What Are Energy Derivatives?

Energy derivatives are financial instruments in which the underlying asset is based on energy products including oil, natural gas, and electricity. They trade either on an exchange or over-the-counter. Energy derivatives can be options, futures, or swap agreements, among others. The value of a derivative will vary based on the changes in the price of the underlying energy product.

Key Takeaways

  • Energy derivatives are financial instruments that have a value based on an underlying energy product, such as oil, natural gas, or electricity.
  • Speculators and companies trade energy derivatives either over-the-counter or on an exchange, such as the Chicago Mercantile Exchange (CME) group.
  • Commodity traders are speculators that trade derivatives with the goal of achieving profit from the price fluctuations that occur in the underlying energy product.
  • Companies that use and produce energy will often use energy derivatives to help hedge against common marketplace risks, such as fluctuations in commodity prices, interest rates, or foreign exchange rates.

Understanding Energy Derivatives

Energy derivatives can be used for both speculation and hedging purposes. Companies, whether they sell or just use energy, can buy or sell energy derivatives to hedge against fluctuations in the movement of underlying energy prices. Speculators can use derivatives to profit from the changes in the underlying price and can amplify those profits through the use of leverage.

Energy derivatives trade both over-the-counter (OTC) and on commodity exchanges. OTC trading occurs directly between two counter-parties outside the framework of an established commodity exchange.

Two of the best-known commodity exchanges in the United States are the Chicago Mercantile Exchange (CME) Group and the New York Mercantile Exchange (NYMEX), which is actually part of the CME Group. The CME Group is the world's leading and most diverse derivatives marketplace, handling billions of contracts per year. The CME offers derivatives that address a variety of marketplace risks. This includes risks associated with interest rates, equity indexes, energy, foreign exchange, metals, and agricultural products.

18.2 million

The average number of derivatives contracts the CME Group handled per day as of November 2019.

Energy Derivative Traders and Users

Energy derivative traders are a type of commodity trader. A commodity trader focuses on trading futures or options contracts in physical substances like oil and gold. Most often these traders are dealing in raw materials used at the beginning of the production value chain, such as copper for construction or grains for animal feed. Energy products such as oil, natural gas, and electricity are part of this broader commodity complex.

Companies that use and produce energy will often use energy derivatives to help reduce price risk. Commodity price risk is the uncertainty that stems from changing prices that adversely impact the financial results of those who both use and produce that commodity. 

Benefits of Energy Derivatives

Commodity price risk can equally impact producers of a commodity, not just users. Some of the world's biggest oil and gas companies use derivatives to offset risks associated with doing business. For example, Chevron, BP plc, and Royal Dutch Shell plc all report their derivative assets and liabilities on their consolidated balance sheets and annual reports.

In addition to commodity price risks, energy companies can also use derivatives to hedge against foreign exchange risks and interest rate risks. Derivatives serve a vital purpose in the energy market to reduce risk, providing all parties with the price certainty needed to plan business operations.