ROLE OF OIL DERIVATIVES IN RISK MANAGEMENT

Role of Oil Derivatives in Risk Management

Executive Summary

The main purpose of this paper is to discuss the role of oil derivatives I risk management. The preceding chapter described the concept of business risk in general and the importance of managing price risk for energy businesses in particular. This chapter looks at the current state of U.S. spot markets for oil and natural gas and shows that derivatives of various kinds have proven useful in managing price risk, especially for small and medium-sized firms operating in only one or a few market segments.

There is vigorous competition among suppliers of risk management tools for energy firms, and the market for derivative contracts is large. But there are problems. Enron's case illustrates that certain derivatives, especially pre-paid swaps, have been used to disguise what appear to be loans from stockholders. The Securities and Exchange Commission (SEC) and the Congress are vigorously investigating these abuses for the purpose of ending them. Table of Content

Contents

INTRODUCTION4

LITERATURE REVIEW5

Crude Oil and Petroleum Products7

Price Risk and Derivatives in Petroleum and Natural Gas Markets11

Basis Contracts13

Crack Spread Contracts15

CONCLUSION15

REFERENCES17

Role Of Oil Derivatives In Risk Management

Introduction

For more than 20 years, enterprises in the petroleum and natural gas commerce have utilized derivatives to decrease their exposure to volatile charges, restrict their require for money cushions, and investment. In latest times, although, derivatives and power dealing usually have been implicated in Enron's bankruptcy, manipulation of the California electrical power market, and foremost downgrades of power business borrowing rankings and development prospects. This makes sensible persons marvel if derivatives conceive more risk than they organize (Aaker 2007).

Domestic oil and petroleum charges were deregulated in the 2000s, and natural gas charges were partially deregulated. Before cost deregulation, the market for household oil and gas derivatives was limited. Under cost guideline, the U.S. Department of Energy (DOE), the Federal Energy Regulatory Commission (FERC), and the State public utility charges (PUCs) exactly or obscurely controlled the charges of household crude oil, petroleum goods, wellhead natural gas, pipeline transmission, and retail gas service.22 Government was furthermore profoundly engaged in concluding the deserves of pipeline buying into and siting. The direct result of cost controls was to stabilize price. Unfortunately, cost certainty was paid for with shortages in some localities and excess in another location and by convoluted cross-subsidies from localities where charges would have been smaller to localities where charges would have been higher, with accompanying effectiveness costs.23

Currently, the charges of crude oil, natural gas, and all petroleum goods are free from Federal regulation. The FERC extends to enforce cost upper exterior on pipeline services and has acceptance administration for new pipeline construction. Most States extend to regulate charges for little users of natural gas (residences and financial enterprises), but large users—particularly, power plants, which accounted for about 21 per hundred of the Nation's natural gas utilization in 2001, and petrochemical plants—are usually free to make their best agreements (Accola 2004).

 

Literature Review

Spot markets have long been a significant part of worldwide trade ...