Handbooks for Professionals in the Commodity & Energy Markets

Markets are complex social systems, flooded with uncertainty. This book addresses how market participants in the commodity and energy markets cope with unpredictability in pricing, what the consequences are of intricacy and variability, and what requirements there are to manage entanglement and precariousness. Attention is also given to the required characteristics of market professionals and what is expected of them to flourish in the business.

This book covers the fundamentals of interest rates and currency exchange rates. In addition, attention is given to exposures that corporates may have in these fields and how these risks can be hedged with swaps. Analogously, commodity and energy exposures are covered, as well as the hedging these of positions with commodity swaps. Attention is also given to the pricing and valuation of swap agreements and how those contracts are entered into. In addition, knowledge is provided about settlement processes and procedures. Both cash settlement and physical delivery are set out. Finally, it is explained what swaptions concern and how these tools help mitigate risk.

This book addresses the basic questions regarding commodity and energy trading. Why do market participants conclude transactions? Where do they do this? When? And how? Besides, attention is given to the organisational structure of trading organisations, as well as the application of mandates and limit settings. Meanwhile, related concepts, processes and related terminology are covered.

Parties in the commodity and energy markets enter into spread positions. Both hedgers and investors set up strategies to effectuate their specific desires. Hedgers aim to secure future margins relating to their physical assets, while investors take a position based on a view, aiming to yield a return.
In this book it is explained what, when, where and how, while related terminology is set out. It is also covered what the related exposures are and how margining takes place to manage this risk.

Weather conditions affect all sorts of things, including the business. Weather conditions have an impact on oil and gas consumption and electricity supply and demand. Hence, the financial performance of energy companies is weather-dependent. In the agro business, precipitation or drought, temperature and sun intensity can influence the quality of crops and the harvest quantities. Furthermore, floodings may limit mining for metals. Altogether, roughly a third of the global economy is exposed to weather risk. This risk can be managed by insurance, but weather derivatives provide an alternative. These instruments, traded in the weather markets, are characterised by specific conditions. In order to price the tools, weather data have to be collected, processed and analysed.

In this book the worldwide shipment of commodities is covered. It is set out what types of vessels are used for this purpose, while an understanding of the routes, conditions and pricing is also provided. The author shares different insights in the chartering of vessels, incoterms and freight rates. The role of freight derivatives is also explained, including the application of futures, options and swaps for the hedging of price exposures.

Large commodity consumers often contract their supplies directly at the source. They enter into bilateral agreements with producers. Giant players transact in bulk. Bespoke terms and conditions may apply to the supply contracts they enter into. However, not all bilateral deals are structured and complex; some transactions concern standard agreements. Straight forward contracts may be less sexy, but allow for swift action. Altogether, bilateral deal-making takes place in the so-called over-the-counter markets. In this book relevant aspects are set out for professionals in the commodity and energy wholesale markets.

‘Adrenaline, the smell of old sweat and a hard-as-nails mentality. Former market maker Jerry de Leeuw describes the history of floor trading in a lively way. With many humorous anecdotes and just a hint of melancholy, the author sketches a fascinating picture of this fast-disappearing world. Thanks to Milkshakes & Butterflies, this history is preserved for future generations.’
Frits Conijn (Journalist on the Dutch financial newspaper Het Financieele Dagblad)

‘Any person who has ever stood in front of shelves of ‘personal finance’ books in a bookshop knows the frustration of there being hardly any books that examine the trading practice of the financial markets in an accessible way. From the RTL television studio on the trading floor in Amsterdam, I’ve seen how my ‘neighbour’, Jerry de Leeuw, has developed from an option-writing trader to an option-trading writer. It is especially the humorous stories about ‘the good old days’ on the exchange floor that make this book, even for non-investors, a joy to read.’
Willem Middelkoop (Journalist for broadcasting company RTL)

REMIT is a regulation aiming to establish integrity and transparency in the EU electricity and gas markets. The legislation’s focus is on fostering the right circumstances for a level playing field. Its essence concerns the prohibition of insider trading and market manipulation. Market participants have to comply, facing various prohibitions and obligations. Non-compliance can lead to sanctioning, including imprisonment of individuals. Awareness of these matters is crucial, especially for prevention and detection of abusive behaviours. This book provides an excellent overview in an easy consumable way so that the mastering of the legal text and its context is facilitated.

Financial crime undermines our values. Corruption, bribery, money laundering, tax fraud and market abuse disrupt society and hurt the economy, whereas modern slavery impacts the lives of individuals. This makes it logical to fight financial crime by all means. Regulations prohibiting abusive behaviours are only effective when it is enforced and sanctions apply. Surveillance is crucial to assure compliance by individuals and organisations. Monitoring aims both to prevent and detect financial crimes. Various
parties in the financial and energy markets have to perform a surveillance function to halt financial crime
and identify suspicious behaviours. To tackle illegal practices requires procedures and systems, as well as knowledgeable professionals with specific abilities.

Traders are said to act rationally, but quite often they make irrational decisions. Emotions, mental traps, heuristics, framing and biases play a crucial role. The fear factor, greed and stress also impact choices. It impacts the performance and it may even lead to unethical behaviour. Managers and Learning and Development teams should consider the psychological side of markets and trading in order to function optimally. Compliance officers need to take context into account when developing or enforcing the company’s compliancy framework. It has to control everyone, not just the bad apples, because everyone can show unethical behaviour. Traders should structure their work and follow a plan that fits them. This way they create consistency. It also allows them to cope with losses and the feelings that come along with it. Next, ego has to be managed and traders need to manage their self-confidence. Indeed, it all starts with becoming more aware of oneself. Self-knowledge is crucial, especially if one needs to control himself.

Commodities form a specific asset class, differing significantly from equity, bonds and currencies. Commodity and energy markets differ a lot from the classical financial markets, because of their physical nature. Consequently, capital markets, credit markets, money markets and FX markets are structured in another way. Next, investors in commodities do not get afinancial compensation, whereas investing in shares may bring dividend, bonds yield a coupon rate, currencies provide interest as reward and real estate returns rent. Furthermore, the pricing of commodities and energy is relatively complex. It requires expertise and that is why specialisation is crucial. The value chain needs to mastered, else understanding the market or a price development is impossible. Knowledge about technical aspects is of utmost importance, but besides physical flows, financial flows have to be pictured. In addition, legal aspects and regulations impact the business significantly; amongst others, politics plays a crucial role. Political agendas drive commodity and energy markets more than any other market.

This book covers the fundamentals and essentials of options, concerning both plain vanilla contracts and exotics. The topics range from the basics, via valuation, to the Greek variables. It is set out how an option can be used as instrument to speculate, or as hedging tool. Furthermore, it is explained how positions are set up and can be managed. Insight is provided to how pricing takes place and which factors impact the option premium. Attention is also given to option valuation models. Furthermore, the put-call-parity is set out, as much as synthetics. It is also explained what Delta, Vega, Theta and Rho concern, as well as second order risk parameters, like Gamma. Altogether, this book provides all the tools you need to familiarise with this type of derivatives contracts.

Over the years, in the financial markets and in the business of financial institutions, lots of scandals, crises and liquidations have been experienced. Raterigging by banks, rogue trading by market participants and mis-selling by financial intermediaries have formed reasons to introduce the Senior Managers and Certification Regime. The objective of the regime is to reduce harm to consumers and to strengthen market integrity. This is achieved by making individuals more accountable for their conduct and competence. The package is made up of three components, namely direct accountability to the authorities, fit and proper employees and conduct rules.

In this book term contracts are covered, both forwards and futures. Attention is given to contract specifications, as well as clearing and settlement. Specific processes, such as delivery, margining and cascading are also explained. Furthermore, pricing is set out. Forward curves, including contango and backwardation, are described and it is explicated how this relates to the rolling of futures positions. Last, but not least, spread futures and futures spreads are considered in detail.

Commodity and energy portfolios are full of flexibility. Various options, embedded in supply contracts and physical assets, require managerial decisions. Often, contracts for delivery of metals, softs, fuels or electricity incorporate optionality. Next, production, consumption, storage and transport capacity allow for various ways of allocation. In order to manage financial and physical assets optimally, business decisions have to be made in an efficient and effective manner. In this light, in this book attention is given to the real option approach. It can be applied to optimise the capitalisation on investments and to monetise on legal agreements. Attention is also given to spread futures and futures spreads, as well as spread options and option spreads. This knowledge has to be applied when modelling and valuating flexibility.

There are several methods and techniques to quantify market risk. The disadvantage of most of the techniques is that they can only be applied to a specific product or a particular group of financial instruments. Therefore, outcomes cannot be compared, nor can numbers be consolidated in a single standard to report on portfolio level. However, the value at risk methodology does make this possible. Under this regime, risk is expressed in comparable numbers and can be consolidated in a single figure.

In addition to value at risk calculations, stress testing is performed to compensate for the limitations of the value at risk method. After all, risk management aims to control the business on regular days, but also in case of irregularities. Event risk needs to be identified, assessed and controlled.

Trading operations involve clearing, as well as settlement. The transaction life cycle takes professionals from order initiation and matching, via deal confirmation and clearing, to the effectuation of the agreement. Counterparty risk management is crucial to the business of organisations who operate in the field of trading. Collateralisation and margining concern associated processes, which have been given a lot of attention since the global financial crisis.

Settlement is another important activity for those who trade or are indirectly involved with this business. It includes lots of relevant processes, such as physical delivery, invoicing and payment. Specific expertise is required to cope with related incidents and risks.

In many markets, algorithmic trading has become the dominant form of price quoting and transacting. No human intervention takes place in the decision-making process, and neither with order submission and execution. In this book it is set out what algorithmic trading concerns, what the consequences for the markets are, and what systems and controls need to be applied. Attention is also given to various forms of misconduct that could result from algorithmic trading and how this is fought with regulations and governance structures.