Business Finance

Energy Derivatives

Written by Bennet Grill for Gaebler Ventures

Energy trading and energy derivatives may seem like a strange concept to some. We offer an explanation of how energy derivatives work and the role they play in risk management.

Energy derivatives are a type of derivative in which the underlying asset is some sort of energy product.

Energy Derivatives

The market for energy derivatives can trace its roots back to 1983 when crude oil futures were first traded on the New York Mercantile Exchange (NYMEX.)

Since then, oil and other energy market derivatives have also been traded on the Tokyo Commodities Exchange (TOCOM,) the Energy Market Exchange (EMEX,) and the newly opened Dubai Mercantile Exchange.

Like other derivative products, energy derivatives can be used as a form of insurance to protect against the often volatile changes of energy prices.

Types of Energy Derivatives

Energy derivatives are chiefly traded through two different financial instruments--swaps and futures.

An energy swap is a transaction which trades the prices two parties pay for the energy commodity. For example, a company purchasing oil at a variable rate can participate in a swap so that they can purchase oil at a fixed rate for a certain amount of time. In a swap transaction there is no transfer of oil, only a transfer of the prices paid for oil. In contrast, a futures contract is an agreement for one part to deliver or receive the energy commodity at a certain price for a specified period of time.

Who Buys Energy Derivatives

The energy derivatives market can be divided up into two major players-- the hedgers and the speculators. While some participants in the market can be seen as both types of players, there is a distinction between the reason a hedger trades and the reason a speculator trades.

Hedgers are usually large energy providers or purchasers who use energy derivatives to protect themselves from the volatile nature of energy prices. An energy producer, for example, would use energy futures to guarantee a selling price of energy so that it would be protected from a sudden drop in prices and thus a decrease in profits. Large consumers of energy, such as transportation services companies and city and state governments, use energy futures to lock in a low price of energy so that they are not subject to the risk of rising energy costs.

The airline industry is a huge hedging player in the energy derivatives market. Each year, airlines compete to purchase energy futures contracts in an attempt to lessen their fuel costs, which often take up more than 20% of an airlines annual budget.

The other part of the energy derivative market is composed of speculators--entities who do not produce or purchase energy but simply make investments by betting on the price of energy. Energy speculators have made a significantly higher number of trades than energy hedgers--that is, more trading of energy derivatives was concerned with essentially betting on the price of energy than with protection from volatile price changes.

Speculators are typically large investment banks, who buy and sell energy derivative contracts from hedging players and from other speculators for a profit. In 2008, speculative players in the energy market drew heavy criticism as gas prices rose to a new high national average of over $4 per gallon.

The following commodities serve as the underlying assets for energy derivatives: crude oil, heating oil, natural gas, electricity, jet fuel and kerosene

Bennet Grill is a writer who has a passion for business and finance. He is currently an Economics major at Duke University in North Carolina.

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