Derivatives

CHAPTER 32Energy and Weather Derivatives

Aims

• To outline the main types of energy and weather derivatives.
• To show how energy derivatives are used for speculation and hedging ‘price risk’.
• To show how weather derivatives are used to hedge ‘volume risk’ of energy producers and users.
• To discuss the use of catastrophe bonds.

There are large oil reserves in a number of countries around the globe, most noticeably the Organisation of the Petroleum Exporting Countries (e.g. the Middle East, Venezuela, Nigeria, etc.) and Russia, who together control about 60% of the world's oil reserves. Russia also has huge natural gas reserves.

Energy prices such as oil and natural gas are highly volatile. This means that large energy suppliers (e.g. in oil exploration and refineries such as BP, Shell, Exxon Mobile) and users of energy (e.g. airlines, transport, and manufacturing companies) face considerable uncertainty about the price they will receive or pay for energy in the future. To mitigate such price risk, consumers and producers can use either over-the-counter (OTC) or exchange traded energy contracts such as forwards, futures, options, and swaps. These ‘commodity derivatives’ are widely used in the energy sector – some are cash settled and some involve physical delivery of the underlying commodity. Electricity is a little different to oil and natural gas since it cannot be stored but its price can also vary tremendously on an hourly basis and derivatives contracts on electricity are also ...