Energy Derivatives: What it is, How it Works, Example

What Are Energy Derivatives?

Energy derivatives are financial instruments whose underlying asset is based on energy products, including oil, natural gas, and electricity. They can either be traded on a formal exchange, such as the Chicago Mercantile Exchange (CME), or on an over-the-counter (OTC) basis.

Energy derivatives are an important part of the modern financial system and are widely used for purposes such as speculation, industrial production planning, and risk hedging.

How Energy Derivatives Are Used

Energy derivatives are a valuable tool used by industrial companies and financial traders. For companies, energy derivatives can help to smooth out production processes, allowing them to secure prices ahead of time for the commodities they need in their production lines.

For example, a company that requires a set amount of oil to run its operations can secure that oil at a predetermined price by purchasing oil futures contracts ahead of time. That way, if the price of oil suddenly increases during the year, the company will not suffer from any unexpected increase in their production costs.

Energy derivatives can also be very useful for financial traders. In addition to letting speculators bet on the anticipated price changes in energy commodities, energy derivatives also permit traders to hedge their risk exposure. For instance, an investment firm that owns a large amount of stock in oil companies might hedge their exposure to the price of oil by purchasing derivatives that would increase in value if the price of oil declines.

Energy Derivatives Investment Methods

Traders who wish to participate in the energy derivatives market have two major methods to choose from.

The first is to participate in a formal commodity exchange, such as the CME or the New York Mercantile Exchange (NYMEX). Through these markets, traders input their orders into a central clearinghouse which then matches buyers and sellers automatically. The system is highly automated and can clear very large volumes of transactions at high speeds.

Alternatively, it's possible to enter into transactions on a more ad-hoc basis by trading energy derivatives OTC. This process involves either relying on a financial intermediary, such as a brokerage company, or by making trades directly with a counterparty. 

Real World Example of Energy Derivatives

The energy derivatives marketplace is large and liquid, with the CME alone handling over 18 million contracts per day. Some of the most popular types of energy derivatives are those relating to crude oil. For example, NYMEX WTI Light Sweet Crude Oil futures trade nearly 1.2 million contracts a day, according to the CME, with each contract representing 1,000 barrels of oil.

Technically, each trader who purchases such a contract would theoretically be required to take physical delivery of the underlying oil if they keep possession of the contract until its expiration date. In practice, however, the vast majority of these contracts are sold to another party prior to expiration, so that the original purchaser does not have to take physical delivery.