PrintBasis Risk: "The financial risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other." (Investopedia.com).
This type of risk takes place when the risk manager is not able to buy or sell a financial product that is an exact match for the product he needs to buy or sell. For instance, the gas purchaser in the example on the last page might not have enough load to buy a contract for each month in the winter. So he might buy just a January contract. If the other contracts were to settle differently than the January contract, this purchaser would have the basis risk associated with the mismatched purchases. In the energy market, there is a very specific basis risk that we call “locational bass risk.” This risk comes from the fact that a commodity may be produced or consumed at a point on the energy transportation network that is different from where the commodity is typically traded. In the second example on the previous page, where the developer is producing electrical energy, the price he would receive at his delivery point into the grid might be less (or more) than is paid at a liquid trading point. This potential differential is called “location” or "transportation” basis risk. (insert diagram here)
Counterparty Risk: "The probability that the other party in an investment, credit, or trading transaction may not fulfill its part of the deal and may default on the contractual obligations." (Investopedia.com).
In our example from the previous page, the seller of the natural gas or the buyer of the developer’s solar output could default on the obligation it has taken on to sell or buy the product in each transaction. This means that when looking at mitigating these risks, it is very important to ensure that the party on the other side of the transaction is credit worthy and will perform their obligations. This phenomenon was of particular concern in late 2001 when Enron started to default on its many obligations to the energy market as it could no longer maintain liquidity. If you’ve never read or seen “The Smartest Guys in the Room” - It is highly recommended. Here's a trailer:
Please watch the following video (2 min):
Speaker: It had taken enron 16 years to go from about 10 billion of assets to 65 billion of assets and took them 24 days to go bankrupt.
Interviewee: "The fatal flaw at enron was pride, arrogance, intolerance."
Enron trader on recorded phone conversation: "All the money you guys stole from from those poor grandmothers?"
Speaker: "We can add a gazillion dollars to the bottom line."
Speaker: "All right! That sounds fantastic!"
Congressman: "id you convert stock worth 66 million dollars"
Enron CEO Jeffrey Skilling: "Ah,I don't know."
Enron employee: "I netted approximately 100 million dollars."
Enron executive: "Enron is a company that deals with everyone with absolute integrity."
Enron employee: "Talk about my compensation... and if i step on somebody's throat on the way that doubles it, well I'll stomp on the guy's throat [laughs]."
Narrator: "The other thing about people at enron is a lot of them were former nerds. You wanted to be the most popular guy on Wall Street, you were going to do whatever you had to do."
Speaker: "They sought out every loophole they could in order to profit."
Enron CEO Jeffrey Skilling: "The rules weren't quite clear."
Speaker: "They could bury debt; they could bury losses.
Speaker: "An industry that was very reliable for a hundred years was all of a sudden turned into a casino."
Speaker: "Those guys could just yank the California economy on its leash whenever they wanted to and they did it and they did it and they did it."
Enron Trader: "You just steal money from California to the tune of a million bucks or two a day."
Another Enron Trader: "Can we rephrase that?"
Speaker: "Could I predict phony energy crisis as a result of the regulation? Yes. Could I predict that Arnold Schwarzenegger would be our governor as a result of deregulation? Oh, i didn't expect that."
Representative Henry Waxman: "How exactly does Enron make its money?"
Speaker: "Accounting doesn't get that creative."
Speaker: "I would like to know if you are on crack.
Reporter: "This is the shredded evidence just came out of Enron."
Speaker: "Everyone was on the bandwagon. And it can happen again."
"We are the good guys. We are on the side of angels."
Speaker: "It has evolved to the corporate crime of the century."