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Aside from Black-Scholes with crazy skews, what major models are used for energy derivatives? I'm thinking particularly of electricity derivatives, but I'm also interested in natural gas and other volatile contracts(*).

(*): pun intended

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up vote 8 down vote accepted

That's a complicated question. There are many paths.

One path is to build a model of the underlying supply/demand relationships. For example, the sudden loss of a power supplier (or transmision corridor) shifts the supply curve to the left spiking the price. The key to the game is data, data, and more data (price, weather/wind, season, power loads, current power generation, stand-by generation, transmission line overload, etc).

There are several books written on the subject. If you dig around, you'll find everything from over-simplified books, to books that over-kill on a specific area of the business. Just a quick Google gives:

http://www.amazon.com/Managing-Energy-Price-Risk-Challenges/dp/1904339190

http://www.amazon.com/Understanding-Todays-Electricity-Business-Shively/dp/0974174416

My reputation level is too low to post more links.

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This guy listed a list of key papers relative to commodities price modeling. That could perhaps help you get started.

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