Energy derivative

Also known as energy trade, oil trade, gas trade, power trade. Major players include major trading houses, oil companies, utilities, financial institutions.

This article can briefly present the definition, applications, and brief history of the energy derivative market.

Definition

The basic building blocks for all derivative contracts are the Futures and swaps contracts. For the energy markets these are traded in New York NYMEX, in Tokyo TOCOM and on-line through the Intercontinental Exchange. A future is a contract to deliver or receive oil (in the case of an oil future) at a defined point in the future. The price is agreed on the date the deal/agreement/bargain is struck together with volume, duration, and contract index. The price for the futures contract at the date of delivery (contract expiry date) may be different. At the expiry date, depending upon the contract specification the 'futures' owner may either deliver/receive a physical amount of oil (this is a rare occurrence), they may settle in cash against an expiration price set by the exchange, or they may close out the contract prior to expiry and pay or receive the difference in the two prices. In futures markets you always trade with a formal exchange, every participant has the same counterpart.

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. The agreement defines the volume, duration, fixed price and floating price. Differences are settled in cash for specific periods usually monthly, but sometimes quarterly, six-monthly or annually. Swaps are also known as "contracts for differences" and as "fixed-for-floating" contracts - terms which summarise 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 one should carefully enter into a swap agreement with other party considering all these parameters.

Applications

There are 3 principal applications for the energy derivative markets:
# Risk Management ("Hedging")
# Speculation ("Trading")
# Investment Portfolio Diversification

Risk Management

This describes the process used by corporates, governments, and financial institutions to reduce their risk exposures to the movement of oil prices. The classic example provided by all text books is the activity of an airline company, jet fuel consumption represents up to 23% of all costs. 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.

That said, 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 specialised 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 minimise (the specialised jet fuel).

External links

* [http://www.yellowjacketsoftware.com YellowJacket OTC Energy Trading Platform] [http://www.weatherbill.com/learn]