Managing Energy Risk: An Integrated View on Power and Other Energy Markets

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Commodity Price Models

Financial and commodity markets have converged in many ways. Availability of commodity exchanges and the standardisation of commodity contracts have made it possible to construct derivative products similar to those known from financial markets and to use similar mathematical approaches to price them and quantify their risks. So what makes modelling commodity prices different from modelling financial markets? The differences are a result of the following market characteristics:

• Storability: Some commodities, such as gold, are easily storable at low costs, while others are hardly storable at all, such as electricity. Storability is a major factor determining the relation between spot price and forward price.
• Consumption: Most commodities are primarily held for consumption and not for investment. This is related to the limited or costly storability of many commodities.
• Delivery: Energy, in form of electricity or gas, is not usually delivered at one point of time, but over a delivery period. Electricity and gas also need special infrastructure to be delivered.
• Market regulation: Energy markets traditionally were highly regulated and are still often dominated by few players. Changes of legal regulations and trading decisions of dominant players may have an impact on market prices.

Fundamental market characteristics have a strong impact on the behaviour of commodity and energy prices. There are two different approaches to stochastic modelling of commodity ...