The Over-the-Counter Energy Markets

OTC energy options and swaps are unique in that essentially all of them are average price (also known as Asian) options. These have been popular for many years and are considered very plain vanilla in the industry. More exotic options, such as barriers, are extremely rare in the energy sector. Greater detail on average price options follows in the next sub-section.

The OTC energy market is not nearly as price transparent as, for example, the OTC foreign exchange market. Despite this, corporate end-users and producers tend to prefer the OTC markets since basis4 issues are fewer and products can be structured to more closely replicate their cash market activities. Barnaud and Dabouineau contend that the OTC energy markets are characterized by "very poor visibility" and that transactions are often private and confidential.⁵ Thus, care in interpreting any pricing "information" is required, particularly for smaller players, such as banks, who may not be active in the physical markets.

In order to allay risk, many banks attempt to deal only in very liquid markets or on a back to back (fully offset) basis. Liquidity concerns have prevented banks from offering an expansive energy product range. Ample liquidity does exist, however, in many tenors of OTC average price crude and natural gas products. Because of the differences in contract design between these instruments and exchange-traded instruments (which are not average price) banks' hedging decisions — either OTC or back to back — are crucial.

Average Price Options⁶

Average price options comprise virtually all OTC energy options. Unlike standard options whose terminal value is the greater of zero or the difference between the strike price and the settlement price, average price options expire based on the greater of zero or the difference between the strike price and the average price traded during the life of the option (or stated averaging interval). This structure places them in the category of path-dependent options; the option's payoff depends on the price path followed by the underlying commodity prior to the option's expiration.

The applicability of average price options to the energy markets is high since firms that buy gas and oil typically do not make a single, periodic purchase. Rather, their energy needs are fairly steady, causing them to be in the markets on a regular basis. Options struck at one price will not capture this "smoothing" effect, and thus will not offer optimal protection in line with the type of risk being hedged.

Averaging for options on crude oil is generally done over the course of a calendar month. The relatively long length of this averaging period means that the average price begins to "set" with the passage of time so that days that fall later in the month have a less pronounced effect on the average than earlier days. This effect is also observable in the gamma statistic. The gamma of an average price option is nearly identical to that of a standard option on the first day of the reference period. However, as the option approaches expiration and the influence of additional observa­tions diminishes, the gamma declines to below that of a standard option.

The volatility of an average price option is also less than that of a standard option. For example, an $18 call on crude oil which settled at $22 but traded at an average price of $20 during the averaging period, would be worth $2 at expiration ($20-$ 18), not $4 ($22-$ 18). This essentially translates into lower volatility; thus, average price options trade at a lower premium (ie, they are cheaper) than conventional options. The smaller gamma, in addition to the more stable volatility, differentiate these options from their standard option counterparts.

The structure of the natural gas market dictates a different approach to setting average prices for natural gas options. Most contracts for next month delivery are finalized during bid week⁷. Thus, most natural gas average price options settle to the average of the last three days' New York Mercantile Exchange (NYMEX) futures contract settlement price during that week. It stands to reason then that average price natural gas options exhibit less volatility and gamma stability than do average price crude oil options. Settlement prices for the last three days are taken from the last two minutes of trading on days t-2 and t-1 and from the final half hour on settlement day (day t). This unique