Order Code RS21401
Updated April 21, 2006
CRS Report for Congress
Received through the CRS Web
Regulation of Energy Derivatives
Mark Jickling
Specialist in Public Finance
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 trading in these energy
derivatives was largely unregulated: no information about the value or volume of
contracts or the identities of traders in this market was available to regulators, except
what was contained in Enron’s own extremely unreliable financial statements. Trading
in energy derivatives rebounded after a post-Enron slump, and much of the market
remains unregulated. This “regulatory gap” strikes some observers and policy makers
as dangerous for two reasons. First, the absence of government oversight may facilitate
various forms of abusive trading and price manipulation. Second, the failure of a large
derivatives dealer could conceivably trigger disruptions of supplies and prices in
physical energy markets (though such effects were minor in the Enron case).
Legislation before the 109th Congress would require currently unregulated energy
derivatives dealers to disclose certain trading data: S. 509 and H.R. 1638 (which applies
only to natural gas contracts). Legislation to reauthorize the Commodity Futures
Trading Commission (CFTC) — H.R. 4473 and S. 1566 — would increase penalties for
fraud and manipulation. H.R. 4473 would in addition authorize the CFTC to collect
certain market data from natural gas traders to aid in investigating manipulation. Some,
including the CFTC commissioners, argue that new legislation is unnecessary because
statutory authority to pursue fraud and manipulation already exists. This report
summarizes the history and current status of energy derivatives regulation, as well as
legislative reform proposals. It will be updated as developments warrant.
Introduction
Energy derivatives — financial contracts whose value is linked to changes in the
price of some energy product — are traded in two kinds of markets in the United States
today: the futures exchanges and the off-exchange, or over-the-counter market. The New
York Mercantile Exchange (Nymex) offers futures contracts based on prices of crude oil,
natural gas, heating oil, and gasoline. (Other futures exchanges offer energy-related
contracts, but Nymex is by far the busiest.) Futures exchanges are regulated by the
Congressional Research Service ˜ The Library of Congress

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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. Derivatives
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 with more than $10 million in assets. The law assumes that
sophisticated parties such as these do not need the kind of investor protection that
government regulation provides for public customers of the futures exchanges.
The CFTC has limited jurisdiction over the OTC market if certain CEA provisions
against fraud and price manipulation are violated. In addition, if OTC contracts are traded
on an electronic exchange-like facility, where multiple buyers and sellers can post bids
and offers and trade with each other, the CFTC can require disclosure of certain
transaction price and volume data.1 At present, however, the OTC market remains
primarily a dealer market, and the dealers do not report to the CFTC.
The evolution of the two energy derivatives markets — one regulated, the other
largely unregulated — is briefly discussed below.
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
1 An electronic trading system like Enron Online did not meet this definition, because a single
dealer — Enron — was involved in all transactions. Enron Online essentially displayed the
prices at which Enron was willing to trade.

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appeared to function well without direct government regulation; Treasury saw no public
interest in bringing them under the new CFTC.
During the 1980s, a large and active 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, stating that although it believed the
CEA gave it authority to regulate swaps, 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.2
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
2 “Exemption for Certain Products Involving Energy Products,” Federal Register, vol. 58, Apr.
20, 1993, p. 21286.

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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, the 106th Congress considered two bills (H.R. 4541 and S. 2697) that
generally followed the Working Group’s recommendations. Energy derivatives were
exempted — as a matter of statute — from many of the provisions of the CEA, but were
not given a blanket exclusion. The treatment of energy derivatives changed in its wording
through the various iterations of the legislation, but the substance remained basically the
same, from the bills as introduced to the final passage of the Commodity Futures
Modernization Act of 2000 (P.L. 106-554, H.R. 5660). That legislation established three
classes of commodities. First, 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 that trading is restricted to “eligible contract participants,”
that is, not marketed to small investors). Second, derivative contracts based on
agricultural commodities cannot be traded except on the futures exchanges; 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 legislation as one
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 present dealer 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.

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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 the CFTC to settle
charges that they manipulated natural gas prices in 2001 and 2002 by providing false
information about supply levels to Platts, the leading source of information about 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 have 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 shutting down power plants during times of tight supplies to drive up prices.
Numerous firms and traders face civil and criminal charges as a result of these
manipulations.3
Enron and other energy dealers engaged in widespread “wash” or “round-trip”
trading of energy derivatives. Such trades essentially consist of two firms buying and
selling identical contracts simultaneously, so that the net effect is zero. These fictitious
trades served two purposes: (1) to create the impression that the OTC derivatives market
was deep and liquid (to boost confidence in the market and encourage real trading) and
(2) to create fictitious revenues that could be reported on the firms’ financial statements,
to disguise their true financial condition.
Legislative Proposals on Derivatives Regulation
Since Enron, the regulatory status of OTC energy derivatives has been much debated.
In the 108th Congress, the Senate twice voted down proposals to increase the regulatory
authority of the CFTC and the Federal Energy Regulatory Commission (FERC) over
manipulative trading in energy markets, and to impose various reporting, registration, and
record keeping requirements on dealers in OTC energy derivatives. These proposals were
offered as amendments to a broad energy policy bill (S.Amdt. 876 to S. 14) and to an
agriculture appropriations bill (S.Amdt. 2083 to S. 2673). Similar legislation has been
introduced in the 109th Congress (H.R. 1638 and S. 509). H.R. 1638 would reclassify
natural gas as an agricultural commodity, which would bring gas contracts under CFTC
regulation. In addition, the CFTC reauthorization bill approved by the Senate Agriculture
Committee on July 21, 2005, increases civil and criminal penalties for manipulation.
H.R. 4473, the reauthorization bill that passed the House on December 14, 2005, in
3 For lists of civil and criminal charges filed in post-Enron scandals, see CRS Report RL31961
and CRS Report RL31866.

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addition, authorizes the CFTC to collect certain market data from natural gas traders (in
all markets, including OTC) to aid in investigating manipulation.
To supporters of such legislation, the Enron scandal, the California electricity crisis
of 2000, and other episodes of manipulation reveal a dangerous gap in regulation. They
seek to fill the gap with enhanced CFTC and FERC enforcement authority, stiffer
penalties for manipulation, or new disclosure requirements for market participants.
Opponents argue that new legislation is unnecessary because regulators already have
the enforcement tools they need to pursue fraud and manipulation in both derivatives and
spot markets. The CFTC view expressed in congressional testimony has generally been
that the rash of manipulations by Enron and other firms was an aberration that has been
corrected by vigorous enforcement actions.
A key issue in this debate is whether the unregulated status of OTC energy
derivatives creates wider opportunities for manipulation than would otherwise exist. The
criminal and civil charges brought by regulators, many of them involving several firms
or traders acting in concert, suggest that manipulation is not a rare occurrence in energy
markets. However, it is not clear whether manipulation (on the scale of what has been
detected so far) has had a major impact on consumer prices. (An exception would be the
California electricity case, but many believe that the half-deregulated market created in
California was structurally flawed and invited “gaming” of the system.) Moreover, most
of these episodes of manipulation involved spot market prices and transactions, rather
than derivatives. It can be argued that derivatives reform would not go to the heart of the
problem, and that increased vigilance by regulators is more important.
It is worth noting that the OTC dealers like Enron and Dynegy — whose business
was destroyed by scandal — have been replaced as market leaders not by other energy
firms, but by financial institutions such as Morgan Stanley, Goldman Sachs, and ABN
Amro. In addition, there has been growing use of clearing house mechanisms in the OTC
market, providing another layer of market self-regulation.4 Market forces, in other words,
have largely swept away the OTC energy market that was evolving up to the time of the
Enron scandal. Of course, this change has not made energy prices more stable.
A second policy concern is that unregulated derivatives markets constitute a web of
obligations and connections that is invisible to regulators. If a major dealer defaulted on
its obligations, energy producers and users who had purchased derivative contracts to
shield them from unfavorable price volatility could suddenly face much higher than
anticipated costs. In extreme cases, the failed dealers’ trading partners could themselves
default. The possibility of this kind of chain reaction is called systemic risk. However,
Enron’s failure appears to have had little impact on cash energy markets, despite the fact
that Enron was the leader in the OTC energy market. As a result, there is no consensus
as to the seriousness of the threat of systemic collapse, nor as to whether disclosure
requirements and other regulation of OTC energy markets would make a crisis less likely
to occur or allow regulators to deal with one more easily.
4 A clearing house, which guarantees payment on derivatives contracts, has a strong incentive to
prevent manipulation and artificial price volatility, which increase the likelihood of customer
default.

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