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.

RELATED TERMS
  1. Exchange Traded Derivative

    An exchange traded derivative is a derivative that is standardized ...
  2. Equity Derivative

    A derivative instrument with underlying assets based on equity ...
  3. Replacement Risk

    Replacement risk is a risk that may be present in over the counter ...
  4. Derivative Product Company - DPC

    A derivatives product company is a ratings-oriented subsidiary ...
  5. Commodities Exchange

    A commodities exchange is an legal entity that determines and ...
  6. Insurance Derivative

    An insurance derivative is a financial instrument that gets its ...
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Trading

    Are Derivatives Safe For Retail Investors?

    These vehicles have gotten a bad rap in the press. Find out whether they deserve it.
  3. Investing

    Commodities trading: An overview

    Trading commodities can seem challenging to a novice trader but we break it down for you. Learn more about the history of commodities, the types of commodities, and how to invest in them.
  4. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  5. Investing

    Is Your Mutual Fund Safe?

    You might be carrying more risk than you think if your fund invests in derivatives.
  6. Investing

    ETFs Provide Easy Access To Energy Commodities

    Hedge against rising energy prices and diversify your portfolio with these funds.
  7. Investing

    How To Capitalize On Rising Energy Prices

    The world's energy demands will keep rising as supplies become harder to find and exploit. These factors should propel a energy stock bull market for some time to come.
  8. Investing

    Where And How To Trade Energy Stocks

    Energy futures set a high bar to entry for individual traders and investors, redirecting exposure into sector equities and exchange-traded funds.
  9. Investing

    Energy ETFs vs. Energy Mutual Funds: Which are Better? (XLE, BNO)

    For investors looking to gain exposure to the energy sector in preparation for a rebound, there are a number of possible options.
  10. Financial Advisor

    When Will it Be Safe to Buy Commodities?

    When will it be safe to buy commodities (and which ones)? A closer look at the commodities markets and how they move.
RELATED FAQS
  1. How big is the derivatives market?

    Learn how different calculations can reduce the estimate of the total derivatives market by as much as 90 to 95%. Read Answer >>
  2. What are the main risks associated with trading derivatives?

    Learn about the primary risks usually associated with trading in the derivatives market, namely market, counterparty, liquidity ... Read Answer >>
  3. Are ETFs considered derivatives?

    Learn why most exchange-traded funds (ETFs) are not considered derivative securities and the special circumstances when this ... Read Answer >>
  4. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center