Hi, I was talking to someone who works in energy/power derivative trading for a power supply firm and he mentioned that energy futures do not follow a log normal trend and can not be modelled using BS. One must fall back on probability based techniques to price such instruments. This tickeled my curiosity and I want to learn a little more about this field. Is there any recommended sources from the folks at Wilmott. My local library has Energy risk management by Fusaro and Energy risk management by goodman rove. I will have a look at them during my next trip to the library.thanks

In his later tomes, professa wilmott refers to the pilipovic pde (sp ? it's been a long time since I looked at it) and the book by pilipovic.I've probably mis-remembered that name, but you could do worse than read the very short section on energy derivatives in Paul Wilmott on Quantitative Finance

Pilipovic wrote one book, and Clewlow and Strickland wrote another - they were my main source for my honours thesis, but they are getting reasonably old now - I'd be inclined to get something written post Enron. A lot of my colleagues have Energy and Power Risk Maangement (Eydeland Wolyniec), or Geman's Commodities and Commodity Derivatives (both in the Wilmott bookshop). If you are taking the cheap option, private message me your email address and I can send you my thesis. In general though, the problem with B-S is separate to the problem of needing probabilistic methods. In liquid (relatively complete) markets you use market based approaches (though perhaps not B-S), calibrated completely to the market. In completely illiquid markets, you base your price on actuarial/historical probabilities (and generally a margin for error). In the 100% of cases that lie between these two extremes, you use a blend of the two. Commodity markets tend to be less liquid than other markets.B-S assumes a certain price path for spot prices, which doesn't necessarily happen in power markets because of the limited ability to store. Hence you get spikes, mean reversion, etc. These have to be taken into account when pricing, and perhaps Black Scholes won't be appropriate.

i would love to see your thesis. can you email me? thanks.