Energy markets are dramatically different from financial markets. As new markets continue to open up around the world in gas and electricity, as well as the more established energy commodities, there is a real sense of pioneering. The map of the terrain is new and there are still large, uncharted areas. The number and complexity of fundamental factors affecting the price of energy in forward markets makes the need for derivatives all the more apparent. Producers and consumers alike are seeking to hedge forward price risk; derivatives seem to be the answer. Paradoxically, the high degree of risk, which makes derivatives an attractive insurance policy, also makes it essential that the risks involved in trading energy derivatives be better understood.
What is it that makes energy markets different? One place to start looking at this question is to compare the energy markets with a more mature, well-established market such as the capital markets. The first thing to note is that energy is more risky simply by virtue of being newer. Many of the participants are new to the game and this, in and of itself makes the market behave less predictably. Secondly, energy is more complex. The numbers of fundamental drivers influencing forward prices are significantly higher. The capital markets these days have few physical aspects. But, energy transactions are dependent on an interplay of physical conditions such as pipeline capacity, the weather, and failure of production facilities, for example. Availability of storage facilities in the right location, the storage injection costs, the rate of flow, the list goes on. In an energy transaction it is not possible to take advantage of an arbitrage opportunity without taking these physical factors into account. In U.K. gas it may be advantageous to buy a large quantity of cheap natural gas but if you do not have the pipeline capacity to ship it then the advantage may be lost.
One consequence of this is that capital markets are more straightforward to model mathematically. Whilst many mathematicians are gainfully employed as quantitative analysts in the capital markets arena using highly sophisticated mathematics, it is nevertheless true to say that billions of dollars are transacted in financial derivatives based on pricing and risk management models which are relatively simple.
Other significant differences exist. Energy markets are highly seasonal. In the U.K. gas markets for example, "winter gas" and "summer gas" are two entirely different commodities. As the market switches from a winter gas month into a summer gas month the price jumps overnight. How then can you build a forward curve of prices? Energy markets also tend to be highly regulated. The U.K. gas market's network code makes certain types of transaction--which would be commonplace in the financial markets--impossible. For example, interruptible consumer gas contracts are currently highly restrictive; it is not possible to have more than one supplier for your gas, which makes it difficult to shop around.
Despite the complexity, the need for derivatives is clearly apparent as a demand from end users of energy products. Energy markets seem to exhibit a curious dual nature. On the one hand much of the activity in the market is simple and on the other hand it is highly complex. For example, currently most traders/brokers in the U.K. gas market will quote prices for options without any quantitative analysis into the premium price or the ability to hedge positions. If you suggest the use of quantitative methods they will regard you with suspicion, preferring to use gut feel entirely. Modeling of risk is difficult and there is precious little historical evidence on which to base assumptions about volatility, for example. At the same time however, due to the demand-driven nature of the need to hedge effectively, the derivative products available are among the most complex in any market. In capital markets the vast majority of derivatives trades are plain vanilla. In the energy markets a disproportionate number are of the highly complex nature--Asian caps or complex seasonal swing options are the norm rather than the exception. Currently, derivative contracts tend to be tailored to individual user requirements, the terms and conditions depending on the counterparties. This is likely to change as key players in the market recognize the power of standardizing terms and conditions and providing a fewer number of standard over-the-counter derivative offerings.
Despite the current frontier town nature, it seems almost inevitable that energy markets will evolve into a more orderly, predictable beast. As the availability of systems to provide analytical tools increases and as trading moves towards a smaller number of less intricate, more standardized derivatives, more players will enter the energy derivatives game. Increased liquidity and increased understanding of the fundamental risk drivers on the part of the players will tend to attract the more risk averse, further fuelling the market for energy derivatives.
This week's Learning Curve was written by Michael Coleman, managing director of FSD International.
