Foreword by Nassim Nicholas Taleb xi

Preface xv

Acknowledgements xix

1 Fundamentals of Commodity Spot and Futures Markets: Instruments, Exchanges and Strategies 1

1.1 The importance of commodity spot trading 1

1.2 Forward and Futures contracts 4

1.3 The actors in Futures markets 6

1.4 The structure of Futures markets 9

1.5 Shipping and freight: Spot and forward markets 16

1.6 Volume, liquidity and open interest in Futures markets 19

2 Equilibrium Relationships between Spot Prices and Forward Prices 23

2.1 Price discovery in Futures markets 23

2.2 Theory of storage, inventory and convenience yield 24

2.3 Scarcity, reserves and price volatility 28

2.4 Futures prices and expectations of future spot prices 31

2.5 Spot-forward relationship in commodity markets under no-arbitrage 35

2.6 Price of a Futures contract and market value of a Futures position 39

2.7 Relationship between forward and Futures prices 42

2.8 The benefits of indexes in commodity markets 45

3 Stochastic Modeling of Commodity Price Processes 49

3.1 Randomness and commodity prices 49

3.2 The distribution of commodity prices and their first four moments 52

3.3 The geometric Brownian motion as a central model in finance 60

3.4 Mean-reversion in financial modeling: From interest rates to commodities 64

3.5 Introducing stochastic volatility and jumps in price trajectories 68

3.6 State variable models for commodity prices 69

3.7 Commodity forward curve dynamics 71

4 Plain-vanilla Option Pricing and Hedging: From Stocks to Commodities 75

4.1 General definitions 75

4.2 Classical strategies involving European calls and puts 78

4.3 Put-call parity 81

4.4 Valuation of European calls: The Black-Scholes formula and the Greeks 83

4.5 Merton (1973) formula and its application to options on commodity spot prices 90

4.6 Options on commodity spot prices 92

4.7 Options on commodity Futures and the Black (1976) formula 93

5 Risk-neutral Valuation of Plain-vanilla Options 95

5.1 Second proof of the Black-Scholes-Merton formula 95

5.2 Risk-neutral dynamics of commodity prices 98

5.3 Commodity Futures dynamics under the pricing measure 99

5.4 Implied volatility in equity options and leverage effect 101

5.5 Implied volatility in energy option prices and inverse leverage effect 105

5.6 Binomial trees and option pricing 109

5.7 Introducing stochastic interest rates in the valuation of commodity options 117

6 Monte Carlo Simulations and Analytical Formulae for Asian, Barrier and Quanto Options 123

6.1 Monte Carlo methods for European options 123

6.2 Asian (arithmetic average) options as key instruments in commodity markets 127

6.3 Trading the shape of the forward curve through floating strike Asian options 135

6.4 Barrier options 135

6.5 Commodity quanto options 138

7 Agricultural Commodity Markets 143

7.1 Introduction 143

7.2 The grain markets 144

7.3 Soft commodities: Coffee, cotton and sugar 153

7.4 Citrus and orange juice 158

7.5 Livestock markets 160

7.6 Technical analysis in agricultural commodity markets 161

8 The Structure of Metal Markets and Metal Prices 169

8.1 Introduction 169

8.2 About metals 169

8.3 Overview of metal markets and their operation 171

8.4 Characterizing general price movements 175

8.5 Characterizing metal price movements 176

8.6 Conclusion 200

9 The Oil Market as a World Market 201

9.1 Why oil is traded and its relationship with worldwide energy prices 201

9.2 Crude oil markets 203

9.3 Refined products markets 217

9.4 Conclusion 224

10 The Gas Market as the Energy Market of the Next Decades 227

10.1 The world gas outlook 227

10.2 The gas-producing countries 231

10.3 Gas spot markets 233

10.4 Natural gas Futures and options 240

10.5 The growing interest in LNG 246

11 Spot and Forward Electricity Markets 251

11.1 Introduction 251

11.2 Structure of the electricity industry: From vertically integrated utilities to unbundling and restructured oligopolies 252

11.3 Spot power markets and issues in market design 254

11.4 The adjustment market and reserves capacity 266

11.5 Electricity derivatives markets 269

11.6 Modeling electricity spot prices: From mean-reversion and jump-diffusion to jump-reversion 276

12 Commodity Swaptions, Swing Contracts and Real Options in the Energy Industry 283

12.1 Commodity swap and swaptions 283

12.2 Exchange options 286

12.3 Commodity spread options 287

12.4 Options involving optimal strategies: American, swing and take-or-pay contracts 294

12.5 Discounted cash flows versus real options for the valuation of physical assets: The example of a fuel-fired plant 298

12.6 Valuation of a gas storage facility 304

13 Coal, Emissions and Weather 309

13.1 The coal market 309

13.2 Emissions 320

13.3 Weather and commodity markets 325

14 Commodities as a New Asset Class 333

14.1 Introduction 333

14.2 The different ways of investing in commodities 336

14.3 Commodity indexes and commodity-related funds 339

14.4 Conclusion 357

Appendix: Glossary 359

References 375

Index 381