Arbitrage and Energy Infrastructure – Part 1

Arbitrage is easy to define. It is a buying/selling strategy that involves taking advantage of price differences between different markets, assets, or time periods to generate profits.

Easy to say, but hard to do.

But to understand arbitrage and to see how it functions in a modern, global economy, let’s take a step back.

The theory of arbitrage is grounded upon the helpful fiction that prices for the same or similar assets should be consistent across different markets or time frames. We say that notion is fiction because it is rarely true, and the reasons why similar things are priced differently in different scenarios are unlimited in number. Production costs, technology, environmental factors, labor availability, cultural influences, geographical variations, trends and fads, and so on all contribute to price differentials. But the ultimate reason why the same stuff is priced differently at different times/places boil downs to good, old-fashioned supply and demand.

Arbitrageurs seek to profit from price differences by buying at a price (Place 1, Time 1, Circumstance 1) and then selling at a higher price (Place 2, Time 2, Circumstance 2). The difference between the prices (minus costs) is the profit.

And just as the case is in all markets where competition and freedom of actors prevails, the profits of arbitrageurs will tend to diminish over time. As market participants respond to price signals, resources flow towards other profitable opportunities, pushing commodity prices towards convergence and eliminating arbitrage opportunities. Which is to say that the helpful fiction mentioned above (that prices for the same or similar assets should be consistent) will eventually emerge.

That is, until the next supply and demand event occurs and another price differential emerges, and the cycle of arbitrage begins again.

That’s very abstract, but let that sink in.

Next we will look at arbitrage in the context of electricity markets.