The impact of energy derivatives on the crude oil market

Abstract

IntroductionBeginning in the 1970s, deregulation dramatically increased the degree of price uncertainty in the energy markets, prompting the development of the first exchangetraded energy derivative securities. The success and growth of these contracts attracted a broader range of participants to the energy markets and stimulated trading in an even wider variety of energy derivatives. Today, many exchanges and over-the-counter markets worldwide offer futures, futures options, swap contracts, and exotic options on a broad range of energy products, including crude oil, fuel oil, gasoil, heating oil, unleaded gasoline, and natural gas.It is well known that derivative securities provide economic benefits. The key attribute of these securities is their leverage (i.e., for a fraction of the cost of buying the underlying asset, they create a price exposure similar to that of physical ownership). As a result, they provide an efficient means of offsetting exposures among hedgers or transferring risk from hedgers to speculators. In addition, derivatives promote information dissemination and price discovery. The leverage and low trading costs in these markets attract speculators, and as their presence increases, so does the amount of information impounded into the market price. These effects ultimately influence the underlying commodity price through arbitrage activity, leading to a more broadly based market in which the current price corresponds more closely to its true value. Because this price influences production, storage, and consumption decisions, derivatives markets contribute to the efficient allocation of resources in the economy.Nonetheless, the tightened cross-market linkages that result from derivatives trading also fuel a common public and regulatory perception that derivatives generate or exacerbate volatility in the underlying asset market. These concerns are often voiced in the context of their "destabilizing" effects around major declines in the market. Following the 1987 stock market crash, for example, John Shad, former chairman of the Securities and Exchange Commission argued, "Futures and options are the tail wagging the dog. They have escalated the leverage and volatility of the markets to precipitous, unacceptable levels" (Wall Street Journal, 1988). This concern has led to studies commissioned by the 2 THE IMPACT OF ENERGY DERIVATIVES ON THE CRUDE OIL MARKETSecurities and Exchange Commission, the Commodity Futures Trading Commission, and a presidential task force; it also has been a driving force behind the adoption of program trading curbs, circuit breakers, and daily price limits in the futures markets, and the staggering of stock index futures and options expirations.There exists little theoretical or empirical evidence, however, to justify these actions. In perfect markets, derivatives should have no effect on the underlying asset market because they are redundant securities (i.e., they can be synthetically created by some combination of the asset and riskless bonds). With market imperfections,...

Crack spread hedging: accounting for time‐varying volatility spillovers in the energy futures markets

“…Given the considerable dependencies observed among energy prices (see e.g. Table I), and, as well, the strong informational timevarying linkages existing across energy markets confirmed by prior research (e.g., Fleming and Ostdiek, 1999), we expect that discrepancies among hedge ratios (and, consequently, CEI's) might be large, depending on the methodology used to determine the hedged portfolio. Of course relative hedging performance is ultimately an empirical issue, to which we now turn.…”

“…Surprisingly, however, from a risk management perspective, there has been no attempt to combine the estimation of time-varying hedge ratios while allowing for time-varying covariability between related energy prices. Indeed, this gap in the literature is all the more surprising in view of the fact there are strong informational linkages across energy markets (Fleming and Ostdiek, 1999). This research therefore builds upon previous work to examine, for the first time, the effectiveness of using crude oil, heating oil and unleaded gasoline futures contracts in helping reduce price uncertainty for energy-traders.…”

“…Several papers have also examined the impact of energy derivatives on spot price volatility by investigating whether trade in energy futures contracts decreases or increases the underlying cash price (e.g. Nainar, 1993;Fleming and Ostdiek, 1999). Other research has presented empirical evidence on market efficiency and the search for time-varying risk premia by using variations of the ARCH-M, and GARCH-M class of models (e.g.…”

Options Introduction and Volatility in the EU ETS

“…it may be either positive or negative depending on the market under consideration (equities, bonds, or commodities). Fleming and Ostdiek (1999) have contributed to the analysis of the introduction of derivatives instruments on the underlying crude oil market and derived products. Thus, detecting whether the introduction of options has increased or decreased volatility in the European Union Emissions Trading Scheme (EU ETS) remains an empirical issue worth of investigation.…”

A State-of-the-Art Review of Finance Research in Physical and Financial Trading Markets in Crude Oil

“…As there, and in the wider commodity futures literature, while there are benefits to hedges, but the magnitude of the optimal hedges and their effectiveness can vary significantly. Numerous other studies have examined additional dimensions of crude oil spot and futures pricing (Agnolucci, 2009;Anderluh & Borovkova, 2008;Barros Luis, 2001;Crosby, 2008;Deaves & Krinsky 1992;Deryabin, 2011;Doran & Ronn, 2008;Fleming & Ostdiek, 1999;Hikspoors & Jaimungal, 2007;Horan et al, 2004;Hughen, 2010;Meade, 2010;Moosa & Al-Loughani, 1994;Moosa & Silvapulle, 2000;Paschke & Prokopczuk, 2010;Tokic, 2011;Trolle & Schwartz, 2009). …”