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

Financial Energy Swaps

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Swaps represent exchanges of payments between two parties. They are financially settled and no physical commodity is delivered or received by either party. They represent a substitute for the futures contracts but rely on NYMEX pricing to establish the financial arrangement for the swap contract. Similar to a NYMEX contract, the elements of a swap contract include the commodity, location, date, and price.

We use the phrase “fixed-for-floating” swap to signify the prices agreed to by both parties in the contract. The “fixed” price is always the current market price. It is the price known at the time the deal is struck. The exchange of payments will occur when the NYMEX settlement price is known. We refer to this settlement price as the “floating” one since it is not known until the contract’s last trading day and “floats” with each day’s trading until then. The difference between the two represents the amount of payment due to one party or the other.

For example, as of this writing, the December 2018 NYMEX crude oil contract is trading $61.16. If I bought a swap, I would be setting my contract price at $61.16. On November 20th, 2018, this contract will settle, and the difference between my $61.16 and the NYMEX Final Settlement price that day, will be the amount exchanged between me and my counterparty. If the contract settles at $61.66, since I bought the swap, I would be selling it back at that price for a profit of $0.50 per contract and, my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $60.66, I would be selling the contracts back at a loss of ($0.50) and I would pay my counterparty $0.50 per contract, or $500. The calculations are the same as those shown in Lesson 7's hedging spreadsheet.

As we learned in previous lessons, Futures contracts are standard contracts. However, swaps can be customized. This is another advantage of swaps that make them popular. The advantage of using swaps for hedging is that you can achieve the same price protection without actually having to buy or sell NYMEX contracts. And you can work with brokers either by phone ("Voice" Brokers) or through an electronic trading platform such as "The Intercontinental Exchange (ICE)".

In a previous lesson and in the textbook, we discussed the fact that physical entities wishing to hedge must take a position in the financial market which is the opposite of their physical position. For instance, a crude oil producer is "long" the commodity. Therefore, in order to execute a proper hedge, they must go "short" in the financial derivative they choose. In Lesson 7, I presented how the physical and financial prices interact in a hedge. The same applies to swaps as to the NYMEX contracts themselves.

Key Learning Points for the Mini-Lecture: Financial Energy Swaps

  • “Swaps” are exchanges of payments between two parties. They are strictly financial. No physical exchange of the commodity takes place.
  • One party to the transaction agrees to pay a current market price (“fixed”) while the other agrees to pay a price in the future (“floating”).
  • They are a simpler and less expensive way to hedge price risk.
  • One very important swap is a “basis swap” which is a market-determined value that represents the difference between the NYMEX Henry Hub and other natural gas trading points in North America.
  • For basis swaps, the "fixed" price or, "known" is the current market price which can be obtained through electronic platforms such as NYMEX Clearport or ICE. In addition, some brokers will give quotes over the phone. The "floating" price becomes known when the NYMEX contract for the particular month settles and the monthly index ("postings" we addressed in Lesson 5) for the cash location is published. This is known as the "actual" or "settlement" basis and represents the other value in settling the swap.

The following mini-lecture is a summary of the points presented above (3:37 minutes).

EBF 301 Lesson 10 Swaps
Click here for the transcript.

In this lesson, we're going to talk about some of the more advanced financial derivatives. Now, you'll find some pretty extensive notes in the actual lesson content page, so I'm going to do a summary here with these slides. And the first financial derivative that we're going to talk about is a swap.

Now, a swap is an exchange of payments between two parties. It can be a form of hedging, it can also be used for outright trading, so speculative traders can use swaps to try and make some revenue. These are generally known as over-the-counter. That is, they're not traded on an official exchange, such as NYMEX, but you do find them on electronic platforms, such as NYMEX's clear port or the Intercontinental Exchange. And then, also, swaps can be had by dealing with the so-called Voice Brokers-- literally a broker that you call up and arrange for a swap transaction. Now, these are strictly financial. In most cases, there is no physical commodity involved. You're strictly swapping out price.

Now, there are two pieces in a swap agreement. One is a fixed price and the other is a floating price. So, we refer to swaps as fixed for floating. One party will pay a fixed price at the time that the swap is actually entered into. And the other pays the floating price, and that's the price that is not known at the time. You have to wait till settlement of the respective underlying contract.

Now, we talk about the NYMEX look-alike because it's the most commonly used swap. It's a Henry Hub financial swap, and one party buys or sells at the current market, which would be the fixed or known price, in other words, whatever the NYMEX is currently trading at. And then the counterparty buys or sells, so the opposite party is going to take the opposite position. They'll buy or sell based on the NYMEX settlement. Now, this is your floating price, and it's unknown at the time of the swap transaction. So, in other words, the price floats as we know every day as NYMEX changes.

So, you set a price on the day that you enter into the swap for the specific month and the commodity that you are interested in. And then, in essence, the two counterparties, you and your counterparty, are going to wait until the NYMEX contract settles. And then, you're going to go ahead and true up, see who owes who money. And again, it's financially settled every month.

And then, we've also addressed the basis swaps. Again, there's more detail and specific examples in the lesson content. But really, in the case of a basis swap, we're looking at the current market value.

Now, the current market value you can find on NYMEX's clear port system. Or, if you have access to the Intercontinental Exchange, you will see natural gas basis swaps quotes for the various cash locations that we have reviewed in the publications, such as Platt's. And then, we have to come up with the second part of this, in other words, the floating price. We can fix the price based on the values on those electronic platforms I mentioned. But then, to settle with our counterparty, we have to wait until the settlement of the basis. Now, we know when a NYMEX final settlement occurs, and so we'll have that piece of the basis swaps settlement, but then we're waiting for the cash prices to come out. So, in other words, Platt's has their monthly price guide, or as I noted, it's more commonly known as the Inside FERC postings. So, those are the first-of-month cash prices for the respective location. And when you take the NYMEX settlement, and you find that cash location, that difference becomes what we call actual basis. It is the settlement price for the basis swap for that particular location.

Credit: Tom Seng