four. In fact, the light crude may be too
expensive and may have to come down in price in order to compete with heavy crude.
Hedge effectiveness.
______
What measure of hedge effectiveness did FASB 133 recommend?
a.
b.
c.
d.
Correct answer:
c.
Reason: FASB has chosen to use a highly effective offset ratio as a measure of hedge
effectiveness, rather than specifying a numeric ratio.
If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for
the component, if any, of that gain or loss that is excluded from the assessment of effectiveness
under the entitys defined risk management strategy for that particular hedging relationship (as
discussed in paragraph 63 in Section 2 of Appendix A), would exactly offset the loss or gain on
the hedged item attributable to the hedged risk. Any difference that does arise would be the
effect of hedge ineffectiveness, which consequently is recognized currently in earnings. The
measurement of hedge ineffectiveness for a particular hedging relationship shall be consistent
with the entitys risk management strategy and the method of assessing hedge effectiveness
that was documented at the inception of the hedging relationship, as discussed in paragraph
20(a).
Nevertheless, the amount of hedge ineffectiveness recognized in earnings is based on the
extent to which exact offset is not achieved. Although a hedging relationship must comply with
an entitys established policy range of what is considered highly effective pursuant to
paragraph 20(b) in order for that relationship to qualify for hedge accounting, that compliance
does not assure zero ineffectiveness. Section 2 of Appendix A illustrates assessing hedge
effectiveness and measuring hedge ineffectiveness. Any hedge ineffectiveness directly affects
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earnings because there will be no offsetting adjustment of a hedged items carrying amount for
the ineffective aspect of the gain or loss on the related hedging instrument.
a.
b.
c.
d.
2.58%; 84.45%
4.28%; 78.97%
5.91%; 71.36%
7.54%; 65.30%
Correct answer:
a.
Reason: The unconditional default probability of a B2 rated bond in year four is calculated as
18.13 15.55 = 2.58%. The probability the bond will survive to end of year three is calculated as
100 15.55 = 84.45%. Each probability represents a cumulative default probability or the
probability of default by that year.
Pipeline rates.
______
If the cost of shipping 1,000 bbl of crude from Tuscon, AZ to St. Louis, MO via truck is $25/bbl,
and by rail is $21/bbl, all things being equal, an ideal charge on a pipeline with existing capacity
to transport 1,000 bbl should be:
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a.
b.
c.
d.
$21.00 - $25.00/bbl
$19.50 - $21.00/bbl
$24.50 - $25.00/bbl
$20.00 - $21.50/bbl
Correct answer:
b.
Reason: The cost of alternative transportation method involves understanding the rates
charged by the competing forms of transportationship, barge, rail, truck. The pipeline charge
will be set equal to or slightly below those rates. Calculating rates using this method can be
very favorable for the pipeline owner, especially for long-distance transportation.
EOG Resources has paid as much as $25/bbl to ship crude by truck, but have switched to rail
because this cost is just uneconomical (Reuters: March 12, 2009).
Correct answer:
a.
Reason: The heart of an LNG project and the largest single investment in the chain is the
liquefaction plant.
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$5.50
$6.50
$7.50
$8.50
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Correct answer:
d.
Reason: This question relates two conceptsthe put call parity and the relationship between
the price of the physical commodity and its representation as a commodity futures contract.
The spot price of a commodity, S(t), is widely considered as the most important indicator of
future spot prices and such acts as the chief factor determining the shape of the futures price
curve. At maturity, the price of the physical, underlying, commodity and the financial
commodity future, F(t,T) should be equal to preclude arbitrage. Because of the equilibrium
assumption, the convergence of physical and financial prices holds true, which at expiration at
time (T) can be expressed as
F(T, T) = S(T).
Up to expiration, i.e., where t<T, the equilibrium relationship between the spot price and the
price of the futures contract can be expressed by the well-known cost-of-carry relationship: F(t,
T) = S(t)e[ r ( t ) + c ( t ) - y ( t ) ] ( T- t ) , where, r(t) is the risk-free rate at t, c(t) are the general storage,
warehousing and other, similar, costs associated with holding the physical commodity in
storage, and y(t) is the convenience yield earned from having the physical commodity in
possession. The above relationship implies that the current price of the commodity is $52.84,
55 * exp(-0.04) = $52.84, assuming that storage costs are zero and there is no convenience
yield.
The traditional put-call parity can be expanded to include the futures contract as the
underlying, and reads: C(t,T) P(t,T) = [S(t) K(T)] e-r (t)(T- t)
K(T) the strike price, S(t) the current price of the underlying, and C(t,T) and P(t,T) the prices of
call and put option respectively, at t with a strike price of K(T). The current price of the
underlying, S(t), WTI, is not given. Substituting in the put-call parity relation yields: 3.90 P(t,T)
= 55 e(-0.08 x 0.5) 60 e(-0.08 x 0.5) = (55 - 60) e(-0.08 x 0.5)
Which when solved for P gives $8.71125.
Volatility.
______
You are trading in an electricity market, where the volatility of electricity generated by peakperiod, gas fired plants is 28% and increasing. What volatility would you then expect from
electricity generated from baseload coal?
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a.
b.
c.
d.
Correct answer:
b.
In all likelihood the baseload material used for electricity generation is coal (see below), and
natural gas trades higher than coal. In this case, baseload coal is being used to provide a
constant energy and natural gas is being used to supplement peak load energy demands.
Of all the fossil fuels, coal is the most widely used. According to the EIA, during 2004, 50% of
the nations electric power was generated at coal-fired plants. Based upon 2004 net generation
shares by energy source, nuclear and natural gas are next in popularity after coal.
While base load is constant and fairly predictable, electric utilities must be prepared at all times
for the sometimes unpredictable demand seasonal weather changes cause. An increase in
demand is referred to as peak load and intermediate load.
Correct answer:
c.
Reason: Methods for managing credit-risk exposure include:
1. master netting
2. collateralization
3. financial guarantees
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4.
5.
6.
7.
credit insurance
credit derivatives
assignment
clearing OTC energy derivatives.
Credit-risk hedging.
______
Emily Smith, ERP, manages the cost of jet fuel for a small charter airline company in the
Northeastern United States. The company is struggling, and a significant consideration for the
company is to hedge against anticipated increases in fuel costs in the coming six months. Due
to the companys poor financial standingit has limited ability to raise cash and its credit lines
are very close to being completely drawn down; Emilys ability to reduce the impact of adverse
price movements is largely limited. Given these constraints, which of the following alternatives
could best mitigate the adverse effect of a significant increase in jet fuel prices?
a.
b.
c.
d.
Correct answer:
a.
Reason: There are some companies whose credit risk is such that it is much easier for them to
buy options rather than sell options. This is because the option buyer normally pays the
upfront premium one or two business days after transacting, and thus poses a far lower credit
risk than an option seller, who does not settle his obligations until maturity (or upon early
exercise). Given smaller credit exposure, companies of lesser credit-standing can normally
transact on equal terms with top credits when they are pure options buyers. With limited credit
lines, futures and forwards (assuming they are margined) pose a potential collateral
requirement in the future which would be a problem for the company in the example.
Typical examples of companies using this kind of option strategy might be a privately owned
shipping company which buys an OTC fuel oil cap as a hedge against an increase in bunker fuel
prices, or a small charter airline that buys a jet fuel cap. Typically, these would settle in cash
against the monthly average price of an appropriate index.
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In this scenario, an out-of-the-money call should be cheaper than an at-the-money call. On the
other hand, it only protects against significant price movements, and even then only a small
portion of the adverse movements negative effects will be offset.
For a futures position, the cash outlay would be smaller for the option than the futures margin
position, where collateral is required.
To trade forward, you should need to post collateral or reduce counterparty credit risk for the
other party.
Labor disputes
Oil and natural gas prices
Tax incentives
Public sentiment
Correct answer:
a. Reason: The following items, while not comprehensive, serve as a good starting point for
understanding alternative energy drivers: oil and natural gas prices; taxes, politics, and
regulations; geopolitical environment; technological advancements; supply chain costs; and
sentiment.
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$45.57 - $96.85
$49.85 - $94.18
$49.85 - $92.57
$45.57 - $94.96
Correct answer:
c.
Reason: Volatility roughly represents the percentage of the price range within which we can
expect to see the prices 66% of the time. For example, if the spot price volatility is 0.1, or 10%,
and if the spot price is currently $20, then over the next year we can-very roughly-expect the
price to be within the $18 to $22 range 66% of the time.
For this problem, $49.85 and $92.57 represent the plus/minus 30% volatility range off of
$71.21.
Correct answer:
a.
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Reason: Supervising financial practices and corporate governance are powers granted under
the Sarbanes-Oxley Act of 2002 and applies to all corporations and industries, not just those in
energy markets.
Which are the five events and disputes that come up with a
physical contract?
______
Events and disputes that may come up with a physical contract include:
1.
2.
3.
4.
5.
Force majeure
Quality of the commodity being delivered
Default on a debt
Missed payments
Missed deliveries
Credit ratings are not created in a contract but rather via third parties.
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Hence, the method can be used for estimating VaR in nonlinear portfolios, which is a valuable
characteristic for energy portfolios with assets.
However, Monte Carlo simulation can be very expensive if many risk factors are being
considered.
Futures can be used only to reduce the impact of ..., and they
do not have any impact on ... .
Futures can be used only to reduce the impact of ..., and they do not have any impact on ...
.______
Futures can be used only to reduce the impact of price volatility, and they do not have any
impact on the availability of a good. The producer is exposed to directional risk, i.e. the price of
Brent crude, and basis risk, i.e. the premiums and discounts in the price formula. Consequently,
by transacting futures he can only reduce the market risk, not the basis risk.
Example:
It is quite usual that crude oils extracted in West Africa are sold based on a formula indexed to
Brent crude plus premiums and discounts, decided case by case on each cargo. If a West African
producer is also executing futures on Brent, which type of risk is likely reduced?
a. Basis risk and supply risk
b. Basis risk and directional risk
c. Supply risk
d. Market risk
Correct answer:
d
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Example:
The largest risk faced by geothermal power is:
a. Loss of reservoir water causing steam generation to diminish.
b. Inducing earthquakes.
c. Underground energy sources expropriated by a government.
d. Starting a volcanic eruption through the geothermal drill hole.
Correct answer:
b.
Explain a countertrade.
______
Countertrade means exchanging goods or services which are paid for, in whole or part, with
other goods or services, rather than with money. A monetary valuation can however be used in
counter trade for accounting purposes.
If there is a netting agreement, a countertrade reduces settlement risk of sold forward
contracts and locks actual replacement risk. Since the countertrade is concluded at the actual
market price and the replacement risk cannot be reduced.
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What were the goals (3) of the FERC Standards of Conduct for
Transmission Providers?
______
The vast majority agreed with the Commissions goals of simplifying the Standards in order to
achieve:
1. Greater clarity
2. Greater efficiencies of operation
3. Greater ease of compliance
The Commission therefore adopts the employee functional approach, as set forth in the
regulatory text, and eliminates the concept of energy affiliates.
FASB Statement No. 161, not Sarbanes-Oxley, requires disclosure of the fair values of
derivative instruments and their gains and losses in a tabular format.
barrels at a price of USD 53/bbl. Put in order the following four different options, from the least
to the riskiest:
I. Doing nothing.
II. Accept the offer from bank A.
III. Accept the offer from bank B.
IV. Unwind everything.
a. II, III, IV, I
b. II, I, III, IV
c. III, IV, II, I
d. I, III, II, IV
Solution:
B.
The net resulting exposure of the four options are: I (-200,000 bbls), II (0 bbls), III (+300,000
bbls), IV (800,000 bbls).
Bcf and a trillion cubic feet is Tcf. Condensate content is measured in barrels per million cubic
feet of gas.
60F (15C)
14.65 psi (101.325 kPa)
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PUC, example.
______
Which of the following statements regarding public utility commissions (PUCs) is NOT true?
a. All states have PUCs to govern actions of state regulated utilities.
b. PUCs are considered quasi-judicial and quasi-legislative entities.
c. PUCs hold hearings to fix rates that may be charged by utilities, but may not investigate
service related issues.
d. PUCs hold hearings to fix rates that may be charged by utilities.
Correct answer:
C.
PUCs are considered to be quasi-judicial and quasi-legislative entities. There is no real
separation of power, since they act as administrator, judge, and legislator . Commissions act as
administrator when, for instance, they investigate rates or service. In a judicial capacity, PUCs
exercise this power when they hold hearings, examine evidence, and make final determinations
of a particular utilitys conduct.
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However attempts have been made to explain or justify the Hubbert phenomenon
mathematically. One such attempt appeals to one of the most celebrated theorems of
probability theory: the central limit theorem. This states that under certain regularity
hypotheses the sum of a large number of independent random phenomena (even if highly
asymmetric or multimodal) tends to produce a random variable with a normal distribution, that
is, symmetrical with a bell-shaped distribution, like that used in the Hubbert approach. But the
probability density of the sum is not equal to the sum of the probability density (in this case the
production profiles of the fields). Furthermore the Hubbert phenomenon does not fall within
the scope of this theorem. In the first place the production profiles summed are obviously not
independent of one another, particularly when they relate to the same geographical zone, and
secondly the theorem relates to numerical distributions rather than temporal distributions, as
in Hubberts model. Temporal distributions are subject to a completely different tool of
probability theory, namely time series analysis. Great care must therefore be taken not to
misuse this method which, however appealing it may seem on the basis of a few examples, has
no scientific basis. If certain aggregated profiles exhibit the characteristics of the normal
distribution, these are curiosities, the real reason for which it would be very interesting to
explore, rather than a phenomenon of general applicability as claimed by Hubbert and his
numerous followers. Hubbert himself ended up by repudiating the normal curve in favor of the
logistic curve which unfortunately is no more justified than the normal curve.
Correct answer:
The payoff from the short put is -max[K-S,0] = -max[40-50,0] = 0.
The payoff for the long call is max[S-K,0] = max[50-40,0] = EUR 10.
The sum is EUR 10.
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Electricity
Natural gas
Oil
Licensing and inspecting LNG projects
The Federal Energy Regulatory Commission, or FERC, is an independent agency in the United
States that regulates the interstate transmission of natural gas, oil, and electricity. FERC also
regulates natural gas and hydropower projects.
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Correct answer:
b.
Capacity requirement = peak load time x (1+ reserve margin %).
For example, receiving facilities located close to producing regions may be permitted to accept
LNG with wide-ranging and fairly high calorific values. The Lake Charles, LN, receiving terminal
can import lean LNG from places such as Trinidad, as well as rich LNG from Australia and Qatar.
This is because the regasified LNG immediately mingles downstream from the terminal with gas
production from the Gulf of Mexico and is often treated in NGL-processing plants before being
sent on to market. But LNG import terminals that are located in market areas or that serve
buyers with specific gas quality restrictions must closely monitor and, where necessary, adjust
the quality of the regasified LNG that is delivered into the local grid.
the residual fuel yield decreases (the residual fuel stream is being converted to
gasoline).
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Vega for puts and calls with the same strike are ... .
______
Vegas for puts and calls with the same strike are the same. This follows from the put call parity
relation, X + c = S + p.
On-peak options.
______
You are concerned with high electricity prices for the upcoming month. Monthly on-peak
options are available at USD 75 per megawatt for a 100 MW contract. If you purchase a
monthly on-peak power option contract, how many megawatt hours will you receive, assuming
there are 20 business days per month?
a. 32,000 mWh
b. 48,000 mWh
c. 16,000 mWh
d. 2,000 mWh
Correct answer:
A.
16 hours per day times 20 days, times 100 MWs = 32,000.
b is incorrect, since calculations assume 24 hours per day. c is incorrect, since calculation
assumes 8 on-peak hours per day. d is incorrect, since calculation
assumes zero hours during the day.
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