Crude Oil and Natural Gas

Table of Contents

Introduction............................................................................................................................................. 1

Banks' Involvement in Energy Markets.................................................................................................... 2

Major Energy Derivative Products............................................................................................................ 2

The Over-the-Counter Energy Markets............................................................................................... 3

Average Price Options.................................................................................................................... 4

Energy Swaps................................................................................................................................. 4

The Exchange-Traded Markets........................................................................................................... 7

Domestic Crude Oil........................................................................................................................ 7

Natural Gas.................................................................................................................................... 8

Electricity....................................................................................................................................... 8

The Term Structure of Energy Prices........................................................................................................ 9

Contango/Backwardation.................................................................................................................... 9

Convenience Yield............................................................................................................................. 9

Behavior of Oil Price Curves............................................................................................................ 10

Risks Associated with Energy Portfolios................................................................................................ 11

Basis Risk......................................................................................................................................... 12

Crack Spreads............................................................................................................................... 12

Volatility........................................................................................................................................... 13

Stack and Roll................................................................................................................................... 14

Examiner Guidance................................................................................................................................ 15

Appendix A............................................................................................................................................ 16

The Crude Oil Market....................................................................................................................... 16

IPE Crude and the International Market........................................................................................ 17

OPEC............................................................................................................................................ 17

The Natural Gas Market.................................................................................................................... 18

Market Structure........................................................................................................................... 18

Contracting................................................................................................................................... 19

References............................................................................................................................................. 21

Introduction

When the price and availability of a class of commodities affect individuals, businesses and governments as signifi­cantly as energy products do, financial hedging, managing and speculating become attractive to a broad spectrum of players. Consequently, the energy markets are actively traded by individuals and institutions who never have any intention of "taking delivery" of a physical barrel of crude oil or a million British thermal units of natural gas. In 1994 we learned a great deal about how an uncertain interest rate environment can give rise to wild fluctuations in the value of financial instruments pegged to market rates of interest; the factors which drive volatility in energy mar­kets are more complex — weather, labor strikes, political events, inflation and pipeline logistics are all capable of affecting the markets. Without an understanding of these factors and the unique concerns which they raise for energy market participants, it is easy to misestimate the risk profile of an energy products portfolio.

While it is not feasible to describe every important nuance of the energy markets in a product of this scope, it is appropriate to describe the markets and identify the risks and special concerns which attach themselves to energy products. With a focus on natural gas and crude oil, this product summary will give examiners and other interested parties a significant foundation from which further analysis can be directed.