Derivatives, Risk Management, and Policy in the Energy Markets

Publication Date: May 2003

Publisher: Library of Congress. Congressional Research Service

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Risk management is important in the energy industries because of the volatility of oil and natural gas prices. Price volatility can reduce the profit of business strategies and hurt consumers. The use of financial derivatives, both traded and overthe-counter, has developed as a low cost method of hedging price risk. However, the use of derivatives has also been linked to major financial scandals and bankruptcies.

Risk management strategies can be undertaken without the use of derivatives. Vertical integration of the production process, inventory control and long-term, fixed price contracts can all compensate for the effects of price volatility. Whether one of these choices, or a derivative strategy, is chosen depends on the cost and flexibility of each alternative. Derivative use has expanded rapidly both in value and volume.

Market traded and over-the-counter derivatives have different characteristics with respect to their liquidity, safety, transparency and flexibility. The benefits and costs of using either instrument depends on the circumstances and goals of the firm setting up the strategy. A wide variety of derivative contracts exist, including forwards, futures, options and swaps which can be put together to achieve a wide variety of objectives.

Although market traded derivatives are self regulated with oversight by the Commodity Futures Trading Commission, over-the-counter derivatives are largely unregulated. Whether these transactions should be regulated might depend on their effect on commodity price volatility, their effect on the stability and integrity of U.S. capital markets, their ability to reduce the cost of capital, enhancing domestic real investment and the value of more open disclosure and price transparency.

Congress considered proposed derivative legislation in the 107th Congress. Senator Dianne Feinstein introduced legislation in the Senate, while Representative Peter DeFazio independently introduced a bill in the House. In the 108th Congress, Representative DeFazio has introduced a derivative regulation bill, (H.R m 1109), and there has been some speculation that Senator Feinstein may introduce legislation in the Senate. In the time since the collapse of Enron, many specific proposals to reform the industry have appeared. These include tying derivative trading more closely to the underlying business interests of the market traders, establishing a clearinghouse to manage transactions, establishing structured derivative trading companies and enhancing reporting and documentation requirements. Each proposal has merit, but each could also reduce the effectiveness of the derivative industry in managing risk, presenting a trade-off that would need to be balanced for an efficient outcome.

This report will be updated as events warrant.