Energy Derivatives Trends Point Upward

Chidem Kurdas

Market changes suggest increasing demand for energy derivatives. This is implied by four developments, discussed at a Capital Link Forum by Nicholas Dazzo of Koch Supply and Trading, a trading house that is part of privately-held giant Koch Industries Inc.

The use of energy futures and swaps grew exponentially in the past 20 years, as have the hedging needs of oil and gas producers and consumers.  Financial participants, in particular global macro hedge funds and commodity trading advisors, will take the other side of a contract, say going short where a commercial consumer like an airline is long. There is yield to be made by taking the other side of commercial flows, said Mr. Dazzo.

Growth is likely to continue for several reasons. One is the increasing use of freight surcharges by transportation providers, which shifts the risk of rising fuel costs on to the customers. This means commercial customers look to hedge their exposure to fuel prices, using derivatives.

Increased supply of liquid natural gas in the US, reflecting the growth of oil and natural gas extraction from shale, has also created demand for energy derivatives. Mr. Dazzo reported significant interest for hedging, with producers wanting to capture the difference in value between natural gas and the liquid version thereof.

Worldwide, derivative use is rising not just for natural gas and oil but also coal. CME Group is preparing to launch a coal swap for China, according to Bernie Muich of CME; the futures exchange operator has already established Indonesian coal swaps. They expect volumes to grow, Mr. Muich said.

Another source of derivatives demand is biofuel hedging.  Mr. Dazzo says this started with the ethanol use mandate in the US, as ethanol producers seek to manage their risk, but there are growth prospects in other countries with plans to use biodiesel.

Then there is the trend toward the convergence of over-the-counter derivatives – swaps – with exchange-traded futures and options. Central clearing for swaps is a provision of the US 2010 Dodd-Frank Act, but to a large extent the market was moving to establish clearing before that regulation.

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