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Modelling Energy Forward Curves (Borovkova) PDF
Modelling Energy Forward Curves (Borovkova) PDF
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Energy markets
Pre-1980s: regulated energy markets 1980s: deregulation of oil and natural gas industries 1990s: deregulation of electricity industries worldwide Energy is the worlds largest traded commodity class Crude oil is the worlds largest commodity Energy markets are extremely volatile (annual volatilities: Oil 40+%, NG 60+%, Electricity 100+% comp. with 15+% for equity indices) = need for ecient risk management Energy prices are negatively correlated to the stock prices and indices = perfect diversication tools
What is traded? Physical crude oil, oil products, NG (spot markets); forward contracts (OTC); Futures contracts on ICE, NYMEX: volumes 9-10 times higher than those in spot markets!
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Futures: standardized contracts for delivery of a commodity (e.g. crude oil) at dierent time points (expiries) in the future. Prices for futures with dierent expiries (e.g., for oil, up to 72 months ahead) are recorded daily. The collection of these futures prices on any particular day is called the forward curve. The set {F (t, T ), T > t} is the forward curve prevailing at date t for a given commodity in a given location; T indicates the expiry, or maturity date (month). The forward curve is the fundamental tool when trading commodities, as spot prices may be unobservable and options illiquid.
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$/bbl
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Oil forward curves: two fundamental market states Backwardation and Contango
Anticipated value of the future spot price is lower (B) or higher (C) than the current one. Inuenced by: current price and inventory levels, transportation and storage costs, supply/demand, strategic and political reasons, ...
06.03.2000, backwardation market 30 16 01.12.1998, contango market
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September 2007
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For oil, seasonality is not signicant, since tankers are rerouted to satisfy a surge of demand in a given region Energy (electricity, natural gas, spark spread) - governed by seasonal demand Agricultural commodities (wheat, soybean, soymeal, crush spread, coee, cocoa) governed by seasonal supply Seasonality in energy or agricultural spot prices: well-understood and easily modelled (e.g. mean-reversion with seasonally varying mean, seasonal component + autoregression) Seasonality in forward curves: much less studied; no explicit models
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F (t, T ) = S (t)e
[r (t)+w(t)](T t)
()
r (t): spot interest rate, w(t): marginal storage costs per $ of spot, per time unit.
In practice () almost never holds (e.g. backwardation or hump-shaped forward curves): strategic importance (oil); limited or non-storability (agricultural, electricity) Convenience of having physical commodity as opposite to futures contract concept of convenience yield y (t):
F (t, T ) = S (t)e
[r (t)y (t)](T t)
- premium (as perceived on the day t) earned by an owner of physical commodity as opposite to an owner of the futures contract with maturity T .
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Convenience yield
Often considered net marginal storage costs: y (t) = y (t) w(t). Convenience yield proportional to the spot price y (S ): Brennan & Schwartz (1985). Stochastic convenience yield y (t) = y (t, ): Gibson & Schwartz (1990), Schwartz (1997). Dependence on t: premium to owner of physical commodity changes with inventories (stocks) and hence, with agents preference for physical rather than paper. At a xed date t, a single value of the process (y (t))t for all maturities is not compatible with the hump-shaped forward curve observed in 2006 in the oil market (and other commodity markets), or with seasonal features of the forward curve.
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One possible modelling answer is to introduce a term structure y (t, T ) of convenience yields at date t, deterministic in the maturity argument T and stochastic in t (Borovkova & Geman, 2006, 2007) This approach is certainly benecial in the case of seasonal commodities such as natural gas where, assuming today = January 2008, y (t, T ) should be dierent for T = September 2008 or T = December 2008. Dependence of convenience yield on maturity T (y (t, T )): to emphasize seasonality of F (t, T ) in [r (t)y (t,T )](T t) F (t, T ) = S (t)e e.g. futures expiring at desirable season (e.g. NG futures expiring in December)
Emphasizes the time-spread option feature of convenience.
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The average level of the forward curve, or the average forward price prevailing at date t:
(t) = F
F (t, T ),
T =1
or
(t) = 1 ln F N
ln F (t, T ),
T =1
Assume: (N mod 12) = 0, i.e. consider maturities up to a (number of) year(s) (t) is not seasonal. that way F (t), so the assumption can be relaxed Other ways of constructing a non-seasonal F Not limited to regularly spaced maturities but can include all traded liquid maturities Can include all (not liquid) maturities, by considering traded-volumeweighted average
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The seasonal premium (s(M ))M =1,...,12 is the collection of long-termaverage premia (expressed in %) on futures expiring in the calendar month M (M = 1, ..., 12) (t). with respect to the average forward price F
Assume (s(1), ..., s(12)) is the deterministic collection of 12 parameters; 12 Require that M =1 s(M ) = 0; Seasonal premium is an absolute quantity and not a rate: premium on futures expiring in July is the same whether today is June or December. Premium on July 2008 futures is the same as on July 2009 futures. Can be dened as a continuous-time periodic function (e.g. trigonometric); however less appropriate for monthly expiries.
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()
where (t, T ), dened by the relationship (), is called the stochastic convenience yield net of seasonal premium, for maturity T , as perceived on the day t. Seasonal (monthly) premium (or discount): in s(T ) Stochastic factors inuencing forward prices: in (t, T ) The relationship () involves only forward prices, hence no interest rates.
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y (t, K )
K =1
(t, T ) can be interpreted as the relative convenience yield net of the (scaled) seasonal premium. Convenience yield can be used for non-storable commodities (e.g. electricity), since spot price plays no role (t) and deterministic s(T ) If (t, T ) 0 one-factor model driven by F If s(T ) = 0 T , then no deterministic seasonality (e.g. oil) and (t, T ) is the relative convenience yield two-factor model similar to Gibson & Schwartz (1990) (t) instead of the spot price. but with F
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(t) is not seasonal by construction F can be modelled as a mean-reversion with constant mean, or GBM. (t, T ) is essentially zero (on average), since all systematic deviations are in s(T ) can be modelled as a mean-reversion with mean zero.
All stochastic convenience yields ( T (t))T =1,...,N are driven by the same Brownian motion, independent of the BM driving the average forward price.
(t), T (t)) = dynamics of (F (t, T ))T . Seasonal cost-of-carry + dynamics of (F Resulting futures prices F (t, T ) are log-normal with instantaneous proportional variance (t, T ) = + ( (T t)) 2 (T t)
2 2 T 2 T
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Model estimation
Historical data of daily forward curves (F (t, 1), ..., F (t, 12))t=1,...,n . Estimate 12 (t) = 1 the daily average forward price by ln F M =1 ln F (t, M ); 12 the seasonal premia (s(M ))M , according to the denition, by
1 s (M ) = n
n t=1
M = 1, ..., 12,
the stochastic convenience yield by (t)) + s (t, T ) = ( ln(F (t, T )/F (T ))/((T t)).
More than 12 maturities: easily incorporated, but if fewer than 12 maturities, the (t) is not available unbiased estimate for F a more complicated estimation procedure.
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0.25
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Seasonal premium in %
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0.1
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0.05 0.1 0.15 0.2
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0.02
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0.12
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The second state variable (stochastic forward premium), for two months to maturity, Gasoil futures, Jan. 2000 - Dec. 2004
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Seasonal component is known monthly premium extract it from a forward curve. If seasonality was the only determining factor, then what is left should always be at, but it is not! = situations similar to backwardation/contango arise:
Deseasoned electricity forward curve, 27.06.01 1 2.5 Deseasoned electricity forward curve, 15.12.01
2 0.5 1.5
Sterling/MWh
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Principal Component Analysis of the forward curve Case I: interest rates and non-seasonal commodities (oil)
A forward curve of almost any shape can be constructed by combining three simple shapes: Level, Slope, Curvature Principal Components of (F(t))tN = (F1(t), F2(t), ..., FN (t))tN
0.35 0.4 0.5 0.3 0.3 0.2 0.3 0.25 0.1 0.2 0.2 0 0.1 0.15 0.1 0 0.2 0.1 0.1 0.3 0.05 0.4 0.4
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First three principal components explain approx. 99% (!) of the forward curves variability. (Litterman & Scheinkmann 91 for US government bonds, Cortazar & Schwartz 94 for copper)
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0.35
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These rst three principal components have clear economic interpretation, explain 95% of the total variability, can be treated as the main risk factors governing the futures prices evolution.
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Applications of PCA
I. Forecasting market transitions (between backwardation and contango): The second principal component reects the slope of the forward curve Values close to 0 indicate a at forward curve (and hence, possible transition) Due to smooth time-series-like structure, it can be used to construct an indicator which anticipates possible transitions Borovkova, EPRM magazine (June 2003). II. Portfolio risk management and VaR estimation First few principal components (of returns) reect main risk factors = the number or risk factors is greatly reduced The distribution of portfolio returns can be approximated via the distribution of the main risk factors In a portfolio context, these risk factors can be hedged
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I (t) =
k=1 (2)
P CLk Fk (t),
(2)
where P CLk (k = 1, ..., N ) are second principal component loadings of the futures prices series. MA-smoothed version: M 1 1 MA I (t) = I (t i). M i=0 Choice of M : take a fast and slow moving average.
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Generate a signal of change when the indicator enters some -neighborhood of zero:
PC test statistics with intermonth differences 3 15
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-neighborhood determined via the distribution of the indicator (under the null-hypothesis of no change), approximated by either Monte-Carlo or bootstrap distribution.
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Apply PCA to deseasonalized forward curves F (t, T ) exp(s(T ))) Second and third PCs for de-seasoned FC (rst PC = level) still reect the slope and curvature:
First principal component loadings, decentered, deseasoned electricity FC 1 0.6 Second principal component loadings, decentered, deseasoned electricity FC
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PC1 loadings
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For deseasonalized forward curves, situations analogous to backwardation/contango markets arise, in terms of deviations from the typical seasonal forward curve. High absolute values of the second PC indicates whether futures with shorter (longer) expiries are overpriced w.r.t. typical seasonal premium Again, use PC indicator: the projection of the daily deseasonalized forward curve on the second PC.
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PC1 scores
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Can construct protable trading strategies based on the indicator. (Borovkova & Geman (SNDE 2006)).
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Conclusions
Extracting deterministic seasonality from forward curves allows to study features obscured by dominant seasonal eects (PCA, cost-of-carry, traditional term structure models) Average forward price is a robust identier of the overall price level, more so than the spot price, although now need to take into account sloping forward curves Stochastic convenience yield is a quantity indicative of market state and economic indicators; it can be exploited to construct market indicators and generate protable trading strategies
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