EBF 301
Global Finance for the Earth, Energy, and Materials Industries

Reducing Commodity Risk

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In Lesson 3, we defined an energy futures contract and the function of the NYMEX. We also identified the two (2) 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, or “spread,” is 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 for 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.