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W1V2 - Energy Commodity Markets - Handout PDF
W1V2 - Energy Commodity Markets - Handout PDF
Sidney Lambert-Lalitte
Later on, crude oil was fairly stable as oil supply was somehow controlled by big private
market players, known as the Seven Sisters. This stability continued with the foundation of
the Organization of the Petroleum Exporting Countries in 1960, controlling approximately
half of the world oil supply.
Suddenly, due to unpredicted geopolitical events (political tensions, revolutions, wars…) this
stability left the floor to pure chaos and two consecutive Oil Shocks in 1973 and 1979.
Since then, there is a consensus among experts that market forces, both physical and
financial, are the main drivers behind the crude oil price formation.
As a matter of fact, practitioners apply some sort of benchmarking system that not only
takes into account these quality differences, but also the transport arbitration, resulting
from the multiple locations of crude sources.
Oil markers are the benchmarks that are used for pricing crude oil from different regions of
the world.
To become a reliable marker, both physical and financial infrastructures are needed, which
means enough reserves, considerable production, proper geographical location, solid
financial liquidity, and of course geopolitical stability.
There are two main pricing systems for natural gas: oil indexation and gas-to-gas
competition. As the name indicates, in the oil indexation system, the price of natural gas is
linked to the crude oil price in the targeted market. The Asian market is a very good example
of this pricing regime.
As for oil markers, natural gas hubs must also have solid properties both in terms of physical
and financial infrastructure, so as to be considered as a reliable reference point for both
producers and consumers.
In parallel to this physical market, there is also the financial market, which enables market
players to trade financial contracts or assets without any physical delivery at the term of the
contract. Futures contracts are one of the most famous and traded products in this market.
The main purpose of this market is to provide market players with some sort of standardized
financial product so as to be able to cover themselves against risks associated with price
volatility.
Let’s take the example of an airline company that needs to supply its aircraft fleet with jet
fuel. This company will want to hedge itself against a future price increase of fuel. To do so,
it can buy oil products under forward contracts in the physical market for the coming
months. Now, imagine at the delivery date agreed in the contract, the price of fuel is far
below the one previously set between the two contractors. So, in some sense, the airline
company will lose money as it is buying fuel at a higher price than what is being announced
on the spot market.
In order to prevent this loss, the company could have covered itself by taking an opposite
position on the financial market. By this, I mean to make a financial deal with another
counter-party in which the airline company bets on the price decrease. In other words, the
airline company will get paid if the price of fuel decreases in the future. And this can
compensate the former loss already produced in the previous physical contract.
Through this example, we have talked only about futures contracts on the financial markets.
But there are also more financial products such as swaps, options and other derivatives that
can help market players in their hedging strategies against future price variation.
Roughly speaking, for market players, better hedging strategy brings more certainty and
stability in terms of the future price of the commodity and hence future income.