Energy Derivatives

An energy derivative is a derivative based on an underlying energy asset or product, such as crude oil, natural gas, gasoline, electricity, or other energy products.

Energy derivatives can exist in the forms of futures and options or OTC derivatives such as swaps, forwards, and other types of options.

Those who participate in the energy derivatives markets include hedge funds, oil and gas companies, utilities, banks and financial institutions, and other trading firms.

Some contend that energy derivatives can distort an important market, with adverse downstream effects on consumer markets and real economy inflation.

For example, if someone buys an OTM call option on crude oil, the entity underwriting that option is short that exposure.

Because of the unlimited loss potential associated with that, they’re going to want to buy some amount of oil to hedge the delta (price) risk associated with that (and also potentially hedge gamma to account for potential price gaps).

The net effect of this is a rise in the price of oil, holding all else equal.

Essentially the derivatives market can be the tail wagging the dog instead of the other way around.

So one can argue that energy derivatives can artificially inflate the price of various energy products. But this can go for any asset or product with derivatives or options markets.

The basics of energy derivatives

Derivative contracts are based on futures and swaps.

Futures

For energy markets, NYMEX is the most common futures exchange in New York. Online, they’re traded through ICE.

A future is essentially a contract that promises to deliver or receive a certain amount of the underlying product in the future at an agreed-upon time.

Of course, for some commodities this isn’t practical. If someone is long cattle futures, they can’t deliver a bunch of a cows to your driveway and someone short cattle futures can’t deliver them when they very rarely have them.

So in many cases positions have to be closed out before expiration to avoid physical delivery.

For oil or natural gas, this involves the delivery or receipt of a certain quantity of those items.

The price is agreed on the date the trade or deal is made along with volume, index, and any other salient factors.

Futures are always part of a formal exchange. So all participants have the same counterparty.

At the expiration date, the owner of the futures contract may either deliver or receive a certain amount of oil or gas (which is very rare), settle in cash based upon the current price and terms of the contract, or close out the position prior to expiration and pay the difference of the two prices.

Swaps

A swap contract involves an agreement where a fixed price is exchanged for a floating price over an agreed-upon period.

A swap agreement will the duration, volume, fixed price, and reference asset, product, or index for the floating price (e.g., CL futures).

In the case of energy markets, the arrangement involves no actual transfer of physical oil, gas, or other energy products. Both sides of the transaction settle the trade through cash.

Differences may be settled in cash periodically for longer-duration obligations, with monthly being most common (but sometimes quarterly or longer).

Swaps are commonly called contracts for differences (CFD) and sometimes as “fixed for floating” arrangements. These terms essentially summarize what they’re all about.

How much cash is transferred is determined by the difference between the price determined at the outset of the agreement and the settlement of the final price of the index, asset, or product.

One party makes payments based on an increase in the value of the underlying assets while the other party makes a payment based on any decreases in the underlying.

Swaps are commonly OTC derivatives where your counterparty is an institution, company, or individual. Traders and investors should enter into swap agreements with counterparties they can trust given the over-the-counter nature of it.

First application of energy derivatives

The first applications of energy derivatives related to gas and petroleum products and came into use after the series of oil shocks and embargoes in 1973 and 1974.

Also around that time period, more energy products and indexes started trading on derivative exchanges.

This included products like crude oil, gasoline, and heating oil futures on NYMEX. Brent crude oil (a more common reference benchmark in Europe) began trading on the International Petroleum Exchange (IPE).

Main application of energy derivatives

The main applications of the energy derivative markets include:

a) hedging and risk management

b) speculation and trading

c) portfolio diversification

Hedging and risk management

Hedging and risk management with energy derivatives involves the process used by investors, companies, governments, and banks and financial institutions to reduce their risk exposures to movements in oil prices.

One common example is oil producers.

Because oil producers’ main business and revenue generation activity is based on selling oil, they have huge risks related to oil prices falling.

In this case, they might put on hedges to limit this exposure.

Revenue is price times volume.

So if production volume is a more predictable part of their business, the main risk to their business model lies in the price.

So, therefore, putting on hedges that would limit the damage to their business if oil falls below a certain price might be beneficial.

Moreover, it could also be beneficial to hedge upside risk as well.

For example, if oil goes up to $100 per barrel, this is going to cause some entities to shift away from oil and demand less of it.

This can lead to lower revenue.

Airlines are another example. About one-quarter of an airline’s cost structure is jet fuel consumption.

These fluctuations can impact airlines significantly. So an airline may want to have hedges in place that will help offset hits to their margins if jet fuel prices increase.

So they might buy call options associated with the jet fuel market or buy a swap from a party that makes a market in these types of transactions.

That way they’re protected if the price of jet fuel rises to levels that would hurt their business and better enables them to predict their future cash flows. This in turn should buoy investor confidence and potentially reward them with a higher multiple in the stock market.

Limitations of risk hedging using energy derivatives

There’s always the risk that certain energy derivatives don’t do a good job of managing the type of risk you have.

For example, let’s say an airline uses a certain form of jet fuel. There may not be a derivatives market in that particular form or it may be too illiquid to reliably trade in.

To create a hedge, they’ll need to construct one that’s highly correlated to the one they want.

This could include a form of jet fuel that’s closely related. Or it could be even broader, if a hedge on that can’t be done, and go to crude oil instead.

When hedges that are only approximate are constructed, there is always the risk that the hedge (e.g., crude oil) doesn’t do a good job of hedging what it’s supposed to minimize the risk of (movements in a certain type of jet fuel).