Energy Derivatives
What Are Energy Derivatives?
Energy derivatives are financial instruments whose underlying asset depends on energy products, including oil, natural gas, and power. They can either be traded on a conventional exchange, like the Chicago Mercantile Exchange (CME), or on a over-the-counter (OTC) basis.
Energy derivatives are an important part of the modern financial system and are widely utilized for purposes, for example, speculation, industrial production planning, and risk hedging.
How Energy Derivatives Are Used
Energy derivatives are a significant instrument utilized by [industrial](/industrial-products area) companies and financial traders. For companies, energy derivatives can assist with streamlining production processes, permitting them to secure prices ahead of time for the commodities they need in their production lines.
For instance, a company that requires a set amount of oil to run its operations can secure that oil at a foreordained price by purchasing oil futures contracts ahead of time. Like that, assuming the price of oil abruptly increases during the year, the company won't experience the ill effects of any surprising increase in their production costs.
Energy derivatives can likewise be extremely helpful for financial traders. As well as letting speculators bet on the anticipated price changes in energy commodities, energy derivatives additionally permit traders to hedge their risk exposure. For example, an investment firm that possesses a large amount of stock in oil companies could hedge their exposure to the price of oil by purchasing derivatives that would increase in value in the event that the price of oil declines.
Energy Derivatives Investment Methods
Traders who wish to participate in the energy derivatives market have two major methods to browse.
The first is to participate in a conventional commodity exchange, like the CME or the New York Mercantile Exchange (NYMEX). Through these markets, traders input their orders into a central clearinghouse which then matches purchasers and venders naturally. The system is highly automated and can get extremely large volumes free from transactions at high velocities.
On the other hand, it's feasible to go into transactions on an all the more impromptu basis by trading energy derivatives OTC. This interaction includes either depending on a financial intermediary, for example, a brokerage company, or by making trades straightforwardly with a counterparty.
Albeit OTC transactions have the benefit of being highly adaptable, they might be less efficient than exchange-based transactions and commonly likewise imply greater counterparty risk.
Real World Example of Energy Derivatives
The energy derivatives marketplace is large and liquid, with the CME alone taking care of over 18 million contracts each day. Probably the most famous types of energy derivatives are those connecting with crude oil. For instance, NYMEX WTI Light Sweet Crude Oil futures trade almost 1.2 million contracts per day, as indicated by the CME, with each contract addressing 1,000 barrels of oil.
Technically, every trader who purchases such a contract would theoretically be required to take physical delivery of the underlying oil in the event that they keep possession of the contract until its expiration date. In practice, nonetheless, by far most of these contracts are sold to another party prior to expiration, with the goal that the original purchaser doesn't need to take physical delivery.
Highlights
- They trade basically on organized exchanges however can likewise be traded on an all the more impromptu basis through OTC transactions.
- The energy derivatives market has become immense, with a wide assortment of products addressed.
- Energy derivatives are a type of financial contract wherein the underlying asset is an energy product, like crude oil.
