Valuation of options structures in energy often follows the same paradigm as in other asset classes. A model for price dynamics is posited, ideally motivated by empirical features of the underlying price dynamics, calibrated to market prices that are available, and then used to price nonstandard structures. The integrity of this approach is predicated on many assumptions, widely discussed in the general mathematical finance literature, that collectively imply the ability of market participants to replicate derivative payoffs by trading the underlying asset [Hul12], [Wil07]. In this chapter we will survey basic derivatives valuation methodology as it pertains to commodities, emphasizing some important facts about commonly traded instruments. All the results here will involve standard arbitrage arguments and apply to any forward or futures contract [Shr04].

The key results that we will establish are

1. Forward prices are martingales under the risk-neutral measures used to value derivatives on forwards. This is to be expected because there is zero cost of entry for forward contracts, and drifts in risk-neutral price processes result from the cost to fund positions.

2. Forwards and futures prices are functionally identical. While technically different, the corrections are very small.

3. American options on forwards should never be exercised early.

4. American options on futures in which the premium is paid at trade inception, commonly referred to as equity-style options, can be optimal to exercise early. The alternative futures-style options, in which the premium is paid at expiration, are never optimal to exercise early. Both types of options are traded on various exchanges.