Energy Trading and Investing: Trading, Risk Management and Structuring Deals in the Energy Market / Edition 1

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Overview

How to profit in one of today’s

fastest-growing financial markets!

With diminishing fossil fuel supplies and the growing specter of environmental

change, governments are using the free market to minimize the cost of adopting

sustainable energy policies. This makes energy one of the few markets that is rapidly

expanding, and it is now one of the hottest investment opportunities in the world.

Energy Trading and Investing offers a comprehensive and practical introduction to

energy trading—from the big picture of how different products are related to each

other to in-depth explanations of the jargon and fi nancial mathematics that trip up

new traders.

Energy Trading and Investing features:

  • A detailed introduction to each of the major energy markets:

    electricity, natural gas, petroleum, coal, and emissions

  • Primers on advanced topics like storage, wheeling,

    load forecasting, and pipeline transportation

  • Examples of ways to invest in wind power, carbon emissions,

    thermal solar power, and other new markets

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Product Details

  • ISBN-13: 9780071629065
  • Publisher: McGraw-Hill Professional Publishing
  • Publication date: 10/13/2009
  • Series: [McGraw-Hill Finance and Investing] Series
  • Edition number: 1
  • Pages: 400
  • Sales rank: 668,140
  • Product dimensions: 6.20 (w) x 9.10 (h) x 1.40 (d)

Meet the Author

Davis W. Edwards is a managing director

at Macquarie Group and is responsible for

managing the credit risks of its North American

energy investments. Macquarie, Australia’s

preeminent fi nancial conglomerate, is one of

the largest energy companies in North America

through its subsidiary, Macquarie Cook

Energy. Previously, Davis headed the Mathematical

Arbitrage Trading Desk at Bear Stearns.

With several billion in capital and operated

like a private hedge fund, the Mathematical

Arbitrage Trading Desk handled Bear Stearns’s

proprietary investments in the equities, energy,

commodities, and option markets.

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Read an Excerpt

ENERGY TRADING & INVESTING

Trading, Risk Management, and Structuring Deals in the Energy Markets
By Davis W. Edwards

McGraw-Hill

Copyright © 2010 Davis W. Edwards
All right reserved.

ISBN: 978-0-07-162907-2


Chapter One

1.1 AN OVERVIEW OF THE ENERGY MARKETS

30-Second Summary

Purpose

This chapter summarizes the most important points in the book. It provides an introduction to the energy market and an overview of energy trading. The chapter is structured the same as the entire book, and is a summary of the major topics that will be discussed in detail.

Summary

The energy market is a collection of interrelated businesses focused on delivering electricity and heating fuel to consumers. One set of businesses finds and develops new sources of power—drilling for new fuel reserves or developing better solar panels. Another group transports these sources of power closer to end consumers using pipelines or cargo ships. Other businesses generate power: power plants, wind farms, and solar installations. Additional businesses, like public utilities, are responsible for actually distributing power and natural gas to consumers. The energy sector affects almost every facet of the U.S. economy

The fragmented nature of the energy market means that most people only see a small portion of the whole market. The energy market is shaped by the details of its subindustries. Ultimately, the market revolves around drilling for fuel reserves, building power plants, and running power lines. Each of these subindustries has unique aspects that need to be understood by decision makers. However, it is also important to understand how the entire market fits together.

The major commodities in the energy market are natural gas and electricity. Coal, carbon emissions (greenhouse gases), nuclear power, solar power, and wind energy are also all part of this dynamic market. Oil is also an energy product. However, oil is more influential as a source of energy for cars than as a source of electricity and heat. Energy has always been a major industry, but with deregulation allowing more active trading, it has also become a major financial market. It now stands alongside stocks, bonds, and other commodity markets as an equal. With the influx of Wall Street and financial interests, a large body of people are now involved in energy trading.

Many complex aspects of energy trading are due to the physical characteristics of energy commodities. Energy is hard to transport and store. Like other commodity markets, a large portion of energy trades are settled by the physical delivery of a commodity. When delivery or receipt is required as part of a trade, it is called a physical trade. When a trade involves only the transfer of cash—without a physical delivery—it is called a financial trade. Physical trading is both more complex and financially rewarding than financial trading.

Several major energy products (electricity and heat) can't be easily stored—they must be generated as they are needed. They are also expensive to transmit over long distances. Because of this, power and heat are typically generated close to the consumers who need those products. As a result, the energy market is further divided into another two pieces: a collection of small local markets concerned with today's activity (spot markets) and a separate market concerned with national expectations of the future (the forward market). Unlike the stock or bond market, the energy spot and forward markets aren't closely linked. This is because it is impossible to buy electricity at one point in time, store it, and deliver it at a later point in time.

Common Terms

Physical Contracts. Contracts settled by a physical transfer of a commodity from one owner to another.

Financial Contracts. Contracts settled by a transfer of cash. Financial contracts are used by investors who don't wish to take delivery of a commodity like crude oil but still want an exposure to prices.

Spot Market. A spot transaction involves a transfer of goods on the spot. A synonym for spot is cash, as in cash market or cash transaction.

Forward Market. A forward transaction involves a transfer of goods at some point in the future. For example, an agreement to have natural gas delivered six months in the future.

Arbitrage. To make a risk-free profit by simultaneously buying one security and selling another. A common assumption in option pricing is that arbitrage opportunities do not exist. Or, if they do exist, they do not last for long.

Liquid Asset. An asset that is easy to buy or sell on short notice. A U.S. government bond is an example of a liquid asset.

Illiquid Asset. An asset that is hard to buy or sell on short notice. A nuclear power plant is an illiquid asset. It may be worth a lot, but it might be hard to resell a power plant for a fair price.

From a trading perspective, the spot markets are complicated. They are full of local regulations and subject to a laundry list of physical constraints. The most liquid markets are the forward financial markets. It is tempting to ignore the physical markets in favor of the easier to understand financial markets—however, this is a mistake. The financial markets contain hundreds of features that are inexplicable unless the physical markets are understood. The complexity of the physical spot markets defines energy trading. Individually, none of these issues are difficult to understand—but there are a lot of distinct issues to keep track of.

The energy market is composed of many separate products concerned with the production and delivery of electricity and heat. Of these, the two most important are natural gas and electricity. Coal, carbon emissions, and alternative energy are examples of some secondary commodities in the energy market. Oil is also an energy product, but it is more influential as a source of energy for cars than as a source of electricity and heat. However, the economic impact of oil is so large that it plays a major role in every aspect of energy trading.

Major Players

To produce electricity and heat, you have to locate some fuel, get the fuel to where it needs go, and turn the fuel into something useful. The start of the process—finding fuel—is usually performed by exploration companies. The fuel has to be extracted and prepared for transport by a drilling company. In specialized parts of the market like solar power, manufacturing solar panels replaces exploration and mining. Likewise, hydroelectricity requires a civil engineering firm to construct a dam.

Next, the fuel needs to be transported somewhere useful. Natural gas can be transported as a gas in a pressurized pipeline or it can be turned into a liquid and transported by cargo ship. If liquefied, the natural gas needs to be returned to gaseous form after transportation. Coal is transported on trucks and railroads. Oil is transported by tanker ship and liquid pipelines. Of course, not all portions of the market require transportation—the sun handles delivery of solar energy by itself.

Finally, useful products must be produced and distributed to end users. Public utilities and merchant power operators generate electricity at power plants. Then they transmit their power to customers over a power grid maintained by a Transmission System Operator (TSO). Natural gas is moved out of transcontinental pipelines and into the systems of local gas utilities. Local gas utilities distribute natural gas to consumers through their own pipeline networks. Petroleum products need to be refined and transported to local residences and gas stations via truck.

Common Terms

Regulated Market. A market where a legislature votes on decisions concerning how to run an industry.

Deregulated Market. A market where legislative involvement has been removed to allow for a more efficient marketplace. Usually a substantial amount of government oversight remains in place.

In the electrical power industry, transmission systems (power grids) are often run by local governments. When a TSO is unaffiliated with the local government, it is called an Independent System Operator (ISO). An ISO that crosses state boundaries is also commonly referred to as a Regional Transmission Operator (RTO). Most electricity trading occurs on power grids run by RTO/ISOs operating in deregulated markets; that is, markets that allow free trading of electricity. Local rules vary between power grids. However, most deregulated power markets are still highly regulated. In this book, TSO is used to describe any power grid operator, and RTO/ISO is used to describe the operator of a power grid in a deregulated market.

Allowing anyone to trade electricity is a relatively new concept. Prior to deregulation, only power plants owned by utilities could sell power into a power grid. After deregulation, anyone could build a power plant, produce power, and offer that power for sale. In deregulated markets, utilities have shifted away from running power plants to concentrating on operating transmission grids. There are power plants now owned by power traders and operated by specialized service companies. These changes revolutionized the power industry—they created a market for electrical power.

The last groups of market participants are the traders, investors, and marketers. Financial trading has grown up around the physical trading business. Funding exploration or building new manufacturing plants isn't cheap—it requires raising capital from investors. Local utilities need to use financial contracts to guarantee a steady supply of fuel and electricity for their customers. Power plants need to buy fuel and sell their electricity. Major industrial facilities might want to guarantee future supplies of affordable power. Financial firms might wish to speculate on the price of power. To do this, any of these parties can enter into transactions. These transactions can be done over the counter—directly between two parties—or by using an intermediary organization (often an exchange). Energy products are commonly traded on the New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE).

Common Terms

Power Marketer. A company specializing in the buying and reselling power.

Long an Asset. A trader is long an asset if he benefits when the price appreciates.

Short an Asset. A trader is short an asset if he benefits when the price declines.

The ramification of buying an asset in the future is often confusing. For example, a trader who agrees to buy an asset at a fixed future price benefits if the future price goes up; he has already locked in a price. However, a trader who agrees to buy an asset in the future without fixing the price benefits if that price declines; he can then buy more cheaply. To clarify the financial implications of owning an asset in the future, traders will use the terms "long" and "short" instead of "buy" or "sell" to describe their financial exposures.

Natural Gas

Natural gas is a fossil fuel used for heating and producing electricity. It is a combination of colorless, odorless gases composed primarily of methane (CH4). It often contains substantial amounts of other hydrocarbons, like ethane (C2H6), propane (C3H8), and butane (C4H10). The composition of natural gas varies from location to location. It is often found mixed with nitrogen, carbon dioxide, and other trace gases. Natural gas is considered "dry" when it is almost pure methane, and "wet" when it has substantial quantities of the other hydrocarbons. Its central role in the energy industry is due to its characteristic as a clean, comparatively inexpensive fuel—almost all the electrical power generators that have been built in the United States for the past 20 years use natural gas as a fuel.

Natural gas is extracted from underground wells and transported to customers through pipelines. End users of natural gas are often called the burner tip because gas appliances were once fitted with special dispersing heads to make natural gas suitable for lighting, cooking, and heating. Modern appliances no longer use burner tips, but the nickname has stuck.

Natural gas pipelines are located throughout the country and are capable of providing a constant supply of gas to consuming regions. Natural gas hubs are located at the interconnection between major pipelines. The most important—Henry Hub—is located on the Gulf Coast, about halfway between New Orleans and Houston. Henry Hub is the delivery location for the NYMEX natural gas futures contract and is used as the benchmark for all natural gas sold throughout the United States. Like many other energy products, the forward and spot markets for natural gas are distinct from one another. There is an extremely well-defined seasonal component to forward prices. Prices in the forward market tend to mirror consumer demand—both are high in the winter and fall dramatically in the spring of every year. Spot prices don't show the same kind of seasonality. However, despite the different behaviors, arbitrage between the two markets is impossible without a physical storage facility. It is possible to make a profit buying gas on the spot market, storing it, and selling it for future delivery. However, this requires an ability to make physical trades—to take delivery and store large quantities of a gas—which many market participants lack.

Common Units

Because the composition of natural gas can vary substantially, it is commonly described in terms of its heat energy rather than as a volume- or weight-based measurement. Heat energy is the amount of energy that can be obtained from burning a substance.

Btu (British Thermal Unit). A Btu is a measurement of heat energy used in the United States. Heat energy is commonly traded in millions of Btus (MMBtu).

Bcf (Billion cubic feet). A common measurement of natural gas storage facilities. There are approximately 1 million MMBtus (million Btus) in 1 Bcf (billion cubic feet) of natural gas.

J (Joule). A measurement of heat energy in most of the world. Commonly, energy is traded in thousands of joules (kilojoules, kJ) or millions of joules (megajoules, or MJ). One Btu is equal to 1054.35 Joules.

Electricity

Generating electricity is one of the major purposes of the energy market. Electricity is used to power a large variety of modern devices and is so common that it is hard to imagine life without it. Unfortunately, electricity can't be stored and it's very expensive to transmit over long distances. Consequently, there is no national electricity market—it's a collection of small regional markets with unique characteristics and regulations. In each of these markets, supply and demand must constantly be matched, which results in a highly volatile spot market.

The most important physical markets are the daily power auctions held in each region. These auctions allow power producers to sell their electricity to consumers on their local power grid. Typically, they allow the sale of power by hourly increments on a day-ahead basis or in five-minute increments during the day that power is to be delivered. These auctions are the mechanism for setting the price of power in a region. Most speculative power trading goes on in forward markets that are separate from the daily power auctions. The forward markets are typically based on the price of delivering power at a major hub. Time horizons for forward trades range from the rest of the current month to approximately five years out.

As a general rule, on the day of delivery, the price for electricity is the same for all the participants in a local market. All producers receive the same price per megawatt and all consumers pay the same price per megawatt. This is called the clearing price for power. In deregulated markets, the clearing price is based upon bids submitted by power producers. These bids contain a price schedule matching volumes of power to prices. Power plants are activated in lowest to highest cost order until the consumer demand is met. The clearing price of power is set by the cost of the most recently activated power plant. The cost of bringing the last unit of electricity into the market is called the marginal price of power, and the most recently activated plant is the marginal power plant. In general, the clearing price is set by the marginal price of power.

(Continues...)



Excerpted from ENERGY TRADING & INVESTING by Davis W. Edwards Copyright © 2010 by Davis W. Edwards. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Part One: Instruments & Markets
1. Major Players
2. Natural Gas
3. Electricity
4. Oil

Part Two: Coal & Carbon Emissions
5. Technical Primer
6. Physics of Gas
7. Physics of Power
8. Financial Options
9. Math of Spread Options
10. Estimating Correlations
11. Monte-Carlo Simulations
12. Game Theory
13. Dynamic Programming

Part Three: Electricity Models
14. Forecasting Demand for Electricity
15. Generation Stack
16. Tolling Agreements
17. Wheeling Power
18. Congestion Models
19. Solar Power
20. Wind Power

Part Four: Natural Gas Models
21. Natural Gas Transportation
22. Natural Gas Storage
23. Liquefied Natural Gas
24. Weather Forecasting
25. Financial Instruments

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