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, and trades 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 of the price of the underlying energy product.

BREAKING DOWN '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 and on commodity exchanges. Over-the-counter 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. CME Group is the world's leading and most diverse derivatives marketplace, handling 3 billion contracts worth approximately $1 quadrillion annually.

Energy Derivative Traders and Users

Energy derivative traders are a form 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. Commodity price risk can equally impact producers of a commodity, not just users. Energy derivatives serve a vital purpose in the market to reduce this risk, providing all parties with the price certainty needed to plan business operations.

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