Financialization of Energy Products

Financialization of oil refers to the trading of oil derivatives for purposes of speculation, hedging, and arbitrage. The major issue powering the debate on financialization is whether or not such trading "adversely influences" the spot price of oil in the market and whether it generates systemic risk for firms and financial institutions that trade in such securities. Financialization of energy products extends the above discussion of oil to other types of energy goods and can also include carbon trading mechanisms, as well.

What are oil derivatives -- 1. Futures 2. Options 3. Swaps

Oil Futures

Crude Oil futures are standardized, exchange-traded contracts in which the contract buyer agrees to take delivery, from the seller, a specific quantity of crude oil (eg. 1000 barrels) at a predetermined price on a future delivery date.

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Consumers and producers of crude oil can manage crude oil price risk by purchasing and selling crude oil futures. Crude Oil producers can employ a short hedge to lock in a selling price for the crude oil they produce while businesses that require crude oil can utilize a long hedge to secure a purchase price for the commodity they need. Crude Oil futures are also traded by speculators who assume the price risk that hedgers try to avoid in return for a chance to profit from favorable crude oil price movement. Speculators buy crude oil futures when they believe that crude oil prices will go up. Conversely, they will sell crude oil futures when they think that crude oil prices will fall.

Oil Options

An option is contract which provides the buyer of the contract the right, but not the obligation, to purchase or sell a particular amount of a specific commodity on or before a specific date or period of time.  There are two primary types of options, call options (also known as a caps) and put options (also knows as floors).  A call option provides the buyer of a call option with protection against rising prices.  Conversely, a put option provides the buyer of the put option with protection against declining prices.

An option is contract which provides the buyer of the contract the right, but not the obligation, to purchase or sell a particular amount of a specific commodity on or before a specific date or period of time.  There are two primary types of options, call options (also known as a caps) and put options (also knows as floors).  A call option provides the buyer of a call option with protection against rising prices.  Conversely, a put option provides the buyer of the put option with protection against declining prices. Some options are for a position on a futures contract in oil. A Light Sweet Crude Oil Put (Call) Option traded on the Exchange represents an option to assume a short (long) position in the underlying Light Sweet Crude Oil Futures traded on the Exchange.

Oil Swaps

A swap is an agreement whereby a floating (or market) price is exchanged for a fixed price, over a specified period(s) of time. In addition to energy commodities, swaps can also be used to exchange a fixed price for a floating (or market) price. Swaps are referred to as such because the buyers and sellers of swaps are “swapping” cash flows.

Let's assume that you are looking to hedge 80% of your anticipated, October fuel consumption, which equates to 100,000 gallons. In order to do accomplish this you could purchase an October Platts’ Gulf Coast ULSD swap from one of your counterparties, often a financial institution or commodity trading firm. If you had purchased this swap yesterday at the prevailing market price, the price would have been (approximately) $1.3166/gallon ($55.30/BBL).

As an example of how an end-user (consumer) utilize a call option, let's assume that you're company has a large fleet and in order to ensure that your gasoline expenses do not exceed your budget, you need to cap the price of your anticipated cost of your gasoline consumption for a specific month.  For sake of simplicity, let's assume that you are looking to hedge 100% of your anticipated, May 2011 gasoline consumption, which equates to 125,000 gallons.    In order to do accomplish this you could purchase a May 2011, NYMEX RBOB gasoline, average price call option from an energy trading company.  Furthermore, let's assume that you wanted to mitigate your exposure above $3.00 per gallon (excluding basis and taxes).  If you had purchased this option last Friday, it would have cost you approximately 13 cents per gallon or $16,250 ($0.1300 X 125,000 gallons). 

Now let's examine how this option would perform if gasoline prices both increase and decrease between now and the end of May. In the first scenario, let's assume that fuel prices increase and that the average price for NYMEX RBOB gasoline futures for each business day in May, was $3.50/gallon.  In this scenario, your hedge would result in a "gain" of 50 cents per gallon ($3.50 – $3.0000 = $0.50) or $62,500.   As a result, you would receive a payment of $62,500 from the energy trading company, which would offset the increase in your actual fuel expenses by $0.50/gallon.  However, given that you paid 13 cents per gallon, your net gain would be 37 cents per gallon or $46,250. In the second scenario, let's assume that fuel prices decrease and that the average price for NYMEX RBOB gasoline futures for each business day in May, was $2.75/gallon.  In this scenario, your hedge would be "out-of-the-money" and you would not receive a return on the option.  However, given that gasoline futures prices have decreased, so should your actual gasoline costs at the pump.  Last but not least, given that you paid 13 cents for the option, your actual net cost per gallon would need to account for the 13 cent premium cost.