Energy derivative

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An energy derivative is a derivative contract based on (derived from) an underlying energy asset, such as natural gas, crude oil, or electricity. [1] Energy derivatives are exotic derivatives and include exchange-traded contracts such as futures and options, and over-the-counter (i.e., privately negotiated) derivatives such as forwards, swaps and options. Major players in the energy derivative markets include major trading houses, oil companies, utilities, and financial institutions.

Contents

Energy derivatives were criticized after the 2008 financial crisis, with critics pointing out that the market artificially inflates the price of oil and other energy providers. [2]

Definition

The basic building blocks for all derivative contracts are futures contracts and swaps contracts. In energy markets, these are traded on the New York Mercantile Exchange NYMEX, in Tokyo TOCOM and online through the IntercontinentalExchange.

Futures contracts

A futures contract is an agreement to buy or sell a commodity (for example, crude oil) at a specified price on a defined date in the future. The investor who agrees to buy the commodity is in a "long" position with respect to the commodity; the investor who agrees to sell is in a "short" position. The specified price, known as the delivery price, is agreed on the date the agreement is struck, together with volume, duration, and the underlying commodity. For example, in 2012 NYMEX futures contracts for light, sweet crude oil were based on delivery of 1,000 barrels of crude oil at Cushing, Oklahoma. [3]

The parties to a futures contract settle daily during the term of the contract: i.e. money is exchanged between buyer and seller at the end of every trading day. This reduces the risk of either party defaulting on the futures contract. The exchange or clearing corporation guarantees the performance of both parties. However, according to derivatives trader and author Michael Durbin, in the event of highly unusual market conditions widespread defaults on futures contract obligations are possible. [4]

Typically, the parties to the contract close out the contract prior to the delivery date. According to Durbin, early cancellations occurs in about 99% of all futures contracts. [5] Depending upon the contractual terms, if the contract is not cancelled, on the expiration date the parties to the futures contract owner may either:

Swap

A swap is an agreement whereby a floating price is exchanged for a fixed price over a specified period. It is a financial arrangement that involves no transfer of physical oil; both parties settle their contractual obligations by means of a transfer of cash. [6] The agreement defines the volume, duration, fixed price, and reference index for the floating price (e.g., ICE Brent). Differences are settled in cash for specific periods usually monthly, but sometimes quarterly, semi-annually or annually.

Swaps are also known as "contracts for differences" and as "fixed-for-floating" contracts, terms that summarize the essence of these financial arrangements. The amount of cash is determined as the difference between the price struck at the initiation of the swap and the settlement of the index. In a swap contract, you trade with your counterpart (a company/institution/individual) and take risk on their capacity to pay you any amount that may be due at settlement. Thus, investors should carefully enter into a swap agreement with other party considering all these parameters.

History

The first energy derivatives covered petroleum products and emerged after the 1970s energy crisis and the fundamental restructuring of the world petroleum market that followed. At roughly the same time, energy products began trading on derivatives exchange with crude oil, heating oil, and gasoline futures on NYMEX and gas oil and Brent Crude on the International Petroleum Exchange (IPE).

Applications

There are three principal applications for the energy derivative markets:

  1. Risk management (hedging)
  2. Speculation (trading)
  3. Investment portfolio diversification

Risk management

This describes the process used by corporations, governments, and financial institutions to reduce their risk exposures to the movement of oil prices. The classic example is the activity of an airline company, jet fuel consumption represents up to 23% of all costs and fluctuations can affect airlines significantly.[ citation needed ] The airline seeks to protect itself from rises in the jet fuel price in the future. In order to do this, it purchases a swap or a call option linked to the jet fuel market from an institution prepared to make prices in these instruments. Any subsequent rise in the jet price for the period is protected by the derivative transaction. A cash settlement at the expiry of the contract will fund the financial loss incurred by any rise in the physical jet fuel, allowing the companies to better measure future cash flows.

There are limitations to be considered when using energy derivatives to manage risk. A key consideration is that there is a limited range of derivatives available for trading. Continuing from the earlier example, if that company uses a specialized form of jet fuel, for which no derivatives are freely available, they may wish to create an approximate hedge, by buying derivatives based on the price of a similar fuel, or even crude oil. When these hedges are constructed, there is always the risk of unanticipated movement between the item actually being hedged (crude oil), and the source of risk the hedge is intended to minimize (the specialized jet fuel).

See also

Related Research Articles

Derivative (finance) Financial instrument

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.

Commodity market Physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

Contango Situation when futures prices are above the expected spot price at maturity

Contango is a situation where the futures price of a commodity is higher than the expected spot price of the contract at maturity. In a contango situation, arbitrageurs or speculators are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.

Futures contract Standard forward contract

In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative product.

Forward contract Agreement to sell or buy a good at a specific time and price

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Futures exchange Central financial exchange where people can trade standardized futures contracts

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. Futures exchanges provide physical or electronic trading venues, details of standardized contracts, market and price data, clearing houses, exchange self-regulations, margin mechanisms, settlement procedures, delivery times, delivery procedures and other services to foster trading in futures contracts. Futures exchanges can be organized as non-profit member-owned organizations or as for-profit organizations. Futures exchanges can be integrated under the same brand name or organization with other types of exchanges, such as stock markets, options markets, and bond markets. Non-profit member-owned futures exchanges benefit their members, who earn commissions and revenue acting as brokers or market makers. For-profit futures exchanges earn most of their revenue from trading and clearing fees.

Hedge (finance) Concept in investing

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

Chicago Mercantile Exchange Financial and commodity derivative exchange located in Chicago, Illinois, United States

The Chicago Mercantile Exchange (CME) is a global derivatives marketplace based in Chicago and located at 20 S. Wacker Drive. The CME was founded in 1898 as the Chicago Butter and Egg Board, an agricultural commodities exchange. Originally, the exchange was a non-profit organization. The Merc demutualized in November 2000, went public in December 2002, and merged with the Chicago Board of Trade in July 2007 to become a designated contract market of the CME Group Inc., which operates both markets. The chairman and chief executive officer of CME Group is Terrence A. Duffy, Bryan Durkin is president. On August 18, 2008, shareholders approved a merger with the New York Mercantile Exchange (NYMEX) and COMEX. CME, CBOT, NYMEX, and COMEX are now markets owned by CME Group. After the merger, the value of the CME quadrupled in a two-year span, with a market cap of over $25 billion.

New York Mercantile Exchange American futures exchange

The New York Mercantile Exchange (NYMEX) is a commodity futures exchange owned and operated by CME Group of Chicago. NYMEX is located at One North End Avenue in Brookfield Place in the Battery Park City section of Manhattan, New York City.

Swap (finance) Exchange of derivatives or other financial instruments

In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

West Texas Intermediate Grade of crude oil used as a benchmark in oil pricing

West Texas Intermediate (WTI) is a grade or mix of crude oil; the term is also used to refer to the spot price, the futures price, or assessed price for that oil. In colloquial usage, WTI usually refers to the WTI Crude Oil futures contract traded on the New York Mercantile Exchange (NYMEX). The WTI oil grade is also known as Texas light sweet, although oil produced from any location can be considered WTI if the oil meets required qualifications. Spot and futures prices of WTI are used as a benchmark in oil pricing. This grade is described as light crude oil because of its somewhat low density, and sweet because of its low sulfur content.

Brent Crude Classification of crude oil that serves as a major worldwide benchmark price

Brent Crude may refer to any or all of the components of the Brent Complex, a physically and financially traded oil market based around the North Sea of Northwest Europe; colloquially, Brent Crude usually refers to the price of the ICE Brent Crude Oil futures contract or the contract itself. The original Brent Crude referred to a trading classification of sweet light crude oil first extracted from the Brent oilfield in the North Sea in 1976. As production from the Brent oilfield declined over time, crude oil blends from other oil fields have been added to the trade classification. The current Brent blend consists of crude oil produced from the Brent, Forties, Oseberg, Ekofisk, and Troll oil fields.

Crack spread is a term used on the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted from it. The spread approximates the profit margin that an oil refinery can expect to make by "cracking" the long-chain hydrocarbons of crude oil into useful shorter-chain petroleum products.

Price of oil Spot price of a barrel of benchmark crude oil

The price of oil, or the oil price, generally refers to the spot price of a barrel of benchmark crude oil—a reference price for buyers and sellers of crude oil such as West Texas Intermediate (WTI), Brent Crude, Dubai Crude, OPEC Reference Basket, Tapis crude, Bonny Light, Urals oil, Isthmus and Western Canadian Select (WCS). Oil prices are determined by global supply and demand, rather than any country's domestic production level.

A commodity broker is a firm or an individual who executes orders to buy or sell commodity contracts on behalf of the clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives. Clients who trade commodity contracts are either hedgers using the derivatives markets to manage risk, or speculators who are willing to assume that risk from hedgers in hopes of a profit.

In finance, a spread trade is the simultaneous purchase of one security and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or futures contracts as the legs, but other securities are sometimes used. They are executed to yield an overall net position whose value, called the spread, depends on the difference between the prices of the legs. Common spreads are priced and traded as a unit on futures exchanges rather than as individual legs, thus ensuring simultaneous execution and eliminating the execution risk of one leg executing but the other failing.

The Dubai Mercantile Exchange (DME) is a commodity exchange based in Dubai currently listing its flagship futures contract, DME Oman Crude Oil Futures Contract (OQD). Launched in 2007, the DME aims to become the crude oil pricing benchmark for the Asian market with its Oman Crude Oil contract, like the Intercontinental Exchange’s (ICE) North Sea Brent is to Europe and the New York Mercantile Exchange’s (NYMEX) West Texas Intermediate is to North America.

Launched by the Dubai Mercantile Exchange (DME) on 1 June 2007, the DME Oman Crude Oil Futures Contract (OQD) is the Asian crude oil pricing benchmark. The contract is traded on the CME Group’s electronic platform CME Globex, and cleared through CME Clearport.

Saint-Petersburg International Mercantile Exchange Russian commodity exchange

The Saint-Petersburg International Mercantile Exchange (SPIMEX) is a Russian commodity exchange that was incorporated in 2008. It has offices in Moscow, Saint Petersburg and Irkutsk.

References

  1. ↑ Investopedia article on energy derivatives
  2. ↑ F. William Engdahl (Mar 18, 2012). "Behind Oil Price Rise: Peak Oil or Wall Street Speculation?". Axis of Logic. Retrieved 29 March 2012.
  3. ↑ Durbin, Michael. All About Derivatives (2011 ed.). New York: McGraw Hill Education. p. 25. ISBN   978-0-07-174351-8.
  4. ↑ Durbin op cit p. 24.
  5. ↑ Durbin op cit p. 25.
  6. ↑ Tracie Mauriello (March 4, 2012). "Idle regulation may impact gas prices". Pittsburgh Post-Gazette . Retrieved 29 March 2012.
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