Regulation of Energy Derivatives
Regulation of Energy Derivatives
Mark Jickling
Specialist in Financial Economics
Government and Finance Division
Summary
After the collapse of Enron Corp. in late 2001, that company’s activities came
under intense scrutiny. Much of its business consisted of trading financial contracts
whose value was derived from changes in energy prices. Enron’s derivatives trading
was largely “over-the-counter” (OTC) and unregulated: little information about
transactions was available. Trading in energy derivatives rebounded after a post-Enron
slump, and much of the market remains unregulated. This “regulatory gap” strikes some
observers as dangerous for two reasons. First, the absence of government oversight may
facilitate abusive trading or price manipulation. A June 2007 report by the Senate
Permanent Subcommittee on Investigations concluded that excessive speculation by the
Amaranth hedge fund, which failed in 2006, distorted natural gas prices. Second, the
failure of a large derivatives dealer could conceivably trigger disruptions of supplies and
prices in physical oil and gas markets (though the effect was minor in the Enron case).
A number of bills before the 110th Congress would give the Commodity Futures
Trading Commission (CFTC) enhanced authority to regulate certain energy trades on
markets other than the regulated futures exchanges. H.R. 2419 (the Farm Bill), enacted
as P.L. 110-234 on May 22, 2008, over the President’s veto, will impose exchange-like
regulations on electronic over-the-counter markets trading contracts that play a
significant role in setting energy prices. This report analyzes the development of energy
derivatives regulation. CRS Report RL34555, Speculation and Energy Prices:
Legislative Responses, by Mark Jickling and L.J. Cunningham, summarizes bills that
address energy speculation. It will be updated as developments warrant.
Energy derivatives — financial contracts whose value is linked to changes in the
price of some energy product — are traded in several kinds of markets: the futures
exchanges and the off-exchange, or over-the-counter market. The New York Mercantile
Exchange (Nymex) is the leading U.S. market for futures contracts based on prices of
crude oil, natural gas, heating oil, and gasoline. Futures exchanges — called “designated
contract markets” — are regulated by the Commodity Futures Trading Commission
(CFTC) under the Commodity Exchange Act (CEA). The CEA imposes a range of
mandates on the exchanges (and on futures industry personnel) regarding record keeping
(including an audit trail for all trades), registration requirements, market surveillance,
financial standards, sales practices, handling of customer funds, and so on.
The second trading venue for energy derivatives is the off-exchange, or over-the-
counter (OTC) market. Unlike the futures market, there is no centralized marketplace for
OTC derivatives. Instead, a number of firms act as dealers, offering to enter into contracts
with others who wish to manage their risk exposure to energy prices. OTC contracts
based on energy products are generally exempt from regulation under the CEA, so long
as the contracts are offered only to “eligible contract participants,” defined as financial
institutions, professional traders, institutional investors, governmental units, and
businesses or individuals who exceed various asset and income thresholds. The law
assumes that sophisticated parties such as these do not need the investor protections that
government regulation provides for small public customers of the futures exchanges.
In recent years, a hybrid form of market has emerged, which resembles the
exchanges in that multiple parties can trade on an electronic platform, but which has been
largely exempt from CFTC regulation. These markets, known as “exempt commercial
markets,” must notify the CFTC before they begin operations, and provide certain basic
information about themselves, but they are not required to monitor trading, publish data
on trading volumes or prices, or enforce CEA prohibitions against fraud or manipulation.
Before the passage of P.L. 110-234, the CFTC had limited jurisdiction, other than
enforcement authority over manipulation and fraud.
To traders, whether they are speculating on price changes in search of profit or using
derivatives to protect themselves from the price risk associated with producing or
purchasing physical energy commodities, these markets are basically interchangeable.
Historical Development of Derivatives Regulation
In 1974, Congress observed that derivatives trading was about to expand from its
traditional base in farm commodities into financial futures — contracts based on bonds,
interest rates, currencies, and so on. To ensure that derivatives traders received the same
protections whether they were trading pork bellies or T-bonds, P.L. 93-463 created the
CFTC to oversee all derivatives trading, regardless of the nature of the underlying
commodity. The CFTC was given exclusive jurisdiction: all contracts that were “in the
character of” futures contracts had to be traded on a CFTC-regulated futures exchange.
There were two major exceptions to this exchange-trading requirement. Forward
contracts, where actual delivery of the commodity would take place at the expiration of
the contract, were considered cash sales and not subject to the CEA. Second, the so-
called Treasury Amendment (part of the same law that created the CFTC) specified that
contracts based on foreign currencies or U.S. Treasury securities could be traded off-
exchange. Existing markets in these instruments had long used futures-like contracts and
appeared to function well without direct government regulation; Treasury saw no public
interest in bringing them under the new CFTC.
During the 1980s, a market in OTC derivatives evolved, utilizing swap contracts
that served exactly the same economic functions as futures. The first swaps were based
on currencies and interest rates; later, OTC contracts based on commodity (including
energy) prices were introduced. These OTC markets were well established before the
CFTC made any move to assert its jurisdiction, despite the fact that swaps were clearly
“in the character of” futures contracts. The potential CFTC jurisdiction, however, created
legal uncertainty for the swaps industry: if a court had ruled that a swap was in fact an
illegal, off-exchange futures contract, trillions of dollars in outstanding swaps could have
been invalidated. This might have caused chaos in financial markets, as swaps users
would suddenly be exposed to the risks they had used derivatives to avoid.
The CFTC issued a swaps exemption in 1989, holding that the CEA gave it authority
to regulate swaps, but that it would not do so as long as they differed from futures
contracts in certain enumerated respects. In 1992, Congress gave the CFTC additional
authority to exempt OTC contracts (P.L. 102-546). In response, the CFTC modified the
1989 swaps exemption in 1993, and also issued a specific exemption for OTC derivatives
based on energy products.1 Under the 1993 exemption, OTC energy derivatives would
not be regulated if all trading was between principals whose business involved the
physical energy commodities underlying the derivatives, if all contracts were negotiated
as to their material terms (unlike futures contracts, where terms are standardized), and if
all contracts were held to maturity (rather than traded rapidly, as futures are).
This exemption was a matter of regulation, not statute. In May 1998, the CFTC
issued a “concept release” that indicated that it was considering the possibility of
extending features of exchange regulation to the OTC market. The release solicited
comments on whether regulation of OTC derivatives should be modified in light of
developments in the marketplace. Among the questions were whether the existing
prohibitions on fraud and manipulation were sufficient to protect the public, and whether
the CFTC should consider additional terms and conditions relating to registration, capital,
internal controls, sales practices, record keeping, or reporting.
The concept release drew strong opposition from the swaps industry and from other
regulators, especially the Federal Reserve. In December 1998, Congress included in the
Omnibus Appropriations Act (P.L. 105-277) a provision directing the CFTC not to
propose or issue any new regulations affecting swap contracts before March 31, 1999.
In November 1999, the President’s Working Group on Financial Markets issued a report
entitled “Over-the-Counter Derivatives Markets and the Commodity Exchange Act.” The
report recommended that, to remove uncertainty about the legal and regulatory status of
the OTC market, bilateral transactions between sophisticated parties that do not involve
physical commodities with finite supplies should be excluded from the Commodity
Exchange Act; that is, the CFTC should have no jurisdiction. While the Working Group’s
report made a distinction between financial commodities and those with finite supplies,
and suggested that continuing CEA jurisdiction was appropriate for the latter, the report
did not recommend that the CFTC should rescind its exemption of OTC energy
derivatives. In other words, the Working Group saw no immediate problem with the
unregulated status of OTC markets in energy derivatives.
In 2000, Congress passed the Commodity Futures Modernization Act of 2000 (P.L.
financial variables (interest rates, stock indexes, currencies, etc.) are defined as “excluded
commodities,” and OTC contracts based on these are not subject to the CEA (provided
1 “Exemption for Certain Products Involving Energy Products,” Federal Register, vol. 58, April
that trading is restricted to “eligible contract participants,” that is, not marketed to small
investors). Second, there is no statutory exemption for derivative contracts based on
agricultural commodities: these remain under CFTC jurisdiction. Finally, there is an “all
other” category — “exempt commodities” — which includes energy products. Contracts
in exempt commodities can be traded in the OTC market without CFTC regulation
provided that no small investors participate. However, certain antifraud and
antimanipulation provisions of the CEA continue to apply. If an OTC exchange is created
— defined in the law as an “electronic trading facility” where multiple buyers and sellers
may post bids and trade with each other — the CFTC has some oversight jurisdiction and
may require disclosure of certain market information.
In summary, the OTC energy derivatives market developed outside CFTC
jurisdiction in the late 1980s and early 1990s, despite the CEA’s apparent prohibition of
such a market. As with financial OTC derivatives, however, the CFTC never challenged
the legality of this off-exchange market. As concerns about legal uncertainty mounted,
the CFTC in 1993 issued an exemption stating that certain OTC energy transactions did
not fall under the CEA. In 2000, Congress essentially codified this exemption, by
including energy in the category of “exempt commodities.” This removed them from even
the possibility of CFTC regulation, except for a limited antifraud and manipulation
jurisdiction and some oversight if the market for OTC contracts should evolve into an
exchange-like market. Thus, the 2000 legislation did not deregulate the OTC energy
derivatives market; that market had been unregulated since its beginnings.
Manipulation in Energy Markets
Since the value of derivatives contracts is linked to the price of the underlying
commodity, traders who can manipulate commodity prices can reap huge profits.
Manipulative strategies may involve either physical (spot) or derivatives markets, or both.
Since the Enron scandal, regulators have taken numerous actions against several types of
manipulation in energy markets.
In 2003, the CFTC charged Enron with manipulation of natural gas prices. The
strategy was simple: Enron purchased an unusual number of contracts for spot gas,
driving up prices by simultaneously increasing demand in the marketplace and making
other traders think that there was some fundamental factor that favored higher prices.
Enron settled CFTC charges by agreeing to pay a $35 million fine in 2004.
Ten energy companies have paid a total of $180 million in fines to settle CFTC
charges that they manipulated natural gas prices in 2001 and 2002 by providing false data
about supply levels to Platts, a private source of information on energy market conditions.
The affected Platts reports sent false signals to other market participants that supplies
were significantly tighter than expected, and prices rose (sharply, but briefly) as a result.
Enron and a number of other firms admitted to “gaming” the marketing system for
electrical power in California in 2000, exacerbating price increases and shortages. The
strategies included deceptive reporting of energy supplies on hand (to create the
impression of shortages to drive up prices), disguising the source of electricity (to take
advantage of variable pricing for in-state and out-of-state power), and in some cases
actually closing power plants during times of tight supplies to drive up prices. Numerous
firms and traders faced civil and criminal charges as a result of these manipulations.
In August 2006, the Amaranth hedge fund lost $2 billion in natural gas derivatives,
and liquidated its entire $8 billion portfolio. A June 2007 staff report by the Senate
Permanent Subcommittee on Investigations (“Excessive Speculation in the Natural Gas
Market”) found that the fund’s collapse triggered a steep, unexpected decline in prices,
and that Amaranth’s large positions had caused significant price movements in the
months before it failed. The report concludes that Amaranth was able to evade limits on
the size of speculative positions (a key feature of the futures exchanges’ anti-manipulation
program) by shifting its trading from Nymex to exempt and unregulated markets.
As energy (and agricultural) commodity prices reached record highs in 2008, there
was concern that financial speculators were driving prices up to levels not justified by
fundamentals of supply and demand. It is common to speak of a “speculative premium,”
or a “bubble,” in the price of oil, but there is no sure methodology for determining what
a commodity price “ought to be” based on the fundamentals. The only price we can
observe is the one generated by the markets, and the “speculative premium” argument
assumes that markets are not setting prices efficiently.
Legislative Proposals on Derivatives Regulation
Since Enron, the regulatory status of OTC energy derivatives has been much debated.
Increases in the price of oil and gasoline have sharpened the debate. Several bills beforeth
the 110 Congress propose to regulate or otherwise affect the OTC energy derivatives
market. Several bills (H.R. 6330, H.R. 6341, H.R. 6372, and S. 3134) would remove
energy commodities from the category of “exempt commodities” and place them on the
same regulatory footing as agricultural commodities. This would require that OTC energy
contracts be approved by the CFTC before they could be traded.
H.R. 6264 would limit participation in the OTC energy market to firms that deal in
the physical commodities. H.R. 3009, S. 577, S. 3131, and S. 3202 would impose new
reporting requirements on energy swap dealers and/or other OTC market participants.
Summaries of these bills (and others) are available in CRS Report RL34555,
Speculation and Energy Prices: Legislative Responses, by Mark Jickling and Lynn J.
Cunningham.
On May 22, 2008, Congress enacted the farm bill (H.R. 2419; P.L. 110-234) over the
President’s veto. Title XIII included provisions reauthorizing the CFTC and creates a new
regulatory regime for certain OTC energy derivatives markets, subjecting them to a
number of exchange-like regulations. The provisions apply to “electronic trading
facilities” — markets where multiple buyers and sellers are able to post orders and
execute transactions over an electronic network. If the CFTC determines that these
markets, currently exempt from most regulation, play a significant role in setting energy
prices, they will be required to register with the CFTC and comply with several regulatory
core principles aimed at curbing manipulation and excessive speculation (including the
establishment and enforcement of position limits). They will be required to publish
and/or report to the CFTC information relating to prices, trading volume, and size of
positions held by speculators and hedgers.
These new regulatory requirements apply only to electronic markets that have come
to resemble the regulated futures exchanges. Bilateral OTC derivative contracts between
two principals (e.g., between a swap dealer and an institutional investor), that are not
executed on a trading facility where multiple bids and offers are displayed, will continue
to be largely exempt from CFTC regulation.
A number of bills would raise the margin requirements for crude oil futures
contracts. Margin is the amount of money that a trader must post with the exchange to
buy or sell a single futures contract: for crude oil, the Nymex margin is currently $11,813
per contract (each contract represents 1,000 barrels of oil). (Margin requirements are
normally set by the futures exchanges.) Higher margins raise the cost of trading: the
theory is that higher costs will drive out speculation, moderating price volatility, and
perhaps easing upward pressure on prices themselves. Empirical research, however, has
not established a strong link between margin levels (or speculation in general) and price
volatility.
Current concerns about excessive speculation in energy raise basic issues about
derivatives markets. The CFTC does not believe that energy markets are being
manipulated, but that they are responding to traders’ expectations of future prices, which
is their proper function. The CFTC’s conception of manipulation, requires that a single
trader (or group of traders) amass a market position that enables them to willfully distort
or dictate prices in defiance of the fundamentals. The CFTC’s observation that it cannot
detect any elements of such a classic “corner” or “squeeze” behind today’s high prices,
and that therefore the markets are functioning well, does little to reassure the many
observers who believe that a flood of money from hedge funds, Wall Street firms, pension
funds, endowments, and other institutional investors has driven prices artificially high.
To these observers, excessive financial speculation is in itself a form of manipulation,
even though it does not meet the legal definition.
A fundamental issue is whether speculation causes prices to become more volatile.
Empirical research suggests that in general it does not, but financial markets in recent
years have witnessed several episodes of price bubbles — dot.com stocks, residential real
estate, mortgage-backed bonds — indicating that markets at times generate prices that are
not supported by fundamental factors of supply and demand. Attempts to limit the
influence of speculators include the call for higher margin requirements in energy futures.
More stringent measures are available: India recently banned trading of agricultural
futures contracts. It is not certain, however, that a market where speculation is restrained
will be less volatile than the ones we have now, nor that we have a better model for
setting prices than a market where traders of all kinds pool their information by taking
risky financial positions based on their expectations of future price trends.