Terms & tricks of the energy trade
This resource provides a selective list of terms frequently used in the energy trade, and in particular the financial energy trade.
This resource provides background on how to analyze financial oil and gas price moves, and, more specifically, offers five major categories of questions to ask about a price move. Not all of these questions will be relevant to every market move, but taken together give a pretty complete picture of what is important.
The who, what, where, when and why of financial energy trading
Who trades energy?
Producers, consumers, and refiners/processors buy and sel physical energy products and use energy derivatives to hedge price risk.
Investors see value in buying and selling financial energy products without the intention of taking physical delivery of them, either because of view about the future direction of price or, more likely, because of a perceived dislocation or arbitrage in the relative value of energy derivatives.
Market makers find value in pairing buyers and sellers of physical or financial energy products who may not have “met” in the market at the right time otherwise. Some market makers warehouse risk, which allows them to bridge possible mismatches in the volume or timing of what market participants want to buy or sell.
How many participants are active in each category, and what their goals are at any given time affects how prices behave.
What determines energy price?
First and foremost, oil and gas are commodities. They are actively bought and sold everyday by producers and end users. Commodities are different than other asset classes, like foreign exchange or equities because they are ultimately physical products that change hands (though there are some similarities, and more than there used to be).
Very little crude oil is used directly. The vast majority is refined into other products, like gasoline or jet fuel. This oil refining process is an important part of the supply chain and helps determine the prices of both crude and refined products. Wellhead gas also requires processing before transport. In addition, waterborne transport of natural gas requires liquefaction followed by regasification. The transformation processes also influence value.
To have value, most oil and natural gas has to be transported and stored, in many cases several times before reaching its end user. This is another critical factor in price formation.
In oil, quality matters and so does location. This is true for both crude and refined products. For natural gas, location determines price. (for additional information about basis spreads and differentials, click here). Benchmarks are widely cited representations of much broader and more heterogeneous markets.
Terms of the trade
Spot: Commodity for immediate delivery. Similar terms include physical, prompt, or cash. Paper: Commodity for future delivery, and/or financial settled. Similar terms include financial, deferred, futures, forwards, or swaps.
Long: A counterparty who owns a commodity and has it available to sell. Short: A counterparty who owes or requires a commodity and needs to buy it.
Bullish: Variables that would cause prices to go up, or a believe that prices will go up. Bearish: Variables that would cause prices to down, or a belief that prices will go down.
Liquidity: The number of market participants able and willing to participate in a given market / trade at a given time.
Bid: Price at which a market participant is willing to buy. Offer(/Ask): Price at which a market participant is willing to sell. Bid-offer spread: The difference between the price at which a buyer is willing to buy, and a seller is willing to sell. Bid-offer spreads are wider in illiquid markets.
Open interest: The total number of options and/or futures contracts that are not closed (netted) or delivered in a particular period. Volume: The number of contracts that traded (changed hands) during a given period.
Tenor / Term Structure: Refers to the duration of a trade, or part of the forward curve. The contracts in the front of the curve may be referred to as short-dated or nearby. The contracts in the back of the curve may be referred to as back end, long-dated, or deferred.
Benchmark: Standardized commodity specification against which other commodities are priced. A good benchmark has large and reliable physical volumes and consistent quality, a large number of buyers and sellers, reasonable transparency, and adequate associated infrastructure to support physical deliverability.
Spread, basis, or differential: The difference between a given commodity price and the recognized benchmark. For example, AECO basis is the spread between natural gas at AECO (Alberta) and Henry Hub. Basis risk is the risk to which a hedger is exposed by only hedging the benchmark as opposed to their specific risk. For example, If an airline uses crude as a proxy to hedge its jet fuel risk, its basis risk is the price difference between crude and jet fuel. Find more on differentials and basis risk here.
Directional trading: Positions taken on whether “flat price” goes up or down. Relative value trading: Positions taken on the difference between two prices — e.g. two locations, two tenors, two qualities, two commodities, two options — irrespective of whether the flat price goes up or down (i.e. irrespective of price direction). An arbitrage is the exploitation of price differences that exist due to market inefficiencies. Spreads may be referred to as “arbs”.
Futures and swaps accomplish the same goal — locking in the price of future volume with certainty today — in slightly different ways
Futures are exchange-traded. This means that a formal exchange determines and standardizes the terms of trade (e.g. trading calendar, lot sizes, product quality, delivery terms). The exchange or an exchange member clears the trade. In other words, while a buyer and seller may arrange a trade bilaterally, they then “face” the exchange as their counterparty, novating the trade in two legs. Commodity futures are physically settled, though the vast majority of positions do not go to physical settlement (this creates volatility in front spreads at certain times of the month, and those price movements might be explained as “expiry-related”)
Swaps are traded over-the-counter (OTC). Terms of trade are not standardized by an exchange, and contracts are settled financially. Counterparties may trade under bilateral credit agreements such as ISDAs, or, increasingly, clearing through exchange facilitation desks (e.g. Clearport) for credit intermediation purposes
Example: Say WTI for December delivery traded in June for $64/bbl, and spot crude ultimately traded at $74/bbl in December. A buyer or seller of paper crude in June for December delivery will have the same financial outcome whether the trade is done with futures or swaps, but the mechanics of the transaction will differ:
As a futures trade:
Buyer purchases one lot of December crude in June for $64/bbl ($64,000).
Money changes hands in June; a clearing member of the exchange or the exchange itself clears the trade to minimize counterparty risk.
If the contract is still held at expiry, the Seller is obligated to deliver 1,000 physical barrels to the Buyer in December, per the terms of the exchange, regardless of the prevailing spot price at that time.
No further money changes hands in December. The Buyer is $10/bbl ($10,000) in the money, the Seller is $10/bbl out of the money
As an OTC trade:
Buyer purchases one December crude swap contract OTC in June for $64 ($64,000).
No money changes hands today, but both counterparties enter into a credit agreement (if the trade is not cleared).
In December, Buyer purchases 1,000 barrels of crude from the spot price at the prevailing price of the day ($74/bbl, or $74,000).
Because the spot price in December is $10/bbl above the $64/bbl originally agreed, the Seller is obligated to pay the $10/bbl difference to Buyer in cash; the Buyer receives $10,000 cash from the Seller.