Edwards - Energy Investing DeMystified

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This book is dedicated to my children,
Spencer and Brianna. Hopefully, they will enjoy the
written word as much as they enjoy science and math.

This book is also dedicated to my wife, Angela,
who has taken care of everything while I spent time writing.

Davis W. Edwards, FRM, ERP, is a senior manager in Deloitte & Touches National Securities Pricing Center managing energy derivatives valuation. Prior to joining Deloitte, he was division director of credit risk at Macquarie Bank and senior managing director on the statistical arbitrage trading desk at Bear Stearns. He is a regular speaker on the topic of financial modeling and mathematics applied to real-world problems. He is the author of the book, Energy Trading and Investing, and the director of the Houston chapter of the Global Association of Risk Professionals.

Energy products have become some of the most heavily traded commodities in the world following deregulation in the gas, oil, and electricity industries in the late 20th century. Prior to deregulation, prices were set by governments or other regulatory agencies. Along with slowing innovation and reducing efficiency, this limited private investments in these industries. As these markets were deregulated, opportunities for small investors multiplied. Currently, there are an abundance of trading and investing opportunities in the energy markets.

Deregulation has not ended government involvement in the energy industry. It merely changed how this involvement is manifested. The energy industry remains one of the most highly regulated industries in the world. Regulations exist at the international, national, and local levels. In many cases, these regulations have conflicting goals. For example, affordable energy has fueled human progress for the past century, eliminating poverty and improving living conditions for many people. However, this has come at the price of increased pollution and the risk of global warming. This can lead to diverging energy policies at different levels of government.

CHAPTER OBJECTIVES

After completing this chapter, the student should have an understanding of

Investing

The role of regulation of energy markets

This book is intended to be both a reference manual and a training course. It is patterned after training courses given to traders and professional investors by energy companies, hedge funds, and investment banks when they first start working on a trading desk. The purpose of this book is to give the reader the same level of knowledge as a professional trader or energy investor might possess on these topics. After reading this book, the reader should have a solid understanding of the products, infrastructure, and industries that make up the energy market.

To first time investors, it might seem odd that this book spends so much time explaining the details of the financial markets that can help someone become a good investor. Initially, it might seem unfair that someone armed with a how-to book should be competing for investment opportunities with MBAs and PhDs from top schools, educated and provided with the best data that money can buy. However, it can be doneand done successfully.

One key is to do your own work. By the time a broker is calling about investment opportunities, there probably isnt a lot of opportunity left. Hundreds of thousands of other smart people have had the chance to look at the opportunity first. Easy profit opportunities disappear pretty quickly, and what gets left over is not always that appealing. Knowing about what is actually going on in the industry allows you to understand trends when they start forming. It dramatically increases the chance of finding a good opportunity early.

However, thats only part of the investing story. What tends to get missed in investing is the concept of risk. Trading isnt always about finding good opportunities. Largely, its a matter of avoiding bad opportunities. If an investor can avoid losing money, most of the other outcomes look pretty good. The better an investor is able to avoid large losses, the more likely they are to be successful in the long run. The key to avoiding investment disasters lies in understanding the details of the industry