In comparison with the pricing mechanisms that prevailed for crude oil and natural gas from the 1940s through the 1960s, the current price environment is exceedingly volatile. In response to this volatility, financial products called derivatives have been developed in the last decade. Of these, the commodity price swap is finding acceptance as a tool to manage price risk. This paper is an introduction to commodity price swaps for those individuals whose responsibilities include managing a portfolio of oil and gas assets, but who have not had direct experience with swaps. In addition to a description of the basic fixed-for-floating swap and its variations, the historical evolution of swaps is outlined. The significant contract terms and the special problems associated with swaps are also summarized.
Selected applications of commodity price swaps which may be useful in managing a portfolio of petroleum assets are described. These applications include:
Locking-in Project Economics
Synthetic oil (or gas) fields
Swaps have experienced a rapid growth rate since their introduction in the interest rate and currency exchange markets in the early 1980s. Commodity swaps offer promise as a new tool to those firms which hold a portfolio of petroleum resources, developed or undeveloped.
Note that this paper is not intended as an authoritative reference with respect to the legal, tax and accounting issues associated with commodity swaps. Given the rapidly changing legal and regulatory context of swaps, it is advised that readers seek current opinions from their appropriate legal and accounting advisers.