Order Code RS21401
Updated May 12, 2008
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 collapsed in August 2006, had distorted natural gas prices.
Second, the failure of a large derivatives dealer could conceivably trigger disruptions of
supplies and prices in physical energy markets (though the effect was minor in the Enron
case). On the other hand, federal financial agencies have taken the position, in hearings
and written statements, that market discipline and self-regulation are sufficient to deter
price manipulation, and that new legislation is not required.
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) would
impose exchange-like regulations on electronic over-the-counter markets that play a
significant role in setting energy prices. This report summarizes energy derivatives
regulation and proposed legislation. 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.

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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 is largely
exempt from CFTC regulation. These markets are known as “exempt commercial
markets.” They must notify the CFTC before they begin operations, and provide certain
basic information about themselves, but they are not required to monitor trading or
enforce CEA prohibitions against fraud or manipulation. The CFTC has limited
jurisdiction over these exempt markets: it can take action against fraud and price
manipulation. In addition, if the exempt market plays a significant role in setting
commodity prices, the CFTC can require public disclosure of certain price and volume
data.
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

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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.
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
1 “Exemption for Certain Products Involving Energy Products,” Federal Register, vol. 58, April
20, 1993, p. 21286.

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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 generally
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 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 leading 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 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

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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. Some analysts believe the
price of oil is headed higher; others think a sharp fall is possible.
Legislative Proposals on Derivatives Regulation
Since Enron, the regulatory status of OTC energy derivatives has been much debated.
In the 110th Congress, H.R. 594 would enhance the CFTC’s authority over the OTC
energy market and require reporting of trade data necessary to prevent price manipulation.
H.R. 3009 would impose reporting requirements on certain natural gas traders. H.R.
4066, S. 577, S. 2058, and S. 2991 would require the reporting of large positions in
energy commodities by traders in the OTC market and on foreign futures exchanges that
are accessible via terminals located in the United States. S. 2058 and H.R. 4066 authorize
the CFTC to establish core principles for exempt commercial markets like ICE, which
would require them to monitor and enforce rules against manipulation and excessive
speculation.
In December 2007, the House Agriculture Committee marked up and approved an
unnumbered bill to reauthorize the CFTC. It would create a new regulatory regime for
exempt commercial markets, subjecting them to a number of exchange-like regulations.
If the CFTC found that exempt markets played a significant role in setting energy prices,
they would be required to register with the CFTC and maintain and enforce rules against
manipulation, fraud, and excessive speculation. Similar language was added to the
version of the Farm Bill (H.R. 2419) that passed the Senate on December 14, 2007.
S. 2991 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 $9,788 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.

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A key issue is whether the exempt status of OTC energy derivatives creates
opportunities for manipulation. The charges brought by the CFTC, 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 controversial 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 flawed and invited “gaming” of the system.)
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.2 A number of private firms,
such as Optionable and ICE, have created electronic trading platforms to support
transactions in both exchange and OTC markets, making OTC prices more transparent.
Market forces, in other words, have swept away the OTC market that was evolving at the
time of the Enron scandal. Of course, this change has not made energy prices more stable.
The current concerns about excessive speculation in energy are a different story. 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, however, requires that a single trader (or group of
traders) amass a market position that enables them to consciously 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, 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 S. 2991’s 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.
2 A clearing house, which guarantees payment on derivatives contracts, has an incentive to
prevent manipulation and artificial price volatility, which increase the likelihood of customer
default.

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