Detailed Glossary of Energy Trading terms

A type of trade or instrument which has a value dependent on an observable value, which is usually, but not always, the price of a physical commodity.

The observable value is called the underlier

Detail

Any energy trade type that does not involve immediate delivery is a derivative - because the value of the future delivery varies with the expected price of that commodity at that location at the time of delivery

The only significant exception is a Spot or Prompt trade, which involves immediate, or near immediate delivery

Calculation of the present day value of a cash flow that will or might occur at some time in the future

Detail

Suppose I offered to give you £1,000 right now - you'd be pretty pleased (wouldn't you?! If not imagine it's £10,000,000)

Suppose I guarantee to give you £1,000 in one year's time - you'd also be pleased I guess, but less pleased of course...

Why?

Well, for starters if you got it today you could use right away

Even if you wanted to use it in a year's time you'd rather have it now because you could put it in the bank and earn some interest over the next year

Conversely, if you really needed some money now, you could borrow it from a bank and then repay it when I paid you in a year's time

But if you borrowed £1,000 now you'd have to pay interest over the year, so you'd actually end up owing a bit more than £1,000, let's say £1,050

So if you worked out how much interest you would pay, and borrowed an amount, such that the initial amount plus the interest over the next year came to £1,000, then the £1,000 would exactly pay it off

Let's say you did the calculation and it came out that you could borrow £965, the interest on that over the year coming to £35

We could then say that £1,000 in a year's time is equivalent to £965 right now

We call that £965 the discounted value of the £1,000 in a year's time

You can see that the general principle is the discounted value is worked back from the actual value from the expected payment date to today using the expected interest rates

In order to calculate a discounted cash value we need:

The payment date - usually available from the contract terms, or the master agreement

The interest rate curve (for the payment currency or an alternative hedging currency)

The unhelpful sounding physics definition: Energy is the capacity of a physical system to perform work

We know energy: light, heat, electricity, kinetic (motional) energy, potential (the energy something gets when we lift it up) energy etc.

Detail

The initial definition is actually more helpful than it might first appear

In general we are more interested in what energy transitions can do for us than the energy itself

For example electricity is a form of energy - but we are interested in what it can do for us - we can use it to generate heat, run washing machines, pumps etc.

Energy commodities that are themselves not energy contain chemical energy that may be released when we burn them:

• Gas can be burnt for heat, and to generate electricity
• Coal can be burnt for heat, and to generate electricity
• Oil can be burned for heat, and in automobiles and trucks for locomotion

Energy = force x distance

Energy = power x time (or power = energy per unit time)

Physicists measure energy in:

• Ergs (cgs system, one dyne force acting over one centimetre)
• Joules (SI unit, one Newton force acting over one metre)

Traders measure energy (most frequently) in

• Megawatt hours (one megawatt flowing for one hour)
• Therms (one therm = 100,000 British Thermal Units (BTUs))

Capacity to flow (usually gas) onto a National Transmission System

Detail

In order to flow gas on to a Transmission System a shipper needs to have Entry Capacity

Entry Capacity represents a maximum flow rate that gas may be flowed onto a Transmission System over a period, and may be bought in long and short term auctions and traded bilaterally

Energy Trading and Risk Management - usually referring to a computer system that allows trades to be electronically recorded, and risk measures to be calculated

An Exchange is a trading organization which matches bids and offers on standardized contracts to form trades. Unlike a Broker the Exchange acts as the counterparty for the trades, and trading is anonymous

Detail

An Exchange offers standardized contracts, normally

• Spots - Forward trades for Prompt delivery (today, tomorrow - day ahead, and sometimes for the forthcoming weekend
• Futures - Contracts for future delivery, usually weeks, months, quarters, seasons and years, in standardized volumes or rates (e.g. therms per day, Megawatts, Tonnes)
• Swaps - Financially settled Contracts in the future, usually between a fixed price and an index, or between two indexes
• Options - Options on standardized contracts for future delivery, offered at a trade price or premium, with a range of strike prices, puts and calls, expiry dates and delivery dates

Spots are delivered and settled in a matter of days - settlement occurring through movement of funds held in a cash account

Futures may be physically or financially settled - credit risk is reduced through daily margining. Physically settled Futures are either converted to equivalent Spots at expiry, or alternative physical delivery is agreed between partners

Swaps are always financially settled through margining

Options, like OTC options, have a defined expiry date, at which time they or may not be exercised, usually into the corresponding exchange traded Futures

Convert an Exchange Futures position to a physical position either with an OTC counterparty, or with the Exchange itself

Detail

Classic Futures contracts are settled physically: if you are long 2,000 pork bellies for delivery in May 2018 then, when the contract expires, the Exchange will arrange for one or more parties that are short those pork bellies to make delivery to you at the location, time and price specified in the Futures contract

we don't usually call this Exchange for Physical, since it is the contracted outcome of the Futures contract. The Exchange usually just calls this "Delivery", it is is also known as "Take to Physical" or "Cascade to physical"

Other Futures contracts do not necessarily contractually go physical, or you may want to exchange your regular Futures position for physical before the expiry date, or under different terms

in these cases you may contact the exchange and request an Exchange for Physical - the Exchange will attempt to match you up with another party who wishes to take their opposite position to physical

alternatively you may arrange off the Exchange to Exchange for Physical with another party, and then both contact the Exchange to  notify them

In general, Exchange for Physical is an expensive process, it is usually simpler to close out the Futures position on the Exchange and open an equivalent OTC position on a broker platform

In trading terms execution is the act that makes a trade a legally binding contract between the trading parties

Detail

A trade may get executed in a number of different ways:

• Two parties agree a trade directly between themselves. Trades executed this way are described as bilateral, or Over the Counter (OTC)
• One party makes a bid or an offer and another party accepts it, usually through a broker
• One party makes a buy or sell on an Exchange

Exposure is the sensitivity of the value of a trade, or a portfolio, to some market variable

A single trade may have Exposure to multiple market variables, and we measure the Exposure to each variable separately. 

In general there is an Exposure to each independent market variable that determines the value of the trade

Detail

Consider a simple Physical fixed price Forward delivering in a year's time

There is an Exposure to the commodity underlier, let's say a Coal value

The Exposure is the shift in value of the trade with each unit shift in the price (or value) of the underlier

So a trade to buy 100 tonnes of coal might shift by $1 per tonne, for each shift of $1 per tonne in the price of coal, the 100 tonnes Exposure is 100

100 whats?

Let's look at the units. We want the shift in price = 100 tonnes * $1 per tonne = $100, per unit shift in the price of coal = $100 / $1 / tonne = 100 tonnes 

So the Exposure has units of the underlier!

If you've looked at the definition of Delta you will have seen that Delta is properly the change in value per unit of the trade per change in value per unit of the underlier

So we get the important formula Exposure = Position * Delta

A trade may have multiple deltas and multiple Exposures - our simple Forward deal may not be as simple as we think:

• There is a Delta and Exposure to the value of coal
• If we want to know the current value of the trade then there is a Delta and Exposure to the interest rate
• If we are a European trading organization and we want to know the value of our trade in Euros then there is a Delta and an Exposure to the FX rate between Dollars and Euros - the FX Exposure

Exposures are additive - they can be summed across a set of trades or portfolios

Deltas are not additive - because they are dimensionless ratios

A fee is a cash payment which may be associated with:

• A single trade
• A group of trades
• No specific trades

Detail

Fees are usually cash payments that are not directly related to delivery of a commodity

There are four general categories of fees:

• Broker and clearing fees - fees associated with the execution of each trade - these can normally be booked directly against each trade as the ay are incurred
• Trade services fees - fees generally associated with the delivery of physically shipped commodities like coal and oil - again normally booked against individual trades as they are incurred
• Non-trade specific fees - cash costs which are incurred as a result of trading - but cannot be allocated to specific trades - for example imbalance costs
• Non-trade fees - cash costs associated with licences, membership costs etc. 

Fees booked against trades are generally associated with a cash flow type, so that they can be correctly allocated in P&L, invoicing and general ledger accounting