Detailed Glossary of Energy Trading terms

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))

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

To offset the delta of an option or other non-linear trade, usually with a linear derivatives position

Detail

If we buy a simple call option, or sell a simple put option, then we may or may not have a long position when the delivery date of the (potentially exercised) contract is made

In reality the option will either get exercised or not - let's say the option is for the delivery of 1,000 MT of coal in January 2016 at ARA (Amsterdam Rotterdam Antwerp location) - we will either have a position of 1,000 MT at that time, or not

On any particular day the option will have a calculable delta, which roughly translates into a probability of the option being exercised:

An option with a delta of 0.01 has a 1% chance of being exercised

An option with a delta of 0.5 has about a 50% chance of being exercised

Traders generally hedge the exposure of the option (which is the delta times the volume), so if the delta is 0.5 they will hedge 500 MT of coal

In general as the option exercise time approaches the delta of the option will swing quite rapidly toward 0 or 1 (or -1) so that the hedge swings toward 1,000 Mt or 0 MT

If you're wondering why an option with a delta of 0.5 (meaning the value of each MT changes by €0.5 for each change in €1 per MT in the value of coal) has a 50% chance of being exercised then think the other way round - if the option was certain to be exercised then its value would change by €1 per MT per change of €1 per MT in the price of coal, so its delta would be one - the delta is effectively the probability of being exercised

A Confirmation is a document describing a trade that has been executed, and is generally sent by the Seller to the Buyer to check the trade details, to be returned by the Buyer confirming that the trade details match the trade as they have recorded it

The Confirmation, or Confirm, process allows both parties to agree the trade details

Detail

The Confirmation process, and the form of the Confirmation document are defined in the Master Agreement, usually as an Appendix

The Confirmation match is the final stage of the contract between the two parties, without it the trade is not legally binding, as well as specifying the trade details the Confirmation also specified the Master Agreement under which the trade was executed

Confirmations are not normally produced for Exchange trades

Some parties produce and send Confirmations for both Buy and Sell trades

Confirmations must be signed by an authorized signatory in the Trading Organization

Confirmations are normally produced and signed electronically

Matching Confirms tends to be a manual process - systems of bar coding have been proposed

There are schemes that electronically confirm trades, generically known as ECM (Electronic Confirmation Matching)

These are generally point to point - but there is no reason not to utilize a centralized matching service 

Flattening an open position to a net zero (or flat) position

Detail

Trading activity in general leads to opening positions, and very often to closing out those positions before the delivery period

For example I may sell 10,000 therms of gas for delivery May 2024 today

I have an open position of 10,000 therms in 2024

Next year the price has dropped and I decide to buy back all 10,000 therms at the lower price, thus locking in a profit

(sell price - buy price) x 10,000

remember when we short a position we make a profit when the price drops!

I have no remaining open position in 2024 gas - so I have closed out my position

I can always re-open it by executing another trade

If my second trade had been to buy 6,000 therms then I would have closed out 6,000 therms, and have 4,000 therms remaining open position

Closing out a Futures position on an Exchange has an additional meaning and consequence

The profit or loss value would immediately be considered as realized P&L for the following reasons:

• There is no valuation uncertainty
• Payment has been made
• There will be no delivery

A form of settlement where responsibility for payment is passed to a third party: a Clearing House or Clearing Broker

The Clearing House accepts responsibility for settling the deal.

Credit risk for the seller in the trade is reduced to almost zero

The Clearing House minimizes its Credit Risk by daily margining

Detail

An organization may trade on an Exchange either by becoming a member of the Exchange, or trading through an Exchange Broker. The clearing principles are similar in either case

In general a trading organization engages a Clearing Broker to act on its behalf

The trading organization is required to open a margin account with the Clearing Broker, which in turn maintains a margin account with the Exchange's Clearing Bank

As the organization enters into a trading position the Exchange marks the trades to market on a daily basis, and transfers cash into or out of margin accounts based on the change of the value of the trading position since the previous day. The Clearing Broker mirrors this operation to its clients' margin accounts

Every trading organization is required to maintain an amount of cash in the margin account to cover a substantial short term loss in the value of its position. If the trading organization does not maintain this margin then the Exchange closes out the position immediately, using the margin account cash to cover any losses as a result of the close out

Payments into the margin account as a result of new trades that cause an increased open position are called Initial Margin payments

Payments into the margin account as a result of the value of trades falling are called Variation Margin payments

A clean spark spread is the spread between the value of power (electricity) on the one hand and the value of the gas needed to generate that power, and any associated carbon costs of generation

Detail

The term clean spark spread may refer to

• the cash value of the spread itself
• a trade executed that has three physical legs
• a trade that has at least one physical leg and up to two financial legs
• a trade that is settled financially based on a fixed ratio of power to gas and carbon

A payment that has been, or will need to be paid, on a particular date

Detail

Every trade creates one or more cash flows, which represent the payments that will be made:

For deliveries made - often at periodic intervals (e.g. weekly)

For fees, including broker and execution fees, and fees incurred in transportation, storage and inspection of commodities

In general the payment date of all cash flows should be known in advance, the amount of the payment may be fixed or based on one or more index, or be calculated form a formula based on a set of observables, underliers, or other factors

The process of decomposing longer tenor Exchange traded derivatives (futures and swaps) contracts for the equivalent shorter contracts

Detail

Let's start with an example - a trader buys a futures contract for delivery for the whole of 2018, a so-called Cal-18 contract

Every day that contract is available to trade, and the Exchange publishes a settlement price for that contract that determines daily margining

At the time of trading (2014) the Exchange does not offer any other contracts covering 2018 - months or quarters for example

At the end of 2017 the trader wants to keep the position open, but the Exchange can't continue to publish a Settlement price for the 2018 yearly contract because it can't be traded (the delivery period has already started)

By this time the Exchange is offering Quarters contracts covering the whole of 2018, and Month contracts covering at least the first three months of 2018

So the Exchange, the Clearing broker and the trader all cascade the year contract into four quarterly contracts; Q1, Q2, Q3, Q4 2018.

Q2, Q3 and Q4 are all still tradable, but the Q1 position needs to be closed out, or itself cascaded into three months, January, February and March

As you've probably realized the January contract will very soon be untradable, so it needs to be

• Closed out - the trader flattens his position in that contract
• Taken to or exchanged for an equivalent physical contract 
• (for financial futures) taken into financial settlement

By cascading longer contracts into shorter contracts shortly before the longer contracts begin delivery the Exchange can effectively offer a small set of monthly, quarterly and yearly contracts, that have monthly granularity in the short term, but cover a period of years into the future

As an example EEX are quoting the following Phelix Futures contracts at the time of writing (11 November 2014):

• Months - usually current month + next nine months - November 2014 to August 2015
• Quarters - next eleven Quarters - Q1 2015 to Q3 2017
• Years - next six years - 2015 to 2020

(If you're wondering why November 2014 is still being quoted then that's because it is financially settled through the delivery month - the contract is not tradable in November)

Gas, oil and coal all contain carbon - when they burn the carbon is oxidized to carbon dioxide.

Carbon dioxide, as we all know, enters the atmosphere, and is generally believed to cause global warming

There are various schemes to reduce the emission of carbon dioxide, called emissions schemes, and these require major emitters of carbon dioxide to provide certificates matching their emission of carbon dioxide. These certificates may be acquired in a number of ways, and there is a market for organizations with surplus certificates to sell, and organizations who need more certificates, to buy

Detail

Naturally wherever a market exists to trade anything, speculators attempt to profit by buying and selling - in this case - carbon (in the form of certificates)