Lecture Notes in Energy 54 Sofia Ramos Helena Veiga E ditors The Interrelationship Between Financial and Energy Markets Lecture Notes in Energy Volume 54 LectureNotesinEnergy(LNE)isaseriesthatreportsonnewdevelopmentsinthe study of energy: from science and engineering to the analysis of energy policy. The series’ scope includes but is not limited to, renewable and green energy, nuclear, fossil fuels and carbon capture, energy systems, energy storage and harvesting, batteries and fuel cells, power systems, energy efficiency, energy in buildings, energy policy, as well as energy-related topics in economics, management and transportation. Books published in LNE are original and timely and bridge between advanced textbooks and the forefront of research. 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More information about this series at http://www.springer.com/series/8874 Sofia Ramos Helena Veiga (cid:129) Editors The Interrelationship Between Financial and Energy Markets 123 Editors SofiaRamos HelenaVeiga Department of Finance Department of Statistics InstitutoUniversitáriode Lisboa Universidad CarlosIII deMadrid (ISCTE-IUL) Getafe Lisboa Spain Portugal ISSN 2195-1284 ISSN 2195-1292 (electronic) ISBN 978-3-642-55381-3 ISBN 978-3-642-55382-0 (eBook) DOI 10.1007/978-3-642-55382-0 LibraryofCongressControlNumber:2014945256 SpringerHeidelbergNewYorkDordrechtLondon ©Springer-VerlagBerlinHeidelberg2014 Thisworkissubjecttocopyright.AllrightsarereservedbythePublisher,whetherthewholeorpartof the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation,broadcasting,reproductiononmicrofilmsorinanyotherphysicalway,andtransmissionor informationstorageandretrieval,electronicadaptation,computersoftware,orbysimilarordissimilar methodology now known or hereafter developed. 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While the advice and information in this book are believed to be true and accurate at the date of publication,neithertheauthorsnortheeditorsnorthepublishercanacceptanylegalresponsibilityfor anyerrorsoromissionsthatmaybemade.Thepublishermakesnowarranty,expressorimplied,with respecttothematerialcontainedherein. Printedonacid-freepaper SpringerispartofSpringerScience+BusinessMedia(www.springer.com) Preface Inthelastdecade,energymarketshavedevelopedsubstantiallyduetothegrowing activity of financial investors. One consequence of this massive presence of investors is a stronger link between the hitherto segmented energy and financial markets.“TheInterrelationshipBetweenFinancialandEnergyMarkets”isthetitle of this book, and it addresses some of the recent developments between financial and energy markets. It aims to further the understanding of the rich interplay between financial and energy markets by presenting several empirical studies that illustrate and discuss some of the main issues on this agenda. Postgraduate students, researchers, and practitioners with a solid background in economic and finance theory are the target audience. Many chapters contain a strong componentof quantitative methods applied to energy finance along with an up-to-date survey of the literature, thus allowing the reader to get up to speed on these topics. A number of issues were omitted, including the regulatory aspects of the European energy markets and financial aspects on renewable and green energy, so astoavoidanoverlapwiththecontentsofotherbooksbySpringer,e.g.Financial AspectsofEnergyandtheHandbookofNaturalResourcesandEnergyEconomics. As a whole, the 12 chapters of “The Interrelationship Between Financial and Energy Markets” aim to provide an overview of important aspects of the oil industry, the impact of oil shocks, electricity markets, and the analytical and quantitative tools applicable to energy finance. Thisbookistheresultofinputfrommanypeople.Inparticular,wewouldliketo thank the authors of the chapters, as well as the reviewers for their helpful comments. v Acknowledgments To our families We are also grateful to the staff of Springer. Lastbutnotleastwearegratefultoourfamiliesandfriends.Sofiaisgratefulto the support of Francisco, Miguel and Paulo, but also her parents António and Gracinda. Sofia is also grateful to the friendship of Helena and José Manuel in all these years of work together. Helena is grateful to her husband, Marc Vorsatz, without him these last few yearswouldbemoredifficulttogo.Helenaisalsogratefultoherparents,Joséand Conceição,for theirunconditional supportandtothefriendshipandenthusiasmof Sofia that makes the research together a pleasure. vii Contents Part I Oil Industry Risk Factors in the Oil Industry: An Upstream and Downstream Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Sofia B. Ramos, Helena Veiga and Chih-Wei Wang Cost, Risk-Taking, and Value in the Airline Industry . . . . . . . . . . . . . 33 Paul A. Laux, He Yan and Chi Zhang Part II The Impact of Oil Shocks Oil Prices, Volatility, and Shocks: A Survey. . . . . . . . . . . . . . . . . . . . 57 Ulrich Oberndorfer Oil Shock Transmission to Stock Market Returns: Wavelet-Multivariate Markov Switching GARCH Approach. . . . . . . . 71 Rania Jammazi Forcing Variables in the Dynamics of Risk Spillovers in Oil-Related CDS Sectors, Equity, Bond and Oil Markets and Volatility Market Risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Shawkat Hammoudeh and Ramazan Sari Oil Futures Market: A Dynamic Model of Hedging and Speculation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 Giulio Cifarelli and Giovanna Paladino Evaluating the Empirical Performance of Alternative Econometric Models for Oil Price Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 Andrea Bastianin, Matteo Manera, Anil Markandya and Elisa Scarpa ix x Contents Part III Electricity Markets Commodity Price Interaction: CO Allowances, Fuel Sources 2 and Electricity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Mara Madaleno, Carlos Pinho and Cláudia Ribeiro An Overview of Electricity Price Regimes in the U.S. Wholesale Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 José G. Dias and Sofia B. Ramos Pricing Futures and Options in Electricity Markets. . . . . . . . . . . . . . . 233 Fred Espen Benth and Maren Diane Schmeck Switching from Feed-in Tariffs to a Tradable Green Certificate Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 Aitor Ciarreta, Maria Paz Espinosa and Cristina Pizarro-Irizar Unobserved Heterogeneous Effects in the Cost Efficiency Analysis of Electricity Distribution Systems . . . . . . . . . . . . . . . . . . . . 281 Per J. Agrell, Mehdi Farsi, Massimo Filippini and Martin Koller Introduction Beforetheearly2000s,commoditiesandenergymarketswerepartiallysegmented from outside financial markets and even from each other. During the 2000s, a series of academic articles publicized negative correlations between commodities and stock market and bond indexes, and the positive correlation with inflation. In investmentlanguagethismeansthatinvestmentsincommodities,andinparticular energy, provide diversification benefits as well as inflation hedging. These attractivefeaturescapturedtheattentionoffinancialinvestorsastheywerecoming totermswiththeburstofthedotcombubble.Theinflationhedgingpropertywas also welcomed by long-term investors for whom the inflation risk is a major concern. World dependence on energy has grown steadily in the last decades. Figure 1 depicts the world consumption of primary energy and the striking increase is evident.Between1965and2012,theconsumptiontripled.Thesteepupwardtrend ofconsumptioninChinaandotheremergingcountriesisalsocleartosee.Overall, the worldwide consumption of energy is dominated by China, the US, and the European Union, and together they accounted for 53 % of the world primary energy consumption in 2012. According to the Energy Information Administration’s International Energy Outlook 2013, world energy consumption will rise to 56 % in the next three decades driven by growth in developing countries such as China and India. Their projectionsalsoindicatethatdemandinChinaisexpectedtodoublethatoftheUS by 2040. Therefore, there is a huge potential for growth in the energy markets. Thederegulationoftheenergysector isanotherfactor thathas further boosted thelinksbetweenmarkets.The1980smarkedthestartofawaveofderegulationof severalstate-ownedindustries,includingelectricity,inmanycountriesliketheUS and the UK. The deregulation process in the energy sector aimed to create a new institutional framework that benefited consumers and fostered welfare. The regulationswerechangedinordertoattractalargernumberofmarketparticipants to competitive sectors given the well-known difficulty inchallenging incumbents. Prices were expected to fluctuate more as they were no longer being curbed, and thisbroughtnewrisksformarketparticipants.Inaddition,theCommodityFutures xi