Energy Derivative - Risk Management

Risk Management

This describes the process used by corporates, governments, and financial institutions to reduce their risk exposures to the movement of oil prices. The classic example is the activity of an airline company, jet fuel consumption represents up to 23% of all costs and fluctuations can effect airlines significantly. The airline seeks to protect itself from rises in the jet fuel price in the future.

In order to do this, it purchases a swap or a call option linked to the jet fuel market from an institution prepared to make prices in these instruments. Any subsequent rise in the jet price for the period is protected by the derivative transaction. A cash settlement at the expiry of the contract will fund the financial loss incurred by any rise in the physical jet fuel. Allowing the companies to better measure future cash flows.

That said, there are limitations to be considered when using energy derivatives to manage risk. A key consideration is that there is a limited range of derivatives available for trading. Continuing from the earlier example, if that company uses a specialized form of jet fuel, for which no derivatives are freely available, they may wish to create an approximate hedge, by buying derivatives based on the price of a similar fuel, or even crude oil. When these hedges are constructed, there is always the risk of unanticipated movement between the item actually being hedged (crude oil), and the source of risk the hedge is intended to minimize (the specialized jet fuel).