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Oil Hedging and Financial Contracts
In this Supply & Trading in Oil and Gas lesson, we discuss financial hedging oil and products through futures, derivatives, and more.
How Does Hedging Work in Oil and Gas?
The Arab oil embargo of 1973, and the subsequent nationalization of significant reserves previously controlled by a handful of large, private companies, ushered in a new era of price instability.
To help the industry manage volatility, in 1978 the New York Mercantile Exchange (NYMEX) launched a heating oil futures contract, followed by a crude oil futures contract in 1983.
Today, the NYMEX crude contract is one of the most actively traded physical futures contracts in the world. Every day billions of dollars of energy products, metals and other commodities are bought and sold on the floor of the NYMEX.
Oil companies, oil traders and speculators hedge their activities with energy derivatives.
This is the term used for financial contract instruments (also often called paper) that derive their value from the underlying commodity (most often crude oil, natural gas or refined products).
This lesson presents an overview of the basic building blocks of the derivatives most applicable to crude oil and refined products, including:
- Futures contracts: Standardized agreements, traded on an exchange or electronic forum, which provide for the sale or purchase of an asset on a specified date in the future
- Forwards: A contract usually negotiated between two oil and gas companies or traders with similar interests. They are not traded on an organized exchange
Spec trading is the term used for those who take a position in financial derivatives with no offsetting position, either physical or financial. Spec traders have no intention of delivering or accepting the physical commodities.
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