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 tradingis 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. Futures Contracts Futures contracts are 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. The specified terms of the transaction are: · Volume · Price · Delivery location · Delivery period · Settlement date The purchaser of a futures contract has a long position (agreement to buy in the future), and The seller of a futures contact has a short position (agreement to sell in the future). Example of Application: For example, in a futures agreement to deliver a specified quantity of crude oil (or gasoline or heating oil) at a specified place, on a specified future date, at a specified price -the seller agrees to make the delivery; the buyer agrees to take delivery.  In reality, most futures traders usually don’t contemplate physical movement of crude. · Suppose a crude oil trader plans to buy a cargo of crude oil at Ras Tanura, Saudi Arabia, and wants to sell it on the spot market in Japan .  The problem for the trader is time – the 23-day transit period during which market events might destroy the economics of the deal and cause a heavy loss. The risk of financial loss can be eliminated if time can be taken out of the equation. · A futures contract enables the crude to be sold at the price expected at receipt in Japan.  It is set as soon delivery is taken in Ras Tanura inste ...

1. 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 tradingis 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.
Futures Contracts
Futures contracts are 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. The
specified terms of the transaction are:

2. · Volume
· Price
· Delivery location
· Delivery period
· Settlement date
The purchaser of a futures contract has a long position
(agreement to buy in the future), and
The seller of a futures contact has a short position (agreement to
sell in the future).
Example of Application:
For example, in a futures agreement to deliver a specified
quantity of crude oil (or gasoline or heating oil) at a specified
place, on a specified future date, at a specified price -the seller
agrees to make the delivery; the buyer agrees to take delivery.
In reality, most futures traders usually don’t contemplate
physical movement of crude.
· Suppose a crude oil trader plans to buy a cargo of crude oil at
Ras Tanura, Saudi Arabia, and wants to sell it on the spot
market in Japan . The problem for the trader is time – the 23-
day transit period during which market events might destroy the
economics of the deal and cause a heavy loss. The risk of
financial loss can be eliminated if time can be taken out of the
equation.
· A futures contract enables the crude to be sold at the price
expected at receipt in Japan. It is set as soon delivery is taken
in Ras Tanura instead of 23 days later.
The vast majority of oil and gas traded on NYMEX and ICE is
never delivered. Instead, the trade is closed, or liquidated, by
assuming an equal and opposite position in the market. What’s
left is a profit or loss on the cost and value of the paper
transaction.
A standard energy contract can take the form of a monthly,
quarterly, or calendar-year contract.
Futures contracts on the NYMEX or ICE trade with monthly
expirations. In order to price longer-term deals at a single price
with a single execution, traders often employ quarterly or

3. annual “strips”.
A strip is quoted as an average price for equal contracts per
month of all of the months within the quoted time period.
Strips can be customized in the OTC market to match the
hedging needs of a particular physical deal.
Forwards
A forward contract is an agreement made today for a trade that
will take place at some point in the future. A forward is usually
negotiated between two oil and gas companies or traders with
similar interests. They are not traded on an organized
exchange.
The components outlined in a forward contract are specific to
the underlying commodity, including:
· quality and grade (for crude oil and products),
· delivery price,
· location,
· notional amount (or quantity) and
· settlement date.
There is much more flexibility in structuring a forward
agreement to a specific business (refiner’s) situation, than use
of the standard futures contracts.
Example of Application:
Oil Producer A agrees to deliver 500,000 barrels of crude oil to
Refiner B three months from today for $120/barrel.
Once this agreement is made, the receiver of the oil is
considered to be long the underlying crude oil while the party
obligated to deliver the crude is considered to be short.
At the settlement date, the forward contract’s value will be
determined by the difference between the spot market crude
value and the contract delivery price, multiplied by the contract
quantity, i.e.:
Quantity (Delivery Price – Spot Market Price) = Value at
Settlement
Forward position exposure can be hedged against fluctuations in
the spot market with a parallel futures contract of similar
quantity and tenure.

4. Options
Options have been one of the fastest growing (20%/yr) energy
derivatives since their introduction in the late 1980’s. Most
options are applied to crude oil.
An option contract is the right, but not the obligation, to buy or
sell a commodity at a fixed price – the strike or exercise price –
during a specified period. In simple terms:
· A call option is a right to buy the commodity
· A put option is the right to sell the commodity.
Like stock trading, one advantage of an option is that the risk of
the transaction is limited to the cost of the option, called
the option premium.
Crude and products option trading is much more complex than
futures trading. For any particular delivery month (expiration
date), the options trader must make an assumption about:
· the direction of the market and
· how fast the market will move up or down.
Then, an option trader must take into account the current market
price, the strike price (exercise price) of the option and the
remaining time left for the option.
As shown on the chart, three terms are common in describing
an options value:
· If an option has value, it is known as an in the money option.
· If the current market price and an option’s strike price are
exactly the same, the option is referred to as at the money.
· If an option has no intrinsic value, it is known as an out of the
money option.
Note that the at the money option is usually the most actively
traded.
Option traders use a mathematical model, called the Black-
Scholes model, to determine how these factors interact and
affect the value of an option. Fortunately, computer programs
are available for option evaluation. Although most option
traders will never have to calculate option equations on their
own, it is important to understand the factors that influence
option pricing.

5. The Black-Scholes (1973) option pricing formulas was
originally designed for a stock that does not pay a dividend or
make other distributions.
When used for crude & products, there are two types of options
– both traded globally:
· European style, where the option can be exercised only on the
expiration date.
· American style, where the option can be exercised at any time
up to the expiration date.
Values for used in the Black-Scholes option formula include
the:
· price of the underlying commodity,
· option strike price,
· continuously compounded risk free interest rate,
· time until the expiration of the option, and
· implied volatility for the underlying commodity.
Implied Volatility
Another standard way that traders, brokers and other specialists
estimate volatility for a given commodity is to use the price of
an option on that commodity to derive a factor called
the implied volatility for the commodity.
Example of Application:
Suppose a call option on crude oil is actively quoted. The
option price is readily obtainable and by applying a suitable
option pricing formula, the volatility can be derived or “back-
calculated.
This derived factor is what is called the implied volatility for
the crude oil.
The implied volatility can then be used to price other, similar
options — perhaps options that are not actively traded or those
where prices are not readily available.
There are four additional instruments available to crude oil and
product traders to help limit exposure.
To limit exposure to increases in the price of crude oil, a refiner
can purchase a cap covering a specified period. A cap, is a call
option, giving the refiner a right to purchase crude oil at the

6. specified strike price, regardless of how much the market price
increases.
To limit exposure to decreases in the price of crude, the
producer selling to the refiner can purchase a floor. A floor is a
put option, giving the producer a right to sell crude oil at the
specified strike price, regardless of how much the market price
decreases.
Some middlemen who match buyers and sellers simply want
predictable prices. To lock in a specified price range, they
purchase a collar. A collar is the combination of a cap and a
floor. Other traders purchase collars to reduce or eliminate the
transaction costs of a cap or floor.
A swap is an agreement to exchange forward obligations. The
most common arrangement is to swap floating prices for fixed
prices.
Using the basic building blocks of futures, forwards, options
and swaps, oil companies and oil traders have devised a
collection of specific industry transactions to help implement a
given supply strategy.
The most common instrument examples are now described in
detail:
· Crack Spread Hedge: A typical spread is the difference
between the futures price of crude and that of one or more
petroleum products.
· WTI – Brent Arbitrage Contract: commonly termed Arb, is
defined as the differential between these two crude contracts,
measured in the same time period.
· Exchange for Physical Contract: An off-exchange transaction
that allows holders of a futures position to exchange the futures
for a physical position of equal volume
Example of Application: Crack Spread Hedge
Traders try to profit within a single exchange from
various spreads. A typical spread is the difference between the
futures price of crude and that of one or more petroleum
products.
Increasingly in crude oil and products, it is also possible to

7. hedge with contracts that cover the price spread between two
(or more) commodities. For example, the crack spread
hedge contract is available for the differential between the price
of crude oil and the price of a set of specific refined products.
Crack spreads are different for each market region and are
highly dependent on crude sources and refinery location.
Trading the crack spread on an exchange allows for the
execution of both the crude and the product hedge as a single
transaction. The two main crack spreads traded in crude and
products are:
· the Heat Crack (Heating Oil – Crude) and
· the Gas Crack (RBOB – Crude), where RBOB is the term for
Reformulated Gasoline Blend Stock for oxygenated gasoline.
Crack spreads typically trade as a one-to-one ratio between
crude and the underlying product. However, different ratios can
be used to better reflect the trader or refiner’s position.
If a refiner felt that the plant profitability was going to go down
because the price of products was not increasing at the same
rate as the cost of crude, a 3-2-1 crack spread hedge could be
purchased to guarantee or lock-in a range of profitability.
So-called “paper refiners” can approximate refining margins in
the physical market with futures contract portfolios
proportionate to average refining yields.
The US is by far the world’s largest importer and consumer of
petroleum products. Crude oil imports currently average 9.0
MMbd or 61% of US refining requirements.
Heavy reliance on foreign crude sources means that price
differences between two key internationally recognized crude
oil price benchmarks play a large part in determining if the US
will be balanced, starved, or flooded with crude oil. The key
benchmarks used are:
· The NYMEX light sweet West Texas Intermediate (WTI)
crude oil futures contract and
· The International Continental Exchange (ICE) North Sea Brent
futures contract
The WTI – Brent Arbitrage, commonly termed Arb, is defined

8. as the differential between these two crude contracts, measured
in the same time period.
This price differential is not a stable relationship. To move
crude oil to the US, the differential must be enough to cover the
cost of the crude, shipping, insurance, interest cost, taxes and
tariffs, and any premiums for delivering Brent on a NYMEX
contract. In this case, an open Arb market exists.
This widely followed, liquid market allows speculation on the
widening or narrowing of the differential itself – even if a
physical cargo is not part of the decision
Example of Application: WTI – Brent Arbitrage
The Arb contract can be traded as a future or swap in the OTC
market. The Arb is calculated using a straight differential
between the two contracts of the same time period.
July WTI (Nymex) contract price minus the July Brent (ICE)
contract price = July Arb
Or
Q2 WTI (Nymex) contract price minus the Q2 Brent (ICE)
contract price = Q2 Arb
Historically WTI trades at premium to Brent are due to its
premium as a light, sweet grade, but this is not always the case.
(WTI maintained an average of $1.30/barrel premium over
Brent from 1990-2000.)
Exchange for Physical (EFP)
An EFP (Exchange for Physical) is an off-exchange transaction
that allows holders of a futures position to exchange the futures
for a physical position of equal volume by submitting notice to
the exchange.
There are advantages to using an EFP to initiate and liquidate
positions on both the futures and physical sides of the
transaction:
· There is flexibility in the negotiation of timing, delivery
location, and grade of product on the physical side of the
transaction, as opposed to adhering to NYMEX or ICE contract
delivery rules.
2. The posting of an EFP allows for a futures position to be

9. either initiated or liquidated in a single transaction and at a
single, pre-determined price.
3. Executing an equivalent transaction on the open market
could involve many smaller transactions at various prices; and
loss of value is a risk in any/all of those related transactions.
Example of Application – Use of EFP:
A producer is long 500,000 barrels of crude and has hedged
against a falling market price by shorting 500 futures contracts.
A refiner needs (is short) 500,000 barrels of crude and has
hedged against a rising market price by purchasing 500 futures
contracts. Their opposite positions in the market can be
perfectly offset in a single EFP transaction. The producer sells
the crude to the refiner at a negotiated price. The producer then
buys the 500 futures from the refiner to unwind its futures
hedge position. The refiner agrees to buy the crude and sell 500
futures contracts. This transaction leaves both parties flat in
both their physical and futures positions.
There are four major ways to execute crude oil and refined
product derivative contracts. Use:
· Organized exchanges: Allow commodity buyers and sellers to
make a market for a certain product.
· Electronic Trading Forums: Internet-based marketplaces which
trade futures and over-the-counter (OTC) energy and commodity
contracts as well as derivative financial products.
· Broker markets: Match anonymous sellers and buyers, and
serve as the transaction counterparties. They actually manage a
portfolio of sale and purchase obligations.
· Over-the-Counter (OTC) markets. Transactions executed
where oil companies and traders simply pick-up the phone and
transact directly with a counterparty.
Similar to other stock and financial markets, crude and product
trading occurs on organized global commodity and derivative
exchanges. An organized exchange allows commodity buyers
and sellers to make a market for a certain product. You must be
a member of the exchange to process transactions on an
exchange, called an Exchange Member Firm.

10. The key benefit of organized exchanges is that company
transactions are with the exchange itself which mitigates
counterparty credit risk. On any given trading day, energy and
non-energy companies alike can buy and sell energy
commodities without even knowing, much less qualifying, the
partner or counterparty in the transaction.
However, exchange contracts are standardized and there is
limited ability for a company to tailor a contract to its specific
business needs.
In March 2008, CME and the major NYMEX shareholders
agreed to merge. The merger means that a high percentage of all
US futures would trade on the CME/NYMEX.
Today, it is possible to trade futures and options contracts for
crude oil and certain petroleum products, plus the non-
petroleum fuel – ethanol. It is also possible to trade in
electricity and three key power generation fuels – natural gas,
uranium and coal.
This chart depicts the flow of futures, options and swaps as they
are placed – either directly on an exchange or through a broker,
called Exchange Member Firm in the diagram. There is still a
mix of electronic transactions and floor executed transactions
on the NYMEX. Whether the floor transactions will disappear
in the future is anyone’s guess
When an order comes into the Exchange, it is time-stamped and
hand-delivered to the floor broker at the earliest possible
moment. When the broker receives the order, he signals his
offer and, upon acceptance, records it and his counterpart’s
code description, as well as the price. This information,
together with quantity and month, which are already on the
order, are fundamental to recording and processing orders.
An Exchange Member Firm trades for customers (or on its own
behalf) on commodity exchanges, charging a commission for its
service.
Exchange Member Firms with a seat on the Exchange can also
provide clearing services – the daily matching and
reconciliation of literally thousands of buys and sells.

11. Clearing members must meet strict financial and capital
requirements and accept primary financial responsibility for all
trades cleared through them, and ultimately share in the
responsibility for liquidity of the Exchange.
All firms in the US are subject to the rules of the Commodity
Futures Trading Commission (CFTC), and the rules of other
various exchanges of which it can also be a member.
IntercontinentalExchange (NYSE: ICE) operates Internet-based
marketplaces which trade futures and over-the-counter (OTC)
energy and commodity contracts as well as derivative financial
products.
ICE was established, in May 2000, by some of the world’s
largest energy traders. The company’s stated mission was to
transform OTC trading by providing an open, accessible, multi-
dealer, around-the-clock electronic energy exchange. The new
exchange offered the trading community better price
transparency, more efficiency, greater liquidity and lower costs
than manual trading.
In June 2001, ICE expanded its business into futures trading by
acquiring the International Petroleum Exchange (IPE). which
operated Europe’s leading open-outcry energy futures exchange.
Since 2003, ICE has partnered with the Chicago Climate
Exchange (CCX) to host its electronic marketplace.
In April 2005, the entire ICE portfolio of energy futures became
fully electronic.
Headquartered in Atlanta, ICE also has offices in Calgary,
Chicago, Houston, London, New York and Singapore, with
regional telecommunications hubs in Chicago, New York,
London and Singapore.
Broker Markets / OTC
In the broker markets, companies execute transactions through a
broker.
Like the organized exchanges, brokers match anonymous sellers
and buyers, and serve as the transaction counterparties. They
actually manage a portfolio of sale and purchase obligations,
rather than matching them on a one-to-one basis.

12. Brokers may tailor contracts to meet the specific timing and
volume needs of the trading parties, at least to the extent that
they can contract with a counterparty that is willing to take the
other side of the transaction (called an offsetting position).
Some of the more familiar energy derivative brokers, ranked by
annual turnover in billions of dollars are:
· Amerex, part of the GFI Group, New York
· TFS Energy, part of Compagnie Financiere Tradition (CFT),
Paris
· ICAP Energy, Louisville, Kentucky
· Tullett Prebon Group Ltd, London
Despite the systems, exchanges, and brokers; companies can
simply pick-up the phone and transact directly with a
counterparty. When executing these transactions, companies are
said to be transacting in the OTC (Over-the-Counter) market.
The OTC market allows companies to enter into very unique
transactions that can specifically meet their business needs with
few, if any, transaction costs.
These direct transactions (also referred to as bilateral
transactions) make-up the majority of energy contracts executed
in today’s marketplace.
However, the OTC markets are inherently risky, and a
significant infrastructure is required to measure, monitor, and
manage the business.