Derivatives: A brief history

Following the introduction of swaps, in the mid-1980's, the energy derivatives market was valued in the year 2000 at $40-bil to $60-bil a year. The total exposure of US banks in energy swaps was conservatively estimated at $20-bil to $40-bil for long term deals. Energy derivatives include forwards, futures, options and swaps.

Swaps are becoming increasingly popular, with no hedging position to manage, no physical delivery and settlement by cash. Furthermore, swaps can be tailored to each individual company's needs.

Oil swaps and futures

Until relatively recently, future exchanges such as the New York Mercantile Exchange, the London International Petroleum Exchange, and the Singapore Monetary Exchange provided the main opportunities for oil traders to hedge their short, medium and long term risks.

The introduction of oil swaps in the mid 1980's changed the oil industry's view on hedging as swaps formed a new environment for risk management.

Besides future exchanges, the most widely used indices for pricing of oil swaps are the daily and weekly Platts crude oil and petroleum products assessments which cover Europe, the United States, Arab Gulf anf Far East markets.

As well as crude oil and petroleum products, Platts weekly petrochemical assessments are used as an index in the propane swaps market. As a result, Platts prices are regarded as an integral part of the swaps market as a means of determining price.

Financial institutions which are closely involved with the oil industry, e.g. providing letters of credit or financing long-term ventures use oil swaps in combination with other financial indices such as LIBOR rates in order to hedge their risks.

According to a survey of commodity risk management instruments published by the United Nations Conference on Trade and Development, three-quarters of all commodity swaps are petroleum-based.

Refinancing of loans could increasingly depend on evidence that countries are using risk management techniques. Mexico in a well-published risk management programme, successfully hedged its entire crude oil production on futures, cash and derivatives' markets for a six-month period during the Gulf War.

Extending forward months on the IPE and NYMEX has allowed swaps' players additional risk management. It is because of this additional risk management that future exchanges have seen a benefit through growth in swaps markets.

The opportunity to offset their swap positions on to the future exchanges by means of an Exchange for Swaps (EFS). This is similar in concept to Exchange for Physical (EFP) where two players offset their physical trade on to the exchange.

However the EFS mechanism is only valid where an IPE contract is the agreed pricing basis of the swap transaction e.g., a jet swap that is priced off a differential to the IPE's gasoil contract.