energy trading & investing This page intentionally left blank energy trading & investing trading, risk Management, and structuring deals in the energy Markets D W. E avis DWarDs New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto Copyright © 2010 by Davis W. Edwards. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-162907-2 MHID: 0-07-162907-6 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-162906-5, MHID: 0-07-162906-8. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please e-mail us at [email protected]. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior consent. You may use the work for your own noncommercial and person- al use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR- ANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMA- TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupt- ed or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of lia- bility shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. C o n t e n t s Pr e f a C e i x 1.1 a o e M 1 n v e r v ie w o f t h e n e r g y ar ke t s 1.2 t M 4 3 ra d i n g a r k e t s 2.1 n g 6 8 at ur a l a s 2.2 e 9 3 leCtriCity 2.3 o 126 il 2.4 C 144 oal vi C o n tE n ts 2.5 e M 158 Missions arkets 3.1 P 168 ollution 3.2 g , l , s 175 ases iquids and olids 3.3 s 184 tatistiCs 3.4 f o 200 inanCial Ptions 3.5 o P 216 Ption riCing 3.6 s o 234 Pread Ptions 4.1 s l f 245 Patial oad oreCasting 4.2 t g s 259 he eneration taCk Co n t E n t s vii 4.3 t a 272 olling greeMents 4.4 w P 284 heeling ower 4.5 s P 293 olar ower 4.6 w P 301 ind ower 4.7 n P 306 uClear ower 4.8 e s 311 leCtriCity torage 5.1 n g t 318 atural as ransPortation 5.2 n g s 328 atural as torage 5.3 l n g 341 iquefied atural as viii C o n tE n ts 6.1 v r 345 al u e a t is k 6.2 d , g , o g 353 eltas aMMas and ther reeks 6.3 M r 357 odel isk 6.4 C C r 361 ounterParty redit isk afterword 364 index 367 P r e f a C e The inspiration for this book came early in my energy trading career. Previously, I had traded a variety of other products. However, after the boom years in the stock markets in the 1990s and the real-estate boom in the early 2000s, energy became the hot new area around 2005. A wave of financial professionals, including me, left our previous trad- ing desks to join the “new” energy market. Of course, it wasn’t really a new market, but with the fall of Enron and market deregulation, trad- ing opportunities were wide-open and expanding. From the start, there was a huge culture clash between long-term energy traders and Wall Street traders. On Wall Street, the old intuitive traders had lost out to disciplined traders with technical backgrounds. Called quants, these math-savvy traders with degrees in physics, sci- ence, or engineering had taken over traditional trading desks by being more disciplined and organized. And, now, those same quants had set their eyes on invading the old-boy network of the energy markets. The U.S. government also wants to change the energy markets and make them more efficient at allocating money to energy projects. More disciplined trading and a government desire to project con- sumers from “predatory” speculation is in the midst of transforming the energy market from a “wild west” of short-term trading into a set of businesses with a long-term focus. It is a market in flux, and Energy Trading & Investing is written for every smart person who looked at a problem and said, “I could do it better than those guys,” but didn’t quite know where to get started. This is the book that I wished I’d had when I started trading energy. It grew out of the notes that I made then and later used to train new analysts. This book explains the en- ergy market, how financial professionals trade energy products, and how they manage their business. It is written at the introductory level, without the use of jargon or complicated mathematics. My philosophy on trading is that there is no substitute for understanding what is actually going on. Details are important. While writing this book, I had to fight back the temptation to eat up a lot of pages on interest- ing mathematical details to keep the discussions at a reasonable length. ix