Major Energy Derivative Products

Similar to the interest rate markets, energy instruments and derivatives are actively traded in the spot (physical), exchange, and over-the-counter (OTC) markets. An understanding of the market structure for both crude oil and natural gas enhances comprehension of the risks attendant to these products. In addition, several OTC instruments are structured to reflect market-specific characteristics. For interested readers, specific information on the crude oil and natural gas markets is included in this document as Appendix A. However, this background information is not critical for obtaining a basic knowledge of the types of products discussed in this section which are most commonly found in banks' energy portfolios.

Though financial markets have seen explosive growth in relatively exotic structures, energy products continue to remain very plain vanilla. This is due, in part, to the motivation of the major market participants who tend to be more bona fide hedgers than speculators on the future trend of energy prices. Speculators in financial markets have demonstrated a willingness to assume significant market risk in return for potential above-market returns. However, energy markets — as mentioned in the introduction to this paper — tend to react materially to disparate factors, often without warning. This uncertainty is reflected in their higher average volatility relative to many financial products.³ Thus, the temptation to speculate and take risk is less pronounced than in the (moderately) more predictable financial sector.

Energy producers have a genuine need to hedge their output, protecting themselves against falling prices, while end users have a genuine need to hedge against price increases for their relatively price-inelastic purchases of oil and gas products. Generally speaking, banks are not permitted to engage in the activity of buying and selling energy prod­ucts; this means they are essentially uninvolved in the physical energy markets. However, a subset of large banks are active in both the OTC and exchange-traded derivative markets.