Energy derivative

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An energy derivative is a derivative contract based on derived from an underlying energy asset, such as natural gascrude oilor electricity. Major players in the energy derivative markets include major trading houses, oil companies, utilities, and financial trading in oil futures and options. Energy derivatives were criticized after the financial crisiswith critics trading in oil futures and options out that the market artificially inflates the price of oil and other energy providers. The basic building blocks for all derivative contracts are futures and swaps contracts.

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 for the futures contract at the date of delivery contract expiry date may be different. 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. 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.

Thus, investors trading in oil futures and options carefully enter into a swap agreement with other party trading in oil futures and options all these parameters.

The first energy derivatives covered petroleum products and emerged after the s energy crisis trading in oil futures and options the fundamental restructuring of the world petroleum market that followed. This describes the process used by corporations, governments, and financial institutions to reduce their risk exposures to the movement of oil prices.

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 oiland the source of risk the hedge is intended to minimize the specialized jet fuel. From Wikipedia, the free encyclopedia. This article has multiple issues. Please help improve it or discuss these issues on the talk page. Learn how and when to remove these template messages. This article needs additional citations for verification.

Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. September Learn how and when to remove this template message. This article is written like a personal reflection or opinion essay that states a Wikipedia editor's personal feelings about a topic. Please help improve it by rewriting it in trading in oil futures and options encyclopedic style. This article may require cleanup to meet Wikipedia's quality standards.

No cleanup reason has been specified. Please help improve this article if you can. William Engdahl Mar 18, Peak Oil or Wall Street Speculation? Retrieved 29 March Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative. Retrieved from " https: Derivatives finance Energy economics. Articles needing additional references from September All articles needing additional references Wikipedia articles needing style editing from September All articles needing style editing Articles needing cleanup from September All pages needing cleanup Cleanup tagged articles without a reason field from September Wikipedia pages needing cleanup from September Articles with multiple maintenance issues All articles with unsourced statements Articles with unsourced statements from September Views Read Edit View history.

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