A Capacitated Commodity Trading Model with Market Power

In commodity markets, physical traders can take advantage of geographical price spreads by buying a commodity at the location where the price is low and reselling it where it is high. These trading decisions may have an impact on future prices, which we refer to as market power. They are also subject to operational capacity constraints. Our objective in this chapter is to understand how to best utilize this capacitated locational spread option in the presence of market power. We model the trader’s market power by altering the drifts of the underlying price stochastic processes. We find that the optimal policy is similar to the classical case without market power: there are two thresholds that determine three regions where it is optimal to: (1) move as much as possible from one market to the other; (2) do the the same in the opposite direction; or (3) do nothing. The values of the thresholds depend on operational costs, as usual, but also on market power and price uncertainty. We characterize these thresholds both in isolation and in a competitive equilibrium.