An energy derivative is a derivative contract based on (derived from) an underlying energy asset, such as natural gas, crude oil, or electricity. 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.
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.
The basic building blocks for all derivative contracts are futures and swaps contracts. In energy markets, these are traded in New York NYMEX, in Tokyo TOCOM and online 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 (extremely rare), 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 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.
There are three principal applications for the energy derivative markets:
Risk management (hedging)
Investment portfolio diversification