Why energy is different – spot versus term markets

An important aspect of many commodity prices and energy in particular is the
significant increase in volatility as a contract nears expiry. In many ways the nature
of spot price movement is very different from those seen in the forward markets.
Spot prices are driven by observable short-run market price signals including
actual supply and demand conditions. In power this will include plant availability
and weather forecasts that provide a good proxy for electricity demand. Prices at this
stage are likely to reduce to ‘floor’ levels or increase rapidly if supply conditions look
like they are going to be particularly tight. This will occur whether you have a
managed spot market, such as an electricity pool, or a pure OTC spot market. Given
these movements away from the ‘expected value’ in the forwards volatility will rise
dramatically as you move from the prompt month to the spot month. Figure 18.7
shows movement of volatilities as you move towards contact expiry, ending with
extremely high volatility compared to other markets.
One consequence of this price movement characteristic is that VaR estimates will
increase rapidly for any contracts that are taken to expiration. This means that risk
managers need to both understand the trading strategy being employed and ensure
that contracts that are not easily trading prior to expiration (such as some option
structures) are treated very carefully.