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Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries

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Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries SR/SMG/2002-01 Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries October 2002 Energy Information Administration U.S. Department of Energy Washington, DC 20585 This report was prepared by the Energy Information Administration, the independent statistical and analytical agency within the U.S. Department of Energy. The information contained herein should be attributed to the Energy Information Administration and should not be construed as advocating or reflecting any policy position of the Department of Energy or any other organization. Service Reports are prepared by the Energy Information Administration upon special request and are based on assumptions specified by the requester. Contacts This report was prepared by the staff of the Energy The Energy Information Administration would like to Information Administration and Gregory Kuserk of the acknowledge the indispensible help of the Commodity Commodity Futures Trading Commission. General Futures Trading Commission in the research and writ- questions regarding the report may be directed to the ing of this report. EIA’s special expertise is in energy, not project leader, Douglas R. Hale. Specific questions financial markets. The Commission assigned one of its should be directed to the following analysts: senior economists, Gregory Kuserk, to this project. He Summary, Chapters 1, 3, not only wrote sections of the report and provided data, and 5 (Prices and Electricity) he also provided the invaluable professional judgment Douglas R. Hale and perspective that can only be gained from long expe- (202/287-1723, [email protected]). rience. The EIA staff appreciated his exceptional pro- ductivity, flexibility, and good humor. Without the Chapter 2 support of the CFTC, EIA would not have been able to Thomas Lee write this report. (202.586.0829, [email protected]) John Zyren The authors would like to acknowledge the contribution (202.586.6405, [email protected]) of three independent expert reviewers. Dr. Hendrik Chapter 4 Bessembinder, University of Utah, Department of James Joosten Finance, and Dr. Alexander J. Triantis, University of (202.287.1918, [email protected]) Maryland, Department of Finance, contributed to fram- Chapter 6 ing the research plan and reviewed two early versions of Gregory Kuserk the report. Dr. Bessembinder also contributed two of the (202.418.5286, [email protected]) report’s examples of the benefits of hedging and swaps. Dr. Bala Dharan, Rice University, Graduate School of Chapters 5 (Accounting) and 7 Management, carefully reviewed all the accounting Jon Rasmussen material in the report. Dr. Dharan also contributed to the (202.586.1449, [email protected]) analyses of questionable uses of derivatives that appear Chapter 8 in Chapters 5 and 7. In addition, Tracy Terry, National James Hewlett Commission on Energy Policy, and Russell Tucker, Edi- (202.586.9536, [email protected]) son Electric Institute, provided exceptionally helpful Other contributors to the report include Preston reviews of drafts of Chapter 4. McDowney, Lawrence Stroud, and Cathy Smith. ii Energy Information Administration / Derivatives and Risk Management in Energy Industries Preface Section 205(a)(2) of the Department of Energy Organiza- • Exploration of the varied uses of energy risk man- tion Act (Public Law 95-91) requires that the Adminis- agement tools trator of the Energy Information Administration (EIA) • Discussion of the impediments to the development carry out a comprehensive program that will collect, of energy risk management tools evaluate, assemble, analyze, and disseminate data and information relevant to energy resources, reserves, pro- • Analysis of energy price volatility relative to other duction, demand, technology, and related economic and commodities statistical information. Federal law prohibits EIA from advocating policy. • Review of the current regulatory structure for energy derivatives markets In February 2002 the Secretary of Energy directed the • A survey of the literature on energy derivatives and Energy Information Administration (EIA) to prepare a trading. report on the nature and use of derivative contracts in the petroleum, natural gas, and electricity industries.1 Derivatives transfer risk, especially price risk, to those Derivatives are contracts (“financial instruments”) that who are able and willing to bear it; but, how they trans- are used to manage risk, especially price risk. In accord fer risk is complicated and frequently misinterpreted. with the Secretary’s direction, this report specifically This report provides energy policymakers with informa- includes: tion for their assessment of the merits of derivatives for • A description of energy risk management tools managing risk in energy industries. It also indicates how policy decisions that affect energy markets can limit or • A description of exchanges and mechanisms for enhance the usefulness of derivatives as tools for risk trading energy contracts management. 1Memo from Secretary of Energy Spencer Abraham to Acting EIA Administrator Mary J. Hutzler (February 8, 2002). Energy Information Administration / Derivatives and Risk Management in Energy Industries iii Contents Page Summary ........................................................................................... ix 1. Introduction ....................................................................................... 1 Purpose of the Report.............................................................................. 1 Findings ......................................................................................... 1 Organization of the Report ......................................................................... 2 2. Derivatives and Risk in Energy Markets............................................................... 3 Introduction ..................................................................................... 3 Risk Management Without Derivatives............................................................... 3 Managing Risk With Derivative Contracts ............................................................ 4 Energy Price Risk ................................................................................. 9 Price Risk and Returns to Investment in a New Combined-Cycle Generator ................................11 3. Managing Risk With Derivatives in the Petroleum and Natural Gas Industries.............................15 Introduction......................................................................................15 Oil and Natural Gas Markets........................................................................15 Price Risk and Derivatives in Petroleum and Natural Gas Markets ........................................20 Markets for Oil and Gas Derivatives: Organized Exchanges, Trading Firms, and Bulletin Boards ..............23 Use of Derivatives by Firms in the Petroleum and Natural Gas Industries ..................................26 4. Derivatives in the Electricity Industry.................................................................29 Introduction......................................................................................29 Structural and Regulatory Constraints on Electricity Markets ............................................29 Risk Management Instruments in the Electricity Industry ...............................................31 The Unique Nature of Electricity as a Commodity ......................................................33 Price Volatility ...................................................................................34 Spot Market Complexity ...........................................................................35 Poor Price Transparency ...........................................................................36 FERC’s Standard Market Design ....................................................................37 Regulatory Challenges Ahead for Electricity Derivatives ................................................38 5. Prospects for Derivatives in Energy Industries .........................................................39 Introduction......................................................................................39 Transparency of Financial Information ...............................................................39 Financial Reporting and Abuse of Derivatives: Some Recent Examples ....................................40 Transparency of Market Information.................................................................42 Electricity Spot Markets............................................................................43 Conclusion.......................................................................................43 6. Derivative Markets and Their Regulation .............................................................45 Introduction......................................................................................45 Development of Derivative Markets .................................................................45 Trading Environments.............................................................................46 Regulation of Exchange-Traded Derivatives ..........................................................48 Regulation of OTC Derivatives ......................................................................49 Energy Information Administration / Derivatives and Risk Management in Energy Industries v Contents (Continued) Page 7. Accounting for Derivatives ..........................................................................53
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