We've learned that NYMEX energy contracts represent the actual right to buy or sell energy commodities. So, for the commercial market participants, these provide both a market for production and a source of supply. For instance, producers of natural gas, crude oil, or refined products such as heating oil and gasoline, can sell financial contracts, thus guaranteeing that they will have a firm market in the future at a fixed price. Conversely, consumers of these same products can buy contracts to ensure that they will have a firm supply source in the future at a set price. Utilizing financial contracts to reduce price and/or commodity risk is known as "hedging." In this lesson, we will discover the ways in which commercial players in the energy industry use the financial markets for hedging their risks.
Key Learning Points – Energy Risk Hedging
- Producers and consumers of energy can reduce both their physical (market or supply) and price risk using financial derivatives such as futures and forwards.
- Futures are exchange-traded contracts such as the NYMEX energy commodities: crude, natural gas, heating oil and unleaded gasoline.
- “Over-the-counter,” or “OTC” contracts, are known as “forwards.” These are non-exchange traded and can either involve an electronic trading platform or “voice” broker.
- Hedgers are not speculators.
- In a hedge, commercial participants in financial markets take the opposite position from what they have in the physical markets.
- Financial positions must be settled monthly.
- Storage capacity can be hedged through buying one month and selling a future month.
At the successful completion of this lesson, students should be able to:
- explain how price risk reduction can occur through the use of basic financial derivatives like NYMEX contracts and “basis swaps”;
- describe how commodity risk can be reduced;
- demonstrate a simple “hedge” structure for:
- energy commodity producers;
- energy commodity consumers;
What is due for this lesson?
This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.
- Lesson 7 Quiz
- Lesson 7 Financial/Physical Price Comparisons Activity
- Fundamental Factors
If you have any questions, please post them to our General Course Questions discussion forum (not email), located under Modules in Canvas. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.