Energy is produced and consumed at myriad locations and across tenor, and supply and demand must balance locationally and temporally. The risks of such portfolios therefore, are, often high-dimensional. Risk management of such portfolios is effected primarily with linear instruments: swaps, forwards, and futures. There is a tendency in the field of financial engineering to focus on complex structures, relegating the topic of the management of swaps positions to a lesser status, perhaps owing to the fact that the mathematics of the former appears more interesting. Whereas options structures in energy trading do play a significant role because of the embedded optionality in many physical assets, linear instruments are the risk-transfer workhorses.

Our focus so far has been on contracts with commonly acknowledged liquidity – the benchmarks. Benchmark trades typically constitute the dominant component of hedging programs; however, many energy portfolios span much broader locational and temporal risks. Swaps portfolios can have a very high-dimensional risk profile, and their level of complexity can become far greater than one might expect, confounding efforts to display risk in usable forms, making sensible profit and loss (P&L) attribution elusive, and rendering the design of effective controls challenging.

In this chapter we will first survey the chain of risk transfer that occurs through linear instruments. We will then build on some of the results from the Chapter 5 to describe methods of organizing risk and ascribing P&L to risk drivers.