PrintSwaps 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 one party or the other.
For example, as of this writing, the December, 2012 crude oil contract is trading $87.00. If I bought a Swap, I would be buying contracts at $87.00. On November 16, 2012, this contract will settle, and the difference between my $87.00 and the Final Settlement price will be the amount exchanged between me and my counterparty. If the contract settles at $87.50, since I bought the Swap, I would be selling it back at that price and my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $86.50, I would be selling the contracts back at a loss of ($0.50) and would pay my counterparty $0.50 per contract, or $500. The calculations are the same as those shown in Lesson 9's hedging spreadsheet.
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).
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.
The following Mini-Lecture is a summary of the points presented above.