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Energy Risk Professional

(ERP) Examination
Practice Exam 1

Energy Risk Professional Examination (ERP) Practice Exam 1

TABLE OF CONTENTS

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

ERP Practice Exam 1 Candidate Answer Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3

ERP Practice Exam 1 Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

ERP Practice Exam 1 Answer Sheet/Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

ERP Practice Exam 1 Explanations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

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Energy Risk Professional Examination (ERP) Practice Exam 1

Introduction

1. Plan a date and time to take the practice exam.

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

Set dates appropriately to give sucient study/review

tions are derived from a combination of theory, as set forth

time for the practice exam prior to the actual exam.

in the core readings, and real-world work experience.


Candidates are expected to understand energy risk man-

2. Simulate the test environment as closely as possible.

agement concepts and approaches and how they would

apply to an energy risk managers day-to-day activities.

erasers) available.

tion, testing an energy risk professional on a number of risk

Minimize possible distractions from other people,


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


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

Have only the practice exam, candidate answer


sheet, calculator, and writing instruments (pencils,

The ERP Examination is also a comprehensive examinamanagement concepts and approaches. It is very rare that

Take the practice exam in a quiet place.

Allocate 2 minutes per question for the practice

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

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

eectively.

80 minutes have passed (or 2-40 minute sessions


with a break in between to simulate the actual exam

The ERP Practice Exam 1 has been developed to aid


candidates in their preparation for the ERP Examination.

conditions). Complete the entire exam but note the

This practice exam is based on a sample of actual questions

questions answered after the 80-minute mark.

from past ERP Examinations and is suggestive of the ques-

Follow the ERP calculator policy. Candidates are only


allowed to bring certain types of calculators into the

tions that will be in the 2012 ERP Examination.


The ERP Practice Exam 1 contains 40 multiple choice

exam room. The only calculators authorized for use

questions. Note that the 2012 ERP Examination will consist

on the ERP Exam in 2012 are listed below, there will

of a morning and afternoon session, each containing 80

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

multiple choice questions. The practice exam is designed to

into the exam room with a personal calculator other

be shorter to allow candidates to calibrate their prepared-

than the following: Texas Instruments BA II Plus

ness for the exam without being overwhelming.

(including the BA II Plus Professional), Hewlett Packard

The ERP Practice Exam 1 does not necessarily cover

12C (including the HP 12C Platinum and the Anniversary

all topics to be tested in the 2012 ERP Examination. For

Edition), Hewlett Packard 10B II, Hewlett Packard 10B II+

a complete list of topics and core readings, candidates

and Hewlett Packard 20B.

should refer to the 2012 ERP Examination Study Guide.


Core readings were selected in consultation with the Energy
Oversight Committee (EOC) to assist candidates in their

3. After completing the ERP Practice Exam 1

Calculate your score by comparing your answer

review of the subjects covered by the exam. Questions for

sheet with the practice exam answer key. Only

the ERP Examination are derived from these core readings

include questions completed within the rst 80

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

minutes in your score.

dates review all core readings listed in the 2012 ERP Study

Guide in-depth prior to sitting for the exam.

Use the practice exam Answers and Explanations to


better understand the correct and incorrect answers
and to identify topics that require additional review.

Suggested Use of Practice Exams

Consult referenced core readings to prepare for

To maximize the eectiveness of the practice exams, candi-

the exam.

dates are encouraged to follow these recommendations:

Remember: pass/fail status for the actual exam is


based on the distribution of scores from all candidates, so use your scores only to gauge your own
progress and level of preparedness.

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Energy Risk

Professional(ERP )
Examination
Practice Exam 1
Answer Sheet

Energy Risk Professional Examination (ERP) Practice Exam 1

a.

b.

c.

d.

a.

1.

24.

2.

25.

3.

26.

4.

27.

5.

28.

6.

29.

7.

30.

8.

31.

9.

32.

10.

33.

11.

34.

12.

35.

13.

36.

14.

37.

15.

38.

16.

39.

17.

40.

b.

c.

d.

18.
19.
20.

Correct way to complete

21.

1.

22.

Wrong way to complete

23.

1.

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Energy Risk

Professional(ERP )
Examination
Practice Exam 1
Questions

Energy Risk Professional Examination (ERP) Practice Exam 1

1.

Which of the statements best explains the shape of the Brent Crude Oil forward price curve illustrated below?

Brent Crude Oil Futures


(USD per Contract)

120.5
120
119.5
119
118.5
118
117.5
117
116.5
1

11

13

15

17

19

21

23

25

Months to Maturity

a.
b.
c.
d.

2.

Higher physical storage costs are causing crude oil futures to trade in contango.
Global economic growth is driving demand for crude oil higher causing the crude oil futures to trade
in contango.
Growing concern that global crude oil supplies are in permanent decline is causing crude oil futures to
trade in backwardation.
Uncertainty over short-term crude oil supplies has placed a premium on physical inventory causing crude
oil futures to trade in backwardation.

A colleague has informed you that a large coal-fired power plant in Pennsylvania will be shutting down for
unplanned maintenance in a few days. You decide the impact of this shut down could potentially be an
increase in demand for natural gas by local gas fired generators that are used to back-up coal fired plants.
What type of natural gas spread trade would you be executing if you purchased gas on the spot market,
stored it briefly and then sold it at a profit when expected demand for natural gas rises?
a.
b.
c.
d.

Location
Heat Rate
Time
Swing

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Energy Risk Professional Examination (ERP) Practice Exam 1

3.

Consider a power marketing firm with a high volume of daily trading activity in a variety of electricity contracts.
Over each of the past six months the firm has experienced losses created by the improper booking of trades
in their back-office system. A data management firm has offered to lease the firm an electronic booking system
for USD 1.2 million per month, claiming the system will eliminate operational risk. Should the firm invest in
this system?
a.
b.
c.
d.

4.

Assume you are modeling the volatility of WTI forward contract prices using a single-factor log-of-price mean
reverting model. What will the output from your model indicate about the correlation between spot and forward
price returns assuming the initial price level in the spot and forward market are equal?
a.
b.
c.
d.

5.

Correlation will remain perfect across all points between the front and back-end of the forward price curve.
Correlation will decrease between the front and back-end of the forward price curve.
Correlation will increase between the front and back-end of the forward price curve.
Correlation will fluctuate due to seasonality.

Karachaganak, Kazakhstan is one of the largest gas condensate fields in the world, with proven reserves
of 1.9 billion barrels of oil and 13 trillion cubic feet of gas. In 2004, the field produced about 220,000 barrels
of oil and 1.3 billion cubic feet of gas per day. What is the producing gas-oil ratio?
a.
b.
c.
d.

Yes, the elimination of operational risk should be the primary goal of any organization.
Yes, but only if the firm is losing more than USD 1.2 million per month due to booking errors.
No, the data management problem can be addressed by hiring more experienced personnel in the
back office.
No, the claim is false since risk can be mitigated, but never eliminated.

4,300
5,909
6,842
7,523

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Energy Risk Professional Examination (ERP) Practice Exam 1

Questions 6-7 use the information below:


Johan has just been named the Executive Director of NewGas Asia, a joint public/private partnership created
to develop a newly-discovered natural gas field in a politically-stable South Asian nation. The local government
has asked Johan to oversee the design and construction of a new LNG export terminal in a coastal city.
Estimates indicate that the reservoir has 40+ years of recoverable natural gas and that the gas is rich
(approximately 10%) in ethane and propane. In addition to constructing the export facility, Johan is tasked
with developing a plan to market the LNG.

6.

How will the properties of the natural gas affect NewGas Asias development of this field?
a.
b.
c.
d.

7.

Johan would like the flexibility to offer NewGas Asias LNG through a commodity exchange, but he is
concerned that the Asian LNG market lacks adequate liquidity to ensure proper price discovery. How can
Johan establish a fair price for NewGas Asias LNG?
a.
b.
c.
d.

8.

The ethane and propane will be removed during LNG liquefaction because they have a higher market
value than methane.
The LNG will sell at a premium because of its higher heating value.
The heavier ethane and propane will naturally remain behind in the reservoir as the lighter methane is
pumped out.
Since ethane and propane are components of natural gas, they will have no effect on the LNG.

Engage in a fixed-for-floating swap to allow for price adjustments later.


Index his LNG prices to a basket of Asian crude oils.
Study the pricing of long-term bilateral contracts in the Pacific basin.
Base his pricing off the daily quote for the NYMEX Henry Hub contract.

Which of the following statement(s) about barrier options is/are correct?


I.
II.

An up-and-out-floor is less expensive than a standard Asian option.


An up-and-out floor is canceled if the underlying market price is less than the barrier price.

a.
b.
c.
d.

Statement I only
Statement II only
Both statements
Neither statement

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Energy Risk Professional Examination (ERP) Practice Exam 1

9.

Although the industry has known about shale gas resources for decades, these resources have only recently
become the focus of serious commercial exploration and production activities. What characteristic of shale
gas has historically made exploration and production uneconomical?
a.
b.
c.
d.

10.

X
X
X
X

=
=
=
=

Refined Product

Refinery X

Refinery Y

Refinery Z

Gasoline

60

50

30

Jet Fuel

15

15

15

Distillate Fuel

25

25

20

Residual Fuel

30

Coke

Refinery Fuel

15

10

Gain

(20)

(5)

(3)

simple, Y = complex, Z = very complex


simple, Y = very complex, Z = complex
complex, Y = simple, Z = very complex
very complex, Y = complex, Z = simple

High operating costs and operational constraints make which of the following types of facility the least
desirable option for underground natural gas storage?
a.
b.
c.
d.

has low natural permeability.


is an extremely dense rock that is difficult to drill through.
gas is typically wet, requiring extensive processing.
reserves tend to be in remote, hard-to-access locations.

Based on the refined product yield from the three refineries summarized in the table below, identify the
complexity of Refinery X, Y and Z assuming they each operate using the same sour, heavy crude oil supply.

a.
b.
c.
d.

11.

Shale
Shale
Shale
Shale

Depleted oil and gas fields


Aquifers
Salt caverns
Storage tanks

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

Energy Risk Professional Examination (ERP) Practice Exam 1

12.

13.

Consider a power grid that relies on combined cycle natural gas turbine plants for electricity production.
What would the spark spread be for this particular power grid based on the following assumptions?

Average plant heat rate is 8,500 Btu/kWh


Current price of natural gas is USD 5.00/MMBtu
Current price of electricity is USD 30.00/MWh

a.
b.
c.
d.

USD
USD
USD
USD

High pressure in subsurface reservoirs can cause a significant volume of natural gas to be dissolved in
underground crude oil reserves. This build-up of gas is known as what?
a.
b.
c.
d.

14.

Non-associated gas
Crude gas
Associated gas
Working gas

Claudio has been put in charge of developing a site for a new nuclear power plant. Because of the disaster in
Fukushima, Japan, public sentiment has turned against nuclear power at this location. For this reason, Claudio
is recommending the construction of a pebble-bed modular reactor (PBMR). What is the main advantage of
the PBMR?
a.
b.
c.
d.

15.

0.0125/kWh
0.1250/kWh
-0.0125/kWh
-0.1250/kWh

The PBMR does not use uranium as fuel.


PBMRs are considered safe because they cannot melt down like other designs.
PBMRs produce more electricity than other similarly-sized reactor designs.
Unlike other reactor designs, PBMRs do not generate high levels of heat.

You have purchased a monthly 100 MW on-peak power call option for a month that has 20 business days.
The strike price is USD 75/MWh and the premium is USD 5/MWh. What would the gross settlement amount
be if you exercised the call option during a month when the average on-peak power price was USD 85/MWh?
a.
b.
c.
d.

USD
USD
USD
USD

160,000
240,000
320,000
480,000

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Energy Risk Professional Examination (ERP) Practice Exam 1

16.

Stebbins Heating Oil is a supplier to residential consumers in the northeastern United States. In July, Stebbins
estimated the average heating oil requirement for the season to be 1,200 gallons per customer based on normal
weather conditions and purchased a sufficient number of heating oil futures contracts with different delivery dates
throughout the winter to fulfill the estimated demand. In September, several long term meteorological forecasts
predict a 70% probability of a warmer than normal winter, with a 1% probability of a colder than normal winter.
Assuming Stebbins customers have contracted to purchase their required heating oil at a fixed price, and a
warmer than normal winter will reduce heating oil demand by 20%, what should Stebbins do to improve the
hedge of its supply obligation?
a.
b.
c.
d.

17.

On June 20, Caufield Refining estimates it will need to purchase 40,000 barrels of crude on October 12.
Caufield decides to hedge price risk using a November NYMEX futures contract. The November futures price
on June 20 is USD 77.00/bbl. On October 12, Caufield is ready to purchase its required crude oil and closes
out the futures contract on that day; at this time the spot price is USD 80.10/bbl and the futures price is
USD 78.50/bbl. What is the effective price paid per barrel?
a.
b.
c.
d.

18.

USD
USD
USD
USD

78.50
78.60
80.10
80.40

Steve Dolan is a power manager at Upstate Electric. He is negotiating a one-day contract to sell 100 MW of
electricity at USD 55/MWh for a 24-hour period and has been asked to calculate the Value-at-Risk (VaR) for
the contract. If the daily volatility of electricity prices is 2%, what is the daily VaR on the contract assuming a
95% confidence interval?
a.
b.
c.
d.

10

Buy put options covering 20% of its original supply obligation.


Buy call options covering 20% of its original supply obligation.
Sell 20% of its original futures position and buy additional supply on the spot market as needed.
Sell excess supply on the spot market as needed throughout the winter.

USD
USD
USD
USD

180
3,447
4,330
5,412

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Energy Risk Professional Examination (ERP) Practice Exam 1

19.

Consider the power grid shown below, which operates using a postage stamp pricing model with two
designated zones labeled Zone A and Zone B. The two zones are interconnected via a high-capacity transmission
line, allowing for electricity generated in one zone to be used in the other.
Zone A

Zone B

Main Transmission

When the transmission line experiences congestion, it is Zone B that sets the market clearing price for both
Zones A and B. Given this information, which of the following statements is correct?
a.
b.
c.
d.

20.

A is a net exporter of electricity to Zone B


B is a net exporter of electricity to Zone A
B has a higher electricity demand than Zone A
A has a higher electricity demand than Zone B

To protect against on-peak electricity price spikes in the PJM market during the month of July, Markus Frackus
has obtained a daily on-peak option quote for 100 MW, with a strike price of USD 100/MWh and a premium of
USD 10/MWh per day. There are 20 business days in the month and 16 on-peak hours per day. Markus forecasts
there will be two days when on-peak prices will spike to USD 500/MWh and USD 700/MWh respectively (the
prices for all other on-peak periods would be less than USD 100/MWh). What will be the profit on his option
strategy if his forecast is accurate?
a.
b.
c.
d.

21.

Zone
Zone
Zone
Zone

USD
USD
USD
USD

320,000
960,000
1,280,000
1,600,000

Which of the following statistical tests is used to demonstrate that model errors are normally distributed and
independent of any previous steps used within the modeling process?
a.
b.
c.
d.

Q-Q plot
Autocorrelation test
Mean-squared error
R-squared

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11

Energy Risk Professional Examination (ERP) Practice Exam 1

22.

Bordeaux Electrique is a utility company in southwest France that is required to meet local clean air emissions
standards. In the past, Bordeaux Electrique has purchased emissions credits through bilateral, over-the-counter
(OTC) trades. This year, Bordeaux Electrique has decided to buy credits through the European Climate
Exchange (ECX). What is the main advantage of buying emission credits through an allowance exchange
instead of through OTC deals?
a.
b.
c.
d.

23.

You are long 100 put options on the March Peak Forward contract. If the delta of the put options is -0.40,
what position in the March Peak Forward contract will you need to create for the combined portfolio to be
delta neutral?
a.
b.
c.
d.

24.

USD
USD
USD
USD

2,520 per contract


3,360 per contract
4,200 per contract
5,040 per contract

The operations manager at an RTO in a deregulated market needs to activate another generation plant to
meet peak demand in a major city. The next plant in bid order has dispatched power at USD 40/MWh, but
the RTO instead activates, out-of-merit order, a plant located twenty-five miles away from the city that has bid
USD 44/MWh. Why would the RTO make this decision?
a.
b.
c.
d.

12

Short 40 March Peak Forward contracts


Long 40 March Peak Forward contracts
Short 60 March Peak Forward contracts
Long 60 March Peak Forward contracts

Samantha is trading heating oil for a large financial institution. Long term forecasts call for unusually volatile
weather patterns for the upcoming months of January and February. Samantha decides to enter into a long
straddle trade. There is currently a 1-month NYMEX heating oil call option with a strike price of USD 3.20 per
gallon and premium of USD 0.15 per gallon and a 1-month NYMEX put option with a strike price of USD 3.20
per gallon and premium of USD 0.17 per gallon. What would be the net profit per contract for this trade if the
price of heating oil is USD 2.80 at the time of expiration?
a.
b.
c.
d.

25.

Exchanges avoid the heavy taxation levied against OTC profits.


There are more arbitrage opportunities available on allowance exchanges.
Allowance exchanges eliminate counterparty risk.
The European Union is mandating the shift from OTC to exchange-based systems for allowance trading.

Transmission constraints that prevent lower cost generators from supplying power to an area of high demand.
Emission quotas that prevent lower cost generators from supplying power to an area of high demand.
Transmission costs are higher for a more distant plant during periods of high demand.
Baseload plants receive preference over peaker plants during periods of high demand.

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Energy Risk Professional Examination (ERP) Practice Exam 1

26.

A 3-month natural gas option with a strike of USD 6.00 on an August contract is trading at a Black-implied
volatility of 45%. A call option with the same contract specifications, but a strike price of USD 6.50, is trading
at a Black-implied volatility of 50%, producing a volatility smile. What conclusion can be made given the
market information above?
a.
b.
c.
d.

Volatility will fall for calls and puts as they move further and further out-of-the-money.
The different volatilities for the call option positions indicate that the lognormal Black model cannot
capture the true underlying price behavior with a single volatility measure.
A third call option with the same contract specifications, but a strike price of USD 7.00 must therefore
be trading at a Black-implied volatility of 55%.
The two options should have exactly the same volatility, creating a market arbitrage opportunity: the
USD 6.00 option is under-priced relative to the USD 6.50 option.

Questions 27 - 28 use the information below:


Colin is the procurement manager for a regional heating oil distributor in Alberta, Canada. In September, Colin
notices the 3-month forward price for heating oil is trading at CAD 4.65/gal a price that appears too high
relative to current market economics. Currently the spot price of heating oil is CAD 4.00/gal, monthly storage
costs are CAD .05/gal and the annual risk-free interest rate is 4.25%.

27.

What would be the net realized profit/loss per gallon in three months if Colin executed a transaction to take
advantage of a perceived mispricing between the spot and forward markets?
a.
b.
c.
d.

28.

CAD
CAD
CAD
CAD

0.12/gal
0.46/gal
0.50/gal
0.61/gal

Assuming Colins market information is accurate, other market participants pursue the same arbitrage opportunity,
and no other market conditions change, what effects would you expect Colins trading strategy to have on
the heating oil market?
a.
b.
c.
d.

Speculative
Speculative
Speculative
Speculative

inventories
inventories
inventories
inventories

will
will
will
will

rise, driving the forward price down and the spot price up.
rise, driving the forward price up and the spot price down.
fall, driving the forward price down and the spot price up.
fall, driving the forward price up and the spot price down.

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Energy Risk Professional Examination (ERP) Practice Exam 1

29.

Roger has constructed a portfolio of crude oil option contracts that he has delta hedged. Over a one month
period, Roger observes that his portfolio is not performing as expected and he is concerned that the change
in portfolio delta, relative to the change in the underlying price of oil, is too high. Which of the following portfolio
risk characteristics should Roger neutralize so that his hedge strategy more effectively responds to changes
in the underlying price of oil?
a.
b.
c.
d.

30.

A power company that uses diesel-fueled generators to produce electricity has amassed a large amount of
debt. How would a fuel supplier best manage its exposure to this company, assuming it is concerned about
the companys ability to pay for physical fuel deliveries?
a.
b.
c.
d.

31.

Move the VaR confidence level down to 90%.


Move the VaR confidence level up to 99%.
Continue VaR testing at the 95% confidence level but adjust her risk limits.
Implement stress testing.

Akiko, an ERP, is pricing a daily transportation deal between Henry Hub and Houston Ship Channel using the
mean-reverting Ornstein-Uhlenbeck process to model gas prices. In order to calculate the at-the-money
(ATM) implied volatilities for Henry Hub and Houston Ship Channel Akiko will need to do which of the following?
a.
b.
c.
d.

14

Credit derivatives
Credit insurance
Financial guarantee
Netting agreement

Eloise, ERP, is the risk manager for a large natural gas company. Her company uses a VaR model with a 95%
confidence level to measure risk exposure and compliance with risk limits. If Eloise is concerned with the
impact of extreme events, she should:
a.
b.
c.
d.

32.

Beta
Gamma
Theta
Vega

Calculate the correct volatilities since the implied volatilities from a Black-Scholes calculation are not the
same volatilities used in the Ornstein-Uhlenbeck process.
365
Scale the implied volatilities by 250
since it is a daily deal.
Roughly estimate implied volatilities. Nothing else needs to be done.
250
Scale the implied volatilities by 365
since it is a daily deal.

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Energy Risk Professional Examination (ERP) Practice Exam 1

33.

Price formation and trading in the European carbon (emissions) market is driven primarily by which of the
following factors?
a.
b.
c.
d.

34.

How are Chinese emissions policies most likely to change during the next five years?
a.
b.
c.
d.

35.

China is in the process of adopting a market-based carbon-trading scheme.


China has mandated that hard emissions caps go into effect in 2015.
China is planning modest voluntary emissions reduction targets for industrial manufacturers.
China has no plans to place caps on greenhouse gas emissions on power generators or heavy industry
as these are considered critical economic drivers.

Which statement about extra heavy crude (oils that typically have an API below 15) is correct?
a.
b.
c.
d.

36.

Global carbon prices


Input fuel costs
Power demand from industrial customers
Weather

Extra-heavy oil is not considered genuine petroleum


Extra-heavy oils are not commercially viable
Though they require special refining equipment, extra heavy oils are naturally low in sulfur, which reduces
their refining cost.
The total global resources of extra-heavy oils may be four times as large as the worlds proven reserves of
conventional oils.

Advancements in turbine technology have helped make levelized electric power generation costs for wind
and coal relatively equal in many situations. Despite these changes price risk remains an issue for which technology
and why?
a.
b.
c.
d.

Coal, because of carbon mitigation costs


Coal, because global coal reserves are rapidly depleting
Wind, because of potential cuts to government subsidies
Wind, because of the intermittent nature of wind power generation

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15

Energy Risk Professional Examination (ERP) Practice Exam 1

37.

What is a weakness in applying single-factor mean-reverting models in option valuation?


a.
b.
c.
d.

38.

Black-equivalent
Black-equivalent
Black-equivalent
Black-equivalent

volatility
volatility
volatility
volatility

goes to zero with increasing time to expiration


increases with increasing time to expiration
decreases with increasing time to expiration
is proportional to spot price volatility

Taurus Trucking is a freight-hauling company that enters into a 1-year fixed-for-floating commodity swap on
NYMEX RBOB future contracts with Rock Solid Bank. Terms of the swap contract are as follows:

Fixed payment: USD 3.09/gal


Floating payment: NYMEX RBOB Spot Price on Mar 31, Jun 30, Sep 30 and Dec 31
Notional volume: 18 Contracts per quarter on RBOB Futures
Cash Settlement: Quarterly

What is the net settlement amount owed to/from Taurus Trucking on March 31 if the NYMEX RBOB spot price
is USD 3.18?
a.
b.
c.
d.

39.

Taurus
Taurus
Taurus
Taurus

Trucking
Trucking
Trucking
Trucking

pays USD 3,780


receives USD 3,780
pays USD 68,040
receives USD 68,040

Consider the following two option contracts:

Option 1: January 2013 daily call, strike price of USD 30.00, call value of USD 5.45
Option 2: January 2013 monthly call, strike price of USD 33.00, call value of USD 6.00

What is the biggest challenge in estimating the implied volatility for these two contracts assuming the following
parameters?

16

Valuation date: November 10, 2012


Risk free rate: 4%
Underlying value: USD 28.00

a.
b.
c.
d.

The options are based on different time intervals (daily vs. monthly)
The option quotes have different strike prices
The option quotes are both for call options
Winter power options are highly volatile due to seasonality factors

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Energy Risk Professional Examination (ERP) Practice Exam 1

40.

An August natural gas futures contract is currently priced at USD 5.60. You have been asked to structure a
costless collar for a client who consumes natural gas and expects natural gas prices to rise. The following
option quotes for calls and puts on August natural gas futures are currently available:
Strike
(USD)
5.650
5.625
5.600
5.575
5.525

Call Price
(USD)
0.31
0.32
0.34
0.35
0.37

Put Price
(USD)
0.36
0.35
0.34
0.32
0.30

Considering the information above, which of the following portfolios would you suggest for your client?
I.
II.

A short call with a strike of 5.575 and a long put with a strike of 5.625
A long call with a strike of 5.625 and a short put with a strike of 5.575

a.
b.
c.
d.

Portfolio I only
Portfolio II only
Both portfolios
Neither portfolio

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17

Energy Risk

Professional(ERP )
Examination
Practice Exam 1
Answers

Energy Risk Professional Examination (ERP) Practice Exam 1

a.

b.

c.

d.

a.

b.

1.

24.

2.

25.

3.

26.

27.

4.




5.
6.

28.




7.

9.

32.




11.

30.
31.

10.





33.
34.

12.

35.

13.

36.

37.

14.

15.
16.




17.

40.




Correct way to complete


1.

22.
23.

20.
21.

18.
19.

38.
39.

d.

29.

8.

c.

Wrong way to complete


1.

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19

Energy Risk

Professional(ERP )
Examination
Practice Exam 1
Explanations

Energy Risk Professional Examination (ERP) Practice Exam 1

1.

Which of the statements best explains the shape of the Brent Crude Oil forward price curve illustrated below?

Brent Crude Oil Futures


(USD per Contract)

120.5
120
119.5
119
118.5
118
117.5
117
116.5
1

11

13

15

17

19

21

23

25

Months to Maturity

a.
b.
c.
d.

Higher physical storage costs are causing crude oil futures to trade in contango.
Global economic growth is driving demand for crude oil higher causing the crude oil futures to trade
in contango.
Growing concern that global crude oil supplies are in permanent decline is causing crude oil futures to
trade in backwardation.
Uncertainty over short-term crude oil supplies has placed a premium on physical inventory causing crude
oil futures to trade in backwardation.

Correct answer: d
Explanation: The correct answer is d. A commodity with a high convenience yield, F(0)= S(0)e(r+uy)T where y is
the convenience yield, will cause the price to decline with maturity.
Reading reference: Helyette Geman (ed). Risk Management in Commodity Markets: From Shipping to
Agriculturals and Energy, Chapter 2 (Pages 11 12 and 15-16).

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21

Energy Risk Professional Examination (ERP) Practice Exam 1

2.

A colleague has informed you that a large coal-fired power plant in Pennsylvania will be shutting down for
unplanned maintenance in a few days. You decide the impact of this shut down could potentially be an
increase in demand for natural gas by local gas fired generators that are used to back-up coal fired plants.
What type of natural gas spread trade would you be executing if you purchased gas on the spot market,
stored it briefly and then sold it at a profit when expected demand for natural gas rises?
a.
b.
c.
d.

Location
Heat Rate
Time
Swing

Correct answer: d
Explanation: Swing trades rely on a traders ability to store gas for short periods of time, allowing them to
buy low and sell high by delivering the gas on the spot market when demand is high. Time spreads are
simultaneous buy/sells of future, forward, or swap contracts with differing maturity dates; winter vs. spring,
for example. Similarly, a locational spread is a simultaneous buy/sell at different locations with the same
maturity while a heat rate is a simultaneous buy/sell of power and gas matching either the spread trading in
the market or the underlying heat rate of a physical plant.
Reading reference: Energy Trading & Investing, Edwards, Chapter 2.1, page 81-82.

3.

Consider a power marketing firm with a high volume of daily trading activity in a variety of electricity contracts.
Over each of the past six months the firm has experienced losses created by the improper booking of trades
in their back-office system. A data management firm has offered to lease the firm an electronic booking system
for USD 1.2 million per month, claiming the system will eliminate operational risk. Should the firm invest in
this system?
a.
b.
c.
d.

Yes, the elimination of operational risk should be the primary goal of any organization.
Yes, but only if the firm is losing more than USD 1.2 million per month due to booking errors.
No, the data management problem can be addressed by hiring more experienced personnel in the
back office.
No, the claim is false since risk can be mitigated, but never eliminated.

Correct answer: d
Explanation: The correct answer is d. The data management firms claim is dubious. While such a system
would likely reduce errors such pass-through systems are a preferred way of managing operational risk due
to back office errors it is impossible to eliminate risk, thus it would not be wise to invest in a system that
promises to do something that is not possible.
Reading reference: Tom James. Energy Markets: Price Risk Management and Trading. Chapter 15, page 312.

22

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Energy Risk Professional Examination (ERP) Practice Exam 1

4.

Assume you are modeling the volatility of WTI forward contract prices using a single-factor log-of-price mean
reverting model. What will the output from your model indicate about the correlation between spot and forward
price returns assuming the initial price level in the spot and forward market are equal?
a.
b.
c.
d.

Correlation will remain perfect across all points between the front and back-end of the forward price curve.
Correlation will decrease between the front and back-end of the forward price curve.
Correlation will increase between the front and back-end of the forward price curve.
Correlation will fluctuate due to seasonality.

Correct answer: a
Explanation: Single factor models assume all factors move in tandem. Assuming the initial price level for spot
and forward prices are equal, the correlation between spot and forward price returns will remain perfect
between the front and back-end of the forward price curve.
Reading reference: Energy Risk: Valuing and Managing Energy Derivatives, Pilipovic, Chapter 8, page 234-236.

5.

Karachaganak, Kazakhstan is one of the largest gas condensate fields in the world, with proven reserves
of 1.9 billion barrels of oil and 13 trillion cubic feet of gas. In 2004, the field produced about 220,000 barrels
of oil and 1.3 billion cubic feet of gas per day. What is the producing gas-oil ratio?
a.
b.
c.
d.

4,300
5,909
6,842
7,523

Correct answer: b
Explanation: Answer b is correct. The definition of producing gas-oil ratio requires gas production (in cubic
feet) to be divided by oil production (in barrels). Thus, GOR = (1,300,000,000 cf)/(220,000 bbl) = 5,909.
Note that the gas-oil ratio of the proved reserves is computed as (13 Tcf)/(1.9 Bbbl) = 6,842 which denotes a
field with oil (condensate) and gas production.
Reading reference: Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, 2nd Edition,
Hyne, Chapter 1, page 11.

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23

Energy Risk Professional Examination (ERP) Practice Exam 1

Questions 6-7 use the information below:


Johan has just been named the Executive Director of NewGas Asia, a joint public/private partnership created
to develop a newly-discovered natural gas field in a politically-stable South Asian nation. The local government
has asked Johan to oversee the design and construction of a new LNG export terminal in a coastal city.
Estimates indicate that the reservoir has 40+ years of recoverable natural gas and that the gas is rich
(approximately 10%) in ethane and propane. In addition to constructing the export facility, Johan is tasked
with developing a plan to market the LNG.

6.

How will the properties of the natural gas affect NewGas Asias development of this field?
a.
b.
c.
d.

The ethane and propane will be removed during LNG liquefaction because they have a higher market
value than methane.
The LNG will sell at a premium because of its higher heating value.
The heavier ethane and propane will naturally remain behind in the reservoir as the lighter methane is
pumped out.
Since ethane and propane are components of natural gas, they will have no effect on the LNG.

Correct answer: a
Explanation: Ethane and propane are among the longer-chain hydrocarbons that are typically removed from
natural gas during the liquefaction process so that the LNG is pure or nearly pure methane. Ethane, propane
and other natural gas liquids can be sold separately and can provide an additional revenue stream for an
LNG project.
Reading reference: Fundamentals of Natural Gas, Chandra: Chapter 2, page 53.

7.

Johan would like the flexibility to offer NewGas Asias LNG through a commodity exchange, but he is
concerned that the Asian LNG market lacks adequate liquidity to ensure proper price discovery. How can
Johan establish a fair price for NewGas Asias LNG?
a.
b.
c.
d.

Engage in a fixed-for-floating swap to allow for price adjustments later.


Index his LNG prices to a basket of Asian crude oils.
Study the pricing of long-term bilateral contracts in the Pacific basin.
Base his pricing off the daily quote for the NYMEX Henry Hub contract.

Correct answer: b
Explanation: To improve the hedge-ability and to more accurately reflect market prices, gas contracts have in
the past been indexed to a basket of oil prices, making b the correct answer. The other answers are incorrect:
answer a is not the proper application of a Fixed-for-Floating swap; long bilateral contracts would not be an
accurate source for pricing information; and Henry Hub serves the US domestic market so it too would not be
an accurate measure of market forces at play in the Pacific.
Reading reference: The Handbook of Commodity Investing, Fabozzi (ed.); Chapter 36, p 833.

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Energy Risk Professional Examination (ERP) Practice Exam 1

8.

Which of the following statement(s) about barrier options is/are correct?


I.
II.

An up-and-out-floor is less expensive than a standard Asian option.


An up-and-out floor is canceled if the underlying market price is less than the barrier price.

a.
b.
c.
d.

Statement I only
Statement II only
Both statements
Neither statement

Correct answer: a
Explanation: Answer a is correct. Statement I is true an up and out floor is by definition less expensive than a
standard Asian option; statement II is false, the option is canceled if the market price exceeds the barrier price.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 3, pages 113-115.

9.

Although the industry has known about shale gas resources for decades, these resources have only recently
become the focus of serious commercial exploration and production activities. What characteristic of shale
gas has historically made exploration and production uneconomical?
a.
b.
c.
d.

Shale
Shale
Shale
Shale

has low natural permeability.


is an extremely dense rock that is difficult to drill through.
gas is typically wet, requiring extensive processing.
reserves tend to be in remote, hard-to-access locations.

Correct answer: a
Explanation: The correct answer is a. Shale naturally has low permeability, meaning only a small amount of a
reservoir is able to flow towards a drilled hole. Improvements in hydraulic fracturing technology and techniques,
which open fissures within the shale allowing for the free flow of gas, have made shale reserves commercially
viable, making a the correct answer. Many shale reserves in the United States are near population and natural
gas consumption centers, while shale gas is not typically wet, but in the cases of wet gas, these hydrocarbons
can form an important revenue stream.
Reading reference: Impact of Shale Gas Development on Global Gas Markets, Kenneth Medlock.

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25

Energy Risk Professional Examination (ERP) Practice Exam 1

10.

Based on the refined product yield from the three refineries summarized in the table below, identify the
complexity of Refinery X, Y and Z assuming they each operate using the same sour, heavy crude oil supply.

a.
b.
c.
d.

X
X
X
X

=
=
=
=

Refined Product

Refinery X

Refinery Y

Refinery Z

Gasoline

60

50

30

Jet Fuel

15

15

15

Distillate Fuel

25

25

20

Residual Fuel

30

Coke

Refinery Fuel

15

10

Gain

(20)

(5)

(3)

simple, Y = complex, Z = very complex


simple, Y = very complex, Z = complex
complex, Y = simple, Z = very complex
very complex, Y = complex, Z = simple

Correct answer: d
Explanation: Answer d is correct. Refinery complexity refers to the capacity and type of processing units that
comprise a refinery. Refinery complexity will increase when complex units with large capacity are added
since they have greater ability to convert (heavy) crude input into gasoline. For a given grade of crude oil (in
this case, medium sour, heavy), as the complexity of the refinery increases the gasoline yield increases and
the residual fuel yield decreases (the residual fuel stream is being converted to gasoline).
Reading reference: Petroleum Refining in Nontechnical Language, 3rd Edition, Leffler, Chapter 20, page 196.

11.

High operating costs and operational constraints make which of the following types of facility the least
desirable option for underground natural gas storage?
a.
b.
c.
d.

Depleted oil and gas fields


Aquifers
Salt caverns
Storage tanks

Correct answer: b
Explanation: Answer b is correct. Aquifers are considered the least desirable underground storage facility for
several reasons the geology of the aquifer is usually not well understood, infrastructure (wells, pumps,
compressors, etc.) is unavailable at the site, greater injection pressures mean higher operating cost, gas will
need to be dehydrated, and more stringent environmental regulations will be in place.
Reading reference: Fundamentals of Natural Gas, Chandra: Chapter 2, page 69-73.

26

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Energy Risk Professional Examination (ERP) Practice Exam 1

12.

Consider a power grid that relies on combined cycle natural gas turbine plants for electricity production.
What would the spark spread be for this particular power grid based on the following assumptions?

Average plant heat rate is 8,500 Btu/kWh


Current price of natural gas is USD 5.00/MMBtu
Current price of electricity is USD 30.00/MWh

a.
b.
c.
d.

USD
USD
USD
USD

0.0125/kWh
0.1250/kWh
-0.0125/kWh
-0.1250/kWh

Correct answer: c
Explanation: Answer c is correct, the calculation for determining the spark spread in this scenario is as follows:
Spark Spread = Output Price Input Price
Output Price = USD 30/MWh x 1MWh/1000kWh = USD 0.03/kWh
Input Price = 8500 Btu/kWh x USD 5/1,000,000Btu = USD 0.0425/kWh
Therefore, the Spark Spread = -0.0125
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 3, page 120.

13.

High pressure in subsurface reservoirs can cause a significant volume of natural gas to be dissolved in
underground crude oil reserves. This build-up of gas is known as what?
a.
b.
c.
d.

Non-associated gas
Crude gas
Associated gas
Working gas

Correct answer: c
Explanation: Answer c is correct. Because of high pressure in the subsurface reservoir, a considerable volume
of natural gas can be dissolved in crude oil. Associated natural gas occurs in contact with crude oil in the
subsurface. It occurs both as gas in the free gas cap above the oil and gas dissolved in the crude oil.
Reading reference: Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, Hyne,
Chapter 1, page 11.

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27

Energy Risk Professional Examination (ERP) Practice Exam 1

14.

Claudio has been put in charge of developing a site for a new nuclear power plant. Because of the disaster in
Fukushima, Japan, public sentiment has turned against nuclear power at this location. For this reason, Claudio
is recommending the construction of a pebble-bed modular reactor (PBMR). What is the main advantage of
the PBMR?
a.
b.
c.
d.

The PBMR does not use uranium as fuel.


PBMRs are considered safe because they cannot melt down like other designs.
PBMRs produce more electricity than other similarly-sized reactor designs.
Unlike other reactor designs, PBMRs do not generate high levels of heat.

Correct answer: b
Explanation: Thanks to their design, PBMRs will shut down if operating temperatures get too high, meaning
that a core meltdown, as nearly happened in the Three Mile Island incident, is impossible, thus b is the correct
answer. PBMRs still use uranium as fuel, generate high temperatures to produce steam to drive a turbine to
generate electricity, and a PBMR does not produce more electricity than other designs, in fact PBMRs are
typically smaller (per unit) than PWRs and BWRs.
Reading reference: Energy for the 21st Century: A Comprehensive Guide to Conventional and Alternative
Sources, Nersesian, Chapter 8, pages 287-88.

15.

You have purchased a monthly 100 MW on-peak power call option for a month that has 20 business days.
The strike price is USD 75/MWh and the premium is USD 5/MWh. What would the gross settlement amount
be if you exercised the call option during a month when the average on-peak power price was USD 85/MWh?
a.
b.
c.
d.

USD
USD
USD
USD

160,000
240,000
320,000
480,000

Correct answer: c
Explanation: The correct answer is c; the payoff does not include the amount of premium (32,000 MWh x
USD 85 USD 75). Payout is max(St k,0) x Q, wherein Q = quantity. Answer a is incorrect, because it
includes the premium cost of USD 160,000 (i.e. 32,000 MWh x USD 5). Answer b is incorrect, because it
assumes an all-day usage of 48,000 MWh and thus a premium cost (48,000 MWh x USD 85 USD 75-USD 5);
while answer d is incorrect, because it assumes 48,000 MWh (48,000 MWh x USD 85 USD 75).
*Assumes candidates will know on-peak power call option means for 16 hours per day.
Reading reference: Managing Energy Price Risk, Kaminski, chapter 2, page 46.

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Energy Risk Professional Examination (ERP) Practice Exam 1

16.

Stebbins Heating Oil is a supplier to residential consumers in the northeastern United States. In July, Stebbins
estimated the average heating oil requirement for the season to be 1,200 gallons per customer based on normal
weather conditions and purchased a sufficient number of heating oil futures contracts with different delivery dates
throughout the winter to fulfill the estimated demand. In September, several long term meteorological forecasts
predict a 70% probability of a warmer than normal winter, with a 1% probability of a colder than normal winter.
Assuming Stebbins customers have contracted to purchase their required heating oil at a fixed price, and a
warmer than normal winter will reduce heating oil demand by 20%, what should Stebbins do to improve the
hedge of its supply obligation?
a.
b.
c.
d.

Buy put options covering 20% of its original supply obligation.


Buy call options covering 20% of its original supply obligation.
Sell 20% of its original futures position and buy additional supply on the spot market as needed.
Sell excess supply on the spot market as needed throughout the winter.

Correct answer: a
Explanation: The best way for Stebbins to offset a volume risk scenario would be by buying put options if
the winter is indeed warmer than expected, Stebbins can sell their excess volume though the puts; if the winter
is not warmer than expected, they will have the needed volume for their customers on hand. Answer b is
incorrect, this would be the appropriate strategy for a colder than expected winter; c is not a wise strategy
since spot prices could climb steeply if there is a sudden cold spell or a supply disruption; d also is not the
best strategy since if the winter is warmer than expected, there may not be sufficient demand on the market
for additional supplies of heating oil and the prices will likely be below what Stebbins paid in the original
futures contracts.
Reading reference: Surviving Energy Prices, Beutel, Chapter 3, pages 29-30.

17.

On June 20, Caufield Refining estimates it will need to purchase 40,000 barrels of crude on October 12.
Caufield decides to hedge price risk using a November NYMEX futures contract. The November futures price
on June 20 is USD 77.00/bbl. On October 12, Caufield is ready to purchase its required crude oil and closes
out the futures contract on that day; at this time the spot price is USD 80.10/bbl and the futures price is
USD 78.50/bbl. What is the effective price paid per barrel?
a.
b.
c.
d.

USD
USD
USD
USD

78.50
78.60
80.10
80.40

Correct answer: b
Explanation: The effective price paid (in dollars per barrel) is the final spot price less the gain on the
futures, or 80.10 1.50 = 78.60. This can also be calculated as the initial futures price plus the final basis,
77.00 + 1.60 = 78.60.
Reading reference: Fundamentals of Trading Energy Futures & Options, Errera and Brown, Chapter 3,
page 43-44.

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29

Energy Risk Professional Examination (ERP) Practice Exam 1

18.

Steve Dolan is a power manager at Upstate Electric. He is negotiating a one-day contract to sell 100 MW of
electricity at USD 55/MWh for a 24-hour period and has been asked to calculate the Value-at-Risk (VaR) for
the contract. If the daily volatility of electricity prices is 2%, what is the daily VaR on the contract assuming a
95% confidence interval?
a.
b.
c.
d.

USD
USD
USD
USD

180
3,447
4,330
5,412

Correct answer: c
Explanation: Answer c is correct. The correct application of the VaR calculation in this case is the lot size
multiplied by the hourly rate multiplied by the time period of the contract multiplied by the daily volatility
measurement multiplied by the confidence level factor, which in this case is: 100 x 55 x 24 x .02 x 1.64 = USD
4,330. Since the contract is for one day, no time adjustment is needed.
Reading reference: Price Risk Management in the Energy Industry: The Value at Risk Approach, Mauro, Section 6.

19.

Consider the power grid shown below, which operates using a postage stamp pricing model with two
designated zones labeled Zone A and Zone B. The two zones are interconnected via a high-capacity transmission
line, allowing for electricity generated in one zone to be used in the other.
Zone A

Zone B

Main Transmission

When the transmission line experiences congestion, it is Zone B that sets the market clearing price for both
Zones A and B. Given this information, which of the following statements is correct?
a.
b.
c.
d.

Zone
Zone
Zone
Zone

A is a net exporter of electricity to Zone B


B is a net exporter of electricity to Zone A
B has a higher electricity demand than Zone A
A has a higher electricity demand than Zone B

Correct answer: a
Explanation: Answer a is correct. Under Postage Stamp pricing, the zone that is a net exporter of electricity
receives the clearing price of the zone that imports from it. Answer b is incorrect because a is correct.
Answer c and d are also incorrect, demand is not the sole factor that drives the MCP in a particular zone.
It is possible that an exporting zone can have a higher demand than the importing zone with the importing
zone still setting the marginal price.
Reading reference: Electricity Markets: Pricing, Structures and Economics, Harris, Chapter 7, pages 250-251.

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Energy Risk Professional Examination (ERP) Practice Exam 1

20.

To protect against on-peak electricity price spikes in the PJM market during the month of July, Markus Frackus
has obtained a daily on-peak option quote for 100 MW, with a strike price of USD 100/MWh and a premium of
USD 10/MWh per day. There are 20 business days in the month and 16 on-peak hours per day. Markus forecasts
there will be two days when on-peak prices will spike to USD 500/MWh and USD 700/MWh respectively (the
prices for all other on-peak periods would be less than USD 100/MWh). What will be the profit on his option
strategy if his forecast is accurate?
a.
b.
c.
d.

USD
USD
USD
USD

320,000
960,000
1,280,000
1,600,000

Correct answer: c
Explanation: Answer c is correct, using the following formula:
Premium = USD 320,000 or (USD 10 x 100 MW x 16 x 20)
Option Payoff = USD 1,600,000 or ((500-100+700-100) x16 x100)
Option Profit = USD 1,280,000 or (USD 1,600,000-USD 320,000)
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 59-60.

21.

Which of the following statistical tests is used to demonstrate that model errors are normally distributed and
independent of any previous steps used within the modeling process?
a.
b.
c.
d.

Q-Q plot
Autocorrelation test
Mean-squared error
R-squared

Correct answer: b
Explanation: Answer b is correct. The autocorrelation test is used for testing that errors are normally distributed
and are independent of previous steps, that is, not correlated with previous results; in this way the
Autocorrelation test is different from the Q-Q plot, which also tests for distribution, but not correlation.
R-squared measure, on the other hand, measures how well the model fits the data. It tells us nothing about
the distribution of the errors, but gives us general information about model performance, while the meansquared error test is the standard deviation of the model residuals. Hence, the correct answer is b.
Reading reference: Energy Risk, Pilipovic, Chapter 4, pages 81-84.

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31

Energy Risk Professional Examination (ERP) Practice Exam 1

22.

Bordeaux Electrique is a utility company in southwest France that is required to meet local clean air emissions
standards. In the past, Bordeaux Electrique has purchased emissions credits through bilateral, over-the-counter
(OTC) trades. This year, Bordeaux Electrique has decided to buy credits through the European Climate
Exchange (ECX). What is the main advantage of buying emission credits through an allowance exchange
instead of through OTC deals?
a.
b.
c.
d.

Exchanges avoid the heavy taxation levied against OTC profits.


There are more arbitrage opportunities available on allowance exchanges.
Allowance exchanges eliminate counterparty risk.
The European Union is mandating the shift from OTC to exchange-based systems for allowance trading.

Correct answer: c
Explanation: In the newly-developing emissions allowance market, often buyers and sellers have no previous
knowledge of one another, making credit, or counterparty, risk a major concern in their transactions; trades
executed through an exchange eliminate this risk, making c the correct answer.
Reading reference: Handbook of Commodity Investing, Fabozzi (ed.), Chapter 37, page 849.

23.

You are long 100 put options on the March Peak Forward contract. If the delta of the put options is -0.40,
what position in the March Peak Forward contract will you need to create for the combined portfolio to be
delta neutral?
a.
b.
c.
d.

Short 40 March Peak Forward contracts


Long 40 March Peak Forward contracts
Short 60 March Peak Forward contracts
Long 60 March Peak Forward contracts

Correct answer: b
Explanation: Answer b is correct. A Long Put is really a short position in the underlying, in this case March
Peak Power. In order to make the portfolio delta neutral you will need to purchase enough forward contracts
to offset the potential downside risk in the option position (-0.4*100 = -40). Consequently, you should be
long 40 March Peak Forward contracts.
Reading reference: Energy Derivatives: Pricing and Risk Management, Clewlow and Strickland, Chapter 9.2,
pages 164-167.

32

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Energy Risk Professional Examination (ERP) Practice Exam 1

24.

Samantha is trading heating oil for a large financial institution. Long term forecasts call for unusually volatile
weather patterns for the upcoming months of January and February. Samantha decides to enter into a long
straddle trade. There is currently a 1-month NYMEX heating oil call option with a strike price of USD 3.20 per
gallon and premium of USD 0.15 per gallon and a 1-month NYMEX put option with a strike price of USD 3.20
per gallon and premium of USD 0.17 per gallon. What would be the net profit per contract for this trade if the
price of heating oil is USD 2.80 at the time of expiration?
a.
b.
c.
d.

USD
USD
USD
USD

2,520 per contract


3,360 per contract
4,200 per contract
5,040 per contract

Correct answer: b
Explanation: Answer b is correct because: at 2.80, the profit is 3.20 - 2.80 -.15 -.17 = .08 multiplied by
42,000 gallons per contract. In this situation the long put provided the profit, while the premium payments
reduced the profit.
Reading reference: Energy Markets: Price Risk Management and Trading, James, Chapter 13, pages 253-255.

25.

The operations manager at an RTO in a deregulated market needs to activate another generation plant to
meet peak demand in a major city. The next plant in bid order has dispatched power at USD 40/MWh, but
the RTO instead activates, out-of-merit order, a plant located twenty-five miles away from the city that has bid
USD 44/MWh. Why would the RTO make this decision?
a.
b.
c.
d.

Transmission constraints that prevent lower cost generators from supplying power to an area of high demand.
Emission quotas that prevent lower cost generators from supplying power to an area of high demand.
Transmission costs are higher for a more distant plant during periods of high demand.
Baseload plants receive preference over peaker plants during periods of high demand.

Correct answer: a
Explanation: The correct answer is a. A plant would be operated out-of-merit order if constraints on transmission
lines prevented a lower cost plant from supplying power to an area of high demand, making a the correct
answer. Emissions costs would be factored into the bid; generators are paid only for power delivered, not for
the gross amount added to the grid, making transmission costs not a factor in the RTO's decision; activation
decisions are based on cost, not whether a plant is baseload or peaker, though peaker plants generally have
higher operating costs and submit higher bids than baseload plants.
Reading reference: Energy Trading & Investing, Edwards; Chapter 2.2, page 97.

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33

Energy Risk Professional Examination (ERP) Practice Exam 1

26.

A 3-month natural gas option with a strike of USD 6.00 on an August contract is trading at a Black-implied
volatility of 45%. A call option with the same contract specifications, but a strike price of USD 6.50, is trading
at a Black-implied volatility of 50%, producing a volatility smile. What conclusion can be made given the
market information above?
a.
b.
c.
d.

Volatility will fall for calls and puts as they move further and further out-of-the-money.
The different volatilities for the call option positions indicate that the lognormal Black model cannot
capture the true underlying price behavior with a single volatility measure.
A third call option with the same contract specifications, but a strike price of USD 7.00 must therefore
be trading at a Black-implied volatility of 55%.
The two options should have exactly the same volatility, creating a market arbitrage opportunity: the
USD 6.00 option is under-priced relative to the USD 6.50 option.

Correct answer: b
Explanation: Answer b is correct. Black-implied volatilities for options with the same contract specifications
but different strikes are necessary to capture the true underlying price behavior and therefore traded option
prices. Black option pricing model assumes log-normal price behavior for the underlying forward prices, which
generally does not capture the full spectrum of behavior of energy prices given a single volatility measure.
Reading reference: Energy Risk, Pilipovic: Chapter 8, page 232.

Questions 27 - 28 use the information below:


Colin is the procurement manager for a regional heating oil distributor in Alberta, Canada. In September, Colin
notices the 3-month forward price for heating oil is trading at CAD 4.65/gal a price that appears too high
relative to current market economics. Currently the spot price of heating oil is CAD 4.00/gal, monthly storage
costs are CAD .05/gal and the annual risk-free interest rate is 4.25%.

27.

What would be the net realized profit/loss per gallon in three months if Colin executed a transaction to take
advantage of a perceived mispricing between the spot and forward markets?
a.
b.
c.
d.

CAD
CAD
CAD
CAD

0.12/gal
0.46/gal
0.50/gal
0.61/gal

Correct answer: b
Explanation: Answer b is correct because, it properly accounts for cash and carry the forward is too high,
so Colin should buy the spot and short the forward. All other answers are incorrect.
FV of Spot = CAD 4.00 *(1.0107) = 4.0428
FV of Storage = .05 + .05 * (1.0035)^1 + .05 * (1.0035)^2 = .1506, so Total FV = 4.19
Forward Price of CAD 4.65 > FV of Spot (including storage) CAD 4.19
Arbitrage profit by buying spot, storing, and selling forward short = .46
Reading reference: Fundamentals of Derivatives Markets, McDonald, Chapter 6, pages 181-183.

34

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Energy Risk Professional Examination (ERP) Practice Exam 1

28.

Assuming Colins market information is accurate, other market participants pursue the same arbitrage opportunity,
and no other market conditions change, what effects would you expect Colins trading strategy to have on
the heating oil market?
a.
b.
c.
d.

Speculative
Speculative
Speculative
Speculative

inventories
inventories
inventories
inventories

will
will
will
will

rise, driving the forward price down and the spot price up.
rise, driving the forward price up and the spot price down.
fall, driving the forward price down and the spot price up.
fall, driving the forward price up and the spot price down.

Correct answer: a
Explanation: The transaction will have the effect of increasing speculative inventories of the commodity and
increasing volumes offered at the current forward price, driving the forward price down and the spot price up.
Reading reference: Fundamentals of Trading Energy Futures & Options, Errera and Brown, Chapter 3, pages 32-33.

29.

Roger has constructed a portfolio of crude oil option contracts that he has delta hedged. Over a one month
period, Roger observes that his portfolio is not performing as expected and he is concerned that the change
in portfolio delta, relative to the change in the underlying price of oil, is too high. Which of the following portfolio
risk characteristics should Roger neutralize so that his hedge strategy more effectively responds to changes
in the underlying price of oil?
a.
b.
c.
d.

Beta
Gamma
Theta
Vega

Correct answer: b
Explanation: The correct answer is b. Rogers delta hedge will not perform as well as expected as price of the
underlying assets diverge from the prices of the options in his portfolio. The way to counteract this trend is
to attempt to neutralize the sensitivity of the portfolio to the change in price between the option and the
underlying. This sensitivity is known as gamma, answer b.
Reading reference: Energy Derivatives, Clewlow and Strickland, Chapter 9, pages 169-173.

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

35

Energy Risk Professional Examination (ERP) Practice Exam 1

30.

A power company that uses diesel-fueled generators to produce electricity has amassed a large amount of
debt. How would a fuel supplier best manage its exposure to this company, assuming it is concerned about
the companys ability to pay for physical fuel deliveries?
a.
b.
c.
d.

Credit derivatives
Credit insurance
Financial guarantee
Netting agreement

Correct answer: b
Explanation: If suppliers are concerned about a buyers ability to pay for a delivered commodity, one step the
seller can take is buy credit insurance on the transaction. Although all options listed are ways of offsetting
credit risk, credit insurance (answer b) is the best choice in this situation. As James describes on page 320,
credit insurance is well-suited for nuts and bolts transactions, like the delivery of a cargo of fuel oil. Credit
derivatives are generally more expensive than credit insurance and focus on financial transactions rather than
physical commodity deliveries; collateralization would be an option, though given the companys finances, it is
doubtful whether they would be able to post collateral; netting would only come into effect at the time of a
default and the fuel supplier would have to launch legal proceedings to recover any netted amount.
Reading reference: Tom James. Energy Markets: Price Risk Management and Trading (Singapore: John Wiley &
Sons, 2008): Chapter 16, p. 320.

31.

Eloise, ERP, is the risk manager for a large natural gas company. Her company uses a VaR model with a 95%
confidence level to measure risk exposure and compliance with risk limits. If Eloise is concerned with the
impact of extreme events, she should:
a.
b.
c.
d.

Move the VaR confidence level down to 90%.


Move the VaR confidence level up to 99%.
Continue VaR testing at the 95% confidence level but adjust her risk limits.
Implement stress testing.

Correct answer: d
Explanation: Answer d is correct, VaR measures only possible realities given a set of inputs, it does not
account for unexpected or extreme events.
Reading reference: Incorporating Stress Tests Into Market Risk Modeling, Aragones, Blanco, and Dowd.

36

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Energy Risk Professional Examination (ERP) Practice Exam 1

32.

Akiko, an ERP, is pricing a daily transportation deal between Henry Hub and Houston Ship Channel using the
mean-reverting Ornstein-Uhlenbeck process to model gas prices. In order to calculate the at-the-money
(ATM) implied volatilities for Henry Hub and Houston Ship Channel Akiko will need to do which of the following?
a.
b.
c.
d.

Calculate the correct volatilities since the implied volatilities from a Black-Scholes calculation are not the
same volatilities used in the Ornstein-Uhlenbeck process.
365
Scale the implied volatilities by 250
since it is a daily deal.
Roughly estimate implied volatilities. Nothing else needs to be done.
250
Scale the implied volatilities by 365
since it is a daily deal.

Correct answer: a
Explanation: Answer a is correct. Volatility has to be estimated in the context of the stochastic process
assumption. The volatility for an Ornstein-Uhlenbeck process has different units to that which is used in the
Black-Scholes model. The volatility for the Ornstein-Uhlenbeck process has units of dollars. The volatilities in
Black-Scholes and Ornstein-Uhlenbeck are not interchangeable.
Reading reference: Energy Derivatives: Pricing and Risk Management, Clewlow and Strickland, Chapter 3.2.2,
page 41.

33.

Price formation and trading in the European carbon (emissions) market is driven primarily by which of the
following factors?
a.
b.
c.
d.

Global carbon prices


Input fuel costs
Power demand from industrial customers
Weather

Correct answer: d
Explanation: The correct answer is d. Weather is a main driver of power demand in Europe high temperatures
increase demand for electricity, while extended periods of drought can affect the operation of nuclear and
hydroelectric plants, all of which increases the demand for power generated from fossil fuels, which causes
increases in carbon emissions and drives the prices of carbon allowances higher.
Reading reference: Frank Fabozzi (ed.). The Handbook of Commodity Investing. Chapter 37, pages 853-854.

2012 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.

37

Energy Risk Professional Examination (ERP) Practice Exam 1

34.

How are Chinese emissions policies most likely to change during the next five years?
a.
b.
c.
d.

China is in the process of adopting a market-based carbon-trading scheme.


China has mandated that hard emissions caps go into effect in 2015.
China is planning modest voluntary emissions reduction targets for industrial manufacturers.
China has no plans to place caps on greenhouse gas emissions on power generators or heavy industry
as these are considered critical economic drivers.

Correct answer: a
Explanation: The correct answer is a. According to the World Bank, China supports emissions-trading
schemes as originally proposed under the Kyoto Protocols, and is in the process of setting up their own carbon
market to operate in six cities by 2013 and a national plan to go into effect perhaps by 2015.
Reading reference: The World Bank. State and Trends of the Carbon Market, Section 2, page 34.

35.

Which statement about extra heavy crude (oils that typically have an API below 15) is correct?
a.
b.
c.
d.

Extra-heavy oil is not considered genuine petroleum


Extra-heavy oils are not commercially viable
Though they require special refining equipment, extra heavy oils are naturally low in sulfur, which reduces
their refining cost.
The total global resources of extra-heavy oils may be four times as large as the worlds proven reserves of
conventional oils.

Correct answer: d
Explanation: According to the text, extra-heavy resources are four times the proven reserves of conventional
oil, making d the correct answer. Answer a is incorrect as per the text, extra-heavy oil is genuine petroleum;
extra-heavy oils are currently produced commercially in Canada and Venezuela, making b incorrect; and while
it is true that the extra heavy oils require special refining equipment, they are not naturally low in sulfur, making
c incorrect.
Reading reference: Oil, Gas Exploration, and Production, Institut Francais du Petrole Publications, Chapter 3,
page 105.

38

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Energy Risk Professional Examination (ERP) Practice Exam 1

36.

Advancements in turbine technology have helped make levelized electric power generation costs for wind
and coal relatively equal in many situations. Despite these changes price risk remains an issue for which technology
and why?
a.
b.
c.
d.

Coal, because of carbon mitigation costs


Coal, because global coal reserves are rapidly depleting
Wind, because of potential cuts to government subsidies
Wind, because of the intermittent nature of wind power generation

Correct answer: a
Explanation: The correct answer is a. As the fossil fuel with typically the highest level of greenhouse gas
emissions, ways are actively sought to reduce coals impact on the environment through carbon capture
technologies. The cost of these carbon mitigation efforts are attached to the price of coal, making it a more
and more expensive fuel to use and exposing coal consumers to price risk situations.
Reading reference: Bloomberg New Energy Finance. Global Trends in Renewable Energy Investment, page 41.

37.

What is a weakness in applying single-factor mean-reverting models in option valuation?


a.
b.
c.
d.

Black-equivalent
Black-equivalent
Black-equivalent
Black-equivalent

volatility
volatility
volatility
volatility

goes to zero with increasing time to expiration


increases with increasing time to expiration
decreases with increasing time to expiration
is proportional to spot price volatility

Correct answer: a
Explanation: Implementing single factor mean-reverting models for option valuation can be very dangerous if
pricing long-term options. Single factor mean-reversion forces price distributions to stop growing in width as
time to expiration gets large, resulting in effective volatility of the option to move toward zero over its life
time. Hence the correct answer is a.
Reading reference: Energy Risk, Pilipovic, Chapter 5, pages 105-09.

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in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

39

Energy Risk Professional Examination (ERP) Practice Exam 1

38.

Taurus Trucking is a freight-hauling company that enters into a 1-year fixed-for-floating commodity swap on
NYMEX RBOB future contracts with Rock Solid Bank. Terms of the swap contract are as follows:

Fixed payment: USD 3.09/gal


Floating payment: NYMEX RBOB Spot Price on Mar 31, Jun 30, Sep 30 and Dec 31
Notional volume: 18 Contracts per quarter on RBOB Futures
Cash Settlement: Quarterly

What is the net settlement amount owed to/from Taurus Trucking on March 31 if the NYMEX RBOB spot price
is USD 3.18?
a.
b.
c.
d.

Taurus
Taurus
Taurus
Taurus

Trucking
Trucking
Trucking
Trucking

pays USD 3,780


receives USD 3,780
pays USD 68,040
receives USD 68,040

Correct answer: d
Explanation: Taurus Truckings fixed portion of the swap for the quarter is: USD 3.09 x 42,000 gal x 18 =
2,336,040; the floating payment received by Taurus at the end of Q1 is USD 3.18 x 42,000 x 18 = 2,404,080.
The difference of 68,040 represents the net settlement amount owed to Taurus.
Reading reference: Steve Leppard. Energy Risk Management: A Non-technical Introduction to Energy Derivatives
(London: Risk Books, 2005). Chapter 4, p. 45-47.

39.

Consider the following two option contracts:

Option 1: January 2013 daily call, strike price of USD 30.00, call value of USD 5.45
Option 2: January 2013 monthly call, strike price of USD 33.00, call value of USD 6.00

What is the biggest challenge in estimating the implied volatility for these two contracts assuming the following
parameters?

Valuation date: November 10, 2012


Risk free rate: 4%
Underlying value: USD 28.00

a.
b.
c.
d.

The options are based on different time intervals (daily vs. monthly)
The option quotes have different strike prices
The option quotes are both for call options
Winter power options are highly volatile due to seasonality factors

Correct answer: a
Explanation: Reconciling the daily volatility of Option 1 with the monthly volatility of Option 2 can make it
very difficult to select the right parameters in the modeling process. The volatilities will tend to be correlated
but different.
Reading reference: Energy Risk, Pilipovic, Chapter 8, pages 222-228.
40

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Energy Risk Professional Examination (ERP) Practice Exam 1

40.

An August natural gas futures contract is currently priced at USD 5.60. You have been asked to structure a
costless collar for a client who consumes natural gas and expects natural gas prices to rise. The following
option quotes for calls and puts on August natural gas futures are currently available:
Strike
(USD)
5.650
5.625
5.600
5.575
5.525

Call Price
(USD)
0.31
0.32
0.34
0.35
0.37

Put Price
(USD)
0.36
0.35
0.34
0.32
0.30

Considering the information above, which of the following portfolios would you suggest for your client?
I.
II.

A short call with a strike of 5.575 and a long put with a strike of 5.625
A long call with a strike of 5.625 and a short put with a strike of 5.575

a.
b.
c.
d.

Portfolio I only
Portfolio II only
Both portfolios
Neither portfolio

Correct answer: b
Explanation: A costless collar is formed with a long out of the money call and a short out of the money put
so that the premium paid for the call and the premium received for selling the put equal out to zero. In this
case only portfolio II qualifies as a costless collar.
Reading reference: Managing Energy Price Risk, Kaminski, Chapter 2, pages 68-72.

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