The idea for this talk came up over lunch with Marco Avellaneda, and Peter Carr, in which

the marvelous peculiarities of the commodities market came up as a topic of conversation. Marco felt that, as commodities was a new and relatively active field, an introductory talk on commodities, for experience financial mathematicians who knew little about this sub-field would attract a lot of interest, and he proposed to me that I give a talk to introduce commodities to experienced modelers. This talk is designed to do just that. It is broken into 3 parts. The first discusses the phenomenology of commodities markets, first the forward curves, and then the vol surface. The second part discusses the novel and difficult types of exotic options that are sold to derivative customers interested in hedging the risks of their business. The final section discusses the modeling implications of the first two sections, and then briefly discusses a few of the basic models that have come into use in the past few years. The philosophy of the talk is captured by the subtitle So you want to be a commodities modeler to teach a modeler every market-specific thing he needs to know to model commodities. The emphasis here is not on historical data, but on known arbitrage relationships, as well as tendencies of forward curve and vol surface behavior. It is hoped that people will find the field of commodities new and interesting, and with such a wealth of interesting unsolved problems, that they will immediately flock to the field, and lend their bright ideas to our effort. Commodities as Financial Assets Commodities have recently come into vogue as a new class of tradable assets in finance. However, the process of taking industrial feedstocks and turning them into something recognizably financial is a nontrivial one, which results in a tradable with properties that are unlike most other financial assets. The first step in modeling them is to understand these quirks. Commodities are different because they are produced, consumed, stored and transported Commodities, as a financial asset differ in several important respects from, e.g. stocks or bonds. Commodities are bulky, and can be difficult to store, or transport. In addition, they are produced and consumed, as well as traded, so that the total market inventory can fluctuate wildly through time. (Contrast this with the situation for a stock the number of shares of IBM is largely constant from one month to the next). Therefore, owning a commodity at one time and place can be totally different thing than owning the same commodity in another time and place. For example, you can have an impending shortage in natural gas, (as we did in Texas, in March 2003), and yet be expecting a glut the very next month. Or we might have a shortage in Texas, and a glut in New York. Because storage and transport can be so expensive, the prices at different times and places do not move in lockstep (though they are quite correlated), and we must consider them separate assets. Prices feel forces bringing them into line with one another only when they are so far apart that it becomes economic to store or transport.

Examples of Commodities What are examples of some commonly traded commodities? There are several categories Agricultural and farm products Soy, pork bellies, orange juice, wheat, corn, cotton Timber products pulp, paper, cardboard Energy raw materials and products crude oil, natural gas, heating oil, fuel oil, electricity Base (industrial) metals Copper, Zinc, Aluminum, Nickel Precious metals Gold, Silver, Platinum, Palladium Weather (!) Heating Degree Days, Cooling Degree Days Bandwidth Freight By far the most liquid, and interesting, of the commodity markets are the energy and metals markets, and we shall speak about commodities in general, the energy markets are the standard example we shall be speaking from. The Customers for Commodity derivatives are primarily industrial, not financial Commodities as an asset are distinct from other financial assets, whose underlying purpose was to raise money for firms, or facilitate its exchange. In the commodities field, financial firms are involving themselves directly in industrial processes. For this reason, the primary customers for commodity derivatives are industrial consumers, who are primarily exceptionally risk-averse hedgers. Their risk-aversion comes about because they suffer non-economic penalties for failure to deliver. Commodity vol surfaces are often driven by inventory, more than views on probability, and forward curves reflect preference to buy and store in spite of the cost. Non-financial players will often manipulate the market when it suits them, because they are not used to the regulatory regime that other fields experience. The Assets Underlying Derivatives are Forwards and Futures, (not Spot) Recall that, because of the costs of storage, a commodity at one place and time is held to be a different financial asset from the same commodity at a different place or time. For that reason, the natural underlying for a commodity is not the commodity itself, but forwards and futures contracts on the commodity. These have not only the advantage of specifying a time of delivery in the future, but in addition it is possible to go short and long futures contracts, whereas it is not possible to go short the spot commodity. This latter fact has important consequences for the shape of the forward curve. Forwards and Futures on commodities have extra quirks --Settlement/Delivery

Though futures markets have by now spread all over finance, within commodities markets they have particular quirks. There are several types of forward contracts, and the most basic is the Physically Settled Forward Contract. This contract settles with actual delivery, which because storage is expensive, is consumed as it is delivered. Thus, delivery takes place in equal quantities spread out over every day of an entire month. Were one to turn around and sell the resulting commodity, one would receive the spot price, so this is something like receiving the spot price averaged over a month. Commodities futures contracts, such as the NYMEX contract, settle on the price of a physical forward contract for the most liquid location, so that they, too, effectively settle on the expected average of the spot price for the coming month. There are several other types of forwards (and strips of forwards, i.e. swaps) derived from these two. One of these is the NYMEX Look-alike, which is a forward settling on the price of a NYMEX future on its expiration day. A third type is a forward (or swap) based on a publication, such as Gas Daily, or Platts. These publications publish an average of different quotes for spot gas for that day, and a Platts swap will typically settle on the average of published Platts prices every day for a month. Finally, a Calendar Swap is a swap that settles on the closing futures price of the contract closest to expiry, over every day for a month. The Shape of the Forward Curve As in fixed income or foreign exchange, the more liquid markets, such as oil or natural gas, have organized futures markets in which to hedge risk. A plot of the prices of all of the futures against maturity defines the futures curve. A slang peculiar to commodities has evolved, and we note it here. The first point in this curve is called the first nearby, or front (or prompt) contract, and is the closest thing in the commodities market to a spot price. The second point, representing the second month, is called the second nearby, and in general the nth point, representing the nth month, is called the nth nearby. When the first nearby future expires, and the second nearby becomes the first nearby, or prompt contract, we say that the front contract has rolled off. At this point the nth nearby becomes the n-1th nearby. Average rate options, swaptions, and other exotic derivatives are usually written to pay off on a nearby, and their term almost always extend beyond the roll-off date of the nearby contract, so they must average over at least two different futures contract prices during their life. Shapes of the Forward Curve -- There are no curve flattening arbitrages The commodities markets are therefore markets for forward and futures contracts, and apart from the oddities in settlement, they are beginning to look familiar, like derivative markets in e.g. fixed income or foreign exchange. However, because of the expense, and sometimes impossibility of storage, and the impossibility of shorting the spot commodity,

the forward curve is free to take a much wider variety of shapes than one might expect, based on an analogy with more traditional markets. ---- You cannot push down on the forward curve (very much) In a forward market with free storage, the forward curve cannot rise above the growth of a bank account. If it did, one could go long the earlier, cheaper contract, and short the expensive, later contract. When the earlier one expired, one could take delivery of the commodity at the cheaper price, and store it, and wait until the later contract expired. At this time one could receive the expensive price, and deliver the commodity. In a market in which storage has a significant cost, however, this trade only makes money if the price difference over the month is greater than the storage cost. Since the storage cost is charged for each day, this implies that this trade limits the slope of the forward curve to be less than the storage cost per unit time, plus the cost of money, known as the contango limit. In addition, in order to carry out this arbitrage, storage must be available in sufficient quantity it can often happen in the commodity markets that all available storage is full, and any further storage just cannot be had at any price. When storage becomes full, the slope of the forward curve may go beyond the contango limit, and is said to be in super-contango. The contango limit has an analogy in the trading FX forwards. Euros, for example, are stored in a bank account. They are not only cheap to store, they actually have a negative storage cost which is equal to the cost of money in Euros, and so the contango limit for the forward curve in dollars is the difference between the domestic interest rate and the Euro interest rate. ---- You cannot push up on the forward curve There is another curve flattening arbitrage trade, common in equity and foreign exchange markets, which is not available in the commodities markets. In such markets the forward curve cannot fall below the rate dictated by interest rates. If the forward curve fell below spot, one could short spot today, and buy the forward contract at a cheaper price. At expiry, one could take delivery of the asset, paying the cheaper price, and close out the short, keeping the difference as a riskless profit. However, in commodities, it is impossible to short spot, so this trade cannot be executed. Therefore, trading does not place any arbitrage limit at all on the downward slope of a forward curve in commodity markets. --Phenomenology of the Forward Curve Thus, there is a much wider variety of shapes that commodities forward curves can take, than in other markets. However, commodities forward curves do tend to take certain characteristic shapes, reflecting the underlying economics governing market participants. --- Violently whipping short end, stable long end

Commodities curves, at their short end, tend to whip around violently as the balance between short-term supply and demand changes with each bit of news. At the long end, they approach an asymptote reflecting the long-term marginal cost of production. In a glut situation, the short end of the curve falls below the long-term asymptote, and in a shortage, the short end is above the long end of the curve. This rising forward curve shape is known as contango, and the falling forward curve is known as backwardation, or normal backwardation. As the latter name suggests, backwardation is the normal situation for a forward curve. ----Market Players are uneconomically biased towards backwardation In a commodity that is storable (but not free to store), market participants may nevertheless prefer to buy earlier rather than later, because the stored commodity gives the holder the option to use, i.e. the option to use the commodity at any time up to the time originally planned. Power companies sometimes pay high penalties for failure to serve the full load demanded, and might prefer to pay extra to be certain of delivery. The commodities markets are therefore biased towards backwardation, rather than contango, and this shape tends to be a function of time to maturity of the future. Notice that this reflects the presence in the market of only risk-averse hedgers. In general, the commodities markets suffer from a lack of speculators to absorb this risk, and presents profit opportunities for those who would enter. Recently, hedge funds have begun to enter the commodities markets, and remove this kind of bias. ----Seasonality Commodities curves may also have peaks and valleys at particular intermediate times, specific dates, when demand or supply is expected to peak or trough. The sensitivity of the forward curve to these expectations, however, depends on the capacity in the market to store additional supplies, or release them into the market. This phenomenon manifests itself most often as seasonality of the forward curve humps in the oil and natural gas forward curve during winter, when demand for heating is high, and also, for natural gas, in summer, when electricity demand is high. The most extreme example of this phenomenon occurs in the power markets, however, in which the forward curve shows intra-day, intra-week, and seasonal peaks and troughs, because of the greater expectations of usage during the working hours of the day and week, as well as the need for greater power in the summer due to air-conditioning, as well as winter, due to heating. Example: Storage and Seasonalities in the US Natural Gas Market In the US today, natural gas production averages around 550(???)bcf/mth. This is just about the same as the monthly average demand, but as one might expect, demand is much greater in the winter, when heating is needed, than at other times of the year. There is also an increase in demand in the summer, of smaller size. Because of this variance in demand, there is a large storage capacity, into which natural gas is injected during injection season, April 1 to October 31, and from which it is drawn, during winter

season, November 1 to March 31. This storage has a capacity of 3.2 tcf, but the total stored must not be allowed to go below 0.5 tcf, in order to maintain sufficient outward pressure in the tanks. The futures curve has a large contango leading up to winter, and is backwardated after that. Because supply and demand are so closely matched (every time there is new supply, additional demand arises to meet it), the end of winter is always a critical time, because a cold winter can cause us to run out of natural gas before the beginning of injection season, leading to large upward spikes in prices. In addition, a cool summer can lead to overfull storage, and large downward spikes in prices, which can sometimes even go negative. Natural gas is priced in $/MMBTU, and prices are in the range $4/MMBTU $7/MMBTU. Transport costs, e.g. across the country, are on the order of $0.03/MMBTU. But there is the additional cost of transport, in that fuel can be lost, on the order of 2%. Example: Storage and Seasonalities in the US Oil Markets Crude oil is not an end product, and as such, there is no direct consumer demand for crude oil. Instead, demand is inferred from demand for its various products. The most important of these are heating oil, fuel oil, and gasoline. A barrel of crude oil is refined into these three products in a proportion that may vary within limits. Heating oil, unsurprisingly, has the largest demand in the winter, and gasoline, has large demand in the summer driving season. Both of these do show up as seasonal humps in the forward curve, but there is storage capacity, anywhere from 20-90 days, in the US, which ameliorates this. Because heating oil, gasoline and fuel oil are produced in tandem, when one is in extreme shortage, with attendant high prices, the other gets produced beyond what demand requires, and depresses prices for that commodity. Thus, while these products are normally positively correlated, due to supply issues, a demand spike can anti-correlate them. Here are a few numbers. Demand The world consumes 80mm bbls of oil per day, the US about 22mm bbls/day. Cost of Production When oil comes out of the ground as crude oil, it is usually extracted for a cost of anywhere between $2.50/BBL (for Saudi oil, which shoots out of the ground like a geyser) and $12.00/BBL (for North American Tar Sands, which must be steamed out of the sand). The long end of the curve is determined by the most expensive field currently in use. Shipping

Oil is shipped around the world in large tankers. There is an enormous fleet of these tankers, which ship at a cost of roughly 20c/bbl/thousand miles. The transport capacity of these tankers ranges from 100k-3mm bbls, but most are 600k, 750k, and 1.9 2mm bbls. There are a few 5mm bbl tankers in the world. Storage Oil is stored in large storage tanks, at a cost of $0.150-$0.30/bbl/ month, and there is 78bn bbls of oil tied up worldwide in industry and government stocks at any one time. 570mm bbls of that is in the US Strategic Petroleum Reserve, which is 26 days worth of the USs oil consumption. The US does have other stocks, totaling about 350bn bbls, and total storage of petroleum products is around 1.1bn bbl. As with natural gas, there is a minimum storage, about 270mm bbls. This is not sharp limit, but below this level supply problems begin to occur, such as insufficient pressure in pipelines, and the price starts to rise sharply. Most countries in the International Energy Agency have 90 days worth of storage to comply with its requirements aimed to share the burden of an oil supply shortage. When oil is glutted, and there is a shortage of storage capacity, tankers may be pulled out of the transport network, and pressed into service as storage capacity, providing an additional few bbls of expensive storage. It is interesting to note that, historically, we do occasionally bump into the storage limit for crude oil most recently we nearly hit in July 1998, when storage reached 355mm bbls, and tankers were indeed brought out of service to sit in ports and store oil, and we almost ran out of those. On the other side, we were very near to the lower limit of storage, actually at 265mm bbls, just one month ago, and oil prices are near historic highs (though, adjusted for inflation, this does not compare to the peaks of the late 70s/early 80s. Example: Storage and Seasonalities in the US Power Market As noted earlier, the power market has no storage at all. The power market has forward contracts on peak power (8am-midnight weekdays), on off-peak power (midnight to 8am + weekends). In addition, it is possible to buy power ahead for particular hours on particular days, leading to a less liquid, but nevertheless functioning market in individual hours of power, which can be purchased as late as 15 minutes before the start of the delivery hour. This power curve shows seasonalities, within a day because power demand is much greater during working hours than otherwise, within a week, because power demand is much greater on workdays than on weekends, and within a year, because power demand is much greater in winter and summer, than in spring and fall, due to heating and air conditioning needs. Because there is no storage at all to ameliorate supply shortages, these show up in the forward curve in exquisite detail. Power is generated as needed, by a series of different technologies known as the generation stack. At the bottom of the generation stack are those power generation methods, such as coal and nuclear, which are both the most marginally cost-efficient, and have the

longest startup time. Above that is natural gas, and then the refinery products of oil. During low power demand periods, only the most efficient plants are running. As demand and prices get higher, more expensive technologies are brought into production, and we move up the generation stack. If we move all the way up, then generation capacity is entirely used up, and the power utility must decide how to balance supply and demand. Because power plants are arrayed on an electrical grid, it is possible at any point in our ride up the generation stack to buy power from elsewhere, instead of operating inefficient plants, as long as there is spare capacity. Electricity may be transported between neighboring electrical locations with losses of around 3%, percent, and at a cost of around 1-5$/MW-hr, out of a price of around $35/MW-hr. Thus, transmission costs are quite substantial, and this means that prices can get pretty far out of line before transmission from neighboring areas can come in to restore them. Example: Storage and Seasonalities in the London Base Metals Market Unsurprisingly, there is not a lot of seasonality in the base metals markets. This is because storage is relatively easy for base metals one can just put it in a junkyard, or any old field, with a fence around it. Thus, base metals as a commodities market are not terribly storage constrained. It used to be true that delivery from the LME warehouses would take three months, and so this was the most liquid point on the forward curve, leading to a contango to that point. Even now, the 3 month point by convention is where most of the liquidity lives on the forward curve. Transport costs over large distances, e.g. London to Midwest USA, are roughly $0.05/lb. to $0.08/lb. Base metal futures are liquid out several years in most cases. The Aluminum curve, the most liquid, is liquid out to 5 years, copper is liquid out to three, as is Zinc. The least liquid is Nickel, which is liquid out to 1 year. Commodity Options The volatility surface The volatility surface in most commodity markets is made up of options on futures or forwards. In this discussion we will concentrate on commodity markets with futures. Vanilla options on futures have an uncomplicated settlement, thankfully. For each future, there is a single maturity of option, usually expiring a few days before the future itself, and the option settles on the futures price on that day, without any averaging. The vol surface extends out quite far in many markets, for example, in the oil markets one has liquid options with deltas of less than 10%, and greater than 90%. In natural gas, it does not extend out quite that far, but still out beyond 75%/25%. In forward markets, such as electricity, most vanilla options are actually swaptions. The important thing to notice about this volatility surface is that it is not really a surface for a single asset; rather each time slice in the surface is the smile for options on a

different future. As these are distinct financial assets, it is not a true volatility surface in the sense we normally understand, and so it need not obey standard theorems for volatility curves and surfaces. Instantaneous and term realized volatility are backwardated, as is implied volatility Consider a forward curve for a simple commodity, without seasonal demand. Recall our picture of the forward curve, a very slowly moving back end, and a front end that whips above and below the back end, with short-term supply and demand. This means that the contracts on the front end experience very high instantaneous volatility (on the order of hundreds of percent, for power and gas), and the contracts on the back end of the curve experience very low instantaneous volatility (on the order of 2-10%). The integrated realized volatility must therefore also be downward sloping. Options trading in the marketplace have implied volatilities that mirror this trend. Thus, we have the following picture of a commodity options life -- throughout most of its life, the underlying barely moves, but towards the end of its life the implied volatility rapidly increases, until the contract evaporates in a brilliant burst of activity. But the curve can contain contangos, too, in crises. This is not the end of the story, however. Just as there can be seasonal effects on the forward curve because of fluctuations in production and consumption, there can be very pronounced crises priced into the vol curve, which can show the same sorts of funny combinations of contango and backwardation that forwards can show, when it isnt clear what will happen. A classic example occurred in spring 2003, when we nearly ran out of natural gas. The winter of 2002/3 was an exceptionally cold one, and it seemed like a real possibility that we would run out of natural gas before the end of the winter withdrawal season. Because of this, the variances on March natural gas options were enormous, greater than in February, not surprisingly. But variances in April were also smaller, because it was clear that by that time, demand would abate, and we would not need stored natural gas to meet demand. Thus, an unusual contango appeared in the ATM vol curve up to March, followed by the usual backwardation beyond. For variance, the normal situation of contango appeared up to March, but was then interrupted by a brief backwardation, a paradox which in other markets would be an arbitrage. In the event, we did run out of natural gas in Texas, but not in other locations. There, prices jumped, and dropped back down about halfway within two days, and slowly reverted to normal ranges over the next few months after that. This not-so-unusual event is instructive, because it demonstrates several behaviors that are largely the province of commodities markets -- spiking, a backwardation in variance, a large seasonal hump in the forward curve, and a complete de-correlation of neighboring futures contracts, all directly traceable to storage problems, and the fact that the total market inventory in a commodities market changes daily, as it is consumed and produced.

The volatility skew is primarily determined by inventory effects. The customers for commodity options are primarily industrial, either producers or consumers, who desire to hedge, rather than speculators or hedge funds. This may be in the process of changing, but this is true right now. Producers of a commodity are naturally long that commodity, and would like to buy puts conversely, consumers are buyers of calls. These are almost always out of the money, to minimize the cost. Often, these are bought or sold in the form of zero cost collars. If the number of producers and consumers were similar, we dealers would be in the ideal situation of a clearing-house, with no net direction on our books. Unfortunately, most markets are dominated either by producers or consumers, producing a large skew entire due to the massive inventory that builds up on one side or other of the vol smile. For example, electricity is almost entirely dominated by producers, because there are no individual consumers of electricity large enough to want to hedge. At the same time, producers hedge a lot, because they are statutorily required to serve any load that is demanded (up to a point), regardless of price. As a result, the electricity skew is sometimes so great that at times some options can be bought at intrinsic value, and dealers like Goldman can only buy so many. Natural gas is an example of a consumer dominated market, because these self-same utilities which produce electricity are consumers of natural gas, and must buy it to produce the electricity that their statutory regime requires. Kurtosis is determined by jumping behavior at the short end, as well as stochastic vollike effects, producing a vol-surface with immediate and long-lasting curvature. In general, a commodities vol surfaces is shaped like a very long, skewed half-pipe. Because the kurtosis doesnt build up slowly, but appears right away, it is considered a poor candidate for purely continuous models such as stochastic volatility, and almost certainly contains some element of discontinuous dynamics. The presence of jumps may be observed directly, and inferred from the slow decay of out-of-the-money option prices as they approach maturity. However, the kurtosis of the vol surface lasts a terribly long time, far longer than most jump models can reasonably produce, and even longer than can be easily found in a stochastic vol model. For this reason, most proposals for commodities smile models contain both elements. Note that this discussion omits mention of the spikes one occasionally sees in the markets, as they do not seem to contribute a great deal to bullet option value. Spikes are important, however, as they can contribute to more exotics, especially barrier options. Non-Black-Scholes behavior: spiking It is often true in commodities markets, particularly those in which storage is difficult or impossible, that prices can suddenly spike. This comes about when stored supplies are exhausted, or when storage is full (as in the example of natural gas), or when the production capacity is exhausted (e.g. the power generation stack). Spikes present a particular modeling difficulty, because they are not like ordinary jumps one would

experience in, e.g. equity markets. As the name implies, upward (downward) spikes are a jump up (down), which is followed shortly thereafter by a jump down (up), (or at least part of the way down). Since the market has to know that it has jumped up in order to greatly increase its probability per unit time to jump down, this appears to be nonMarkov behavior. In reality it is a change of state, at least in the picture provided by the fundamental economics. When natural gas spikes, the market reacts industrial users of natural gas (e.g. fertilizer manufacturers) sell their natural gas supplies, and contracts, and shut down their plants for a while. This behavior represents a changed state brought on by the spiking market price. A natural approach to such behavior is therefore a regimeswitching model, in which the two regimes are unspiked (with a low but nonzero probability to jump upwards and change its regime to spiked) and spiked (with a high probability to jump downwards and change its regime back to unspiked). A model of this kind was introduced by Shijie Deng. Non-Black-Scholes Behavior: negative prices One oddity of commodities markets is that commodities prices can occasionally be (very briefly) negative. This happens most often in markets, such as power, in which there is no storage, and supply and demand must be in tight balance to avoid damage to the infrastructure. However, it can happen in any market, because markets with storage behave like markets without storage when that storage is full. In the case of the US natural gas market, we test that limit every November, when injection season is ending, and storage tanks are nearly full. In the case of the oil markets, nearly full storage happens much more rarely, however, it did happen as recently as 1998, when it became necessary to use old tankers sitting in port to store additional oil. Though it is hard to believe, it is just conceivable that oil prices might some day go negative, briefly, with the right confluence of events. You cant, after all, store it in your apartment. Types of vanillas and vanilla exotics, with maturity/strike spectrum --Oil Oil is the most liquid market in all of commodities, it is a futures market, and the options it trades are bullet options, monthly average options, swaptions, term settled (i.e. long term) average options, and time spread options. Bullet options maturity/strike spectrum: 1 option on each future, expiring 5 days before the future. Liquid options available out to 12 months, illiquid to 24 months. Strikes trade in $0.50 increments, each is liquid within 0.75 < F/K < 1.33. Thereafter liquid options are struck in 1$ increments (though smaller increments are still available), and these are available for strikes 0.5 < F/K < 2. Monthly Averages Maturity Spectrum:

This is an OTC market, with generally 1 option/month available. Strike prices trade in 1$ increments, for 0.5 < F/K < 2. Options expire right after the end of averaging. These are much more liquid for longdated options, liquid as far out as 60 months. Time Spreads Maturity/Strike Spectrum: Traders can get options on the difference of neighboring (1 month) futures out to 1 year. These options expire 1 day before the expiry of earlier future. 6 and 12 month time spreads also trade liquidly. Strikes are ATM only. Swaptions Maturity Spectrum: Swaptions trade the following maturities: 6m on 6m, 6m on 12m, 12m on 12m, 24m on 12m, 36m on 12m. Strikes are ATM +- $5. Term Settled Options Maturity Spectrum: There are two maturities that trade liquidly, 12 month average starting in 6 months, and 12 month average starting in 12 months. Strikes are ATM. Natural Gas: Natural Gas is a futures market, and the options it trades are bullet options, time spreads, swaptions, monthly average options Bullet options maturity/strike spectrum: There is 1 option on each future, expiring 5 days before the future. Liquid options available out to 36 months. Strike prices trade within the range 0.25 < F/K < 4. Monthly Averages Maturity Spectrum: This is an OTC market, with generally 1 option/month available. Strike prices trade in 1$ increments, for 0.5 < F/K < 2. Options expire right after the end of averaging. These are much more liquid for longdated options, liquid as far out as 60 months. Time Spreads Maturity/Strike Spectrum: Traders can get options on the difference of neighboring (1 month) futures out to 1 year. These options expire 1 day before the expiry of earlier future. Strikes are ATM only. Swaptions Maturity Spectrum: Swaptions trade only 1y on 1y. Not very liquid.

Electricity: Electricity is primarily an OTC market, and trades almost entirely swaps, with daily payoffs, as underlying instruments. They are traded in daily strips for a number of months, quarters or years, or if the period has already started, people will trade balance of month, balance of quarter, or balance of year swaps, i.e. a swap lasting for the remaining portion of the time period. Swaps can go out as far as 15 years, and are mostly physical settled. Electricity options trades are almost entirely swaptions Swaptions Maturity Spectrum: Swaptions trade OTC, and are liquid out to 1-2 years. They typically expire 1 week before the beginning of the swap. Base Metals (London): Base metal markets trade bullet options, swaptions, and monthly averages. The bullet options are liquid several years out, just like the futures. Aluminum bullet options, the most liquid, are liquid out to 5 years, copper options liquid out to three, as with Zinc. The least liquid is the Nickel options market, which is liquid out to 1 year. Common Exotic Options Transport Options Very often traders will buy an option paying the difference between the commodity futures price in one location, at a particular time, and the futures price in another location at the same time. This is called a transport option. Often consumers who must buy a commodity in a less liquid location will hedge their main risk to e.g., natural gas, in the most liquid market location, which is Henry Hub, and any residual risk that they have they hedge by buying transport options. These options are sold in strips, and typically include a loss factor, so that if the future in location 1 is F1_T, and the future in location 2 at time T is F2_T, then the payoff is Sum_Ti max( Loss * F_2Ti F_1Ti K,0 ), where the sum is over all the delivery dates in the strip of options. Time Spread Options A producer or consumer who does not know when he might sell/use his commodity might prefer to buy it early, but does not want to be exposed to the cost of storage will

buy a time spread option, which pays the difference between the futures price on a commodity in one month, and the futures price of the same commodity in the next month. Clearly, the difference is the effective cost of storage. Load Serving Deals For a utility, the electric power he must deliver has an unknown, unhedgeable, stochastic notional. When utilities hedge, what they would really like to hedge is not just the power price, but the power price multiplied by this stochastic, time-dependent, and highly correlated notional, or load. Although there is no market in load, load is highly correlated to weather. Models of load can be calibrated, after a fashion, to uplift. Uplift is defined as the ratio between the load-weighted average power price, and the unweighted average power price, and it is this quantity that the market for load-serving deals trades on. Therefore, although there are no vanilla options on load, there is a small amount of historical data to calibrate to, written in terms of the uplift, defined as Sum_t P_t L_t / Sum_t P_t Sum_t L_t. Load is believed to be driven in the short term by weather, and in the long term by economic growth. Since load is effectively the demand for power, and the cost for power production is given by the cost of its fuel (plus certain fixed and operating costs), it is sometimes observed that the proper model for power should contain these three factors. To date, however, there has been very little work done on load modeling, in spite of the clear need. It is an ideal problem for academics in the sense that it is a green field, and there is an opportunity to put ones stamp on the field, and help a grateful bank make some money, at the same time. Crack Spread Options These options pay off on the difference between crude oil and either heating oil (heating crack) or fuel oil (fuel crack). These options capture the margin that is currently available to refiners, for their services. They are natural hedges for these industries. Spark Spread Options These options, quite analogous to the crack options, above, pay off on the difference between power prices, and natural gas prices, and capture the margin that is currently available to gas-burning power plants. They have an additional complication, in that the spark spread requires an efficiency parameter, known as the heat rate, which is different for different plants. Thus, the payoff is actually Payoff = ( P H * G)^+, and H is not a single standard number, but varies with the counterparties. The spark spread, P H*G, is also known as the toll. Swing Options These are very complicated options, in which the user has contracted to buy a certain volume of natural gas from a supplier over a period of time, at a floating price, and has

retained the option to choose on which dates to buy. Thus, the bulk of the deliveries may swing from one end of the period to the other. The user exercises an option each day to decide how much, if any, gas he will buy that day, and often there are penalties and rebates across different periods for excess or insufficient purchases. Storage Options This is an option in which the user buys the right to use a natural gas storage tank, to inject or withdraw (paying operating fees), up to some daily limit. He again exercises an option each day on whether to buy gas at the market price and inject, or withdraw and sell at the market price. Basic Features of Commodities Models Commodities Models are either models of a curve, or models of the spot price In futures or forward markets, such as fixed income or commodities, one has the choice of modeling the curve, or modeling the spot rate, and realizing the forward curve as the expectations of the spot rate through time. Both approaches are taken in commodities modeling. --Modeling with the spot price Models of spot are typically constructed by adding factors in some way (typically with an economic interpretation) to a process with distribution or behavior close to the observed behavior. Spot models almost always have some mean-reversion, as they should, and sometimes include influences from e.g. fuel costs, weather, long term prices, etc, and we show several examples in the next section. The futures curve is then recovered from the spot model by evaluating F_tT = E( S_T | S_t ). -- a convenient parametrization: the convenience yield One important parametrization popular in commodities modeling through spot prices is derived from the relation between forwards and spot in a lognormal model, F_tT = E( S_T | S_t ) = S_t exp( r(T-t) ). This relationship, as written, takes no account of storage costs, so we add them, parametrized as follows F_tT = E( S_T | S_t ) = S_t exp( (r + u)(T-t) ). As we have seen, however, this relation cannot be enforced by arbitrage, and in general it will differ. The difference is given the economic interpretation that it is the value of the

option to use discussed earlier, and, when parametrized as another modification of the interest rate, F_tT = E( S_T | S_t ) = S_t exp( (r + u y)(T-t) ). is known as the convenience yield y. In further developments of spot models, a common approach is to consider a stochastic convenience yield. This approach has a parallel in the hazard rate models in credit modeling. --- Difficulties with spot models I take the point of view that spot models cannot work well, for several reasons, which are principally relevant for markets with strong storage constraints, such as natural gas, or power. The first is that tightly storage-constrained markets can have very sharp slope to the forward curve, possibly even discontinuities. On the other hand, the forward curve relationship in a spot model F_tT = E( S_T | S_t ) is almost certain to be a smooth function, and usually a function of the integral of parameters and . This can force a spot model to have delta-functions in its parameters, which will cause at the very least numerical problems, and in some models will not be well-defined model. The second is that spot models cannot ever have decreasing variance, and this is observed in the marketplace. And the third is that, empirically, the overwhelming majority of trading volume does not take place in the spot market, it takes place in the futures and forwards market. Finally, while in a spot model the futures prices are all written as expectations of the same spot process, for a general model of the futures curve, there need not exist a process whose expectation gives the value of all futures in todays market. --Modeling the forward curve directly If we pursue the idea of a model for the forward curve, rather than spot, we are naturally led to the suggestion of BGM-like factor models, and this is the method underlying many currently popular models. These methods do not, of course, include any sort of a volatility smile, but they have enjoyed some success, are a therefore a natural jumpingoff point for inclusion of more advanced features. Factor models, i.e. models in which the curve is driven by a very few driving factors, and a matrix of coefficients giving the relative influence of each factor on each future, also have difficulties. In particular, they can force neighboring futures contracts to be strongly correlated. Often, this is a good thing, but we can see evidence for decorrelation in the high prices for time spread options, which can require three or more factors to calibrate. In addition, factor models also have trouble accommodating the decorrelation that can happen near extremes of storage, where variance can actually

decrease with time, or for markets that simply have no storage, as factor models have a very limited ability to accommodate decreasing variance. We shall see an example of a simple curve model in the next section. Interest Rates, though natural to include, are often too small an effect Though interest rate volatility may be incorporated naturally in such models, the additional computation time this necessitates is not justified by the (modest) increase in accuracy. This is because the massive short-term commodity volatilities easily swamp the modest volatility of interest rates. This is particularly true because payoffs of commodity products rarely, if ever, involve explicit interest rates, so that these options depend only on interest rates through discount factors, which have very little volatility. That said, commodity options deals can extend out beyond 5 years, sometimes, and longterm commodity volatilities are quite slow, so that discount factor variances eventually do catch up to commodity variances. Furthermore, as investor interest in commodities increases, one may start to see the current set of commodity-linked investor products modified to include interest rate coupons as well. -- Additional Desiderata A Commodities model must have some equivalent of mean reversion Although the short end swings violently, it swings around the level of the long end, and does not wander away. The short end of the curve must exhibit some form of mean reversion to the long end. A commodities model must often be a multi-commodity model, both across locations, and across different types of commodities. Many exotic options, and even some semi-vanillas, are written on several commodities. Examples are spark- and crack-spread options. Thus, when making a commodities model, the modeler ought to have in the back of his mind its interaction with other models for closely related commodities, such as gas with power, or oil with its products. Further, some options are written on several locations of the same commodity, such as transport options. This can be particularly tricky, as the underlying is the difference of two tightly correlated processes, which often has volatility an order of magnitude lower. The difference of two very similar and highly correlated processes will be highly sensitive to correlation, as the model is near a singular point. A commodities model of the vol smile must be calibratable to odd-shaped vol surfaces, distorted by inventory effects. Because of the extensive vol surface, standard vol-smile models wont be sufficient to capture all the information in the vol surface. This makes smile modeling particularly difficult, in commodities.

A commodities model should probably be a jump model The huge implied volatilities that appear right at the end of an options life, along with the high kurtosis, are a typical sign that the underlying model shows true jumping behavior. One can presumably fake the high volatilities by having instantaneous volatility running off to infinity, but the kurtosis is more difficult to fake. Market Specific Modeling Features Storage Limits on Natural Gas A natural idea for a natural gas model would be to incorporate known information about the state of storage into the model, so that effects like storage driven de-correlation of futures that we described might be adequately captured, but only when truly needed. Off-peak/on-peak power are separate assets In power, the market for peak power, and off-peak power often have very little to do with one another, because peak power is often high up on the generation stack, whereas off peak power is very far down. As such, they have completely different marginal costs, and involve a different set of sellers as the active market agents. It is natural, therefore, to think of them, and model them, as though they were just different assets altogether. Spot Models: The Gibson-Schwartz model is a lognormal process with a stochastic, mean-reverting drift. It is given by dS/S = ( _S c ) dt + _S dZ_S dc = k( c ) dt + _c dZ_c dZ_S dZ_c = dt. This model is a continuous model, Gaussian even, and does not mean-revert. The mean reversion means that term vols will be much too large at long times to expiry, and the continuous nature means that the model will be require a exploding vols in order to capture the jumpy behavior of expiring options as time to maturity goes to zero. This model cannot have decreasing forward variance, and likely cannot accommodate nearly singular, e.g. sharp intraday, seasonalities. The model of Schwartz and Smith writes the spot as a sum of a slowly varying lognormal factor representing the long end of the curve, and a rapidly varying mean reverting (to zero) factor representing the deviation of the short end from the long.

The model is written as d = - k dt + _dZ_ d = _dt + _dZ_ with dZ_dZ_= dt, and the futures price F is related to , and the time to maturity as F( , , ) = exp( A() + N() + ). This model is an improvement over the model of Gibson-Schwartz, in that the model readily accommodates the sharply decreasing term vols, by virtue of the mean reversion of its high-vol factor. This model of spot has additional degrees of freedom to allow for some de-correlation of different parts of the curve, making it possible to calibrate some of the calendar spreads, but probably not in very volatile markets. It cannot calibrate to any sizeable backwardation in variance, nor very sharply varying forward curves. A very similar model, that is popular on the street is the Gabillon model, in which a process for the spot process is correlated with process for the long end of the curve, and these two can be shown to behave like a factor model, with log forward prices a linear combination of the logs of the factors. It is written dS / S = ( ln L ln S ) dt + _S dZ_S dL / L = _L dt + _L dZ_L dZ_L dZ_S = dt. This model has many of the virtues of the Schwartz-Smith model, in that it naturally accommodates strongly backwardated vols, and allows for some de-correlation of futures at different points in the curve, but probably not enough for the US markets. It is Gaussian, and has no vol smile. It is also completely soluble, and can be readily calibrated to bullet vols. It is also readily generalizable to a multi-location model, or a multi-commodity model. Finally Shijie Deng has introduced a family of three discontinuous models, aim to capture jumpy behavior in the electricity markets. Deng models electricity spot price as a mean reverting jump-diffusion process, and also includes a mean-reverting jump-diffusion fuel spot price, aiming to generate some of the non-Black-Scholes behavior of power through dependence of power on its non-Black-Scholes behaving fuel price. Let X be 2 dimensional process representing our commodities prices, the first component representing the power price, and the second representing the natural gas price. Let (t) be a vector of deterministic power and natural gas prices towards which X mean reverts at time t. Let C be the (time dependent) correlation matrix between the continuous part

of the fuel and power prices, and let M be its Cholesky decomposition. Let dW be an uncorrelated Brownian motion in 2 dimensions. Let K be a 2x2 diagonal matrix of mean reversion speeds, also dependent on time. Finally, let Z^j be a pair of compound Poisson processes in R^2, the j = 1 jumps being upward jumps with intensity _1(t), and the j=2 jumps being downward jumps with intensity _2(t). The simplest Deng model is written as dX = K ( X ) dt + M dW + Z^1_t+ Z^2_t His two different jump processes have different signs, and different statistics, in order to account for the different behaviors of up and down jumps. This model makes an admirable attempt to model the spikes and jumps of the vol curve. As such, it will do a good job of capturing the short maturity vanilla prices. The spikes will probably not contribute much to vanilla or average rate options, and therefore unless one models things like barrier options, the spiking behavior will contribute little. It is a spot model, and therefore cannot have decreasing variance. Although the model has an arbitrary parameters _i(t) towards which it mean reverts, I suspect that this model cannot have a nearly discontinuous forward curve, at least not without huge mean-reversion speeds K_i(t), and therefore will have trouble calibrating to some realistic forward curves, and vol curves. The jumps are liable to die away too quickly to be a realistic electricity model, and it is not clear how the extremely sharp put skew in the US markets will be modeled. This model is also tricky to calibrate to, and will be even more tricky in a multi-commodity or multi-location setting. Also, as the effect of jumps on the kurtosis is known to die away quickly, it is expected that the vol surface of this model will flatten out too soon (within a couple of weeks, according to rumor), instead of the year or more that commodity kurtoses tend to last. Deng also introduces regime switching and stochastic volatility versions of this model. The stochastic volatility should go some ways towards getting the kurtosis to last long enough, but even stochastic volatility is said (I havent tried this myself) to die away too soon. The regime switching is principally useful for creating realistic spikes. Deng actually calibrates this model to historical data we at Goldman, and I believe at other banks, too, do not find this approach useful, and always calibrate to market data. For one thing, the market data is extremely thin, as these markets are too new have many years of data whereas the equity, fx, and fixed income markets have data going back the better part of a century, the commodities markets usually have less than 10 years worth of data. A Curve Model

The Audet, Heiskanen, Keppo, Vehvilainen model of electricity forwards for the Nordic electricity market, is actually the simplest possible curve model. They take an HJM approach, with time-dependent volatility. Forward prices, following the SDE dF_{tT}/F_{tT}=exp(-(T-t))(T)dB_{T}(t) are each driven by their own factor, correlated to each other as dB_T(t) dB_T(t) = exp( *|T-T|) dt. Here the spot price is defined as the limit as Tt. The principal advantages of this model are that it is a curve model, and is therefore capable of rather naturally fitting arbitrary shapes of the forward curve and ATM vol curve without nearly singular parameter functions, as well as time spread options. It is also a Gaussian model, and therefore quite tractable. It is also readily generalizable to multi-location and multi-commodity models. Its disadvantages are that it has no vol smile or skew at all, and the vol curve parameters will have to get huge to calibrate to realistic option prices.

Bibliography of Commodities Modeling and Market Structure Platts Gas Daily, Platts Electricity Daily Eydeland, A. and Wolyniec, K. Energy and Power Risk Management, Wiley Finance, 2003 Pillipovic Geman & Vasicek Plugging into Electricity, Risk, Aug. 2001. Shijie Deng, Stochastic Models of Energy Commodity Prices and Their Applications: Mean-reversion with Jumps and Spikes Cavus, Mustafa and Paxson, Dean A. The Valuation and Effectiveness of Long Term Forward Contracts. Audet, N., Heiskanen, P., Keppo, J. and Vehvilainen, I Modelling of Electricity forward curve dynamics. Advertising: the GSCI Recently commodities have come into vogue with investors who seek an asset class uncorrelated with equities and other standard investments. The typical backwardated shape of the forward curve presents an opportunity for investors to simply ride up the curve, which is a money-making strategy whenever the market does not go into a glut. This trade pays off a very high percentage of the time (dont ask me for numbers), and so is an easy win for investors. The Goldman-Sachs Commodities Index was invented to make commodities as an asset class more accessible to a wider class of investor. Rather than picking a single commodity, it uses a collection of commodities, in an effort to obtain further diversification. Goldman-Sachs sells investor products based on the GSCI.

The GSCI is a simple average of commodities prices, cash settled, that is easy to buy and sell. It was created in 1991 and the GSCI futures and options were listed on the CME in July 1992. It is the only freely licensed commodity index in the marketplace The GSCI is the global benchmark for institutions making allocations to commodities. It is a world-production weighted index, the analogue to market capitalization weighting for equities, and so therefore is an excellent indicator of real economic activity, with commodities included in the index based upon the quantity produced and utilized in the global economy There is approximately $8Bn benchmarked globally to the GSCI. There are other rival commodities indices, but theyre much smaller eg DJ AIG Index ($9mm OI; approx 500mm in OTC products), SPCI ($123mm OI, and the JPM Index (previously the Chase Index; no listed futures contract) Strategically, clients invest because of the Negative Correlation to both Stocks & Bonds High equity-like returns (since 1970, GSCI has returned an High equity-like returns (since 1970, GSCI has returned an average 11.4% per annum) Hedge against rising inflation Historically has exhibited highest returns when financial assets are exhibiting their worst returns Acknowledgments: I would like to express my gratitude to the following people for their willing and able help. Jamie Cox-Jones, Ben Freeman, Michael Kirch, Ilya Ustilovsky, Dan Sharfman, Elisha Wiesel, Alex Lesin, Roberto Caccia, Derek Yi, Sofia Cheidvasser, Karhan Akcoglu, Bill Cowieson, Jeremy Glick, Lavanya Viswanathan, Alan Yamamura and Pavel Langer for their advice and criticisms. I would also like to thank Peter Carr, Marco Avellaneda, Bob Kohn, as well as Valerie Perugini, Gabrielle Maloney and Lillibeth Gecale for setting up this event so helpfully.