Mean reversion

We discussed earlier that energy prices tend to mean revert, i.e. to move back to
some mean over time. A number of models have been developed to adjust for mean
reversion. The crucial components that are needed to adjust in mean reversion
models are the mean itself and the speed of reversion. Two basic forms of mean
reversion occur: short run and long run.
Short-run mean reversion occurs when the particular events that have ‘knocked’
prices away from their mean recede. In power, this seems to occur between three to
five days after the event, which is generally weather driven. Long-run mean reversion
is driven more by the economics of the industry. For instance, the ability to bring
additional production on line or shut down uneconomic production will tend to put
caps and floors on prices over longer-term periods. However, such supply/demand
mismatches can last for periods of up to two or three years.
Additionally, given the extreme market movements in the power markets up- and
down-volatilities are not symmetric. Down-volatilities will be high when prices are
high and up-volatilities will be high when prices are low. This will have a material
impact on the pricing models. The impact on VaR will, however, depend on the
holding period being used. We have generally observed reversion taking five days or
longer, resulting in a minimal impact on a 5-day or less holding period VaR.