No energy trading desk should be without it. Energy markets are much more volatile than other commodity markets, so risk mitigation is more of a concern. Energy prices, for example, can be affected by weather, geopo9litical turmoil, changes in tax and legal systems, OPEC decisions, analysis' reports, transportation issues, and supply and demand - to name just a few factors. Tom James's book is a practical guide to assessing and managing these risks.
It is a must-read for senior management as well as risk and financial professionals. It provides the reader with a tangible experience of derivatives in today's capital and energy markets. The breadth and scope of the passages are immense, in that both developed and developing countries' energy markets are considered and examples applied. Terrific read! In this new market of "hot" commodities, he has been able to give a fresh course to those who are new to the energy markets and a solid review for those that are well seasoned.
Derivatives, Risk Management, and Policy in the Energy Markets
Coming from a financial background myself, it's good to finally find a book that can bring a better understanding to the field of energy commodities. About the Author Professor Tom James has been involved in energy and commodity markets since and is an internationally know business architect, leading market analyst, and trader in the commodity sector within top tier financial institutions. Permissions Request permission to reuse content from this site.
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Upcoming SlideShare. Like this document? Why not share! OTC contracts are, in effect, the opposite. Since they are one-on-one arrangements, the principals to the agreement are closely related to one another. The contract may require substantial fees paid to the manager or broker, and, since they are privately negotiated, they are not the result of a competitive process, although more than one dealer may compete to set up the transaction.
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Set against these limitations is the important benefit of flexibility. A market traded derivative contract can, at best, implement only a portion of the firm's risk management strategy. For example, a California firm interested in purchasing natural gas might try to hedge its price risk by purchasing NYMEX futures contracts.
However, the reference price for these contracts is at Henry Hub in Louisiana. The price of natural gas in California is different than the price at Henry Hub, and therefore, the firm can only cover a portion of the price risk it faces. Through the use of OTC derivatives, the firm may be able to eliminate basis risk and more effectively hedge the effects of price risk.
In more extreme cases, the firm may have a strategy which is incompatible with exchange traded derivatives, leaving only a choice between doing nothing or entering into OTC contracts.
The most basic type of derivative contract is a forward contract. In a forward contract the terms are very similar to a cash-and-carry agreement, except that delivery and transfer of ownership of the underlying commodity is in the future. If an oil refiner enters into a forward contract for crude oil delivery, the refinery avoids price risk by locking in a price now, or avoids storage costs if current purchase and storage are an option. The refiner faces the potential of default risk if the price of oil changes substantially, tempting the contract's counterparty not to perform.
Also, in these arrangements the credit worthiness of both parties is critical to performance of the contract. Finally, the liquidity of these contracts is low because they are one-on-one relationships that can only be changed by mutual consent.
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A futures contract is similar in intent to a forward contract, but has some important differences. A futures contract has standard terms and is traded on organized exchanges. It specifies trades of a particular quantity of the underlying commodity at a particular price, at a particular time.
For example, NYMEX natural gas futures contracts are for gas equivalent to 10, million British thermal units, at Henry Hub, LA, for any one of seventy two consecutive months into the future, at a dollars and cents price for 10, million British thermal units of gas equivalent.
Although the contract can be settled at expiration in the physical commodity, it is more normally settled in cash through the exchange. An options contract gives the owner the right, but not the obligation, to buy or sell quantities of the underlying asset at a fixed price known as the strike price. The two basic options are calls and puts. A call gives the owner the right to buy the underlying asset at the contract terms, while a put gives the owner the right to sell the underlying asset at the contract terms.
For example, on the NYMEX, a call option on crude oil gives the owner the right to buy oil futures contracts at a fixed price, while the owner of a put has the right to sell oil futures contracts at a fixed price. An options contract will only be exercised if it is in the financial interest of the owner, and is allowed to expire if it is not.
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As a result, option based strategies allow the owner to participate in favorable outcomes while minimizing the effect of negative outcomes. Offsetting this favorable result, options based strategies are more expensive to implement than futures based strategies. Not only are options available on futures contracts directly linked to the underlying physical commodity, but they are also available on critical spreads, or differences, that affect profit.
A crack spread option protects against an expansion or contraction in the difference between prices. A user of refined products might want protection against price increases when refinery margins grow, even if the price of crude oil is constant. A calendar spread option is used to lock in profits over time. For example, a storage facility can lock in a profit on the storage of natural gas by using a calendar spread. A swap contract allows the two parties to the agreement to exchange streams of returns derived from underlying assets.
Derivatives, Risk Management, and Policy in the Energy Markets
Ownership rights, if any, remain intact and the physical asset is not exchanged. Settlement payments are made in cash at pre-determined points during the life of the agreement to balance out differences in the value of the swapped return streams. For example, a refiner and an oil producer might agree to a five year agreement which has scheduled, periodic payments over its life.
The payment, which might either be paid out, or received, by the firm, is equal to the difference between a negotiated fixed price and the currently prevailing spot price for a given amount of oil. If the spot price is above the fixed price, the producer pays the refiner; if the spot price is below the fixed price, the refiner pays the producer the difference. The intent is to insure that both parties to the agreement have predictable, stable costs and revenues, respectively. Swaps represent some of the most common examples of OTC contracts. In many strategies, options are put together in combination to achieve the risk management goals of the company.
The simple building blocks of calls, puts, and future contracts combined with positions in the underlying assets can achieve a wide variety of final outcomes. Many of these outcomes are desirable and perform well in controlling risk and stabilizing profit. However, it is also possible to use the same tools to conceal debt, inflate profit, and render the financial reports of the company opaque.
This section will illustrate in more detail how derivative contracts manage price risk and at what cost. The first example is concerned with natural gas transactions. A variety of participants in the natural gas markets might find it useful to use derivative contracts. Marketers can use futures contracts to offer their suppliers and customers futures-based pricing arrangements.