Topic 9: Energy Pricing and Trading in Financial Markets. () Global Energy Issues, Industries and Markets 1 / 41

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1 Topic 9: Energy Pricing and Trading in Financial Markets () Global Energy Issues, Industries and Markets 1 / 41

2 Introduction Energy prices determined in many ways E.g. long term contracts for natural gas based on negotiations between buyer and seller E.g. OPEC posted price system E.g. Regulators setting prices for electricity But increasingly prices for many forms of energy established in financial markets Energy trading a vast topic (involving financial theory, etc.) Some issues have already been discussed in previous lectures (e.g. on International Oil Markets) In this lecture, offer a general outline of issues and terminology relevant for energy trading () Global Energy Issues, Industries and Markets 2 / 41

3 Benefits of Markets With deregulation and internationalization of energy trading, energy just another commodity Some of this lecture is general theory for commodity markets Markets with many buyers and sellers (liquid markets) can: Establish transparent prices (supply = demand) Adapt quickly to new information Uninformed buyers/sellers minimize risk of being taken advantage of () Global Energy Issues, Industries and Markets 3 / 41

4 Drawbacks of Markets Uncertainty With long term contract you know price for long term, but market price in long term future hard to predict Problems of uncertainty magnified by fact commodity markets can be volatile In light of these, energy players want tools for managing risk Hence, important theme in this lecture will be management of risk Note: if demand/supply for energy is inelastic, then small changes in demand/supply curve can induce large price changes Magnifying volatility Next slide illustrates this () Global Energy Issues, Industries and Markets 4 / 41

5 () Global Energy Issues, Industries and Markets 5 / 41

6 Financial Risks Faced By Energy Companies Market risk: future changes in price of assets/liabilities E.g. Oil company will not know future price of its oil (asset) E.g. Electricity generator will not know how much it has to pay for gas a year from now (liability) Liquidity risk: relates to failure to meet cash flows or lack of market activity Credit risk: relates to defaults on contracts Legal risk: regulatory changes or failure to comply with law Operational risk: technical problems with financial trading/fraud E.g. EU ETS phishing problems Financial markets mainly relate to market risk, but can help with others () Global Energy Issues, Industries and Markets 6 / 41

7 Financial Derivatives to Manage Risk Volatility in prices is an important source of risk Volatility = variance Note: there is more to risk than just variance In finance, properties of correlation between returns on different assets can be used to reduce risk (CAPM) Price of any asset (e.g. oil) depends not only on its expected value in the future but also its risk People are risk-averse, require higher returns to reward them for buying riskier asset E.g. energy company choosing between new projects in Australia or Turkmenistan If equal expected returns on each, will choose Australia Will require higher expected return on investment in Turkmenistan to take on risk (e.g. political and transportation/pipeline uncertainties) () Global Energy Issues, Industries and Markets 7 / 41

8 Financial Derivatives to Manage Risk Financial derivative is general term for any financial asset that derives its value from an underlying asset Many types of financial derivatives popular with energy traders Financial derivative can be complicated, but most are based on a few basic instruments: futures, forwards, options and swaps Note: the standard market (e.g. for buying 1 barrel of oil now) is called spot market Trading of financial derivatives can often far outweigh spot trading () Global Energy Issues, Industries and Markets 8 / 41

9 Financial Derivatives to Manage Risk Energy Futures Energy futures contract: agreement to buy/sell an energy asset at future point in time Contract purchased through an exchange with contract in standard format including delivery details These statements raise 4 issues: What is an exchange? What is an energy asset? What is a contract in standard format? What do we mean by delivery details? () Global Energy Issues, Industries and Markets 9 / 41

10 Financial Derivatives to Manage Risk Exchanges Exchanges (since around 2005) have mostly been electronic (replacing open outcry exchanges) NYMEX (New York Mercantile Exchange) is world s biggest market for energy derivatives ICE (Intercontinental Exchange) is also very big European Climate Exchange (ECX) largest carbon trading market, bought by ICE in 2010 Exchanges for energy futures in Asia slower to develop, but this is a growth area () Global Energy Issues, Industries and Markets 10 / 41

11 Financial Derivatives to Manage Risk Defining an Energy Asset It sounds obvious that an energy asset is, e.g., a barrel of oil But fossil fuels not homogeneous products E.g. ICE s Brent futures contract popular benchmark for oil prices In Asia Middle East, Dubai is common reference for oil In US, WTI (West Texas Intermediate) is popular oil price index () Global Energy Issues, Industries and Markets 11 / 41

12 Financial Derivatives to Manage Risk Defining an Energy Asset WTI = Texas light sweet Light = low density sweet = low sulfur content Brent Crude is classification of sweet light crude oil comprising Brent Blend, Forties Blend, Oseberg and Ekofisk crudes Problem is that benchmarks can be affected by specific things not relevant to price of oil in world as a whole Financial Times, 5 July, 2012: Crude jumps to one month high on Norwegian lock-out...the country s production of high quality, low sulphur crude oil is particularly important for the Brent market as it is part of the Brent benchmark. () Global Energy Issues, Industries and Markets 12 / 41

13 Financial Markets for Energy Trading Format of Future Contracts Futures involve standardized contract specifying: Quantity and then the settlement date (i.e. date in future when transaction occurs) Exchange matches buyers with sellers at market price E.g. 1 barrel of oil to be delivered on 30 December, 2016 for $100 agreed now (1 September, 2015) But buyer does not put up $100 now (money only changes hands on 30 December, 2016) This could (in theory) be end of story, but exchanges have added more features to reduce risk that one party defaults Buyer and seller put up some initial cash called the margin held by the exchange The price of this futures contract changes daily and exchange switches money from buyers to sellers margin account or vice versa Difference in price of futures now and day contract originally bought determines size of switches () Global Energy Issues, Industries and Markets 13 / 41

14 An Example of Specifications in a NYMEX Gas Futures Contract Trading unit: million British thermal units (MBtu). Price quotation: USD and cents per MBtu Trading months: The current year and the following five years. Last trading day: Three business days prior to the first calendar day of the delivery month Settlement type: Physical delivery at Henry Hub in Louisiana at a uniform rate over the delivery month. () Global Energy Issues, Industries and Markets 14 / 41

15 Financial Markets for Energy Trading Forward Contract Same idea as a futures contract But not sold on exchanges and not standardized Can be customized to buyer and seller s needs Sold over-the-counter (OTC) This means not an exchange (deal organized by market maker) But pricing is less transparent than futures () Global Energy Issues, Industries and Markets 15 / 41

16 Financial Markets for Energy Trading Options An option is right to buy or sell and asset at a future data at a specific price Price = strike price But unlike a future there is no obligation to do so Right to buy an asset is a call option Right to sell is a put option Options can be either standardized and traded on exchanges or OTC () Global Energy Issues, Industries and Markets 16 / 41

17 Financial Markets for Energy Trading Swaps Increasingly popular in energy markets OTC contracts where 2 agents swap cash flows of different sorts E.g. an independent energy company wants fixed price but in practice has to sell its gas on the spot market Independent can swap the uncertain cash flow from sales of spot market for a fixed flow of cash from a bank (e.g. J.P. Morgan) at an agreed price Suppose agreed price is $2.35 per MBtu If actual spot price of gas is below $2.35, J.P. Morgan will pay independent the difference between spot price and $2.35 If spot price of gas above $2.35, independent will pay J.P. Morgan the difference () Global Energy Issues, Industries and Markets 17 / 41

18 Managing Risk with Financial Derivatives The previous example for swaps gives you the basic idea: The independent energy company no longer faces risk of volatility in spot price of gas Can make long term plans knowing it will get $2.35 per MBtu for its gas J.P. Morgan is taking on risk associated with gas price volatility (and is being paid for taking on this risk) Financial derivatives, in a sense, are like insurance Terminology: hedging () Global Energy Issues, Industries and Markets 18 / 41

19 Hedgers versus Speculators Risk management issues explain why many agents want to buy financial derivatives which reduce risk E.g. small energy company wants guaranteed price for gas it produces Note: with shale gas revolution and low current price of gas, several US gas companies who did not hedge are facing bankruptcy Airline wants to know price of aviation fuel it will pay 1 year from now E.g. EU ETS requires carbon permits to be surrendered at end of year Electricity generating companies buy carbon futures with settlement date in December In July they do not need the carbon permits, but good to know what price has to be paid in December All these are hedgers (want to minimize risk) () Global Energy Issues, Industries and Markets 19 / 41

20 Hedgers versus Speculators But every time a hedger buys a derivative to reduce risk someone must be selling it Often it can be someone who has no interest in taking delivery of the energy Purely interested in making money by successfully anticipating price movement These are speculators Speculators are controversial But they are probably necessary, someone must exist to sell the insurance buyers want Speculators provide liquidity () Global Energy Issues, Industries and Markets 20 / 41

21 Hedgers versus Speculators Lots of speculators are, e.g., pension funds, sovereign wealth funds or hedge funds who want to make money for clients out of commodity price movements E.g. The Quest by Daniel Yergen tells of a large European state pension fund, fearing a war in Iran, bought large amount of oil futures If war in Iran occurs, price of oil will rise, pension fund will make money Pension fund justified this as risk management: if war in Iran occurred other parts of its portfolio (e.g. stocks) would be hurt This pension fund would argue its speculation was risk management to protect its pensioners Some equate speculator = market manipulator Probably little manipulation of oil price in general, its movements can be explained by demand and supply (see work of Lutz Kilian) But short term manipulation of benchmarks might have occurred () Global Energy Issues, Industries and Markets 21 / 41

22 Hedgers versus Speculators With big, transparent, liquid markets, manipulation should not be possible More evidence that excessive speculation can lead to bubbles (not just in energy markets, but other financial markets) Irrational exuberance can drive prices above what fundamentals say they should be (at least until a crash occurs) Fundamentals = what laws of supply and demand say they should be Energy trading involves huge amounts of money And many traders never touch a barrel of oil But good and bad consequences to this Probably impossible to stop speculation in any case () Global Energy Issues, Industries and Markets 22 / 41

23 What Determines Energy Futures Prices? I will derive a few results from financial theory of commodity markets Begin with simple example with no storage or transactions costs Begin with a non-commodity example, just a treasury bill or bond Suppose you have a choice between two investment options at time t You want your investment to pay off at time T You buy a treasury bill now and just earn interest at rate r Spot market price is S t () Global Energy Issues, Industries and Markets 23 / 41

24 What Determines Energy Futures Prices? Rules of continuously compounded interest imply at time T you have r (T t) S t e Your second choice of an investment is future for treasury bill with price Ft T These two investments must yield exactly the same amount: F T t r (T t) = S t e If futures pays more (Ft T > S t e r (T t) ) then speculators will buy futures and sell on spot markets, forcing futures price up and spot price down Reverse holds if spot market yields more than futures markets This is called arbitrage In transparent, liquid markets, arbitrageurs will ensure Ft T = S t e r (T t). Note: e r (T t) > 1 so in spot/futures markets for stocks and bonds futures price always above spot price () Global Energy Issues, Industries and Markets 24 / 41

25 What Determines Energy Futures Prices? For energy commodities, slight extensions are required A barrel of oil must be stored spot price of a barrel of oil today (t) is S t It must be stored until time T Note: oil inventories are substantial and an important feature of oil industry If µ is storage cost per unit of time, then seller of future must pay until settlement date Result is futures price equation of: F T t (r +µ)(t t) = S t e r + µ are called carrying costs () Global Energy Issues, Industries and Markets 25 / 41

26 What Determines Energy Futures Prices? Storage is a cost which must be paid by seller of future But there can also be benefits to having inventories Seller of future holds oil in inventory between t and T In this period, might be able to use inventory to benefit from shortages in market which arise, etc. Such additional benefits are called convenience yield, δ If they exist, then futures price takes them into account: F T t (r +µ δ)(t t) = S t e () Global Energy Issues, Industries and Markets 26 / 41

27 Contango and Backwardation In markets without convenience yields, it must be the case that Ft T > S t Futures price greater than spot price (this is the normal thing) This is called contango However, if convenience yields are high (r + µ < δ) then it is possible for spot to be less than futures This is called backwardation Next figure are the Phase II EU ETS carbon market spot and futures (with December 2012 settlement date) () Global Energy Issues, Industries and Markets 27 / 41

28 Euros per mt (spot, future, offset) or % (for interest rate) 35 Spot Future () Global Energy Issues, Industries and Markets 28 / 41

29 Effi cient Markets Hypothesis Futures markets good for hedging risk But also give price transparency and expectations about future prices Note: preceding relationships linked Ft T t is the present, T is the future and S t Note: previous material had S t in it, now you will see S T What do we expect (now) the spot price will be in the future? Notation: E (S T ) for expected value of future spot price () Global Energy Issues, Industries and Markets 29 / 41

30 Effi cient Markets Hypothesis Ignoring risk, market effi ciency says Why? F T t = E (S T ) Both Ft T and S T are prices of energy at time T If Ft T > S T it means people willing to pay higher price now than they expect to have to pay in future If Ft T < S T it means people paying lower price now than they expect to have to pay in future Effi cient markets hypothesis says neither makes sense () Global Energy Issues, Industries and Markets 30 / 41

31 Effi cient Markets Hypothesis If either holds, arbitrageurs can step in and make money (in an expected value sense) E.g. on futures market can buy a barrel of oil in December 2015 for $100 If you expect actual oil price in December 2015 to be $120 then buy futures (pushing their price up) Only sustainable thing is F T t = E (S T ) This is informal justification for effi cient markets hypothesis () Global Energy Issues, Industries and Markets 31 / 41

32 Effi cient Markets Hypothesis Previous argument ignores the role of risk Buyers in futures market willing to pay a premium to eliminate risk of unfavourable movements in the spot price Let π t be this risk premium, then F T t = E (S T ) + π t Why is this useful? F T t can be used now to forecast future energy prices Note: if risk premium is roughly constant over time, then change in futures = change in expected future spot price Can be used to test for market effi ciency or obtain estimates of risk premium () Global Energy Issues, Industries and Markets 32 / 41

33 Valuing Options In order to use financial derivatives effi ciently for hedging and speculation need to know their value For futures and forwards preceding material addresses this question But what about options (puts, calls) and swaps, etc. Financial literature on option pricing exists (and is large) Too much (and too technical) to cover as part of one lecture Let me just note here that this literature exists (Black-Scholes option price formula, etc.) If you ever plan on becoming an energy trader you should learn about option pricing () Global Energy Issues, Industries and Markets 33 / 41

34 Electricity Trading The Product Being Traded Electricity trading uses similar tools as trading in any form of energy However, the unique characteristics of electricity raise a few distinctive points Remember: electricity is not storable (timing of delivery critical, supply and demand must match at each point in time) Remember: electricity requires grid to ship (local/regional markets, no global market) Because electricity supplier cannot predict demand perfectly, must be someone responsible for balancing demand and supply Remember: Peak load pricing issues () Global Energy Issues, Industries and Markets 34 / 41

35 Electricity Trading The Product Being Traded In general, these issues lead to electricity prices being quite volatile With storable products and global trade, price changes smoothed out Price increase in one location/time mitigated by trade from other locations or time periods These characteristics do not hold with electricity leading to price volatility Transmission system operator (TSO) responsible for balancing demand and supply TSO defines a balancing period (e.g. 30 minutes in UK, 15 minutes in Germany) Electricity markets involve buying/selling electricity for time units of this balancing period or slightly longer (e.g. one hour) Map on next slide gives location of major electricity trading exchanges Note: mostly in Europe and eastern part of North America () Global Energy Issues, Industries and Markets 35 / 41

36 () Global Energy Issues, Industries and Markets 36 / 41

37 Electricity Trading Electricity Markets Four types of electricity markets 1 Futures and forward markets 2 Day ahead market 3 Intraday market 4 Balancing and reserve markets () Global Energy Issues, Industries and Markets 37 / 41

38 Electricity Trading Electricity Markets Futures/forward markets same idea as for fossil fuels Use for managing risk/hedging (also speculation) Traded on exchanges or over-the-counter (OTC) Day ahead market similar to a spot market Intra day market for within a day need to adjust supply These two markets involve trades on exchanges or bilaterally between suppliers With preceding markets demand and supply are generally pretty close to being in balance over each balancing period But balancing or reserve market exist to fill any cases where demand not equal to supply Details of this market differs by country, but trading/exchanges not involved () Global Energy Issues, Industries and Markets 38 / 41

39 Electricity Trading Electricity Markets TSO typically runs it and charges/reimburses suppliers if demand and supply are not equal in a balancing period The details of where TSO gets this electricity also differ by country and can be complicated Usually involve pre-arrangements with reserve plants which must be able to reduce/increase production at short notice E.g. if disturbance lasts for 30 seconds, primary reserve plants are called on If disturbance lasts longer and up to one hour, secondary reserve called on, etc. Another refinement in energy markets is there is usually distinction between base load and peak load times () Global Energy Issues, Industries and Markets 39 / 41

40 Electricity Trading Power Exchanges Power exchanges are typically included in energy exchanges discussed previously But more local E.g. NYMEX also trades electricity but only for parts of US delivery ICE futures involve delivery of electricity to or from National Grid in the UK European Energy Exchange (EEX) in Leipzig covers Central Europe Nord Pool covers electricity trading in Northern Europe (biggest spot market in the world) () Global Energy Issues, Industries and Markets 40 / 41

41 Summary In this lecture I have covered: Increasing role of financial markets/exchanges for energy products Benefits and drawbacks of this increase The risks faced by energy traders Financial derivatives for managing risk Futures, forwards, options and swaps Hedgers and speculators Determination of futures prices Futures as expectations of future spot prices (market effi ciency) Electricity trading () Global Energy Issues, Industries and Markets 41 / 41

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