Energy Markets


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Energy Markets

  1. 1. Introduction to Energy Markets & Modelling Rouveyrollis Nicolas 07 10 2010
  2. 2. Introduction <ul><li>Energy has become one of the most traded commodities after the deregulation in the oil and natural gas industries in the 1980s, followed by the deregulation in the electricity industry in the 1990s.Until then the prices were set by regulators, i.e., governments. Energy prices were relatively stable, but consumers had to pay high premia. </li></ul><ul><li>Due to the deregulation a free market with more competitive prices arose that revealed that energy prices are the most volatile among all commodities. This exposed both energy producers and consumers to many financial risks. </li></ul><ul><li>As the financial risks stem from the different interesting characteristics displayed in price processes of the energy market, we need to account for these characteristics when we are trying to model the consisting price processes. Worth knowing is that it is these characteristics that distinguish the energy market from others . </li></ul><ul><li>Contents : </li></ul><ul><ul><li>Key Figures </li></ul></ul><ul><ul><li>Markets & Players </li></ul></ul><ul><ul><li>Core Products </li></ul></ul><ul><ul><li>Modelling </li></ul></ul>
  3. 3. Contents <ul><li>Key Figures </li></ul><ul><li>Markets & Players </li></ul><ul><li>Core Products </li></ul><ul><li>Modelling </li></ul>
  4. 4. Key Figure : World primary energy consumption
  5. 5. Key Figure : Regional primary energy consumption patterns
  6. 6. Key Figure : Oil Production
  7. 7. Key Figure : Historical Prices
  8. 8. Contents <ul><li>Key Figures </li></ul><ul><li>Markets & Players </li></ul><ul><li>Core Products </li></ul><ul><li>Modelling </li></ul>
  9. 9. Markets 1/2 <ul><li>Energies available for trading: </li></ul><ul><ul><li>Oil & Reffined products </li></ul></ul><ul><ul><li>Gas </li></ul></ul><ul><ul><li>Electricity </li></ul></ul><ul><ul><li>CO2, COAL </li></ul></ul><ul><li>Major Markets: </li></ul><ul><ul><li>NYMEX -> CME Group, ICE </li></ul></ul><ul><ul><li>ECX, Nyse </li></ul></ul><ul><ul><li>Powenext, EEX, NordPool </li></ul></ul><ul><li>Kind of Markets : </li></ul><ul><ul><li>Spot </li></ul></ul><ul><ul><li>Futures </li></ul></ul><ul><ul><li>Derivatives </li></ul></ul><ul><li>What Make Energies Different ? </li></ul>
  10. 10. Markets 2/2 <ul><li>NYMEX New York Mercantile Exchange </li></ul><ul><li>1872, NYMEX used to be one of the most important </li></ul><ul><li>maket place for trading commodities </li></ul><ul><li>CME Chicago Mercantile Exchange </li></ul><ul><li>1919, le chicago mercantile exchange first pool for </li></ul><ul><li>commodity dérivatives, recently merged with Nymex </li></ul><ul><li>IPE International Petroleum Exchange: </li></ul><ul><li>1980, London based, Oil Gas, CO2 & Electricity trading </li></ul><ul><li>market place, now merged with ICE </li></ul><ul><li>ICE Intercontinental Exchange: </li></ul><ul><li>2000, initialy electronic platform for trading commodity, in 2001merged </li></ul><ul><li>with IPE </li></ul><ul><li>ECX European Climate Exchange </li></ul><ul><li>2005, recent market place for futures on EUA(European Union </li></ul><ul><li>Allowances) & CER (Certified Emission Reduction) – following </li></ul><ul><li>Kyoto protocol </li></ul>
  11. 11. Who Trades Energy Today & Why ? 1/4 <ul><li>Corporates, macro hedge funds and CTAs, and institutional investors all trade commodities in very different ways. </li></ul><ul><li>It is important to consider the behavior of each type of market participant collectively in any period of time, since no one participant gives a complete picture of market activity and no one participant determines price. </li></ul><ul><li>No one market participant — including institutional investors — determines energy prices, but collectively, market participation does influence not only price but the shape of forward curves and the price of volatility. </li></ul>
  12. 12. Who Trades Energy Today & Why ? 2/4 <ul><li>Producers & Consumers </li></ul><ul><li>The hedging behavior of energy producers and consumers is important because it determines, on both a macro </li></ul><ul><li>and regional basis, the number of ‘natural’ longs or shorts in markets. </li></ul><ul><li>Pure Financial Players </li></ul><ul><li>Outside of producer and consumer risk management, there is a temptation to group all ‘speculative’ energy </li></ul><ul><li>market participants together. In reality, these players fall into distinct categories that we would roughly define </li></ul><ul><li>as financial institutions, commodity trading advisors (CTAs) & macro hedge funds, institutional investors </li></ul><ul><li>e.g. Hedge funds </li></ul><ul><li>In recent years have not only committed more money to the commodity space but have also become increasingly sophisticated in terms of how they trade commodities, focusing not only on directional views but relative value trading in longer dated tenors, and volatility plays. </li></ul><ul><li>e.g. Institutional investors </li></ul><ul><li>are the newest entrants, and possibly the most poorly understood. During a period of low interest rates and relatively few opportunities in traditional investment arenas, the notion of commodities as an asset class and vehicle for portfolio diversification has caught on, aided by a supportive fundamental bull story that has become prominent even in the mainstream media. This group includes pension funds, mutual funds, and even retail investors who may have a broad, macro view of the sector but little expertise in the intricacies of these markets. Investor products, such as commodity indices, commoditylinked notes, and exchange-traded funds (ETFs) give the nonexpert an opportunity to add commodity exposure to a diversified portfolio . </li></ul>
  13. 13. Who Trades Energy Today & Why ? 3/4
  14. 14. Who Trades Energy Today & Why ? 4/4
  15. 15. Contents <ul><li>Key Figures </li></ul><ul><li>Markets & Players </li></ul><ul><li>Core Products </li></ul><ul><li>Modelling </li></ul>
  16. 16. Most Popular Derivatives <ul><li>What are they? </li></ul><ul><li>Contracts based on a underlying commodity or asset price </li></ul><ul><li>Financial & Physical </li></ul><ul><li>What do they do? </li></ul><ul><li>Transfer risk, especially price risk </li></ul><ul><li>Hedging </li></ul><ul><li>Why care? </li></ul><ul><li>Energy price risk is a problem, but derivatives have facilitated fraud & failure (Enron) </li></ul><ul><li>What forms do they take? </li></ul><ul><li>Forwards, futures, options, swaps & exotics </li></ul>
  17. 17. Core Derivatives <ul><li>Spot / intraday trading: any transaction where delivery either takes place immediately or within a short delay </li></ul><ul><li>Futures contracts (FUT): any standardized transaction where delivery takes place in the future </li></ul><ul><li>Ex : Powernext : 3 next months , 4 next quarters , 3 next years </li></ul><ul><li>Forward contracts (FW) : any transaction where delivery takes place in the future </li></ul><ul><li>Ex : Counterparty X 2 next weekends, 4 next weeks, 12 next months 4 next quarters, 4 next years … </li></ul><ul><li>FUT/FW do not trade in shares like stocks. They trade in contracts. Each FUT/FW contract has a size that has been set up. </li></ul><ul><li>e.g. : Buying 25 MW of Cal 2009 Baseload electricity at 61.65€/MWh </li></ul><ul><li> Cash = 61.65 * 25 * 8760 = 13 501 350 € </li></ul>
  18. 18. Contract Specification
  19. 19. Most Popular Derivatives
  20. 20. How Price Risk is Managed (Oil & Natural Gas) ?
  21. 21. Example : Tolling Deal 1/4 <ul><li>Tolling deals </li></ul><ul><ul><li>call on power with strike price dependent on the cost of fuels, emission and variable costs = option on spread between power prices and prices of fuels and emission </li></ul></ul><ul><ul><li>basket of correlated commodity products (three or four products in the basket) </li></ul></ul><ul><ul><li>objectives: </li></ul></ul><ul><ul><ul><li>power operator will guarantee stable cash flows stream (option premium) typically from an institution with higher credit rating </li></ul></ul></ul><ul><ul><ul><li>power plant operator may also use these options to hedge against adverse power and fuel market movements </li></ul></ul></ul><ul><ul><ul><li>marketers use these options to financially replicate power plant operation without taking on operational and other risks associated with running the plant </li></ul></ul></ul>
  22. 22. Example : Tolling Deal 2/4 <ul><li>Unit Contingent Toll with Callback on High Gas </li></ul><ul><ul><li>Standard Toll: Buyer has the right to call for power. When the right is exercised the buyer pays the cost: </li></ul></ul><ul><ul><li>Number MWh x Price of 1MMBtu of NG x Heat Rate + costs </li></ul></ul><ul><ul><li>Callback: Seller has the right not to deliver power during not more than 10% of all hours of the year (if a specified unit is forced out) </li></ul></ul><ul><li>Tolling Deal with Limited Number of Start-ups during the year - complex path-dependent option </li></ul><ul><li>Tolling deals with fuel substitution option </li></ul>
  23. 23. Example : Tolling Deal 3/4 <ul><li>Example “Swing option” : is equal to N nested American-style call options (N being the number of exercise rights), similar to a Bermudan option. But while the Bermudan option has predetermined exercise dates, the swing option has further optionality. </li></ul><ul><ul><li>An upper bound of the value of the swing option with N exercise rights is given by N identical American options. </li></ul></ul><ul><ul><li>A lower bound is given by the maximum value of N European options, with predetermined exercise dates. When N = n (n being the number of exercise dates), the value of the swing option is equal to a series of European options. </li></ul></ul><ul><li>Constraints : Daily Contract Quantity, : Annual Contract Quantity, Carry Forward, Temperature Adjustement, Penality, Storage Constraints … </li></ul>
  24. 24. Example : Tolling Deal 4/4
  25. 25. Contents <ul><li>Markets </li></ul><ul><li>Specifications & price characteristics </li></ul><ul><li>Core Products </li></ul><ul><li>Modelling </li></ul>
  26. 26. Modelling <ul><li>As the financial risks stem from the different interesting characteristics displayed in price processes of the energy market, we need to account for these characteristics when we are trying to model the consisting price processes. Worth knowing is that it is these characteristics that distinguish the energy market from others . </li></ul><ul><li>Different Products – Different Models </li></ul><ul><li>Non – Normal </li></ul><ul><li>Seasonal </li></ul><ul><li>Weather Dependent </li></ul><ul><li>Market Model issue : Volatility, Correlation, </li></ul>
  27. 27. Modelling Oil 1/3 <ul><li>Crude Oil : Biggest Energy Market .. Looks the simplest to Model </li></ul>
  28. 28. Modelling Oil 2/3
  29. 29. Modelling Oil 3/3 <ul><li>Forward vs Spot strategies Backwardation or Contango ? </li></ul><ul><ul><ul><li>Contango = futures price > spot price </li></ul></ul></ul><ul><ul><ul><li>Backwardation (inverted curve) = futures price < spot price </li></ul></ul></ul>
  30. 30. Modelling Gas 1/2 <ul><li>Natural Gas : Much More Complicated </li></ul>
  31. 31. Modelling Gas 2/2 <ul><li>Regionality Models </li></ul>
  32. 32. Modelling Electricity 1/3 <ul><li>Electricity Basics </li></ul>
  33. 33. Modelling Electricity 2/3 <ul><li>Seasonnality, Regime Switching, Mean Reversion, Spikes </li></ul>
  34. 34. Modelling Electricity 3/3 <ul><li>Let’s Model Electricity </li></ul>
  35. 35. Correlations 1/2 <ul><li>Correlation : More Linkages, Across Space & time, Across Energies </li></ul>
  36. 36. Correlations 2/2 <ul><li>Correlation has a complex term structure: seasonality, dependence on time to maturity </li></ul><ul><li>“ Correlation smile”: in Black-Scholes-type models used to price complex spread options correlation parameters may depend on underlying prices </li></ul><ul><li>Example: Correlation vs Power_price/NG_price </li></ul>
  37. 37. Volatilities 1/3 <ul><li>Hight Levels </li></ul>
  38. 38. Volatilities 2/3 <ul><li>Term Structure </li></ul>
  39. 39. Volatilities 3/3 <ul><li>Skew & Volatility Dynamic </li></ul>
  40. 40. Choosing a model <ul><li>Main Goal : Physical / Financial Management ? </li></ul><ul><li>e.g. Electricity Markets : Is a sophisticated spot price model really usefull ? </li></ul><ul><ul><li>Sure if you are able to hedge and manage the spikes </li></ul></ul><ul><ul><li>Sure on a short time horizon (namely the BoM) for the physical scheduling and management </li></ul></ul><ul><ul><li>Sure if your trader’s will buy several Power Plants on the spot market </li></ul></ul><ul><ul><li>Not sure if your core business is not the physical management </li></ul></ul><ul><ul><li>Not sure if you have no skills in hedging the spikes and your risk manager have restricted the spot business on a couple of MWh </li></ul></ul><ul><ul><li>Not sure if you will be globally short on spot markets </li></ul></ul><ul><li>Future </li></ul><ul><ul><li>Modelling individual futures Vs Modelling whole forward curve & Spot/Future relationship </li></ul></ul><ul><ul><li>Parametric form for volatility cube & correlation structure </li></ul></ul>
  41. 41. Conclusion & References <ul><li>Energy Markets : </li></ul><ul><ul><li>increasing prices & volumes on the long term </li></ul></ul><ul><ul><li>Fundamentals </li></ul></ul><ul><ul><li>Quite representation in terms of exchanged commodity </li></ul></ul><ul><ul><li>Growing interests </li></ul></ul><ul><ul><li>Specific asset, Specific Risk Management ? </li></ul></ul><ul><li>Physical delivery , Theory of storage Transport & Convenience Yield </li></ul><ul><li>There is room for people : </li></ul><ul><ul><li>Taking into account economical and / or technical constraints </li></ul></ul><ul><ul><li>Having skills for the exploitation of low quality data </li></ul></ul><ul><li>Alexander Eydeland & Krzysztof Wolyniec: Energy and Power Risk Management </li></ul><ul><li>Angelo Barbieri and Mark B. Garman: Understanding the Valuation of Swing Contracts </li></ul><ul><li>Carlos Bianco, Sue Choi & David Soronow: Energy Price processes Used for DerivativesPricing & Risk Management </li></ul><ul><li>Rafal Weron: Energy Price risk management </li></ul><ul><li>Market website </li></ul>