PREFACE
PREFACE TO THE SECOND EDITION
In the seven years since I wrote the first edition, lots of things have changed. I’ve received a lot of feedback about the original edition, and there have been many dramatic changes in the energy markets. For this edition, I substantially expanded the coverage of oil markets, added more mathematical discussions, and provided clear-English descriptions on some of the less documented parts of the energy markets. I also substantially expanded the discussions on mark-to-market accounting, hedging, and risk management. I kept the same structure as the original book—broad discussions at the beginning of the book followed by separate discussions on specific aspects of the energy markets later in the book.
The energy markets have also changed. In the original book, policy makers were very concerned with the world running out of affordable energy. Less than a decade later, those concerns are much less pronounced. Concerns about global warming and carbon emissions are still present, but it is less clear how these concerns should be addressed. Despite having a string of record temperatures, few changes have been driven by legislation or international treaties. Progress has largely been made by the adoption of new technology in free markets.
The first major shift occurred with the development of technology that could be used to free fuel trapped in shale rock formations, called hydraulic fracturing or fracking. Fracking opened up a vast supply of natural gas in the United States. In 2009, when I wrote the first edition, a major concern of the energy market was that rapidly dwindling supplies of fuel would soon lead to imports from other countries. By 2016, fracking was flooding the United States with cheap natural gas. Natural gas terminals constructed to import gas in 2009 were undergoing conversion to export fuel.
This has had a domino effect across other energy markets. First, it drove down the price of electricity since fuel costs are one of the major components of electricity prices. Second, by lowering the cost of natural gas, coal became much less attractive as an electrical generation fuel. This largely achieved the goals of carbon legislation proposed between 2000 and 2010. Finally, fracking triggered a price war in the crude oil markets by raising the possibility that a very large economy (the United States) might transform from a net importer of fuel to a net exporter.
In the future, other technologies could have a similar transformative effect. For example, mobile telephones and tablets have driven down the cost of batteries and low-power video displays. Energy-efficient tablets and phones are replacing energy-hungry televisions and desktop computers at a very fast rate. These technologies are also spilling over into related areas like electric cars and LED lightbulbs. Along with better home insulation, these changes have kept consumer demand for electricity stable for nearly a decade.
It seems likely that technology changes will continue to drive changes in the energy markets for the immediate future. Across the energy industry, change is usually a mix of both good and bad news. With any market change, there will both be winners and losers. However, as an investor, rapidly changing markets provide opportunities unavailable in less turbulent periods.
As always, I am grateful for the support of my wife, Angela, and my two children, Spencer and Brianna. Writing doesn’t keep regular hours, and they helped me through the process. I would also like to thank my long-time agent, John Willig, the editor of the second edition, Cheryl Ringer, and the project manager, Dipika Rungta.
Davis W. Edwards
Houston, 2016
Preface to the First Edition
The inspiration for this book came early in my energy trading career. Previously, I had traded a variety of other products. However, after the boom years in the stock markets in the 1990s and the real-estate boom in the early 2000s, energy became the hot new area around 2005. A wave of financial professionals, including me, left our previous trading desks to join the hot “new” energy market. Of course, it wasn’t really a new market, but with the fall of Enron and market deregulation, trading opportunities were wide-open and expanding.
From the start, there was a huge culture clash between long-term energy traders and Wall Street traders. On Wall Street, the old intuitive traders had lost out to disciplined traders with technical backgrounds. Called quants, these math-savvy traders with degrees in physics, science, or engineering had taken over traditional trading desks by being more disciplined and organized. And, now, those same quants had set their eyes on invading the old-boy network of the energy markets.
In reality, it takes both an intuition and discipline to be successful. Energy Trading and Investing is written for every smart person who looked at a problem and said, “I could do it better than those guys,” but didn’t quite know where to get started. This is the book that I wished I’d had when I started trading energy. It grew out of the notes that I made then and later used to train new analysts. This book explains the energy market, how financial professionals trade energy products, and how they manage their business. It is written at the introductory level, without the use of jargon or complicated mathematics.
My philosophy on trading is that there is no substitute for understanding what is actually going on. Details are important. While writing this book, I had to fight back the temptation to eat up a lot of pages on interesting mathematical details to keep the discussions at a reasonable length. My major goal here is to provide a comprehensive introduction of energy trading from the first principles of exploration all the way to deal structuring. Even in a book of this size, that’s a lot of material to cover. I decided to tackle this material using the divide and conquer method. Energy Trading and Investing is organized to introduce energy trading in several steps. The first part—the executive summary—is a microcosm of the entire book. It’s the abbreviated version for people who want a nontechnical overview of the energy market without a lot of details. It’s a good starting point that hits most of the key points in the book. I expand on the summary in later chapters.
The detailed sections start with a discussion of each energy product. These are products like electricity, natural gas, and oil. Next, I go into cross-disciplinary discussion. I show how chemistry, physics, and option pricing all affect energy trading. I then move on to a discussion of specialized energy topics like alternative energy investments, energy storage, and transmission. I finish with a discussion of how traders actually manage their trading through risk management techniques.
To make things easier, I begin each chapter with a summary that lets you know what to expect from the chapter. Not every chapter is important to every job, and right at the start I try to indicate why each chapter is important. Stylistically, I break up discussions every couple of paragraphs and separate beneficial, but off-topic, details into sidebars.
In a number of examples, I use financial options to model nonfinancial assets like power plants, storage facilities, and undeveloped oil wells. In the industry, this is called a real options approach. Because of their simplicity and relatively few parameters, I have found that options are a useful way for me to think about real-life issues. I also think it is a good way to make people comfortable with options mathematics. That doesn’t imply that options are universally superior to other approaches to solving these problems. For example, Monte Carlo simulations are also commonly used to solve the same problems. However, statistical sampling techniques, like Monte Carlo simulations, make for less intuitive descriptions of how to solve a problem.
I also include several discussions on global climate change and pollution. These issues are closely linked to the power industry and are shaping its future. Any solution to the world’s energy problems will probably require consumers to use less power. However, this isn’t a book about conservation. It is about meeting 100 percent of consumer demands for power in a cost affordable and ecologically sensible manner.
I owe a debt of gratitude to my wife, Angela, for her help on this book. Without her editing and assistance, this book would never have gotten off the ground. My brother, Colin, was also instrumental with his help and editing. I would also like to thank my editor at McGraw-Hill, Leah Spiro, and my agent, John Willig, for their enthusiastic support of this project. Finally, I would like to thank my long-time boss at Bear Stearns, Eli Wachtel. He took a chance to put a young guy in charge of a lot of money and a team of traders, and I am grateful for being offered that opportunity.
Davis W. Edwards
New York, 2009