In Lesson 3, we defined an energy futures contract and the function of the NYMEX. We also identified the two main participants in financial energy markets as “commercial” and “non-commercial” players.
Commercial entities have an interest in the commodity itself due to the particular business they are in. For example, an oil refinery not only needs actual crude oil but also has a stake in the future price of oil. This is the basic feedstock for all of the refined products they produce, and therefore, their profitability is impacted by the purchase price of crude.
In addition, refiners sell products such as gasoline and heating oil, both of which are traded in the financial markets. So, the refiner’s profit is also dependent on the feedstock price for crude and the market price for what it produces.
On the other hand, exploration and production companies need to know the future market price of the crude oil they will extract from their wells.
The same holds true for natural gas. In some cases, natural gas is a component of manufacturing costs in such industries as fertilizers and food processing. In the power industry, the price of natural gas impacts the cost of generating electricity. And for midstream processors, natural gas is the main component for the extraction of valuable natural gas liquids (NGLs).
E&P companies that produce natural gas can also see the future market prices for their production.
Keeping in mind that futures contracts are legally binding obligations to buy or sell a commodity, they guarantee a market for producers and a source of supply for consumers. They also guarantee a set or “fixed” price, thereby reducing price risk as well.
In lesson 4, we learned about the spot market (it is also called the physical market, or the cash market), as the market where the actual physical commodity is traded. Local spot market price is determined by the local supply and local demand and it can become very volatile because local supply has to be planned by the producers in advance and producers don’t know the exact demand ahead of time. The difference between financial and physical market prices is called basis.
The effectiveness of hedging is highly dependent on the relationship between futures and spot market prices. This relationship can be explained by parallelism and convergence.
Parallelism represents the close relationship between futures and spot market prices and the fact that both are influenced by similar factors. Parallelism explains the fact that futures and spot market prices track each other (they are highly correlated). The fact that futures contract price tends to get very close to the cash market price is called convergence.