Detecting Market Transitions and Energy Futures Risk Management Using Principal Components

An empirical approach to analysing the forward curve dynamics of energy futures is presented. For non-seasonal commodities-such as crude oil-the forward curve is well described by the first three principal components: the level, slope and curvature. A principal component indicator is described that detects transitions between the two fundamental market states remarkably well. For seasonal commodities-such as electricity and natural gas-it is shown how to extract the seasonal component from the forward curve. The principal component indicator can then be applied to the de-seasoned forward curve to detect significant price deviations that may support profitable trading strategies. A principal component approach to forward curve modelling is applied to computing portfolio value-at-risk. This approach is combined with a new two-step resampling procedure to improve value-at-risk estimates. © 2006 Taylor & Francis.